##### 



F
i n a n c i a l    H i g h l i g h t s   Massbank
Corp. and Subsidiaries
 Selected
Consolidated Financial Data
 (In thousands) At December 31,
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Balance Sheet Data:Total assets
    
    $
    976,168
    
    
    $
    1,010,733
    
    
    $
    1,009,367
    
    
    $
    971,317
    
    
    $
    938,702Mortgage loans
    
    
    226,197
    
    
    
    241,886
    
    
    
    302,788
    
    
    
    296,469
    
    
    
    272,951Other loans
    
    
    10,001
    
    
    
    11,120
    
    
    
    16,011
    
    
    
    34,548
    
    
    
    37,196Allowance for loan losses
    
    
    1,307
    
    
    
    1,554
    
    
    
    2,271
    
    
    
    2,494
    
    
    
    2,594Allowance for loan losses on
off-balance sheet credit exposures
    
    
    588
    
    
    
    626
    
    
    
    384
    
    
    
    149
    
    
    
    Investments(1)
    
    
    704,611
    
    
    
    722,079
    
    
    
    669,875
    
    
    
    618,545
    
    
    
    607,096Deposits
    
    
    849,465
    
    
    
    882,508
    
    
    
    883,928
    
    
    
    849,684
    
    
    
    823,625Stockholders equity
    
    
    110,015
    
    
    
    110,927
    
    
    
    117,285
    
    
    
    114,904
    
    
    
    108,243
 (In thousands)Years Ended December 31,
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Operating Data:Interest and dividend income
    
    $
    33,581
    
    
    $
    38,137
    
    
    $
    47,103
    
    
    $
    55,117
    
    
    $
    60,280Interest expense
    
    
    12,729
    
    
    
    15,854
    
    
    
    22,701
    
    
    
    32,391
    
    
    
    35,397Net interest income
    
    
    20,852
    
    
    
    22,283
    
    
    
    24,402
    
    
    
    22,726
    
    
    
    24,883Provision (credit) for loan losses
    
    
    (242
    )
    
    
    (502
    )
    
    
    
    
    
    
    40
    
    
    
    60Gains on securities, net
    
    
    1,229
    
    
    
    639
    
    
    
    1,718
    
    
    
    4,363
    
    
    
    3,525Other non-interest income
    
    
    1,257
    
    
    
    1,283
    
    
    
    1,205
    
    
    
    1,450
    
    
    
    1,463Non-interest expense
    
    
    12,302
    
    
    
    12,615
    
    
    
    12,037
    
    
    
    11,721
    
    
    
    12,513Income before income taxes
    
    
    11,278
    
    
    
    12,092
    
    
    
    15,288
    
    
    
    16,778
    
    
    
    17,298Income tax expense
    
    
    3,898
    
    
    
    4,229
    
    
    
    5,474
    
    
    
    6,019
    
    
    
    6,187Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814
    
    
    $
    10,759
    
    
    $
    11,111
 Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Other Data:Yield on average interest-earning assets
    
    
    3.52
    %
    
    
    3.87
    %
    
    
    4.85
    %
    
    
    5.88
    %
    
    
    6.67
    %Cost of average interest-bearing liabilities
    
    
    1.48
    
    
    
    1.78
    
    
    
    2.61
    
    
    
    3.87
    
    
    
    4.32Interest rate spread
    
    
    2.04
    
    
    
    2.09
    
    
    
    2.24
    
    
    
    2.01
    
    
    
    2.35Net interest margin
    
    
    2.19
    
    
    
    2.26
    
    
    
    2.52
    
    
    
    2.43
    
    
    
    2.76Non-interest expense to average assets(3)
    
    
    1.26
    
    
    
    1.25
    
    
    
    1.21
    
    
    
    1.23
    
    
    
    1.35Efficiency ratio (2)(3)
    
    
    51.5
    
    
    
    49.9
    
    
    
    43.9
    
    
    
    41.1
    
    
    
    41.9Return on assets (net income/average assets)
    
    
    0.75
    
    
    
    0.78
    
    
    
    0.99
    
    
    
    1.13
    
    
    
    1.20Return on equity (net income/average
stockholders equity)
    
    
    6.71
    
    
    
    7.08
    
    
    
    8.39
    
    
    
    9.53
    
    
    
    10.93Percent non-performing loans to total loans
    
    
    0.03
    
    
    
    0.09
    
    
    
    0.13
    
    
    
    0.19
    
    
    
    0.18Percent non-performing assets to total assets
    
    
    0.01
    
    
    
    0.02
    
    
    
    0.04
    
    
    
    0.07
    
    
    
    0.06Stockholders equity to assets, at year-end
    
    
    11.27
    
    
    
    10.97
    
    
    
    11.62
    
    
    
    11.83
    
    
    
    11.53Book value per share, at year-end(4)
    
    $
    25.11
    
    
    $
    25.17
    
    
    $
    25.45
    
    
    $
    24.34
    
    
    $
    22.83Market price  close, at year-end(4)
    
    
    37.45
    
    
    
    43.01
    
    
    
    28.30
    
    
    
    23.867
    
    
    
    19.50Earnings per share:(4)Basic
    
    
    1.67
    
    
    
    1.77
    
    
    
    2.09
    
    
    
    2.30
    
    
    
    2.30Diluted
    
    
    1.64
    
    
    
    1.73
    
    
    
    2.04
    
    
    
    2.24
    
    
    
    2.25Cash dividends paid per share(4)
    
    
    1.00
    
    
    
    0.92
    
    
    
    0.88
    
    
    
    0.84
    
    
    
    0.79Dividend payout ratio
    
    
    60
    %
    
    
    52
    %
    
    
    42
    %
    
    
    37
    %
    
    
    34
    %
   (1)Consist of securities held to maturity and available for sale, trading securities,
short-term investments, term federal funds sold and interest-bearing deposits in banks.(2)Determined by dividing non-interest expense (including the provision (credit) for
loan losses) by fully taxable equivalent net interest income plus non-interest
income.(3)Includes non-recurring non-interest expense of $363 thousand in 2000 related to the
successful litigation to protect the Companys principal trademark.(4)All share information presented has been adjusted to reflect the 3-for-2 split of the
Companys common stock effective April 19, 2002. 3




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Managements
Discussion and Analysis of Financial
Condition and Results of Operations
 General The following discussion should be read in conjunction with the consolidated financial
statements and related notes included in this report. Certain amounts reported for prior years have
been reclassified to conform to the 2004 presentation. The preparation of consolidated financial statements requires management to make estimates and
assumptions, in the application of certain of its accounting policies, about the effect of matters
that are inherently uncertain. These estimates and assumptions affect the reported amounts of
certain assets, liabilities, revenues and expenses. Different amounts could be reported under
different conditions, or if different assumptions were used in the application of these accounting
policies. The accounting policies considered significant in this respect are the determination of
the allowance for loan losses and allowance for loan losses on off-balance sheet credit exposures,
and the determination of investment securities considered other than temporarily impaired. These
significant accounting policies are discussed in the Provisions (Credit) for Loan Losses and
Investment Securities Other Than Temporarily Impaired sections of this discussion and analysis and
in Note 1 of the Notes to Consolidated Financial Statements. The
financial condition and results of operations of
Massbank Corp. (the Company) essentially reflect the operations of
its subsidiary, Massbank (the Bank). The Banks principal business has historically consisted of offering savings and other
deposits to the general public and using the funds from these deposits to primarily make loans
secured by residential real estate and consumer loans, and make investments in debt and equity
securities. Most residential mortgage loans granted by the Bank are for terms of 10, 12, 15 or 20
years and are
generally low credit risk loans. The Banks debt securities portfolio consists primarily of
U.S. Treasury and Government agency securities and Government agency mortgage-backed securities. The Companys consolidated net income depends largely upon net interest income, which is the
difference between interest and dividend income from loans and investments (interest-earning
assets), and interest expense on deposits (interest-bearing liabilities). Net interest income is
significantly affected by general economic conditions, particularly changes in interest rates,
competition, government legislation and policies affecting fiscal affairs, monetary policies of the
Federal Reserve System, and the actions of the bank regulatory authorities. Earnings results are
also affected by the Companys provision (credit) for loan losses; loan and investment activities,
particularly residential mortgage loan and mortgage-backed securities prepayment activity; changes
in non-interest income, such as fee-based revenues and securities gains or losses; non-interest
expense; and income taxes. Forward-Looking Statement Disclosure This annual report may contain forward-looking information, including information concerning
the Companys expectations of future business prospects. These forward-looking statements are made
pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995.
These forward-looking statements involve known and unknown risks, uncertainties and other factors
that may cause the Companys actual results or performance to be materially different from the
results and performance expressed or implied by the forward-looking statements. Forward-looking
statements include, but are not limited to, statements concerning the Companys belief,
expectations or intentions concerning the Companys future performance, the financial outlook of
the markets it serves and the performance and activities of its competitors. These statements
reflect the Companys current views, are based on numerous assumptions and are subject to numerous
risks and uncertainties, including unexpected fluctuations in market interest rates, unexpected
fluctuations in the markets for equities, bonds, federal funds and other financial instruments, an
increase in the level of nonperforming assets, an increase in competitive pricing pressures within
the Companys market, adverse legislative or regulatory developments, adverse impacts resulting
from the continuing war on terrorism, an increase in other employee-related costs, the impact of
deflation or inflation, and other factors described in this report. 9




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##### 



Critical Accounting Policies The Companys consolidated financial statements have been prepared in accordance with U.S.
generally accepted accounting principles. As such, the Company is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the balance sheet dates
and the reported amounts of income and expense during the reporting periods. Actual amounts could
differ from such estimates. The Company believes that the following accounting policies are among the most critical
because they involve significant judgments and uncertainties and could potentially result in
materially different results under different assumptions and conditions. Provisions
(Credit) for Loan losses The provision (credit) for loan losses represents a charge or credit against current
earnings and an addition to or deduction from the allowance for loan losses. In determining the
amount to provide for loan losses, the key factor is the adequacy of the allowance for loan losses
(loan allowance). Management uses a methodology to systematically measure the amount of estimated
loan loss exposure inherent in the portfolio for purposes of establishing a sufficient loan
allowance. The
methodology includes three elements: an analysis of individual loans deemed to be impaired, general
loss allocations for various types of loans based on loss experience factors and an unallocated
allowance. The unallocated allowance is maintained based on managements assessment of many factors
including the risk characteristics of the portfolio, concentrations of credit, current and
anticipated economic conditions that may affect the borrowers ability to pay, and trends in loan
delinquencies and charge-offs. The provision (credit) for loan losses on off-balance sheet credit exposures represents a
charge or credit against current earnings (reported in other non-interest expense) and an addition
to or deduction from the allowance for loan losses on off-balance sheet credit exposures
(off-balance sheet exposures). In determining the amount to provide for off-balance sheet
exposures, the key factor is the adequacy of the balance. The balance of the off-balance sheet
exposures is maintained based on expected drawdowns of committed loans, their loss experience
factors, managements assessment of various other factors including current and anticipated economic
conditions that may affect the borrowers ability to pay and trends in loan delinquencies and
charge-offs. Any significant changes in assumptions and/or conditions could result in higher than estimated
losses that could adversely affect the Companys earnings results. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review the Banks
allowances. Such agencies may require the Bank to recognize additional allowances based on
judgements different from those of management, which could also adversely affect the Companys
earnings results. Investment
Securities other than
Temporarily Impaired Management judgment is involved in the evaluation of declines in value (impairment) of
individual investment securities held by the Company. Declines in value that are deemed other than
temporary are recognized in the income statement through write-downs in the recorded value of the
affected securities. Management considers many factors in their analysis of other than temporarily
impaired securities, including industry analyst reports, sector credit ratings, volatility in
market price and other relevant information, such as the financial condition, earnings capacity and
near term prospects of the company and the length of time and extent to which the market value has
been less than cost. Whenever a debt or equity security is deemed to be other than temporarily impaired due to a
fundamental deterioration in its financial condition as determined by managements analysis, it is
written down to its current fair market value. U.S. Treasury Securities and other securities backed
by the U.S. Government are never considered impaired due to a fundamental deterioration in
financial condition. If due to general market conditions an investment security declines in price from its cost
basis by 25% or more for more than a year, between 30% and 40% for more than nine months, between
40% and 50% for more than six months or over 50% for more than ninety days, and in each case the
value of the investment security has been below its cost basis for the entire period in question,
then the security is considered other than temporarily impaired and it is written down to its
current fair market value and the loss is recognized in earnings. U.S. Treasury and Government
Agency securities fluctuate in value based on changes in market interest rates and other factors;
however, they can be redeemed at par value if held to maturity and therefore, if their maturity
date is less than one year into the future regardless of their market value they are considered
only temporarily impaired. Any unfavorable change in general market conditions could cause an
increase in the Companys impairment write downs of investment securities. This would have an
adverse effect on the Companys earnings results. Other than temporary impairment write downs of
investment securities in 2003 and 2002 totaled $9 thousand and $67 thousand, respectively. There
were no other than temporary impairment write downs of investment securities in 2004. Securities deemed temporarily impaired are carried at market value in the asset section of the
Companys balance sheet. Any change in value is reflected in accumulated other comprehensive income
in the stockholders equity section of the Companys balance sheet. 10




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##### 



Financial Overview Massbank Corp. provides a broad range of banking services through its subsidiary,
Massbank (the Bank). The Bank offers a full range of retail and commercial deposit
products through its fifteen banking offices located in Eastern Massachusetts. The Banks lending
business includes residential and commercial real estate mortgages, construction loans, commercial
loans and a variety of consumer loans. The Banks loan portfolio is concentrated among borrowers
from the municipalities in which it operates banking offices and all of the contiguous cities and
towns. The Bank also invests a significant portion of its funds in U.S. Treasury and Government
agency securities, mortgage-backed securities, federal funds sold and other authorized investments.
The Banks earnings depend largely upon net interest income. Securities gains are also an important
source of revenue for the Bank. The Bank faces strong competition from banks and other financial services providers in our
market area. The principal methods of competition are through interest rates, financing terms and
other customer conveniences. Among the external factors affecting
Massbanks operating
results are market interest rates, the shape of the U.S. Treasury securities yield curve, the
condition of the financial markets and both regional and national economic conditions. In 2004, the Company generated net income of $7.4 million, or $1.64 per diluted share,
compared with $7.9 million, or $1.73 per diluted share, in 2003. Return on assets and return on
equity were 0.75% and 6.71%, respectively, in 2004, compared to 0.78% and 7.08%, respectively, in
2003. Our net interest margin was under continued pressure in 2004 as a result of the asset
sensitive position of our balance sheet and the low interest rate environment. Decreases in 2004 earnings and operating ratios were mainly due to a decrease in net interest
income driven by both a decline in yield and a decline in the size of the Banks loan and
mortgage-backed securities portfolios. This is the result of the significant refinancing and
prepayment activity experienced in 2003 and to a lesser extent in 2004. The Companys earnings and operating ratios were positively affected by an increase in net
securities gains in 2004 and an increase in the Federal Funds rate in the second half of 2004. The
Federal Reserve Bank Boards Federal Open Market Committee (FOMC) raised the target rate for
Federal Funds by 25 basis points five times from the end of June to year-end 2004, increasing the
rate from 1.00% to 2.25%. In 2005, we would expect to benefit from any sustained increases in
interest rates, partially offset by any decreases in the difference between the five year Treasury
yield and the yield on Federal Funds (curve flattening). Years
ended December 31, 2004 compared to 2003: (In
thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    

changeIncome Statement DataInterest and dividend income:Mortgage and other loans
    
    $
    14,247
    
    
    $
    18,516
    
    
    $
    (4,269
    )Mortgage-backed securities
    
    
    6,571
    
    
    
    8,250
    
    
    
    (1,679
    )Federal funds sold
    
    
    2,438
    
    
    
    2,266
    
    
    
    172Other securities and investments
    
    
    10,325
    
    
    
    9,105
    
    
    
    1,220Total interest and dividend income
    
    
    33,581
    
    
    
    38,137
    
    
    
    (4,556
    )Total interest expense
    
    
    12,729
    
    
    
    15,854
    
    
    
    3,125Net interest income
    
    
    20,852
    
    
    
    22,283
    
    
    
    (1,431
    )Provision (credit) for loan losses
    
    
    (242
    )
    
    
    (502
    )
    
    
    (260
    )Gains on securities, net
    
    
    1,229
    
    
    
    639
    
    
    
    590Other non-interest income
    
    
    1,257
    
    
    
    1,283
    
    
    
    (26
    )Non-interest expense
    
    
    12,302
    
    
    
    12,615
    
    
    
    313Income tax expense
    
    
    3,898
    
    
    
    4,229
    
    
    
    331Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    (483
    )Diluted earnings per share (in dollars):
    
    $
    1.64
    
    
    $
    1.73
    
    
    $
    (0.09
    )
 (In
thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    

changeAverage Balance Sheet DataEarning assets:Mortgage and other loans
    
    $
    243,351
    
    
    $
    284,001
    
    
    $
    (40,650
    )Mortgage-backed securities
    
    
    115,847
    
    
    
    133,037
    
    
    
    (17,190
    )Federal funds sold
    
    
    186,615
    
    
    
    209,463
    
    
    
    (22,848
    )Other securities and investments
    
    
    409,454
    
    
    
    361,354
    
    
    
    48,100Total average earning assets
    
    $
    955,267
    
    
    $
    987,855
    
    
    $
    (32,588
    )Total average deposits
    
    $
    862,691
    
    
    $
    892,329
    
    
    $
    (29,638
    )
 11




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##### 



Earnings results for 2004 included the following that are more fully discussed in other
sections of managements discussion and analysis:  
    Reduction in net interest income of $1.4 million due essentially to a decline in
yield and a decline in the size of the Banks loan and mortgage-backed securities
portfolios due to the significant refinancing and prepayment activity experienced in 2003
and to a lesser extent in 2004.
    A negative provision for loan losses that was $260 thousand less than the prior year.
The negative provision is due to a reduction in the size of the loan portfolio and a low
level of problem loans.
    An increase in net securities gains of $590 thousand.
    A decrease in non-interest expense of $313 thousand primarily attributable to a
reduction in the number of bank employees.
    A decrease in income tax expense of $331 thousand due to lower income before taxes
and a reduction in the Companys effective income tax rate. Condensed Consolidated Balance Sheets (In
thousands) at December 31,
    
    2004
    
    
    2003
    
    

changeShort-term investments
    
    $
    194,250
    
    
    $
    214,532
    
    
    $
    (20,282
    )Interest-bearing deposits in banks
    
    
    2,718
    
    
    
    5,685
    
    
    
    (2,967
    )Securities available for sale, at market value
    
    
    443,753
    
    
    
    429,229
    
    
    
    14,524Securities held to maturity, at amortized cost
    
    
    4,877
    
    
    
    
    
    
    
    4,877Trading securities, at market value
    
    
    59,013
    
    
    
    72,633
    
    
    
    (13,620
    )Total investments
    
    
    704,611
    
    
    
    722,079
    
    
    
    (17,468
    )Total loans
    
    
    236,198
    
    
    
    253,006
    
    
    
    (16,808
    )Allowance for loan losses
    
    
    (1,307
    )
    
    
    (1,554
    )
    
    
    247Net loans
    
    
    234,891
    
    
    
    251,452
    
    
    
    (16,561
    )Other assets
    
    
    36,666
    
    
    
    37,202
    
    
    
    (536
    )Total assets
    
    $
    976,168
    
    
    $
    1,010,733
    
    
    $
    (34,565
    )Total deposits
    
    $
    849,465
    
    
    $
    882,508
    
    
    $
    (33,043
    )Escrow deposits of borrowers
    
    
    1,074
    
    
    
    1,139
    
    
    
    ( 65
    )Other liabilities
    
    
    15,614
    
    
    
    16,159
    
    
    
    (545
    )Total liabilities
    
    
    866,153
    
    
    
    899,806
    
    
    
    (33,653
    )Total stockholders equity
    
    
    110,015
    
    
    
    110,927
    
    
    
    (912
    )Total liabilities and stockholders equity
    
    $
    976,168
    
    
    $
    1,010,733
    
    
    $
    (34,565
    )
 Financial Condition The Companys total assets decreased $34.6 million, or 3.4% to $976.2 million at December
31, 2004 from $1.011 billion at December 31, 2003. This was due essentially to a decline of $33.0
million in total deposits. Investments At December 31, 2004 the Companys investment portfolio consisted of short-term investments,
interest-bearing deposits in banks and securities available for sale, held to maturity and trading
totaling $704.6 million or 72.2% of assets. This reflects a decrease of $17.5 million compared to
$722.1 million representing 71.4% of total assets at December 31, 2003. The Companys investment
portfolio is concentrated in U.S. Treasury and Government agency securities and mortgage-backed
securities. U.S. Treasury and Government agency securities totaled $371.5 million at year-end. This
included $158.8 million in callable agency securities. The portfolio of mortgage-backed securities
consists primarily of 15-year contractual life mortgage-backed securities issued by GNMA, FNMA and
FHLMC. The Companys strategy is to purchase liquid investments with short to intermediate
maturities that generally match the Companys deposit structure. This strategy helps ensure that
the Companys overall interest rate risk position stays within policy requirements. The Company
also holds $7.4 million in equity securities at December 31, 2004. This portfolio has been reduced
from $11.5 million at December 31, 2003. In 2004, the Company increased its mortgage-backed
securities portfolio from $95.7 million at December 31, 2003 to $127.6 million at December 31, 2004
to help improve its net interest margin. If interest rates increase in 2005 and the shape of the
yield curve is positive, the Company will likely add to its mortgage-backed securities portfolio.
We believe that this addition would tend to improve the Companys net interest margin. 12




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##### 



Loans Massbanksloan portfolio at December 31, 2004 was $236.2 million, compared to
$253.0 million at December 31, 2003, and was comprised of $224.6 million of residential mortgage
loans, $1.6 million of commercial mortgage loans, $9.9 million of consumer loans and $0.1 million
of commercial loans. This compares to $240.3 million of residential mortgage loans, $1.6 million of
commercial mortgage loans, $11.0 million of consumer loans and $0.1 million of commercial loans at
December 31, 2003. The loan portfolio decreased by 6.6% during 2004 to $236.2 million principally due to loan
principal payments, pay downs and payoffs combined with a decline in loan origination activity.
Loan
originations totaled $60.3 million in 2004, down 27.0% from $82.6 million in 2003. Non-Performing Assets Non-accrual loans, generally those loans that are 90 days or more delinquent declined to $74
thousand at December 31, 2004 from $230 thousand at December 31, 2003. This represents 0.03% of
total loans at December 31, 2004. The Bank had no real estate acquired through foreclosure at
year-end 2004. Deposits Deposits have traditionally been the Banks primary source of funds for lending and
investment activities. Massbank attracts deposits within its primary market area by
offering a variety of deposit instruments including demand and NOW accounts, money market accounts,
different types of savings accounts, certificates of deposit and retirement savings plans. Deposit
flows vary significantly and are influenced by prevailing interest rates, market conditions,
economic conditions and competition. The Banks management attempts to manage its deposits through
selective pricing and marketing. Total deposits at December 31, 2004 were $849.5 million, compared to $882.5 million at
December 31, 2003. Increased competition for deposits and more attractive returns on other
investment opportunities were the principal reasons for the deposit outflows. In 2004, savings deposits decreased $46.5 million or 7.7% year-over-year, to $561.3 million
from $607.8 million at year-end 2003. Conversely, certificates of deposit increased by $10.9
million or 5.7% to $200.5 million at year-end 2004 as customers began to shift deposits from
savings accounts to certificates of deposit seeking a higher rate of return on their deposits.
Demand and NOW deposits totaled $87.7 million at December 31, 2004 compared to $85.1 million at
December 31, 2003. For information concerning deposit balances at year-end 2004 and 2003, their
average cost and the maturity distribution and related rate structure of the Banks time
certificates of deposit, see Note 10 of Notes to Consolidated Financial Statements. Stockholders Equity Total stockholders equity decreased $0.9 million to $110.0 million at December 31, 2004,
representing a book value of $25.11 per share, from $110.9 million representing a book value of
$25.17 per share at December 31, 2003. The decrease in total stockholders equity was due principally to the Companys repurchase of
73,823 shares of treasury stock at a cost of $2.6 million, the payment of dividends to stockholders
of $4.4 million and the decrease in other comprehensive income of $2.2 million due primarily to the
decline in market value of the Banks debt securities portfolio. This was partially offset by the
net income for the year of $7.4 million and the payments and related tax benefits received from the
exercise of stock options by the Companys officers and directors of $0.9 million. 13




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##### 



Results
of Operations Comparison
of the years 2004 and 2003 Net Interest Income Net interest income is the primary source of Massbanks operating income. The
level of net interest income is affected by the volume and mix of average interest-earning assets
and interest-bearing liabilities, market interest rates and other factors. Net interest income on a fully taxable equivalent (FTE) basis totaled $20.9 million in 2004
compared to $22.4 million in 2003. The decrease was primarily attributable to a decrease in net
interest margin. The Companys net interest margin (net interest income on a FTE basis divided by
average interest earning assets) for the year ended December 31, 2004 decreased to 2.19% from 2.26%
in the prior year. Total average earning assets decreased $32.6 million or 3.3% to $955.3 million
in 2004, from $987.9 million in 2003. The tables on pages 26 and 27 set forth, among other things, the extent to which changes in
interest rates and changes in the average balances of interest earning assets and interest-bearing
liabilities have affected interest income and expense during the years indicated. Information is
provided for each category of interest-earning assets and interest-bearing liabilities, on changes
due to (1) volume and (2) interest rates. Interest on investment securities available for sale on a FTE basis was $9.0 million for 2004
compared to $7.6 million for 2003. The increase in interest income was due to the increase in the
average balance of investment securities available for sale from $259.1 million in 2003 to $324.2
million in 2004, offset in part by a lower yield on these securities due primarily to securities
maturing and securities purchased in 2004 at lower market interest rates. Interest on mortgage-backed securities available for sale and held to maturity was $6.6
million for 2004 compared to $8.3 million for 2003. The average balance of mortgage-backed
securities was $115.8 million with an average yield of 5.67% for 2004 compared to an average
balance of $133.0 million with an average yield of 6.20% for 2003. The prepayment activity
experienced in 2003 and 2004 reduced the balance and the yield on the banks mortgage-backed
securities portfolio. In addition, mortgage-backed securities purchased in 2004 were at lower
yields due to the low interest rate environment. Interest on trading securities was $1.1 million for 2004, essentially unchanged from the prior
year. The average balance of trading securities was $69.3 million for 2004 compared to $72.5
million for 2003. The yield on these securities improved to 1.65% for the recent year, from 1.53%
for 2003. Interest income on Federal funds sold and short-term investments was $2.7 million for 2004 and
2003. The average balance of these investments decreased from $239.1 million for 2003 to $202.5
million for 2004. This was offset by a higher yield on these investments due to a rise in
short-term interest rates. The Federal Reserve Bank Boards Federal Open Market Committee raised
the target interest rate for Federal Funds five times from the end of June to year-end 2004,
increasing the rate from 1.00% to 2.25%. Interest on loans fell to $14.2 million for 2004, from $18.5 million for 2003. The average
balance for mortgage and other loans for 2004 was $243.4 million with an average yield of 5.85%.
This compares to an average balance for mortgage and other loans of $284.0 million for 2003 with an
average yield of 6.52%. The decline in average balances is due to principal payments, pay downs and
prepayments on mortgages and lower loan origination volume for 2004 compared to 2003. Loans
originations totaled $60.3 million in 2004 compared to $82.6 million in 2003. The decline in yields
year to year is due to the low market interest rate environment that resulted in higher refinancing
and prepayment activity on the Banks portfolio of higher yielding fixed rate loans, with proceeds
being reinvested and new loans being originated at lower yields. Interest on total deposits was $12.7 million for 2004 compared to $15.9 million for 2003. The
average balance of total deposits was $862.7 million with an average cost of 1.48% for 2004
compared to an average balance of $892.3 million with an average cost of 1.78% for 2003. The
decrease in average balance was due primarily to increased competition for deposits and more
attractive returns on other investment opportunities. The decrease in average cost of deposits in
2004 was the result of the relatively low interest rate environment. Provisions
(credit) for Loan
Losses In 2004, the Bank recorded a negative provision for loan losses of $242 thousand due to the
quality of loans in the portfolio and a decrease in the size of the Banks loan portfolio. This
compares to a negative provision for loan losses of $502 thousand in 2003. The Banks loan
portfolio decreased $16.8 million or 6.6% from $253.0 million at December 31, 2003 to $236.2
million at December 31, 2004. In determining the amount to provide for loan losses, the key factor
is the adequacy of the allowance for loan losses. Management uses a methodology to systematically
measure the amount of estimated loan loss exposure inherent in the portfolio for the purposes of
establishing a sufficient allowance for loan losses. The methodology includes three elements: an
analysis of individual loans deemed to be impaired, general loss allocations for various loan types
based on loss experience factors, and an unallocated allowance which is maintained based on
managements assessment of many factors including the risk characteristics of the portfolio,
concentrations of credit, current and anticipated economic conditions that may effect the 14




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##### 



borrowers ability to pay, and trends in loan delinquencies and charge-offs. At December 31,
2004, the allowance for loan losses was $1.3 million representing 0.55% of total loans and 1766% of
non-accrual loans. This compares to an allowance for loan losses of $1.6 million representing 0.61%
of total loans and 676% of non-accrual loans at December 31, 2003. Non-accrual loans totaled $74
thousand at December 31, 2004, down from $230 thousand a year earlier. The Banks net charge-offs
totaled $5 thousand in 2004 compared to net recoveries of $11 thousand in 2003. The Bank also maintains an allowance for loan losses on off-balance sheet credit exposures
(shown separately on the balance sheet) that totaled $588 thousand and $626 thousand, respectively,
at December 31, 2004 and 2003. In 2004, the Company recorded a negative provision for off-balance
sheet credit exposures of $39 thousand compared to a charge of $16 thousand in 2003. The credit or
provision is included in other non-interest expense. Non-Interest Income Non-interest income consists of gains or losses on securities, deposit account service fees
and other non-interest income. Non-interest income for the year ended December 31, 2004 increased
$564 thousand or 29.3% to $2.5 million, from $1.9 million for the year ended December 31, 2003. The
increase is due primarily to an increase in net gains on securities available for sale and trading
securities of $590 thousand, from $639 thousand in 2003 to $1.2 million in 2004. Net securities
gains in 2004 were comprised of $1.5 million in net gains on equity securities and $299 thousand in
net losses on debt securities. This compares to $347 thousand in net gains on equity securities and
$292 thousand in net gains on debt securities in 2003. Management, consistent with many analysts,
is cautious concerning its outlook regarding the likely performance of the equity markets over the
next several years, expecting only moderate returns in the near term. Deposit account service fees and other non-interest income combined were $1.3 million in
2004 and 2003. Non-Interest Expense Non-interest expense totaled $12.3 million for the year ended December 31, 2004 compared to
$12.6 million for the prior year, a decrease of $313 thousand or 2.5%. Salaries and employee
benefits, the largest component of non-interest expense, decreased $264 thousand or 3.4% to $7.4
million in 2004 from $7.7 million in 2003. The decrease in salaries and employee benefits is due
principally to a reduction in the number of bank employees. The Companys other expenses consisting of occupancy and equipment, data processing,
advertising and marketing, deposit insurance and other expenses totaled $4.2 million in 2004
reflecting a decrease of $286 thousand from the prior year. This was partially offset by an
increase in professional services expenses of $237 thousand, from $394 thousand in 2003 to $631
thousand in 2004. The increase is principally a result of the higher fees paid to our independent
registered public accounting firm to complete their audit of the Companys internal control over
financial reporting as required by the Sarbanes-Oxley Act of 2002. In 2003, the Company paid $146
thousand in audit fees to its independent registered public accounting firm. In 2004, the fees for
the audits of the Companys financial statements and internal control over financial reporting
totaled $353 thousand. Income Tax Expense For the years ended December 31, 2004 and 2003, income tax expense amounted to $3.9 million
and $4.2 million, respectively. The decrease in income tax expense is primarily due to lower income
before taxes and a decrease in the Companys effective income tax rate. The Companys effective
income tax rate for the year ended December 31, 2004 was 34.56%, down from 34.97% for the year
ended December 31, 2003. 15




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##### 



Financial Overview Comparison
of the years 2003 and 2002 Massbank Corp.s earnings for 2003 were $7.9 million, or $1.73 per diluted share,
compared to $9.8 million, or $2.04 per diluted share, in 2002. Basic earnings per share for 2003
were $1.77 compared to $2.09 in the prior year. Return on assets and return on equity were 0.78%
and 7.08%, respectively, in 2003, compared to 0.99% and 8.39%, respectively, in 2002. Decreases in earnings and operating ratios were mainly due to the historically low market
interest rate environment in 2003 which resulted in significant mortgage-backed securities and
residential mortgage loan prepayment activity, and a Federal Reserve Bank monetary policy that
reduced the Federal Funds rate to 1% for most of 2003, due to concerns about the slowdown in the
U.S. economy. The Companys earnings and operating ratios were also affected by the decline in net
gains on equity securities in 2003. Years
Ended December 31, 2003 compared to 2002: (In
thousands) Years ended December 31,
    
    2003
    
    
    2002
    
    

changeIncome Statement DataInterest and dividend income:Mortgage loans
    
    $
    17,682
    
    
    $
    20,819
    
    
    $
    (3,137
    )Mortgage-backed securities
    
    
    8,250
    
    
    
    14,863
    
    
    
    (6,613
    )Federal funds sold
    
    
    2,266
    
    
    
    2,974
    
    
    
    (708
    )Other
    
    
    9,939
    
    
    
    8,447
    
    
    
    1,492Total interest and dividend income
    
    
    38,137
    
    
    
    47,103
    
    
    
    (8,966
    )Total interest expense
    
    
    15,854
    
    
    
    22,701
    
    
    
    6,847Net interest income
    
    
    22,283
    
    
    
    24,402
    
    
    
    (2,119
    )Provision (credit) for loan losses
    
    
    (502
    )
    
    
    
    
    
    
    502Gains on securities, net
    
    
    639
    
    
    
    1,718
    
    
    
    (1,079
    )Other non-interest income
    
    
    1,283
    
    
    
    1,205
    
    
    
    78Non-interest expense
    
    
    12,615
    
    
    
    12,037
    
    
    
    (578
    )Taxes
    
    
    4,229
    
    
    
    5,474
    
    
    
    1,245Net income
    
    $
    7,863
    
    
    $
    9,814
    
    
    $
    (1,951
    )Diluted earnings per share (in dollars):
    
    $
    1.73
    
    
    $
    2.04
    
    
    $
    (0.31
    )
 (In
thousands) Years ended December 31,
    
    2003
    
    
    2002
    
    

changeAverage Balance Sheet DataEarning assets:Mortgage loans
    
    $
    270,826
    
    
    $
    308,710
    
    
    $
    (37,884
    )Mortgage-backed securities
    
    
    133,037
    
    
    
    233,627
    
    
    
    (100,590
    )Federal funds sold
    
    
    209,463
    
    
    
    183,968
    
    
    
    25,495Other
    
    
    374,529
    
    
    
    246,877
    
    
    
    127,652Total average earning assets
    
    $
    987,855
    
    
    $
    973,182
    
    
    $
    14,673Total average deposits
    
    $
    892,329
    
    
    $
    870,685
    
    
    $
    21,644
 Earnings results for 2003 included the following that are more fully discussed in other sections of
this discussion and analysis:  
    Reduction in net interest income of $2.1 million due essentially to the extraordinary
prepayment activity on mortgage- backed securities and residential mortgages that
significantly reduced interest income on these (higher yielding) earning assets and a
reduction in interest income on Federal funds sold due to a lower Federal funds rate.
    Negative provision for loan losses in the amount of $502 thousand due to the quality
of loans in the portfolio and a decrease in the Banks loan portfolio.
    A reduction in net securities gains taken during the year in the amount of $1.1
million.
    An increase in non-interest expense in the amount of $578 thousand primarily
attributable to broad based salary increases of $106 thousand, an increase in health and
other benefit costs for employees of $51 thousand, an increase of $237 in deferred
compensation expense related to the Banks supplemental retirement plan for certain
executive officers that is offset by a corresponding increase in other non-interest income
and an increase of $250 thousand in occupancy and equipment expense.
    A reduction in income tax expense of $1.2 million due to lower income before income
taxes and a reduction in the Companys effective income tax rate. 16




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##### 



Condensed Consolidated Balance Sheets (In
thousands) at December 31,
    
    2003
    
    
    2002
    
    

changeShort-term investments
    
    $
    214,532
    
    
    $
    248,750
    
    
    $
    (34,218
    )Interest-bearing deposits in banks
    
    
    5,685
    
    
    
    4,854
    
    
    
    831Securities available for sale, at market value
    
    
    429,229
    
    
    
    380,022
    
    
    
    49,207Trading securities, at market value
    
    
    72,633
    
    
    
    36,249
    
    
    
    36,384Total investments
    
    
    722,079
    
    
    
    669,875
    
    
    
    52,204Total loans
    
    
    253,006
    
    
    
    318,799
    
    
    
    (65,793
    )Allowance for loan losses
    
    
    (1,554
    )
    
    
    (2,271
    )
    
    
    717Net loans
    
    
    251,452
    
    
    
    316,528
    
    
    
    (65,076
    )Other assets
    
    
    37,202
    
    
    
    22,964
    
    
    
    14,238Total assets
    
    $
    1,010,733
    
    
    $
    1,009,367
    
    
    $
    1,366Total deposits
    
    $
    882,508
    
    
    $
    883,928
    
    
    $
    (1,420
    )Escrow deposits of borrowers
    
    
    1,139
    
    
    
    1,387
    
    
    
    (248
    )Other liabilities
    
    
    16,159
    
    
    
    6,767
    
    
    
    9,392Total liabilities
    
    
    899,806
    
    
    
    892,082
    
    
    
    7,724Total stockholders equity
    
    
    110,927
    
    
    
    117,285
    
    
    
    (6,358
    )Total liabilities and stockholders equity
    
    $
    1,010,733
    
    
    $
    1,009,367
    
    
    $
    1,366
 Financial Condition The Companys total assets were $1.011 billion at December 31, 2003 compared to $1.009
billion at December 31, 2002 reflecting virtually no asset growth in 2003. This was due to a
decrease in stockholders equity and deposits declining slightly in 2003. Investments At December 31, 2003 the Companys investment portfolio, consisting of securities available
for sale and trading, short-term investments and interest-bearing bank deposits totaled $722.1
million or 71.4% of total assets, an increase of $52.2 million or 7.8%, compared to $669.9 million
representing 66.4% of total assets at December 31, 2002. The increase in investments was
essentially due to an increase of $36.4 million in trading securities consisting primarily of U.S.
Treasury obligations, and an increase of $49.2 million in securities available for sale, partially
offset by a reduction in short-term investments. The mix of available for sale securities in 2003,
as in 2002, continued to shift from a large concentration of mortgage-backed securities to U.S.
Treasury and Government agency securities, including callable government agency securities totaling
$192.4 million at year-end 2003. The banks mortgage-backed securities portfolio declined by $93.4
million in 2003, from $189.1 million at year-end 2002 to $95.7 million at year-end 2003. The
decrease in mortgage-backed-securities (MBS) results from significant prepayment activity in 2003.
In addition, because of the historically low interest rate environment in 2003 and the anticipation
of higher rates in 2004, the bank only purchased $9.9 million in MBS in 2003. Instead, the Bank
increased its holdings of callable agency securities in order to help improve its net interest
spread. 17




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##### 



Loans The loan portfolio, net of allowance for loan losses, decreased $65.1 million or 20.6% in
2003. At December 31, 2003 the loan portfolio, net of allowance for loan losses, totaled $251.5
million representing 24.9% of total assets compared to $316.5 million representing 31.4% of total
assets at December 31, 2002. The decrease in loans is due to a year of low interest rates that
dramatically increased the number of refinances, pay downs and payoffs for the Bank. Although the
Bank originated $82.6 million in loans in 2003, it saw its loan portfolio decline as a result of
the extraordinary prepayment activity. The Banks loan portfolio consists predominately of residential mortgages. Residential
mortgage loans amounted to $240.3 million at December 31, 2003, representing 95% of the loan
portfolio. At year-end 2003, 90.4% and 9.6% of the Companys residential mortgage loans were fixed
rate and variable rate loans, respectively. See Note 5 of Notes to Consolidated Financial
Statements for a table setting forth the composition of the loan portfolio at year-end 2003. Non-Performing Assets Non-accrual loans, generally those loans that are 90 days or more delinquent, declined to
$230 thousand at December 31, 2003 from $420 thousand at December 31, 2002. This represents 0.09%
of
total loans at December 31, 2003. The Bank had no real estate acquired through foreclosure at
year-end 2003. Deposits Deposits have traditionally been the Banks primary source of funds for lending and
investment activities.
Massbank attracts deposits within its primary market area by
offering a variety of deposit instruments including demand and NOW accounts, money market accounts,
different types of savings accounts, certificates of deposit and retirement savings plans. Deposit
flows vary significantly and are influenced by prevailing interest rates, market conditions,
economic conditions and competition. The Banks management attempts to manage its deposits through
selective pricing and marketing. Total deposits at December 31, 2003 amounted to $882.5 million, reflecting a decrease of $1.4
million from the prior year total of $883.9 million. Deposits in 2003 remained essentially
unchanged from the prior year. Increased competition for deposits in the latter part of 2003 and
more attractive returns on equity securities were the principal reasons for deposit outflows. Savings deposits continued to increase in 2003 as in the prior year, increasing $58.9 million
or 10.7% year-over-year, to $607.8 million from $548.9 million at year-end 2002. Conversely,
certificates of deposit decreased by $60.0 million or 24.0% to $189.6 million as customers
continued the trend of shifting their deposits upon maturity from certificates of deposit to
savings accounts seeking liquidity in this low interest rate environment. Demand and NOW account
deposits amounted to $85.1 million at December 31, 2003 compared to $85.3 million at December 31,
2002. Stockholders Equity Total stockholders equity decreased $6.4 million to $110.9 million at December 31, 2003,
representing a book value of $25.17, per share from $117.3 million representing a book value of
$25.45 per share at December 31, 2002. The decrease in stockholders equity was essentially the result of the Companys repurchase of
278,751 shares of treasury stock in 2003 at a cost of $8.1 million, the payment of dividends to
stockholders of $4.1 million and the decrease in other comprehensive income of $3.7 million due
primarily to the decline in market value of the Banks debt securities portfolio. This was
partially offset by the net income for the year of $7.9 million and the payments and related tax
benefits received from the exercise of stock options by the Companys officers and directors of
$1.7 million. 18




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##### 



Results Of Operations Comparison
of the years 2003 and 2002 Net Interest Income Net interest income is the
primary source of
Massbanks operating income. The
level of net interest income is affected by the volume and mix of average interest-earning assets
and interest-bearing liabilities, market interest rates and other factors. Net interest income on a fully taxable equivalent (FTE) basis totaled $22.4 million in 2003
compared to $24.5 million in 2002. This decrease was primarily attributable to a decrease in net
interest margin partially offset by growth in average earning assets. The Companys net interest
margin for the year ended December 31, 2003 decreased to 2.26% from 2.52% in the prior year.
Average earning assets increased $14.7 million or 1.5% to $987.9 million in 2003, from $973.2
million in 2002. The tables on pages 26 and 27 set forth, among other things, the extent to which
changes in interest rates and changes in the average balances of interest-earning assets and
interest-bearing liabilities have affected interest income and expense during the years indicated.
Information is provided for each category of interest-earning assets and interest-bearing
liabilities, on changes due to (1) volume and (2) interest rates. Interest
and Dividend Income Interest and dividend income on a fully taxable equivalent basis totaled $38.2 million for
the year ended December 31, 2003, compared to $47.2 million for the year ended December 31, 2002.
The decrease in interest and dividend income was the result of a decline in yield on average
earning assets partially offset by the increased interest income from higher average earning
assets. The yield on average earning assets dropped 98 basis points to 3.87% in 2003 from 4.85% the
prior year. The average earning assets of the Company increased $14.7 million in 2003. The yield on earning assets has declined for three consecutive years due to declining market
interest rates, including the Federal Funds rate that is currently at 1%, and the change in the mix
of the Companys average earning assets. The interest income from the Banks mortgage-backed
securities (MBS) and loans declined significantly in 2003 from the prior year as a result of
extraordinary prepayment activity in the historically low interest rate environment of 2003. With
respect to the MBS portfolio, the Bank only added $9.9 million in MBS to the portfolio in 2003
because of low market interest rates. Additionally, because the Bank maintained a significant
portion of its earning assets in Federal funds sold in 2003, the decrease in Federal funds rate
also contributed to a reduction in interest income in 2003. As shown in the rate/volume analysis table on page 27, the decline in yield on average earning
assets in 2003 resulted in decreased interest and dividend income of $3.6 million from 2002 levels.
The total effect of the change in mix of the Companys average earning assets on interest and
dividend income in 2003, partially offset by the effect of higher average earning assets was a $5.4
million decrease from 2002. This resulted in a net decrease in interest and dividend income of $9.0
million compared to the prior year. Interest Expense Total interest expense decreased $6.8 million or 30.2% to $15.9 million for the year ended
December 31, 2003 from $22.7 million for the year ended December 31, 2002. The decrease in interest
expense is due primarily to the lower interest rate environment in 2003 and the continued shift in
the deposit mix from certificate of deposit accounts to savings accounts. (This trend is expected
to start to reverse if market interest rates rise). This resulted in a decrease in the Companys
average cost of funds, from 2.61% in 2002 to 1.78% in 2003. The decrease in average cost of funds
was partially offset by an increase in interest expense resulting from an increase in the Companys
average deposits. Average deposits in 2003 increased $21.6 million or 2.5% to $892.3 million, from
$870.7 million in the prior year. As shown in the rate/volume analysis table on page 27, the effect on total interest expense
from changes in interest-bearing deposit rates was a decrease of $6.8 million from 2002 levels. The
total effect of higher average deposits on interest expense was mitigated by the change in mix of
the Companys average deposits resulting in essentially no change in interest expense due to volume
when compared to 2002. 19




---



##### 



Provisions
(credit) for Loan
Losses In 2003, the Bank recorded a negative provision for loan losses of $502 thousand due to the
quality of loans in the portfolio and a decrease in the Banks loan portfolio. This compares to a
zero provision
for loan losses in the prior year. The Banks loan portfolio decreased $65.8 million or 20.6% from
$318.8 million at December 31, 2002 to $253.0 million at December 31, 2003. In determining the
amount to provide for loan losses, the key factor is the adequacy of the allowance for loan losses.
Management uses a methodology to systematically measure the amount of estimated loan loss exposure
inherent in the portfolio for the purposes of establishing a sufficient allowance for loan losses.
The methodology includes three elements: an analysis of individual loans deemed to be impaired,
general loss allocations for various loan types based on loss experience factors, and an
unallocated allowance which is maintained based on managements assessment of many factors
including the risk characteristics of the portfolio, concentrations of credit, current and
anticipated economic conditions that may affect the borrowers ability to pay, and trends in loan
delinquencies and charge-offs. At December 31, 2003, the allowance for loan losses was $1.6 million
representing 0.61% of total loans and 676% of non-accrual loans. Non-accrual loans totaled $230
thousand at December 31, 2003, down from $420 thousand a year earlier. The Bank recorded $11
thousand in net loan recoveries in 2003 compared to $12 thousand in 2002. The Bank also maintains an allowance for loan losses on off-balance sheet credit exposures
(shown separately on the balance sheet) that totaled $626 thousand at December 31, 2003. This
compares to $384 thousand at December 31, 2002. In 2003, the Company recorded a provision for off-balance sheet credit exposures of $16
thousand. There was no charge to earnings in 2002. This provision is included in other non-interest
expense. Non-Interest Income Non-interest income consists of gains or losses on securities, deposit account service fees
and other non-interest income. Non-interest income for the year ended December 31, 2003 decreased
$1.0 million or 34.2% to $1.9 million, from $2.9 million for the year ended December 31, 2002. The
decrease is due primarily to a decrease in net gains on securities available for sale and trading
securities of $1.1 million, from $1.7 million in 2002 to $639 thousand in 2003. Net securities
gains in 2003 were comprised of $347 thousand in net gains on equity securities and $292 thousand
in net gains on debt securities. This compares to net gains on equity securities of $1.2 million
and net gains on debt securities of $484 thousand in 2002. Deposit account service fees and other non-interest income combined increased $78 thousand to
$1.3 million in 2003 from $1.2 million the prior year. Non-Interest Expense Non-interest expense totaled $12.6 million for the year ended December 31, 2003 compared to
$12.0 million for the prior year, an increase of $578 thousand or 4.8%. Salaries and employee
benefits, the largest component of non-interest expense, increased $394 thousand or 5.4% to $7.7
million in 2003 from $7.3 million in 2002. The increase in salaries and employee benefits is
primarily the result of broad based salary increases of $106 thousand and an increase in health and
other benefit costs for employees of $51 thousand. Also reflected is an increase of $237 thousand
in deferred compensation expense related to the Banks supplemental retirement plan for certain
executive officers. This expense, however, is essentially offset by a corresponding increase in
other non-interest income. Occupancy and equipment expense increased $250 thousand to $2.2 million
in 2003 due to an increase in depreciation expense of $123 thousand and increases in a variety of
other occupancy and equipment related costs. Additionally, the Companys data processing,
advertising and marketing, deposit insurance and other expenses combined totaled $2.7 million in
2003 reflecting a decrease of $66 thousand compared to the prior year. Income Tax Expense For the years ended December 31, 2003 and 2002, income tax expense amounted to $4.2 million
and $5.5 million, respectively. The decrease in income tax expense is primarily due to lower income
before taxes and a decrease in the Companys effective income tax rate. The Companys effective
income tax rate for the year ended December 31, 2003 was 34.97%, down from 35.81% for the year
ended December 31, 2002. 20




---



##### 



Contractual Obligations The Companys contractual cash obligations and commitments to extend credit as of December
31, 2004 are as follows: Payments
Due or Commitments Expiring  By PeriodLess than
    
    
    One to
    
    
    Four to
    
    
    More than(In thousands)
    
    Total
    
    
    one year
    
    
    three years
    
    
    five years
    
    
    five yearsContractual cash obligations:Operating lease obligations
    
    $
    1,451
    
    
    $
    296
    
    
    $
    463
    
    
    $
    361
    
    
    $
    331Data processing service obligations(1)
    
    
    936
    
    
    
    618
    
    
    
    318
    
    
    
    
    
    
    
    Pension benefit obligations
    
    
    364
    
    
    
    364
    
    
    
    
    
    
    
    
    
    
    
    Supplemental retirement benefit
obligations
    
    
    55
    
    

    
    55
    
    
    
    
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    2,806
    
    
    $
    1,333
    
    
    $
    781
    
    
    $
    361
    
    
    $
    331Other commitments:Commitments to originate residential
mortgage loans
    
    $
    3,811
    
    
    $
    3,811
    
    
    $
    
    
    
    $
    
    
    
    $
    Unused lines of credit
    
    
    33,909
    
    
    
    364
    
    
    
    1,463
    
    
    
    8,917
    
    
    
    23,165Other loan commitments
    
    
    4,115
    
    
    
    89
    
    
    
    
    
    
    
    3,926
    
    
    
    100Total other commitments (2)
    
    $
    41,835
    
    
    $
    4,264
    
    
    $
    1,463
    
    
    $
    12,843
    
    
    $
    23,265
    (1)The fees charged by our data processing service provider fluctuate based on the number
of deposit and loan accounts serviced and therefore have been estimated.  (2)Commitments to extend credit are agreements to lend to a customer as long as there is
no violation of any condition established in the contract. These commitments generally
have fixed expiration dates. The total commitment amounts do not necessarily represent
future cash requirements since many of the commitments may expire without being drawn
upon. 21




---



##### 



Liquidity and Capital Resources The Bank must maintain a sufficient level of cash and assets which can readily be converted
into cash in order to meet cash outflows from normal depositor requirements and loan demands. The
Banks primary sources of funds are deposits, loan and mortgage-backed securities amortization and
prepayments, sales, calls or maturities of investment securities and income on earning assets. In
addition to loan payments and maturing investment securities, which are relatively predictable
sources of funds, the Bank maintains a high percentage of its assets invested in federal funds sold
and money market funds, which can readily be converted into cash, and United States Treasury and
Government
agency securities, which can be sold or pledged to raise funds. At December 31, 2004, the Bank had
$194.3 million or 19.9% of total assets and $371.5 million or 38.1% of total assets invested,
respectively, in federal funds sold and money market funds, and United States obligations. The Bank
is a Federal Deposit Insurance Corporation insured institution subject to the FDIC regulatory
capital requirements. The FDIC regulations require all FDIC insured institutions to maintain
minimum levels of Tier I capital. Highly rated banks (i.e., those with a composite rating of 1
under the CAMELS rating system) are required to maintain a minimum leverage ratio of Tier I capital
to total average assets of at least 3.00%. An additional 100 to 200 basis points are required for
all but these most highly rated institutions. The Bank is also required to maintain a minimum level
of risk-based capital. Under the risk-based capital standards, FDIC insured institutions must
maintain a Tier I capital to risk-weighted assets ratio of 4.00% and are generally expected to meet
a minimum total qualifying capital to risk-weighted assets ratio of 8.00%. The risk-based capital
guidelines take into consideration risk factors, as defined by the regulators, associated with
various categories of assets, both on and off the balance sheet. Under the guidelines, capital
strength is measured in two tiers which are used in conjunction with risk adjusted assets to
determine the risk-based capital ratios. Tier II capital components include supplemental capital
components such as qualifying allowance for loan losses, qualifying subordinated debt and up to 45
percent of the pretax net unrealized holding gains on certain available for sale equity securities.
Tier I capital plus the Tier II capital components are referred to as total qualifying capital. The capital ratios of the Bank and the Company currently exceed the minimum regulatory
requirements. At December 31, 2004, the Bank had a leverage Tier I capital to average assets ratio
of 10.67%, a Tier I capital to risk-weighted assets ratio of 37.48% and a total capital to
risk-weighted assets ratio of 38.32%. The Company, on a consolidated basis, had ratios of leverage
Tier I capital to average assets of 11.15%, Tier I capital to risk-weighted assets of 39.16% and
total capital to risk-weighted assets of 40.00% at December 31, 2004. Asset and Liability Management The goal of asset/liability management is to ensure that liquidity, capital and market risk
are prudently managed. Asset/ liability management is governed by policies reviewed and approved
annually by the Banks Board of Directors (the Board). The Board establishes policy limits for
long-term interest rate risk assumption and delegates responsibility for monitoring and measuring
the Companys exposure to interest rate risk to the Risk Management and Asset/Liability Committee
(theCommittee). The Committee which is comprised of members of the Companys Board of Directors,
members of senior management and the Banks controller, generally meets four times a year to review
the economic environment and the volume, mix and maturity of the Companys assets and liabilities. 22




---



##### 



Interest Rate Risk The primary goal of interest-rate risk management is to control the Companys exposure to
interest rate risk both within limits approved by the Board and within narrower guidelines approved
by the Risk Management and Asset/Liability Committee. These limits and guidelines reflect the
Companys tolerance for interest rate risk over both short-term and long-term time horizons. The
Company monitors its interest rate exposures using a variety of financial tools, including income
simulation models. These models, produced quarterly, estimate the effect that instantaneous and
permanent market interest rate shocks of +/-100, 200 and 300 basis points would have on the
Companys net interest income, with no effect given to any steps that management might take to
counter the effect of these interest rate movements. These results are compared to a flat interest
rate scenario and a consensus forecast that represents the most likely future course of interest
rates. The Company also produces a GAP analysis quarterly, reflecting the known or assumed
maturity, repricing and other
cash flow characteristics of the Companys interest-earning assets and interest-bearing
liabilities. Interest rate risk materializes in two forms, market value risk and reinvestment risk. Financial instruments calling for future cash flows show market value increases or decreases
when rates change. Management monitors the potential change in market value of the Companys debt
securities assuming an immediate (parallel) shift in interest rates of up to 200 basis points up or
down. Results are calculated using industry standard analytics and securities data from Bloomberg.
The Company uses the results to review the potential changes in market value resulting from
immediate rate shifts and to manage the effect of market value changes on the Companys capital
position. Reinvestment risk occurs when an asset and the liability funding the asset do not reprice
and/or mature at the same time. The difference or mismatch with respect to repricing frequency
and/or maturity is a risk to net interest income. Complicating managements efforts to control the Companys exposure to interest rate risk is
the fundamental uncertainty of the maturity, repricing and/or runoff characteristics of a
significant portion of the Companys assets and liabilities. This uncertainty often reflects
optional features embedded in these financial instruments. The most important optional features are
embedded in the Companys deposits, loans, mortgage-backed securities and callable U.S. Government
agency securities. For example, many of the Companys interest-bearing deposit products (e.g., savings, money
market deposit accounts and NOW accounts) have no contractual maturity. Customers have the right to
withdraw funds from these deposit accounts freely. Deposit balances may therefore run off
unexpectedly due to changes in competitive or market conditions. In addition, when market interest
rates rise, customers with time certificates of deposit (CDs) often pay a penalty to redeem their
CDs and reinvest at higher rates. Given the uncertainties surrounding deposit runoff and repricing,
the interest rate sensitivity of the Companys liabilities cannot be determined precisely. Similarly, customers have the right to prepay loans, particularly residential mortgage loans,
usually without penalty. As a result, the Companys mortgage based assets (i.e., mortgage loans and
mortgage-backed securities) are subject to prepayment risk. This risk tends to increase when
interest rates fall due to the benefits of refinancing. Since the future prepayment behavior of the
Companys customers is uncertain, the interest rate sensitivity of mortgage based assets cannot be
determined exactly. Additionally, some of the Companys callable U.S. Government agency securities
may be called prior to maturity. As a result, the interest rate sensitivity of these investment
securities cannot be determined precisely. Management monitors and adjusts the difference between the Companys interest-earning assets
and interest-bearing liabilities repricing within various time frames (GAP position). GAP analysis provides a static view of the maturity and repricing characteristics of the
Companys balance sheet positions. The interest rate GAP is prepared by scheduling all
interest-earning assets and interest-bearing liabilities according to scheduled or anticipated
repricing or maturity. The GAP analysis identifies the difference between an institutions assets
and liabilities that will react to a change in market rates. GAP analysis theory postulates that if
the GAP is positive and rates increase, the institutions net interest spread will increase as more
assets than liabilities react to the rate change. If the GAP is negative, more liabilities than
assets will react to a change in market rates. If rates rise, the institutions net interest spread
will fall as more liabilities react to market rates than assets. If rates fall and the GAP is
positive, the institutions net interest spread will decrease as more assets than liabilities react
to the rate change. If the GAP is negative and rates fall, the institutions net interest spread
will improve as more liabilities react to market rates than assets. 23




---



##### 



Interest Rate Risk (continued) The Company, despite having a one-year negative GAP position as of year-end 2004, expects
its net interest income and net interest spread in 2005 to move in the same direction as the change
in market rates rather than in the opposite direction as GAP analysis theory postulates. One of the
more significant reasons for this is the fact that a GAP presentation does not reflect the degrees
to which interest earning assets and deposit costs respond to changes in market interest rates. The
rates on all financial instruments do not always move by the same amount as the general change in
market rates. Since the Company has elected to raise rates by a modest amount on some savings and
transaction-oriented accounts in response to a change in market rates and expects to raise rates
further if market rates continue to rise, these deposits are included in the three months or less
category. As a result, the Companys one-year cumulative GAP position was converted from asset
sensitive to liability sensitive as of year-end 2004. The Company has historically managed its interest rate GAP primarily by lengthening or
shortening the maturity structure of its securities portfolio, by continually modifying the
composition of its securities portfolio and by selectively pricing and marketing its various
deposit products. In anticipation of higher interest rates in 2005, the Companys strategy has been
to purchase liquid investments with short to intermediate maturities. The following table presents the amounts of interest-earning assets and interest-bearing
liabilities at December 31, 2004 that are assumed to mature or reprice during the periods
indicated. The table also summarizes the Companys GAP position at December 31, 2004. As of this
date, the Companys one-year cumulative GAP position was negative $301.4 million, representing
approximately 30.9% of total assets compared to a negative GAP of $68.8 million or 6.8% of total
assets at December 31, 2003. The cumulative GAP-asset ratio measures the direction and extent of
imbalance between an institutions assets and liabilities repricing through the end of a particular
period. Interest Sensitivity Periods3 Months
    
    
    3 to 6
    
    
    6 Months
    
    
    1 to 5
    
    
    Over(In thousands)
    
    or Less
    
    
    Months
    
    
    to 1 Year
    
    
    Years
    
    
    5 Years
    
    
    TotalInterest-earning assets:Loans(3)
    
    $
    18,476
    
    
    $
    11,863
    
    
    $
    19,670
    
    
    $
    128,587
    
    
    $
    57,602
    
    
    $
    236,198Short-term investments:Federal funds sold
    
    
    193,728
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    193,728Other
    
    
    522
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    522Interest-bearing deposits in banks
    
    
    671
    
    
    
    522
    
    
    
    654
    
    
    
    871
    
    
    
    
    
    
    
    2,718Securities available for sale(3)
    
    
    37,042
    
    
    
    66,933
    
    
    
    46,386
    
    
    
    268,437
    
    
    
    24,955
    
    
    
    443,753Securities held to maturity
    
    
    303
    
    
    
    285
    
    
    
    530
    
    
    
    3,239
    
    
    
    520
    
    
    
    4,877Trading securities
    
    
    59,013
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    59,013Total interest-earning assets
    
    $
    309,755
    
    
    $
    79,603
    
    
    $
    67,240
    
    
    $
    401,134
    
    
    $
    83,077
    
    
    $
    940,809Interest-bearing liabilities:Deposits(1) (2) (4)
    
    $
    704,817
    
    
    $
    25,868
    
    
    $
    27,344
    
    
    $
    62,946
    
    
    $
    902
    
    
    $
    821,877Total interest-bearing liabilities
    
    $
    704,817
    
    
    $
    25,868
    
    
    $
    27,344
    
    
    $
    62,946
    
    
    $
    902
    
    
    $
    821,877GAP for period
    
    $
    (395,062
    )
    
    $
    53,735
    
    
    $
    39,896
    
    
    $
    338,188
    
    
    $
    82,175
    
    
    $
    118,932Cumulative GAP  December 31, 2004
    
    $
    (395,062
    )
    
    $
    (341,327
    )
    
    $
    (301,431
    )
    
    $
    36,757
    
    
    $
    118,932Cumulative GAP as a percent of total assets
    
    
    (40.5
    )%
    
    
    (35.0
    )%
    
    
    (30.9
    )%
    
    
    3.8
    %
    
    
    12.2
    %Cumulative GAP  December 31, 2003
    
    $
    (162,516
    )
    
    $
    (125,816
    )
    
    $
    (68,836
    )
    
    $
    268,019
    
    
    $
    120,386
    (1)
    Excludes non-interest bearing demand accounts of $28,662.(2)
Includes escrow deposits of borrowers of $1,074.(3)
    Loans and mortgage-backed securities reflect regular amortization of principal and
prepayment estimates. Callable U.S. Government agency securities of $158,841 thousand are
shown in the period they are expected to be called or reprice, otherwise they are shown
based on their maturity date.
It is assumed that a security will be called if the coupon rate on the security exceeded
market interest rates at year-end 2004.(4)
    It is assumed that the Banks Savings and NOW account rates will be increased within
3 months or less. 24




---



##### 



Interest Rate Risk (continued) The following table shows the Companys financial instruments that are sensitive to changes
in interest rates, categorized by expected call date or maturity, and the instruments fair values
as of December 31, 2004. Expected Maturity DateAt December 31, 2004Fair Value(In thousands)
    
    2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    Thereafter
    
    
    Total
    
    
    at 12/31/04Interest
sensitive assets:Fixed rate securities(5)
    
    $
    121,663
    
    
    $
    81,827
    
    
    $
    62,207
    
    
    $
    71,941
    
    
    $
    22,527
    
    
    $
    52,845
    
    
    $
    413,010
    
    
    $
    415,103Average interest rate(1)
    
    
    2.97
    %
    
    
    3.22
    %
    
    
    3.66
    %
    
    
    3.80
    %
    
    
    4.86
    %
    
    
    5.17
    %
    
    
    3.65
    %Variable rate securities(2) (5)
    
    
    12,529
    
    
    
    5,000
    
    
    
    2,000
    
    
    
    4,000
    
    
    
    9,000
    
    
    
    173
    
    
    
    32,702
    
    
    
    33,533Average interest rate(1)
    


    
    3.36
    %
    
    
    2.16
    %
    
    
    2.15
    %
    
    
    3.00
    %
    
    
    2.67
    %
    
    
    3.93
    %
    
    
    2.87
    %Trading securities(6)
    
    
    59,013
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    59,013
    
    
    
    59,013Average interest rate
    

    
    2.32
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2.32
    %Fixed rate loans
    
    
    72,523
    
    
    
    44,424
    
    
    
    34,626
    
    
    
    13,900
    
    
    
    7,677
    
    
    
    30,808
    
    
    
    203,958
    
    
    
    206,311Average interest rate
    

    
    5.59
    %
    
    
    5.58
    %
    
    
    5.64
    %
    
    
    5.81
    %
    
    
    6.02
    %
    
    
    5.24
    %
    
    
    5.58
    %Variable rate loans
    
    
    6,295
    
    
    
    5,247
    
    
    
    3,994
    
    
    
    3,229
    
    
    
    2,629
    
    
    
    10,846
    
    
    
    32,240
    
    
    
    31,735Average interest rate
    

    
    5.58
    %
    
    
    5.59
    %
    
    
    5.58
    %
    
    
    5.56
    %
    
    
    5.50
    %
    
    
    5.88
    %
    
    
    5.67
    %Other fixed rate assets(4)
    
    
    1,847
    
    
    
    871
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,718
    
    
    
    2,718Average interest rate
    

    
    3.08
    %
    
    
    2.85
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3.01
    %Other variable rate assets(3)
    
    
    194,250
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    194,250
    
    
    
    194,250Average interest rate
    

    
    2.17
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2.17
    %Total interest sensitive assets
    
    $
    468,120
    
    
    $
    137,369
    
    
    $
    102,827
    
    
    $
    93,070
    
    
    $
    41,833
    
    
    $
    94,672
    
    
    $
    937,891
    
    
    $
    942,663Interest
sensitive liabilities:Savings and money market
deposit accounts
    
    $
    561,313
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    561,313
    
    
    $
    561,313Average interest rate
    

    
    1.51
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.51
    %Fixed rate certificates of deposit
    
    
    81,401
    
    
    
    39,080
    
    
    
    18,876
    
    
    
    2,389
    
    
    
    2,601
    
    
    
    902
    
    
    
    145,249
    
    
    
    145,025Average interest rate
    

    
    1.92
    %
    
    
    2.55
    %
    
    
    3.01
    %
    
    
    3.21
    %
    
    
    3.84
    %
    
    
    3.61
    %
    
    
    2.29
    %Variable rate certificates of deposit
    
    
    23,057
    
    
    
    20,351
    
    
    
    7,257
    
    
    
    4,585
    
    
    
    
    
    
    
    
    
    
    
    55,250
    
    
    
    55,249Average interest rate
    

    
    3.04
    %
    
    
    3.05
    %
    
    
    3.14
    %
    
    
    3.15
    %
    
    
    
    
    
    
    
    
    
    
    3.06
    %NOW accounts
    
    
    58,991
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    58,991
    
    
    
    58,991Average interest rate
    

    
    0.33
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.33
    %Escrow deposits of borrowers
    
    
    1,074
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,074
    
    
    
    1,074Average interest rate
    
    
    0.25
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    0.25
    %Total interest sensitive liabilities
    
    $
    725,836
    
    
    $
    59,431
    
    
    $
    26,133
    
    
    $
    6,974
    
    
    $
    2,601
    
    
    $
    902
    
    
    $
    821,877
    
    
    $
    821,652
    (1)
    Securities rates presented are on a tax equivalent basis.(2)
    Includes equity securities.(3)
    Consist of Federal funds sold, money market funds and interest-bearing bank money
market accounts.(4)
    Consist of interest-bearing deposits in banks.(5)
    Securities presented are at amortized cost.(6)
    Securities presented are at market value. The Company uses certain assumptions to estimate fair values and expected maturities.
For interest-sensitive assets, except callable government agency securities, expected maturities
are based upon contractual maturity, and projected repayments and prepayments of principal. For
callable government agency securities expected maturities are based upon the next call date for
those securities expected to be called, otherwise, the securities are shown at their expected
maturity date. For interest-sensitive deposit liabilities, maturities are based on contractual
maturity. The actual maturity of the Companys financial instruments could vary significantly from
what has been presented in the above table if actual experience differs from the assumptions used. Other Market Risks The Companys investment securities portfolio includes equity securities with a market value
of approximately $7.4 million at December 31, 2004. The net unrealized gains on these securities
totaled $0.9 million at year-end 2004. Movements in equity prices may effect the amount of
securities gains or losses which the Company realizes from the sale of these securities and thus
may have an impact on earnings. 25




---



##### 



Average Balance Sheets (In
thousands) Years ended December 31,
    

2004
    
    2003
    
    2002Interest
    
    
    Average
    
    
    
    
    
    
    Interest
    
    
    Average
    
    
    
    
    
    
    Interest
    
    
    AverageAverage
    
    
    Income/
    
    
    Yield/
    
    
    Average
    
    
    Income/
    
    
    Yield/
    
    
    Average
    
    
    Income/
    
    
    Yield/Balance
    
    
    Expense(1)
    
    
    Rate
    
    
    Balance
    
    
    Expense(1)
    
    
    Rate
    
    
    Balance
    
    
    Expense(1)
    
    
    RateAssets:Earning assets:Federal funds sold
    
    $
    186,615
    
    
    $
    2,438
    
    
    
    1.31
    %
    
    $
    209,463
    
    
    $
    2,266
    
    
    
    1.08
    %
    
    $
    183,968
    
    
    $
    2,974
    
    
    
    1.62
    %Short-term investments(4)
    
    
    15,870
    
    
    
    239
    
    
    
    1.51
    
    
    
    29,672
    
    
    
    435
    
    
    
    1.47
    
    
    
    31,063
    
    
    
    671
    
    
    
    2.16Securities available for sale:Investment securities(2)
    
    
    324,239
    
    
    
    9,002
    
    
    
    2.78
    
    
    
    259,148
    
    
    
    7,638
    
    
    
    2.95
    
    
    
    158,978
    
    
    
    5,815
    
    
    
    3.66Mortgage-backed securities(2)
    
    
    112,445
    
    
    
    6,398
    
    
    
    5.69
    
    
    
    133,037
    
    
    
    8,250
    
    
    
    6.20
    
    
    
    233,627
    
    
    
    14,863
    
    
    
    6.36Mortgage-backed securities
held to maturity
    
    
    3,402
    
    
    
    173
    
    
    
    5.09
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Trading securities
    
    
    69,345
    
    
    
    1,145
    
    
    
    1.65
    
    
    
    72,534
    
    
    
    1,113
    
    
    
    1.53
    
    
    
    31,814
    
    
    
    685
    
    
    
    2.15Mortgage loans(3)
    
    
    232,709
    
    
    
    13,578
    
    
    
    5.83
    
    
    
    270,826
    
    
    
    17,682
    
    
    
    6.53
    
    
    
    308,710
    
    
    
    20,819
    
    
    
    6.74Other loans(3)
    
    
    10,642
    
    
    
    669
    
    
    
    6.29
    
    
    
    13,175
    
    
    
    834
    
    
    
    6.33
    
    
    
    25,022
    
    
    
    1,362
    
    
    
    5.44Total earning assets
    

    
    955,267
    
    
    
    33,642
    
    
    
    3.52
    %
    
    
    987,855
    
    
    
    38,218
    
    
    
    3.87
    %
    
    
    973,182
    
    
    
    47,189
    
    
    
    4.85
    %Allowance for loan losses
    
    
    (1,460
    )
    
    
    
    
    
    
    
    
    
    
    (2,388
    )
    
    
    
    
    
    
    
    
    
    
    (2,644
    )Total earning assets
less allowance for
loan losses
    
    
    953,807
    
    
    
    
    
    
    
    
    
    
    
    985,467
    
    
    
    
    
    
    
    
    
    
    
    970,538Other assets
    

    
    25,541
    
    
    
    
    
    
    
    
    
    
    
    22,410
    
    
    
    
    
    
    
    
    
    
    
    22,410Total assets
    
    $
    979,348
    
    
    
    
    
    
    
    
    
    
    $
    1,007,877
    
    
    
    
    
    
    
    
    
    
    $
    992,948Liabilities:Deposits:Demand and NOW
    
    $
    85,066
    
    
    
    171
    
    
    
    0.20
    %
    
    $
    83,583
    
    
    
    247
    
    
    
    0.30
    %
    
    $
    82,964
    
    
    
    366
    
    
    
    0.44
    %Savings
    
    
    585,239
    
    
    
    8,563
    
    
    
    1.46
    
    
    
    595,464
    
    
    
    11,032
    
    
    
    1.85
    
    
    
    471,734
    
    
    
    12,161
    
    
    
    2.58Time certificates of deposit
    
    
    192,386
    
    
    
    3,995
    
    
    
    2.08
    
    
    
    213,282
    
    
    
    4,575
    
    
    
    2.15
    
    
    
    315,987
    
    
    
    10,174
    
    
    
    3.22Total deposits
    
    
    862,691
    
    
    
    12,729
    
    
    
    1.48
    %
    
    
    892,329
    
    
    
    15,854
    
    
    
    1.78
    %
    
    
    870,685
    
    
    
    22,701
    
    
    
    2.61
    %Other liabilities
    
    
    6,660
    
    
    
    
    
    
    
    
    
    
    
    4,474
    
    
    
    
    
    
    
    
    
    
    
    5,225Total liabilities
    
    
    869,351
    
    
    
    
    
    
    
    
    
    
    
    896,803
    
    
    
    
    
    
    
    
    
    
    
    875,910Stockholders Equity
    
    
    109,997
    
    
    
    
    
    
    
    
    
    
    
    111,074
    
    
    
    
    
    
    
    
    
    
    
    117,038Total liabilities and stockholders equity
    
    $
    979,348
    
    
    
    
    
    
    
    
    
    
    $
    1,007,877
    
    
    
    
    
    
    
    
    
    
    $
    992,948Net interest income (tax-equivalent basis)
    
    
    
    
    
    
    20,913
    
    
    
    
    
    
    
    
    
    
    
    22,364
    
    
    
    
    
    
    
    
    
    
    
    24,488Less adjustment of tax-exempt interest income
    
    
    
    
    
    
    61
    
    
    
    
    
    
    
    
    
    
    
    81
    
    
    
    
    
    
    
    
    
    
    
    86Net interest income
    
    
    
    
    
    $
    20,852
    
    
    
    
    
    
    
    
    
    
    $
    22,283
    
    
    
    
    
    
    
    
    
    
    $
    24,402Interest rate spread(5)
    
    
    
    
    
    
    
    
    
    
    2.04
    %
    
    
    
    
    
    
    
    
    
    
    2.09
    %
    
    
    
    
    
    
    
    
    
    
    2.24
    %Net interest margin(6)
    
    
    
    
    
    
    
    
    
    
    2.19
    %
    
    
    
    
    
    
    
    
    
    
    2.26
    %
    
    
    
    
    
    
    
    
    
    
    2.52
    %
    (1)Income on equity securities is included on a tax equivalent basis.(2)Averages balances include net unrealized gains on securities available for sale.(3)Loans on non-accrual status are included in average balances.(4)Short-term investments consist of interest-bearing deposits in banks and investments
in money market funds.(5)Interest rate spread represents the difference between the yield on earning assets
and the cost of the Companys deposits.(6)Net interest margin represents net interest income (tax equivalent basis) divided by
average interest-earning assets. 26




---



##### 



Rate/Volume Analysis The following table presents, for the years indicated, the changes in interest and dividend
income and the changes in interest expense attributable to changes in interest rates and changes in
the volume of earning assets and interest-bearing liabilities. A change attributable to both volume
and rate has been allocated proportionately to the change due to volume and the change due to rate. 2004 Compared to 2003
    
    
    2003 Compared to 2002(In thousands)
    
    Increase (Decrease)
    
    
    Increase (Decrease)Years ended December 31,
    
    Due to
    
    
    Due toVolume
    
    
    Rate
    
    
    Total
    
    
    Volume
    
    
    Rate
    
    
    TotalInterest and dividend income:Federal funds sold
    
    $
    (265
    )
    
    $
    437
    
    
    $
    172
    
    
    $
    372
    
    
    $
    (1,080
    )
    
    $
    (708
    )Short-term investments
    
    
    (208
    )
    
    
    12
    
    
    
    (196
    )
    
    
    (29
    )
    
    
    (207
    )
    
    
    (236
    )Investment securities
    
    
    1,813
    
    
    
    (429
    )
    
    
    1,384
    
    
    
    3,081
    
    
    
    (1,253
    )
    
    
    1,828Mortgage-backed securities
    
    
    (1,011
    )
    
    
    (668
    )
    
    
    (1,679
    )
    
    
    (6,247
    )
    
    
    (366
    )
    
    
    (6,613
    )Trading securities
    
    
    (50
    )
    
    
    82
    
    
    
    32
    
    
    
    671
    
    
    
    (243
    )
    
    
    428Mortgage loans
    
    
    (2,338
    )
    
    
    (1,766
    )
    
    
    (4,104
    )
    
    
    (2,490
    )
    
    
    (647
    )
    
    
    (3,137
    )Other loans
    
    
    (159
    )
    
    
    (6
    )
    
    
    (165
    )
    
    
    (723
    )
    
    
    195
    
    
    
    (528
    )Total interest and dividend income
    
    
    (2,218
    )
    
    
    (2,338
    )
    
    
    (4,556
    )
    
    
    (5,365
    )
    
    
    (3,601
    )
    
    
    (8,966
    )Interest expense:Deposits:Demand and NOW
    
    
    4
    
    
    
    (80
    )
    
    
    (76
    )
    
    
    3
    
    
    
    (122
    )
    
    
    (119
    )Savings
    
    
    (186
    )
    
    
    (2,283
    )
    
    
    (2,469
    )
    
    
    2,757
    
    
    
    (3,886
    )
    
    
    (1,129
    )Time certificates of deposit
    
    
    (437
    )
    
    
    (143
    )
    
    
    (580
    )
    
    
    (2,762
    )
    
    
    (2,837
    )
    
    
    (5,599
    )Total interest expense
    
    
    (619
    )
    
    
    (2,506
    )
    
    
    (3,125
    )
    
    
    (2
    )
    
    
    (6,845
    )
    
    
    (6,847
    )Net interest income
    
    $
    (1,599
    )
    
    $
    168
    
    
    $
    (1,431
    )
    
    $
    (5,363
    )
    
    $
    3,244
    
    
    $
    (2,119
    )
 Impact of Inflation and
Changing Prices Massbank Corp.s financial statements presented herein have been prepared in
accordance with accounting principles generally accepted in the United States of America which
require the measurement of financial position and operating results in terms of historical dollars,
without
considering changes in the relative purchasing power of money over time, due to the fact that
substantially all of the assets and liabilities of a financial institution are monetary in nature.
As a result, interest rates have a more significant impact on a financial institutions performance
than the effects of general levels of inflation. Interest rates do not necessarily move in the same
direction or in the same magnitude as the prices of goods and services. 27




---



##### 



Recent Accounting Pronouncements Accounting For Stock-Based
Compensation  Transition and Disclosure In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS)
No. 123-Revised 2004 (SFAS 123(R)), Share-Based
Payment. This is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and
supersedes APB No. 25, Accounting for Stock issued to Employees. As noted in the notes to
consolidated financial statements, we do not record compensation expense for stock-based
compensation. Under SFAS 123(R), we will be required to measure the cost of employee services
received in exchange for stock based on the grant-date fair value (with limited exceptions). That
cost will be recognized over the period during which an employee is required to provide service in
exchange for the award (usually the vesting period). The fair value will be estimated using an
option-pricing model. Excess tax benefits, as defined in SFAS 123(R), will be recognized as an
addition to paid-in capital. This is effective as of the beginning of the first interim or annual
reporting period that begins after June 15, 2005. We are currently in the process of evaluating the
impact of SFAS 123(R) on our consolidated financial statements, including different option-pricing
models. The pro forma table in Note 1 of the Notes to the Consolidated Financial Statements
illustrates the effect on net income and earnings per share if we had applied the fair value
recognition provisions of SFAS 123. Employers
Disclosures about Pensions
and other Postretirement Benefits In December 2003, the FASB issued FASB Statement No. 132-Revised 2003 (SFAS 132R),
Employers Disclosures about Pensions and Other Postretirement Benefits. This standard increases
the existing disclosure requirements by requiring more details about pension plan assets, benefit
obligations, cash flows, benefit costs and related information. Companies are required to segregate
plan assets by category, such as debt, equity and real estate, and to provide certain expected
rates of return and other informational disclosures. SFAS 132R also requires companies to disclose
various elements of pension and postretirement benefit costs in interim-period financial statements
for quarters beginning after December 15, 2003 (see Note 15 of the Notes to the Consolidated
Financial Statements). We have complied with the disclosure requirements of SFAS 132R. 28




---



##### 



Massbank Corp. Managements Annual Report on
Internal Control Over Financial
Reporting Massbank Corp.s management is responsible for the preparation, content and
integrity of the financial statements and other statistical data and analyses compiled for this
annual report. The financial statements and related notes have been prepared in conformity with
U.S. generally accepted accounting principles and reflect managements best estimates and
judgments. Management believes that the financial statements and notes present fairly Massbank
Corp.s financial position, results of operations and cash flows in all material respects. Management is responsible for establishing and maintaining a system of internal control that
is intended to protect Massbank Corp.s assets and the integrity of its financial
reporting. This
corporate-wide system of controls includes self-monitoring mechanisms, written policies and
procedures, proper delegation of authority and organizational division of responsibility, and the
selection and training of qualified personnel. An annual code of ethics certification process is conducted, and compliance with the code of
ethics is required of all Company employees. Although any system of internal control can be
compromised by human error or intentional circumvention of required procedures, management believes
the Companys system provides reasonable assurances that financial transactions are recorded and
reported properly, providing an adequate basis for reliable financial statements. The Board of Directors discharges its responsibility for Massbank Corp.s financial
statements through its Audit Committee. This committee, which draws its members exclusively from
the independent directors, also hires the independent registered public accounting firm. Managements Assessment of Internal
Control Over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over
financial reporting forMassbank Corp. Management has assessed the effectiveness of
Massbank Corp.s internal control and procedures over financial reporting using criteria
described in Internal Control  Integrated Framework, issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on that assessment, management believes that the
Company maintained an effective system of internal control over financial reporting as of December
31, 2004. Massbank Corp.s independent registered public accounting firm has issued an
attestation report, dated March 14, 2005, on managements assessment of Massbank Corp.s
internal control over financial reporting, which is included in this annual report. Gerard H. Brandi
Chairman, President and CEO Reginald E. Cormier
Sr. Vice President, Treasurer and CFO 29




---



##### 



report of independent registered public
accounting firm (KPMG LOGO) The Board of Directors and
StockholdersMassbank Corp.: We have audited managements assessment, included in the accompanying Managements Report on
Internal Control Over Financial Reporting, that Massbank Corp. (the Company)
maintained effective internal control over financial reporting as of December 31, 2004, based on
criteria established in Internal Control  Integrated Frameworkissued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). The Companys management is responsible
for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on managements assessment and an opinion on the effectiveness of the Companys internal
control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over
financial reporting, evaluating managements assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable basis for our
opinion. A Companys internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted accounting
principles. A companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the Company are being made only in accordance with authorizations of management and
directors of the Company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the Companys assets that could have
a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. In our opinion, managements assessment that the Company maintained effective internal control
over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based
on criteria established in Internal Control  Integrated Frameworkissued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company
maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2004, based on criteria established in Internal Control  Integrated Frameworkissued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of the Company and subsidiaries as
of December 31, 2004 and 2003, and the related consolidated statements of income, cash flows and
changes in stockholders equity for each of the years in the three-year period ended December 31,
2004, and our report dated March 14, 2005 expressed an unqualified opinion on those consolidated
financial statements. (KPMG LOGO) Boston, Massachusetts
March 14, 2005 30




---



##### 



report of independent registered public
accounting firm (KPMG LOGO) The Board of Directors and Stockholders Massbank Corp.:
 We have audited the accompanying consolidated balance sheets of Massbank Corp. and
subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated
statements of income, cash flows and changes in stockholders equity for each of the years in the
three-year period ended December 31, 2004. These consolidated financial statements are the
responsibility of the Companys management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for
our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Massbank Corp. and subsidiaries as of
December 31, 2004 and 2003, and the results of their operations and their cash flows for each of
the years in the three-year period ended December 31, 2004, in conformity with U.S. generally
accepted accounting principles. We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of the Companys internal control over financial reporting
as of December 31, 2004, based on criteria established in Internal Control  Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our
report dated March 14, 2005 expressed an unqualified opinion on managements assessment of, and the
effective operation of internal control over financial reporting. (KPMG LOGO) Boston, Massachusetts
March 14, 2005 31




---



##### 



Massbank Corp. and SubsidiariesConsolidated Balance Sheets (In thousands except share data) At December 31,
    
    2004
    
    
    2003Assets:Cash and due from banks
    
    $
    9,829
    
    
    $
    8,862Short-term investments (Note 2)
    
    
    194,250
    
    
    
    214,532Total cash and cash equivalents
    
    
    204,079
    
    
    
    223,394Interest-bearing deposits in banks
    
    
    2,718
    
    
    
    5,685Securities available for sale, at market value
(amortized cost of $440,835 in 2004 and $422,875 in 2003) (Note 3)
    
    
    443,753
    
    
    
    429,229Securities held to maturity, at amortized cost
(market value of $4,883 in 2004) (Note 3)
    
    
    4,877
    
    
    
    Trading securities, at market value (Note 4)
    
    
    59,013
    
    
    
    72,633Loans (Notes 5 and 7):Mortgage loans
    
    
    226,197
    
    
    
    241,886Other loans
    
    
    10,001
    
    
    
    11,120Total loans
    
    
    236,198
    
    
    
    253,006Allowance for loan losses (Note 6)
    
    
    (1,307
    )
    
    
    (1,554
    )Net loans
    
    
    234,891
    
    
    
    251,452Premises and equipment (Note 9)
    
    
    6,464
    
    
    
    6,943Accrued interest receivable
    
    
    3,416
    
    
    
    3,854Goodwill
    
    
    1,090
    
    
    
    1,090Income tax receivable, net
    
    
    164
    
    
    
    325Deferred income tax asset, net (Note 12)
    
    
    588
    
    
    
    Other assets
    
    
    15,115
    
    
    
    16,128Total assets
    
    $
    976,168
    
    
    $
    1,010,733Liabilities and Stockholders Equity:Deposits (Note 10):Demand and NOW
    
    $
    87,653
    
    
    $
    85,056Savings
    
    
    561,313
    
    
    
    607,831Time certificates of deposit
    
    
    200,499
    
    
    
    189,621Total deposits
    
    
    849,465
    
    
    
    882,508Escrow deposits of borrowers
    
    
    1,074
    
    
    
    1,139Deferred income tax liability, net (Note 12)
    
    
    
    
    
    
    783Allowance for loan losses on off-balance
sheet credit exposures
    
    
    588
    
    
    
    626Other liabilities
    
    
    15,026
    
    
    
    14,750Total liabilities
    
    
    866,153
    
    
    
    899,806Commitments and contingent liabilities (Notes 8 and 9)Stockholders equity (Notes 12, 14, 15 and 16):Preferred stock, par value $1.00 per share; 2,000,000 shares authorized, none issued
    
    
    
    
    
    
    Common stock, par value $1.00 per share; 10,000,000 shares
authorized, 7,736,430 and 7,688,333 shares issued, respectively
    
    
    7,736
    
    
    
    7,688Additional paid-in capital
    
    
    55,313
    
    
    
    54,417Retained earnings
    
    
    102,003
    
    
    
    99,038165,052
    
    
    
    161,143Treasury stock at cost, 3,354,703 and 3,280,880 shares, respectively
    
    
    (56,794
    )
    
    
    (54,177
    )Accumulated other comprehensive income
    
    
    1,757
    
    
    
    3,961Shares held in rabbi trust at cost, 25,804 and 25,200 shares, respectively (Note 15)
    
    
    (553
    )
    
    
    (515
    )Deferred compensation obligation
    
    
    553
    
    
    
    515Total stockholders equity
    
    
    110,015
    
    
    
    110,927Total liabilities and stockholders equity
    
    $
    976,168
    
    
    $
    1,010,733
 See accompanying notes to consolidated financial statements. 32




---



##### 



Massbank Corp. and SubsidiariesConsolidated Statements of Income (In thousands except share data) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Interest and dividend income:Mortgage loans
    
    $
    13,578
    
    
    $
    17,682
    
    
    $
    20,819Other loans
    
    
    669
    
    
    
    834
    
    
    
    1,362Securities available for sale:Mortgage-backed securities
    
    
    6,398
    
    
    
    8,250
    
    
    
    14,863Other securities
    
    
    8,941
    
    
    
    7,557
    
    
    
    5,729Mortgage-backed securities held to maturity
    
    
    173
    
    
    
    
    
    
    
    Trading securities
    
    
    1,145
    
    
    
    1,113
    
    
    
    685Federal funds sold
    
    
    2,438
    
    
    
    2,266
    
    
    
    2,974Other investments
    
    
    239
    
    
    
    435
    
    
    
    671Total interest and dividend income
    
    
    33,581
    
    
    
    38,137
    
    
    
    47,103Interest expense:Deposits:NOW
    
    
    171
    
    
    
    247
    
    
    
    366Savings
    
    
    8,563
    
    
    
    11,032
    
    
    
    12,161Time certificates of deposit
    
    
    3,995
    
    
    
    4,575
    
    
    
    10,174Total interest expense
    
    
    12,729
    
    
    
    15,854
    
    
    
    22,701Net interest income
    
    
    20,852
    
    
    
    22,283
    
    
    
    24,402Provision (credit) for loan losses(Note 6)
    
    
    (242
    )
    
    
    (502
    )
    
    
    Net interest income after provision (credit) for loan
losses
    
    
    21,094
    
    
    
    22,785
    
    
    
    24,402Non-interest income:Deposit account service fees
    
    
    448
    
    
    
    494
    
    
    
    567Gains on securities available for sale, net
    
    
    1,361
    
    
    
    558
    
    
    
    1,566Gains (losses) on trading securities, net
    
    
    (132
    )
    
    
    81
    
    
    
    152Other
    
    
    809
    
    
    
    789
    
    
    
    638Total non-interest income
    
    
    2,486
    
    
    
    1,922
    
    
    
    2,923Non-interest expense:Salaries and employee benefits
    
    
    7,428
    
    
    
    7,692
    
    
    
    7,298Occupancy and equipment
    
    
    2,169
    
    
    
    2,248
    
    
    
    1,998Data processing
    
    
    521
    
    
    
    528
    
    
    
    528Professional services
    
    
    631
    
    
    
    394
    
    
    
    526Advertising and marketing
    
    
    110
    
    
    
    154
    
    
    
    168Deposit insurance
    
    
    160
    
    
    
    177
    
    
    
    182Other
    
    
    1,283
    
    
    
    1,422
    
    
    
    1,337Total non-interest expense
    
    
    12,302
    
    
    
    12,615
    
    
    
    12,037Income before income taxes
    
    
    11,278
    
    
    
    12,092
    
    
    
    15,288Income tax expense(Note 12)
    
    
    3,898
    
    
    
    4,229
    
    
    
    5,474Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814Weighted average common shares outstanding:Basic
    
    
    4,408,293
    
    
    
    4,439,394
    
    
    
    4,697,826Diluted
    
    
    4,501,537
    
    
    
    4,544,594
    
    
    
    4,822,501Earnings per share(in dollars):Basic
    
    $
    1.67
    
    
    $
    1.77
    
    
    $
    2.09Diluted
    
    
    1.64
    
    
    
    1.73
    
    
    
    2.04
 See accompanying notes to consolidated financial statements. 33




---



##### 



Massbank
Corp.
and Subsidiaries Consolidated
Statements of Cash Flows
 (In thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Cash flows from operating activities:Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814Adjustments to reconcile net income to net cash (used in) provided
by operating activities:Depreciation and amortization
    
    
    676
    
    
    
    721
    
    
    
    658Loan interest capitalized
    
    
    (8
    )
    
    
    (12
    )
    
    
    (33
    )Amortization of ESOP shares committed to be released
    
    
    
    
    
    
    
    
    
    
    202Tax benefit resulting from dividends paid on unallocated shares
held by the ESOP
    
    
    
    
    
    
    
    
    
    
    4Decrease in accrued interest receivable
    
    
    438
    
    
    
    72
    
    
    
    24Increase in other liabilities
    
    
    276
    
    
    
    11,038
    
    
    
    966(Increase) decrease in income tax receivable, net
    
    
    161
    
    
    
    (126
    )
    
    
    9Amortization of premiums (accretion of discounts)
on securities, net
    
    
    566
    
    
    
    613
    
    
    
    450Net trading securities activity
    
    
    13,488
    
    
    
    (36,303
    )
    
    
    (33,008
    )Gains on securities available for sale, net
    
    
    (1,361
    )
    
    
    (567
    )
    
    
    (1,633
    )Valuation writedowns of equity securities available for sale
    
    
    
    
    
    
    9
    
    
    
    67Gains (losses) on trading securities, net
    
    
    132
    
    
    
    (81
    )
    
    
    (152
    )Decrease in deferred mortgage loan origination fees,
net of amortization
    
    
    (231
    )
    
    
    (562
    )
    
    
    (344
    )Deferred income tax expense (benefit)
    
    
    28
    
    
    
    236
    
    
    
    (219
    )(Increase) decrease in other assets
    
    
    847
    
    
    
    (12,443
    )
    
    
    (42
    )Provision (credit) for loan losses
    
    
    (242
    )
    
    
    (502
    )
    
    
    Provision for loan losses on off-balance
sheet credit exposures
    
    
    (38
    )
    
    
    16
    
    
    
    Transfer from allowance for loan losses
    
    
    
    
    
    
    (226
    )
    
    
    (235
    )Transfer to allowance for loan losses on
off-balance sheet credit exposures
    
    
    
    
    
    
    226
    
    
    
    235Gains on sales of premises and equipment
    
    
    (4
    )
    
    
    
    
    
    
    Decrease in escrow deposits of borrowers
    
    
    (65
    )
    
    
    (248
    )
    
    
    (16
    )Net cash (used in) provided by operating activities
    
    
    22,043
    
    
    
    (30,276
    )
    
    
    (23,253
    )Cash flows from investing activities:Purchases of term federal funds
    
    
    
    
    
    
    (15,000
    )
    
    
    Proceeds from maturities of term federal funds
    
    
    
    
    
    
    15,000
    
    
    
    Net (increase) decrease in interest-bearing bank deposits
    
    
    2,967
    
    
    
    (831
    )
    
    
    587Proceeds from sales of investment securities available for sale
    
    
    28,942
    
    
    
    36,810
    
    
    
    50,158Proceeds from maturities and redemption of investment securities
held to maturity and available for sale
    
    
    207,509
    
    
    
    175,000
    
    
    
    76,500Purchases of investment securities available for sale
    
    
    (225,318
    )
    
    
    (355,995
    )
    
    
    (209,923
    )Purchases of mortgage-backed securities available for sale
    
    
    (63,922
    )
    
    
    (9,937
    )
    
    
    (19,977
    )Purchases of mortgage-backed securities held to maturity
    
    
    (4,925
    )
    
    
    
    
    
    
    Principal repayments of mortgage-backed securities
    
    
    35,671
    
    
    
    97,916
    
    
    
    99,266Principal repayments of securities available for sale
    
    
    1
    
    
    
    2
    
    
    
    90Loans originated
    
    
    (60,332
    )
    
    
    (82,598
    )
    
    
    (104,631
    )Loan principal payments received
    
    
    77,369
    
    
    
    148,966
    
    
    
    117,207Purchases of premises and equipment
    
    
    (193
    )
    
    
    (859
    )
    
    
    (465
    )Proceeds from sale of premises and equipment
    
    
    4
    
    
    
    
    
    
    
    Net cash (used in) provided by investing activities
    
    
    (2,227
    )
    
    
    8,474
    
    
    
    8,812
 (Continued) 34




---



##### 



Massbank Corp. and SubsidiariesConsolidated Statements of Cash Flows(Continued) (In thousands) Years Ended December 31,
    
    2004
    
    
    2003
    
    
    2002Cash flows from financing activities:Net (decrease) increase in deposits
    
    
    (33,043
    )
    
    
    (1,420
    )
    
    
    34,215Payments to acquire treasury stock
    
    
    (2,617
    )
    
    
    (8,097
    )
    
    
    (7,230
    )Purchase of
company stock for deferred compensation plan, net of distributionsIncrease in deferred compensation obligation
    
    
    (38
    )
    
    
    (38
    )
    
    
    (55
    )Options exercised, including tax benefit
    
    
    944
    
    
    
    1,675
    
    
    
    2,325Cash dividends paid on common stock
    
    
    (4,415
    )
    
    
    (4,068
    )
    
    
    (4,139
    )Net cash (used in) provided by financing activities
    
    
    (39,131
    )
    
    
    (11,910
    )
    
    
    25,171Net (decrease) increase in cash and cash equivalents
    
    
    (19,315
    )
    
    
    (33,712
    )
    
    
    10,730Cash and cash equivalents at beginning of year
    
    
    223,394
    
    
    
    257,106
    
    
    
    246,376Cash and cash equivalents at end of year
    
    $
    204,079
    
    
    $
    223,394
    
    
    $
    257,106Supplemental cash flow disclosures:Cash transactions:Cash paid during the year for interest
    
    $
    12,769
    
    
    $
    15,922
    
    
    $
    22,765Cash paid during the year for taxes, net of refunds
    
    
    3,401
    
    
    
    3,608
    
    
    
    5,080
 See accompanying notes to consolidated financial statements. 35




---



##### 



Massbank Corp. and SubsidiariesConsolidated Statements of Changes in Stockholders Equity   (In thousands except share data) Years ended December 31, 2004, 2003 and 2002  Accumulated
    
    
    Shares
    
    
    
    
    
    
    CommonAdditional
    
    
    
    
    
    
    
    
    
    
    other
    
    
    held in
    
    
    Deferred
    
    
    stockCommon
    
    
    paid-in
    
    
    Retained
    
    
    Treasury
    
    
    comprehensive
    
    
    Rabbi
    
    
    compensation
    
    
    acquiredstock
    
    
    capital
    
    
    earnings
    
    
    stock
    
    
    income
    
    
    Trust
    
    
    obligation
    
    
    by ESOP
    
    
    TotalBalance at December 31, 2001
    
    $
    7,495
    
    
    $
    62,453
    
    
    $
    99,996
    
    
    $
    (61,327
    )
    
    $
    6,443
    
    
    $
    (422
    )
    
    $
    422
    
    
    $
    (156
    )
    
    $
    114,904Net Income
    
    
    
    
    
    
    
    
    
    
    9,814
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,814Other comprehensive income, net
of tax:Unrealized gains on securities, net of
reclassification adjustment (Note 1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,249
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,249Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,063Cash dividends paid ($0.88 per
share)
    
    
    
    
    
    
    
    
    
    
    (4,139
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,139
    )Tax benefit resulting from
dividends paid
on unallocated shares held by the ESOP
    
    
    
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4Net decrease in liability to ESOP
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    156
    
    
    
    156Amortization of ESOP shares
committed to be released
    
    
    
    
    
    
    202
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    

    
    
    
    
    202Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,230
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,230
    )Purchase of company stock for
deferred compensation plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (55
    )
    
    
    55
    
    
    
    
    
    
    
    Exercise of stock options and
related tax benefits
    
    
    115
    
    
    
    2,210
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,325Transfer resulting from
three-for-two stock split
    
    
    
    
    
    
    (12,045
    )
    
    
    (10,432
    )
    
    
    22,477
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2002
    
    
    7,610
    
    
    
    52,820
    
    
    
    95,243
    
    
    
    (46,080
    )
    
    
    7,692
    
    
    
    (477
    )
    
    
    477
    
    
    
    
    
    
    
    117,285Net Income
    
    
    
    
    
    
    
    
    
    
    7,863
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,863Other comprehensive loss, net of
tax:Unrealized losses on securities, net of
reclassification adjustment (Note 1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,731
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,731
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,132Cash dividends paid ($0.92 per
share)
    
    
    
    
    
    
    
    
    
    
    (4,068
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,068
    )Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8,097
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8,097
    )Purchase of company stock for
deferred compensation plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (38
    )
    
    
    38
    
    
    
    
    
    
    
    Exercise of stock options and
related tax benefits
    
    
    78
    
    
    
    1,597
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,675Balance at December 31, 2003
    
    
    7,688
    
    
    
    54,417
    
    
    
    99,038
    
    
    
    (54,177
    )
    
    
    3,961
    
    
    
    (515
    )
    
    
    515
    
    
    
    
    
    
    
    110,927Net Income
    
    
    
    
    
    
    
    
    
    
    7,380
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,380Other comprehensive loss, net of
tax:Unrealized losses on securities, net of
reclassification adjustment (Note 1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,204
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,204
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,176Cash dividends paid ($1.00 per
share)
    
    
    
    
    
    
    
    
    
    
    (4,415
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,415
    )Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,617
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,617
    )Purchase of company stock for
deferred compensation plan,
net of distributions
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (38
    )
    
    
    38
    
    
    
    
    
    
    
    Exercise of stock options and
related tax benefits
    
    
    48
    
    
    
    896
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    944Balance at December 31, 2004
    
    $
    7,736
    
    
    $
    55,313
    
    
    $
    102,003
    
    
    $
    (56,794
    )
    
    $
    1,757
    
    
    $
    (553
    )
    
    $
    553
    
    
    $
    
    
    
    $
    110,015
 See accompanying notes to consolidated financial statements. 36




---



##### 



Massbank Corp. and SubsidiariesNotes to Consolidated Financial Statements Years
ended December 31, 2004, 2003 and 2002
  1.
    Summary of Significant Accounting Policies  MASSBANK Corp. (the Company) is a Delaware chartered holding company
whose principal subsidiary is MASSBANK (the Bank).
The Bank operates fifteen full service banking offices in Reading, Melrose, Stoneham,
Wilmington, Medford, Chelmsford, Tewksbury, Westford, Dracut, Lowell and Everett,
Massachusetts providing a variety of deposit, lending and trust services. As a Massachusetts chartered savings bank whose deposits are insured by the Federal Deposit Insurance
Corporation (FDIC) and the Depositors Insurance Fund (DIF), the activities of the Bank
are subject to regulation, supervision and examination by federal and state regulatory
authorities, including, but not limited to the FDIC, the Massachusetts Commissioner of
Banks and the DIF. In addition, as a bank holding company, the Company is subject to
supervision, examination and regulation by the Board of Governors of the Federal Reserve
System. Basis of Presentation The consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiary MASSBANK and its subsidiaries: Readibank Properties, Inc.,
Readibank Investment Corporation and Melbank Investment Corporation. The Company has one reportable operating segment. All significant intercompany balances and
transactions have been eliminated in consolidation. The accounting and reporting policies of the
Company conform to U.S. generally accepted accounting principles and to general practices within
the banking industry. In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and liabilities at the
balance sheet date and income and expenses for the period. Material estimates that are particularly
susceptible to change in the near term relate to the determination of the allowance for loan
losses, the allowance for loan losses on off-balance sheet credit exposures and other than
temporary declines in value of investment securities requiring impairment write downs due to general market conditions or
other factors. Certain amounts in the prior years consolidated financial statements were reclassified to
facilitate comparison with the current fiscal year. Investments in Debt and Equity Securities Under its investment policy, management determines the appropriate classification of
securities at the time of purchase. Those debt securities that the Company has the intent and the
ability to hold to maturity are classified as securities held to maturity and are carried at
amortized historical cost. Those securities held for indefinite periods of time and not intended to be held to maturity
are classified as available for sale. Securities held for indefinite periods of time include
securities that management intends to use as part of its asset/liability management strategy and
that may be sold in response to changes in market conditions, interest rates, prepayment risk, the
need to increase regulatory capital and other factors. The Company records investment securities
available for sale at aggregate market value with the net unrealized holding gains or losses
reported, net of tax effect, as a separate component of stockholders equity until realized. As of
December 31, 2004, stockholders equity included approximately $1.8 million of accumulated other
comprehensive income, representing the net unrealized gains on securities available for sale, less
applicable income taxes. Securities that are bought and held principally for the purpose of sale in
the near term are classified as trading securities.Trading generally reflects active and frequent
buying and selling, and trading securities are generally used with the objective of generating
profits on short-term differences in price caused by market volatility. Investments classified as
trading securities are stated at market value with unrealized gains and losses included in
earnings. Income on debt securities is accrued and included in interest and dividend income. The
specific identification method is used to determine realized gains or losses on sales of securities
available for sale which are also reported in non-interest income under the caption gains on
securities available for sale, net. When a security suffers a loss in value which is considered
other than temporary, such loss is recognized by a charge to earnings. 37




---



##### 



1.

Summary
of Significant Accounting Policies(continued)  LoansLoans are reported at the principal amount outstanding, net of unearned fees. Loan
origination fees and related direct incremental loan origination costs are offset and the resulting
net amount is deferred and amortized over the life of the loan using the level-yield method.The Bank generally does not accrue interest on loans which are 90 days or more past due. When
a loan is placed on nonaccrual status, all interest previously accrued but not collected is
reversed from income and all amortization of deferred loan fees is discontinued. Interest received
on nonaccrual loans is either applied against principal or reported as income according to
managements judgment as to the collectibility of principal. Interest accruals are resumed on such
loans only when they are brought current with respect to interest and principal and when, in the
judgment of management, the loans are estimated to be fully collectible as to both principal and
interest.Impairment on loans for which it is probable that the creditor will be unable to collect all
amounts due according to the contractual terms of the loan agreement are measured on a discounted
cash flow method, or at the loans observable market price, or at the fair value of the collateral
if the loan is collateral dependent. However, impairment must be measured based on the fair value
of the collateral if it is determined that foreclosure is probable. Impaired loans consist of all
nonaccrual commercial loans.Allowance for Loan Losses and Allowance for Loan Losses on Off-Balance Sheet Credit ExposuresThe Company maintains an allowance for probable losses that are inherent in the Companys
loan portfolio. The allowance for loan losses is increased by provisions charged to operations
based on the estimated loan loss exposure inherent in the portfolio. Management uses a methodology
to systematically measure the amount of estimated loan loss exposure inherent in the portfolio for
purposes of establishing a sufficient allowance for loan losses. The methodology includes three
elements: an analysis of individual loans deemed to be impaired, general loss allocations for
various loan types based on loss experience factors and an unallocated allowance which is
maintained based on managements assessment of many factors including the risk characteristics of
the portfolio, concentrations of credit, current and anticipated economic conditions that may
affect borrowers ability to pay, and trends in loan delinquencies and charge-offs. Realized
losses, net of recoveries, are charged directly to the allowance. While management uses the
information available in establishing the allowance for loan losses, future adjustments to the
allowance may be necessary if economic conditions differ from the assumptions used in making the
evaluation. In addition, various regulatory agencies, as an integral part of their examination
process, periodically review the Banks allowance for loan losses. Such agencies may require the
Bank to recognize additions to the allowance based on judgments different from those of management.The Company also maintains an allowance for probable losses on its outstanding loan
commitments. The allowance for loan losses on off-balance sheet credit exposures (shown separately
on the balance sheet) is maintained based on expected drawdowns of committed loans and their loss
experience factors and managements assessment of various other factors including current and
anticipated economic conditions that may effect the borrowers ability to pay, and trends in loan
delinquencies and charge-offs. 38




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##### 



Premises
and Equipment Land is carried at cost. Premises, equipment and leasehold improvements are stated at cost,
less accumulated depreciation and amortization computed primarily by use of the straight-line
method over the estimated useful lives of the related assets or terms of the related leases. Impairment
of the long-lived Assets  Except Goodwill
The Company reviews long-lived assets for impairment at least annually or whenever events or
changes in business circumstances indicate that the remaining useful life may warrant revision or
that the carrying amount of the long-lived asset may not be fully recoverable. The Company performs
undiscounted cash flow analyses to determine if impairment exists. If impairment is determined to
exist, any related impairment loss is calculated based on the fair value. Impairment losses on
assets to be disposed of, if any, are based on the estimated proceeds to be received, less any cost
of disposal. Stock
Option Plan
The Company applies the intrinsic-value-based method to account for its fixed-plan stock
options. Under this method, compensation expense is recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price. Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, established
accounting and disclosure requirements using a fair-value-based method of accounting for
stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to
continue to apply the intrinsic-value-based method of accounting described above, and has adopted
only the disclosure requirements of SFAS No. 123, as amended, to require prominent disclosures in
both annual and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 123-Revised 2004 (SFAS 123(R)), Share-Based
Payment. This is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, and
supersedes APB No. 25, Accounting for Stock issued to Employees. Under SFAS 123(R), we will be
required to measure the cost of employee services received in exchange for stock based on the
grant-date fair value (with limited exceptions). That cost will be recognized over the period
during which an employee is required to provide service in exchange for the award (usually the
vesting period). The fair value will be estimated using an option-pricing model. Excess tax
benefits, as defined in SFAS 123(R), will be recognized as an addition to paid-in capital. This is
effective as of the beginning of the first interim or annual reporting period that begins after
June 15, 2005. We are currently in the process of evaluating the impact of SFAS 123(R) on our
consolidated financial statements, including different option-pricing models. The following pro
forma table illustrates the effect on net income and earnings per share if we had applied the fair
value recognition provisions of SFAS 123. 39




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##### 



1. Summary of Significant Accounting Policies (continued) (In
thousands except per share data) Years Ended December 31,
    
    2004
    
    
    2003
    
    
    2002Net income, as reported
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects
    
    
    (170
    )
    
    
    (74
    )
    
    
    (75
    )Pro forma net income
    
    $
    7,210
    
    
    $
    7,789
    
    
    $
    9,739Earnings per share:Basic  as reported
    
    $
    1.67
    
    
    $
    1.77
    
    
    $
    2.09Basic  pro forma
    
    
    1.64
    
    
    
    1.75
    
    
    
    2.07Diluted  as reported
    
    $
    1.64
    
    
    $
    1.73
    
    
    $
    2.04Diluted  pro forma
    
    
    1.60
    
    
    
    1.71
    
    
    
    2.02Weighted average fair value
    
    $
    9.55
    
    
    $
    5.44
    
    
    $
    5.76Expected life
    
    7.3 years
    
    7.3 years
    
    7.2 yearsRisk-free interest rate
    
    
    3.49
    %
    
    
    3.55
    %
    
    
    4.62
    %Expected volatility
    
    
    21.9
    %
    
    
    21.8
    %
    
    
    21.3
    %Expected dividend yield
    
    
    2.3
    %
    
    
    3.2
    %
    
    
    3.3
    %
 Goodwill Impairment
The Company adopted SFAS No. 142, Goodwill and Other Intangibles, effective January 1, 2002.
The statement addresses the method of identifying and measuring goodwill and other intangible
assets acquired in a business combination, eliminates further amortization of goodwill, and
requires periodic impairment evaluations of goodwill. Impairment evaluations are required to be
performed annually and may be required more frequently if certain conditions indicating potential
impairment exists. In the event that the Company were to determine that its goodwill were impaired,
the recognition of an impairment charge could have an adverse impact on its results of operations
in the period that the impairment occurred or on its financial position. Pension Plan
The Bank accounts for pension benefits on the net periodic pension cost method for financial
reporting purposes. This method recognizes the compensation cost of an employees pension benefit
over that employees approximate service period. Pension costs are funded in the year of accrual
using the aggregate cost method. Earnings Per Common Share
Basic EPS is computed by dividing net income by the weighted average number of shares of
common stock outstanding during the year reduced by the weighted average number of unallocated
shares held by the Employee Stock Ownership Plan (ESOP). There were no unallocated shares held by
the ESOP in 2004 and 2003. Diluted EPS reflects the effect on the weighted average shares
outstanding of the number of additional shares outstanding if dilutive stock options were converted
into common stock using the treasury stock method. The treasury shares acquired in connection with the Companys directors deferred compensation
plan are considered outstanding in the computation of earnings per share and book value per share. A reconciliation of the weighted average shares outstanding for the years ended December 31,
2004, 2003 and 2002 follows: (In
thousands) Years Ended December 31,
    
    2004
    
    
    2003
    
    
    2002Basic shares(1)
    
    
    4,408
    
    
    
    4,439
    
    
    
    4,698Dilutive impact of stock options(1)
    
    
    94
    
    
    
    106
    
    
    
    125Diluted shares(1)
    
    
    4,502
    
    
    
    4,545
    
    
    
    4,823
   (1) All share information presented has been adjusted to reflect the 3-for-2 split
of the Companys common stock effective April 19,
2002.
 40




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##### 



1.
    Summary of
Significant Accounting Policies (continued)  Comprehensive
IncomeAccounting principles generally require that recognized revenue, expenses, gains and losses
be included in net income. Although certain changes in assets and liabilities, such as unrealized
gains and losses on available-for-sale securities, are reported as a separate component of the
equity section of the balance sheet, such items, along with net income, are components of
comprehensive income. The components of other comprehensive income and related tax effects at December 31 are as
follows: (In
thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Unrealized holding gains (losses) on available-for-sale
securities
and when issued securities contracts arising during period
    
    $
    (2,242
    )
    
    $
    (5,298
    )
    
    $
    3,429Less: reclassification adjustment for gains realized in income
    
    
    1,361
    
    
    
    558
    
    
    
    1,566Net unrealized gains (losses)
    
    
    (3,603
    )
    
    
    (5,856
    )
    
    
    1,863Tax (expense) or benefit
    
    
    1,399
    
    
    
    2,125
    
    
    
    (614
    )Other comprehensive income (loss)
    
    $
    (2,204
    )
    
    $
    (3,731
    )
    
    $
    1,249
 Cash
and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents consist of cash and due from
banks, and short-term investments with original maturities of less than 90 days. As a regulated financial institution, the Bank is required to maintain certain reserve
requirements of vault cash and/or deposits with the Federal Reserve Bank of Boston. The amount of
this reserve requirement, included in Cash and Due from Banks, was $6.2 million and $5.6 million
at December 31, 2004 and 2003, respectively. Income
Taxes
The Bank recognizes income taxes under the asset and liability method. Under this method,
deferred tax assets and liabilities are established for the temporary differences between the
accounting basis and the tax basis of the Banks assets and liabilities at enacted tax rates
expected to be in effect when the amounts related to such temporary differences are realized or
settled. The Banks deferred tax asset is reviewed and adjustments to such asset are recognized as
deferred income tax expense or benefit based upon managements judgment relating to the
realizability of such asset. Based on the Banks historical and current pre-tax earnings,
management believes it is more likely than not that the Bank will realize its existing gross
deferred tax asset.  2.Short-Term
Investments  Short-term investments consist of the following: (In
thousands) At December 31,
    
    2004
    
    
    2003Federal funds sold
    
    $
    193,728
    
    
    $
    190,684Money market investment fund
    
    
    302
    
    
    
    23,337Interest-bearing bank money market accounts
    
    
    220
    
    
    
    511Total short-term investments
    
    $
    194,250
    
    
    $
    214,532
 The investments above are stated at cost which approximates market value. 41




---



##### 



3. Investment Securities  The amortized cost and market value of investment securities follows: Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    Market(In thousands)At December 31, 2004
    
    Cost
    
    
    Gains
    
    
    Losses
    
    
    ValueSecurities held to maturity:Mortgage-backed securities:Federal National Mortgage Association
    
    $
    4,877
    
    
    $
    6
    
    
    $
    
    
    
    $
    4,883Total
    
    $
    4,877
    
    
    $
    6
    
    
    $
    
    
    
    $
    4,883Securities available for sale:Debt securities:U.S. Treasury obligations
    
    $
    125,491
    
    
    $
    126
    
    
    $
    (520
    )
    
    $
    125,097U.S. Government agency obligations
    
    
    190,032
    
    
    
    81
    
    
    
    (1,594
    )
    
    
    188,519Total
    
    
    315,523
    
    
    
    207
    
    
    
    (2,114
    )
    
    
    313,616Mortgage-backed securities:Government National Mortgage Association
    
    
    5,622
    
    
    
    297
    
    
    
    
    
    
    
    5,919Federal Home Loan Mortgage Corporation
    
    
    112,929
    
    
    
    3,694
    
    
    
    (66
    )
    
    
    116,557Federal National Mortgage Association
    
    
    94
    
    
    
    4
    
    
    
    
    
    
    
    98Collateralized mortgage obligations
    
    
    133
    
    
    
    2
    
    
    
    
    
    
    
    135Total mortgage-backed securities
    
    
    118,778
    
    
    
    3,997
    
    
    
    (66
    )
    
    
    122,709Total debt securities
    
    
    434,301
    
    
    
    4,204
    
    
    
    (2,180
    )
    
    
    436,325Equity securities
    
    
    6,534
    
    
    
    933
    
    
    
    (39
    )
    
    
    7,428Total securities available for sale
    
    
    440,835
    
    
    $
    5,137
    
    
    $
    (2,219
    )
    
    $
    443,753Net unrealized gains on securities
available for sale
    
    
    2,918Total securities available for sale, net
    
    
    443,753Total investment securities, net
    
    $
    448,630The amortized cost and market value of investment securities follows:
 Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    Market(In thousands) At December 31, 2003
    
    Cost
    
    
    Gains
    
    
    Losses
    
    
    ValueSecurities available for sale:Debt securities:U.S. Treasury obligations
    
    $
    122,902
    
    
    $
    900
    
    
    $
    (160
    )
    
    $
    123,642U.S. Government agency obligations
    
    
    199,057
    
    
    
    531
    
    
    
    (1,125
    )
    
    
    198,463Total
    
    
    321,959
    
    
    
    1,431
    
    
    
    (1,285
    )
    
    
    322,105Mortgage-backed securities:Government National Mortgage Association
    
    
    9,002
    
    
    
    617
    
    
    
    
    
    
    
    9,619Federal Home Loan Mortgage Corporation
    
    
    80,957
    
    
    
    4,669
    
    
    
    
    
    
    
    85,626Federal National Mortgage Association
    
    
    198
    
    
    
    8
    
    
    
    
    
    
    
    206Collateralized mortgage obligations
    
    
    204
    
    
    
    3
    
    
    
    
    
    
    
    207Total mortgage-backed securities
    
    
    90,361
    
    
    
    5,297
    
    
    
    
    
    
    
    95,658Total debt securities
    
    
    412,320
    
    
    
    6,728
    
    
    
    (1,285
    )
    
    
    417,763Equity securities
    
    
    10,555
    
    
    
    1,177
    
    
    
    (266
    )
    
    
    11,466Total securities available for sale
    
    
    422,875
    
    
    $
    7,905
    
    
    $
    (1,551
    )
    
    $
    429,229Net unrealized gains on securities
available for sale
    
    
    6,354Total securities available for sale, net
    
    
    429,229Total investment securities, net
    
    $
    429,229
 42




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##### 



3.Investment
Securities (continued)  During the years ended December 31, 2004, 2003 and 2002, the Company realized gains
and losses on sales and recorded other-than-temporary impairment writedowns of securities
available for sale as follows: (In
thousands) At December 31,
    
    2004
    
    
    2003
    
    
    2002Realized
    
    
    Realized
    
    
    RealizedGains
    
    
    Losses
    
    
    Gains
    
    
    Losses
    
    
    Gains
    
    
    LossesSales:U.S. Treasury obligations
    
    $
    35
    
    
    $
    (68
    )
    
    $
    309
    
    
    $
    
    
    
    $
    363
    
    
    $
    Marketable equity securities
    
    
    1,720
    
    
    
    (326
    )
    
    
    1,303
    
    
    
    (1,045
    )
    
    
    4,721
    
    
    
    (3,451
    )Other-than-temporary impairment writedowns:Marketable equity securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9
    )
    
    
    
    
    
    
    (67
    )Total realized gains (losses)
    
    $
    1,755
    
    
    $
    (394
    )
    
    $
    1,612
    
    
    $
    (1,054
    )
    
    $
    5,084
    
    
    $
    (3,518
    )
 Proceeds from sales of debt securities available for sale during 2004, 2003 and 2002 were $18.3
million, $26.0 million and $35.0 million, respectively. Proceeds from sales of equity securities
available for sale during 2004, 2003 and 2002, were $10.6 million, $11.4 million and $14.6 million, respectively. There were no sales of investment securities held-to-maturity during 2004, 2003 and 2002. The amortized cost and market value of debt securities available for sale by contractual maturity are as follows: (In
thousands) At December 31,
    
    2004
    
    
    2003Amortized
    
    
    Market
    
    
    Amortized
    
    
    MarketCost
    
    
    Value
    
    
    Cost
    
    
    ValueInvestment securities available for sale:U.S. Treasury obligations:Maturing within 1 year
    
    $
    77,895
    
    
    $
    77,794
    
    
    $
    53,281
    
    
    $
    53,583Maturing after 1 year but within 5 years
    
    
    45,633
    
    
    
    45,306
    
    
    
    62,449
    
    
    
    62,891Maturing after 5 years but within 10 years
    
    
    1,963
    
    
    
    1,997
    
    
    
    7,172
    
    
    
    7,168Total
    
    
    125,491
    
    
    
    125,097
    
    
    
    122,902
    
    
    
    123,642U.S. Government agency obligations:Maturing within 1 year
    
    
    10,010
    
    
    
    9,954
    
    
    
    
    
    
    
    Maturing after 1 year but within 5 years
    
    
    155,987
    
    
    
    154,607
    
    
    
    175,015
    
    
    
    174,691Maturing after 5 years but within 10 years
    
    
    23,995
    
    
    
    23,918
    
    
    
    22,000
    
    
    
    21,708Maturing after 10 years but within 15 years
    
    
    40
    
    
    
    40
    
    
    
    2,042
    
    
    
    2,064Total
    
    
    190,032
    
    
    
    188,519
    
    
    
    199,057
    
    
    
    198,463Mortgage-backed securities:Maturing within 1 year
    
    
    7
    
    
    
    7
    
    
    
    40
    
    
    
    41Maturing after 1 year but within 5 years
    
    
    7,988
    
    
    
    8,408
    
    
    
    5,160
    
    
    
    5,481Maturing after 5 years but within 10 years
    
    
    28,829
    
    
    
    30,595
    
    
    
    34,065
    
    
    
    36,328Maturing after 10 years but within 15 years
    
    
    81,755
    
    
    
    83,495
    
    
    
    50,825
    
    
    
    53,531Maturing after 15 years
    
    
    199
    
    
    
    204
    
    
    
    271
    
    
    
    277Total
    
    
    118,778
    
    
    
    122,709
    
    
    
    90,361
    
    
    
    95,658Total debt securities available for sale
    
    
    434,301
    
    
    
    436,325
    
    
    
    412,320
    
    
    
    417,763Net unrealized gains on debt securities
available for sale
    
    
    2,024
    
    
    
    
    
    
    
    5,443
    
    
    
    Total debt securities available for sale,
net carrying value
    
    $
    436,325
    
    
    $
    436,325
    
    
    $
    417,763
    
    
    $
    417,763
 Maturities of mortgage-backed securities are shown at final contractual maturity but are expected
to have shorter lives because borrowers have the right to prepay obligations without prepayment
penalties. Included in U.S. Government agency obligations are investments that can be called prior to
final maturity with an amortized cost of $160.0 million and a market value of $158.8 million at
December 31, 2004 and an amortized cost of $193.0 million and a market value of $192.4 million at
December 31, 2003. 43




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##### 



3.
    Investment
Securities (continued)  The fair value and unrealized losses of temporarily impaired investments aggregated
by category of investments is as follows: (In
thousands) At December 31, 2004
    
    Less than 12 months
    
    
    12 months or longer
    
    
    TotalUnrealized
    
    
    
    
    
    
    Unrealized
    
    
    
    
    
    
    UnrealizedDescription of Securities
    
    Fair value
    
    
    Losses
    
    
    Fair Value
    
    
    Losses
    
    
    Fair Value
    
    
    LossesDebt securities:U.S. Treasury obligations
    
    $
    81,077
    
    
    $
    (520
    )
    
    $
    
    
    
    $
    
    
    
    $
    81,077
    
    
    $
    (520
    )U.S. Government agency obligations
    
    
    116,846
    
    
    
    (1,152
    )
    
    
    21,557
    
    
    
    (442
    )
    
    
    138,403
    
    
    
    (1,594
    )Mortgage-backed securities
    
    
    7,619
    
    
    
    (66
    )
    
    
    
    
    
    
    
    
    
    
    7,619
    
    
    
    (66
    )Total debt securities
    
    
    205,542
    
    
    
    (1,738
    )
    
    
    21,557
    
    
    
    (442
    )
    
    
    227,099
    
    
    
    (2,180
    )Equity securities
    
    
    594
    
    
    
    (39
    )
    
    
    
    
    
    
    
    
    
    
    594
    
    
    
    (39
    )Total temporarily impaired securities
    
    $
    206,136
    
    
    $
    (1,777
    )
    
    $
    21,557
    
    
    $
    (442
    )
    
    $
    227,693
    
    
    $
    (2,219
    )
 At December 31, 2004 the Company had U.S. Treasury and Government agency securities,
mortgage-backed securities and equity securities investment positions that had been in a loss
position for less than twelve months that it considered temporarily impaired. This is due to the
volatility of market interest rates and the price volatility of equity securities. U.S. Treasury
and Government agency securities, and mortgage-backed securities fluctuate in value based on
changes in market interest rates and other factors, however, they can be redeemed at par or face
value if held to maturity and therefore if their maturity date is less than one year into the
future regardless of their market value they are considered only temporarily impaired. At December 31, 2004 the Company had four U.S. Government agency securities that had been in a
continuous unrealized loss position for twelve or more months that it considered temporarily
impaired. The total unrealized losses on these four securities were $169 thousand, $109 thousand,
$98 thousand and $66 thousand, respectively, representing a 1.7%, 1.8%, 2.5% and 3.3% loss in
value, respectively. Management considers industry analyst reports, sector credit ratings, volatility in market
price and other relevant information, such as the financial condition, earnings capacity and near
term prospects of the company, in determining whether an equity securitys impairment is due to a
fundamental deterioration in its financial condition or due to general market conditions. If the
impairment is due to a fundamental deterioration in its financial condition as determined by the
Companys analysis, it is written down to its current fair market value and the loss is
recognized. If the impairment is due to general market conditions and the equity or debt security
declines in price from its cost basis by more than 25% for more than a year, between 30% and 40%
for more than nine months, between 40% and 50% for more than six months or over 50% for more than
ninety days, and in each case the value of the investment security has been below its cost basis
for the entire period in question, then the security is considered other than temporarily
impaired and it is written down to its current fair market value and the loss is recognized. The fair value and unrealized losses of temporarily impaired investments aggregated by category of
investments is as follows: (In
thousands) At December 31, 2003
    
    Less than 12 months
    
    
    12 months or longer
    
    
    TotalUnrealized
    
    
    
    
    
    
    Unrealized
    
    
    
    
    
    
    UnrealizedDescription of Securities
    
    Fair value
    
    
    Losses
    
    
    Fair Value
    
    
    Losses
    
    
    Fair Value
    
    
    LossesDebt securities:U.S. Treasury obligations
    
    $
    30,350
    
    
    $
    (160
    )
    
    $
    
    
    
    $
    
    
    
    $
    30,350
    
    
    $
    (160
    )U.S. Government agency obligations
    
    
    98,867
    
    
    
    (1,125
    )
    
    
    
    
    
    
    
    
    
    
    98,867
    
    
    
    (1,125
    )Total debt securities
    
    
    129,217
    
    
    
    (1,285
    )
    
    
    
    
    
    
    
    
    
    
    129,217
    
    
    
    (1,285
    )Equity securities
    
    
    1,436
    
    
    
    (164
    )
    
    
    2,622
    
    
    
    (102
    )
    
    
    4,058
    
    
    
    (266
    )Total temporarily impaired securities
    
    $
    130,653
    
    
    $
    (1,449
    )
    
    $
    2,622
    
    
    $
    (102
    )
    
    $
    133,275
    
    
    $
    (1,551
    )
 At December 31, 2003 the Company had thirty-one U.S. Treasury and Government agency securities and
eight equity securities investment positions that had been in a loss position for less than twelve
months that it considered temporarily impaired. This is due to the volatility of market interest
rates and the price volatility of equity securities. U.S. Treasury and Government agency securities
fluctuate in value based on changes in market interest rates and other factors, however, they can
be redeemed at par value if held to maturity and therefore if their maturity date is less than one
year into the future regardless of their market value they are considered only temporarily
impaired. At December 31, 2003 the Company had three equity investment positions that had been in a
continuous unrealized loss position for twelve or more months that it considered temporarily
impaired. The total unrealized losses on these three securities were $77 thousand, $22 thousand and
$3 thousand, respectively, representing a 4.2%, 3.8% and 0.9% loss in value, respectively. 44




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##### 



3.
    Investment
Securities (continued)  The amortized cost and market value of U.S. Government agency securities available
for sale that can be called prior to maturity by scheduled maturity and next call date are
as follows: (In
thousands) At December 31,
    

2004
    
    

2003Amortized
    
    
    Market
    
    
    Amortized
    
    
    MarketBased on Scheduled Maturity
    
    Cost
    
    
    Value
    
    
    Cost
    
    
    ValueInvestment securities available for saleU.S. Government agency obligations:Maturing within 1 year
    
    $
    4,000
    
    
    $
    3,969
    
    
    $
    
    
    
    $
    Maturing after 1 but within 2 years
    
    
    28,998
    
    
    
    28,682
    
    
    
    13,000
    
    
    
    13,011Maturing after 2 but within 3 years
    
    
    40,000
    
    
    
    39,697
    
    
    
    43,998
    
    
    
    44,048Maturing after 3 but within 4 years
    
    
    40,000
    
    
    
    39,666
    
    
    
    42,000
    
    
    
    41,990Maturing after 4 but within 5 years
    
    
    23,000
    
    
    
    22,909
    
    
    
    69,992
    
    
    
    69,636Maturing after 5 but within 10 years
    
    
    23,995
    
    
    
    23,918
    
    
    
    22,000
    
    
    
    21,708Maturing after 10 but within 15 years
    
    
    
    
    
    
    
    
    
    
    2,000
    
    
    
    2,021Total
    
    $
    159,993
    
    
    $
    158,841
    
    
    $
    192,990
    
    
    $
    192,414
 Amortized
    
    
    Market
    
    
    Amortized
    
    
    MarketBased on Next Call Date
    
    Cost
    
    
    Value
    
    
    Cost
    
    
    ValueInvestment securities available for saleU.S. Government agency obligations:Callable within 1 year
    
    $
    151,993
    
    
    $
    150,857
    
    
    $
    178,990
    
    
    $
    178,287Callable after 1 but within 2 years
    
    
    8,000
    
    
    
    7,984
    
    
    
    10,000
    
    
    
    10,124Callable after 2 but within 3 years
    
    
    
    
    
    
    
    
    
    
    4,000
    
    
    
    4,003Total
    
    $
    159,993
    
    
    $
    158,841
    
    
    $
    192,990
    
    
    $
    192,414
  4.
    Trading Securities  The carrying amount and market value of trading securities are as follows: (In
thousands) At December 31,
    
    2004
    
    
    2003Market
    
    
    MarketValue
    
    
    ValueU.S. Treasury obligations
    
    $
    57,878
    
    
    $
    72,408Marketable equity securities
    
    
    1,131
    
    
    
    222Investments in mutual funds
    
    
    4
    
    
    
    3Total trading securities
    
    $
    59,013
    
    
    $
    72,633
 During the years ended December 31, 2004, 2003 and 2002, the Company realized gains and losses on
sales of trading securities as follows: (in
thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Realized
    
    
    Realized
    
    
    RealizedGains
    
    
    Losses
    
    
    Gains
    
    
    Losses
    
    
    Gains
    
    
    LossesU.S. Treasury obligations
    
    $
    101
    
    
    $
    (40
    )
    
    $
    145
    
    
    $
    (262
    )
    
    $
    77
    
    
    $
    (50
    )Marketable equity securities
    
    
    72
    
    
    
    (19
    )
    
    
    88
    
    
    
    
    
    
    
    30
    
    
    
    Total realized gains (losses)
    
    $
    173
    
    
    $
    (59
    )
    
    $
    233
    
    
    $
    (262
    )
    
    $
    107
    
    
    $
    (50

    )
 Proceeds from sales of trading securities during 2004, 2003 and 2002 were $46.4 million, $72.9
million and $49.5 million, respectively. Mark-to-market adjustments included in income in 2004,
2003 and 2002 were $(246) thousand, $110 thousand and $95 thousand, respectively. 45




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##### 



5.
    Loans  The Banks lending activities are conducted principally in the local communities in
which it operates banking offices, and to a lesser extent, in selected areas of
Massachusetts and southern New Hampshire. The Bank offers single family and multi-family residential mortgage loans and a variety of
consumer loans. The Bank also offers mortgage loans secured by commercial or investment property
such as apartment buildings and commercial or corporate facilities; loans for the construction of
residential homes, multi-family properties and for land development; and business loans for other
commercial purposes. Most loans granted by the Bank are either collateralized by real estate or
guaranteed by federal or local governmental authorities. The ability of single family residential
and consumer borrowers to honor their repayment commitments is generally dependent on the level of
overall economic activity within the borrowers geographic areas. The ability of commercial real
estate and commercial loan borrowers to honor their repayment commitments is generally dependent on
the economic health of the real estate sector in the borrowers geographic areas and the overall
economy.
The composition of the Banks loan portfolio is summarized as follows: (In
thousands) At December 31,
    
    2004
    
    
    2003Mortgage loans:Residential:Conventional:Fixed rate
    
    $
    203,010
    
    
    $
    217,487Variable rate
    
    
    21,532
    
    
    
    22,956FHA and VA
    
    
    45
    
    
    
    84Commercial
    
    
    1,623
    
    
    
    1,601Construction
    
    
    84
    
    
    
    81Total mortgage loans
    
    
    226,294
    
    
    
    242,209Premium on loans
    
    
    5
    
    
    
    10Deferred mortgage loan origination fees
    
    
    (102
    )
    
    
    (333
    )Mortgage loans, net
    
    
    226,197
    
    
    
    241,886Other loans:Consumer:Installment
    
    
    327
    
    
    
    415Guaranteed education
    
    
    1,616
    
    
    
    2,333Other secured
    
    
    504
    
    
    
    518Home equity lines of credit
    
    
    7,284
    
    
    
    7,549Unsecured
    
    
    161
    
    
    
    166Total consumer loans
    
    
    9,892
    
    
    
    10,981Commercial
    
    
    109
    
    
    
    139Total other loans
    
    
    10,001
    
    
    
    11,120Total loans $
    
    $
    236,198
    
    
    $
    253,006
 In the ordinary course of business, the Bank makes loans to its directors, officers and their
associates and affiliated companies (related parties) at substantially the same terms as those
prevailing at the time of origination for comparable transactions with unrelated borrowers. An
analysis of total related party loans for the year ended December 31, 2004 follows: (In thousands)Balance at December 31, 2003
    
    $
    1,586Additions
    
    
    1,091Repayments
    
    
    (902
    )1,2Balance at December 31, 2004
    
    $
    1,775
 46




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##### 



6.Allowance for Loan Losses  An analysis of the activity in the allowance for loan losses is as follows: (In
thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Balance at beginning of year
    
    $
    1,554
    
    
    $
    2,271
    
    
    $
    2,494Provision (credit) for loan losses
    
    
    (242
    )
    
    
    (502
    )
    
    
    Transfer to allowance for loan losses on
off-balance sheet credit exposures
    
    
    
    
    
    
    (226
    )
    
    
    (235
    )Recoveries of loans previously charged-off
    
    
    
    
    
    
    15
    
    
    
    16Total
    
    
    1,312
    
    
    
    1,558
    
    
    
    2,275Charge-offs:Mortgage loans
    
    
    
    
    
    
    
    
    
    
    Other loans
    
    
    (5
    )
    
    
    (4
    )
    
    
    (4
    )Balance at end of year
    
    $
    1,307
    
    
    $
    1,554
    
    
    $
    2,271
 The following table shows the allocation of the allowance for
loan losses by category of loans at December 31, 2004, 2003
and 2002. (In
thousands) At December 31,
    
    2004
    
    
    2003
    
    
    2002Percentage
    
    
    
    
    
    
    Percentage
    
    
    
    
    
    
    Percentageof Loans
    
    
    
    
    
    
    of Loans
    
    
    
    
    
    
    of LoansAmount
    
    
    to Total
    
    
    Amount
    
    
    to Total
    
    
    Amount
    
    
    to TotalMortgage loans:Residential
    
    $
    767
    
    
    
    95
    %
    
    $
    934
    
    
    
    95
    %
    
    $
    1,309
    
    
    
    94
    %Commercial
    
    
    79
    
    
    
    1
    
    
    
    76
    
    
    
    1
    
    
    
    9
    
    
    
    1Consumer loans
    
    
    154
    
    
    
    4
    
    
    
    185
    
    
    
    4
    
    
    
    198
    
    
    
    5Commercial loans
    
    
    46
    
    
    
    
    
    
    
    48
    
    
    
    
    
    
    
    69
    
    
    
    Unallocated
    
    
    261
    
    
    
    
    
    
    
    311
    
    
    
    
    
    
    
    686
    
    
    
    Total
    
    $
    1,307
    
    
    
    100
    %
    
    $
    1,554
    
    
    
    100
    %
    
    $
    2,271
    
    
    
    100
    %
 An integral component of the Companys risk management process is to ensure the proper allocation
of the allowance for loan losses based upon an analysis of risk characteristics, demonstrated
losses and other factors. The unallocated component of the allowance for loan losses represents
managements view that there are probable losses that have been incurred within the portfolio but
have not yet been specifically identified. The unallocated portion of the allowance for loan losses
is based on managements assessment of many factors including the risk characteristics of the loan
portfolio, concentrations of credit, current and anticipated economic conditions that may affect
borrowers ability to pay, and trends in loan delinquencies and charge-offs. The unallocated
portion of the allowance for loan losses may change periodically after evaluating factors impacting
assumptions utilized in the calculation of the allocated portion of the allowance for loan losses.
In addition, various regulatory agencies, as an integral part of their examination process,
periodically review the Banks allowance for loan losses. Such agencies may require the Bank to
recognize additions to the allowance based on judgments different from those of management.  7.
    Non-performing
Assets The following schedule summarizes
non-performing assets at the dates shown: (In
thousands) At December 31,
    
    2004
    
    
    2003
    
    
    2002Total nonaccrual loans
    
    $
    74
    
    
    $
    230
    
    
    $
    420Total non-performing assets
    
    $
    74
    
    
    $
    230
    
    
    $
    420Percent of non-performing loans to total loans
    
    
    0.03
    %
    
    
    0.09
    %
    
    
    0.13
    %Percent of non-performing assets to total assets
    
    
    0.01
    %
    
    
    0.02
    %
    
    
    0.04
    %
 47




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##### 



7.Non-performing
Assets  (continued)  The reduction in interest income associated with nonaccrual loans is as follows: (In
thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Interest income that would have been recorded under original terms
    
    $
    4
    
    
    $
    17
    
    
    $
    31Interest income actually recorded
    
    
    1
    
    
    
    20
    
    
    
    27Reduction (increase) in interest income
    
    $
    3
    
    
    $
    (3
    )
    
    $
    4During 2004, 2003 and 2002 the Company had no impaired loans.
  8.Financial Instruments with Off-Balance Sheet Risk  The Bank is party to financial instruments with off-balance sheet risk in the normal
course of business to meet the financing needs of its customers and to reduce its own
exposure to fluctuations in interest rates. These financial instruments include commitments
to extend credit and involve, to varying degrees, elements of credit risk in excess of the
amount recognized in the consolidated balance sheet. The contract or notional amounts
reflect the extent of involvement the Bank has in particular classes of these instruments.
The Banks exposure to credit loss in the event of nonperformance by the other party to the
financial instrument is represented by the contractual or notional amount of those
instruments. The Bank uses the same credit policies in making commitments and conditional
obligations as it does for on-balance sheet instruments. Contract
or Notional Amount(In
thousands) At December 31,
    
    2004
    
    
    2003Financial instruments whose contract amounts represent credit risk:Commitments to originate residential mortgage loans
    
    $
    3,811
    
    
    $
    3,300Unadvanced portions of construction loans
    
    
    89
    
    
    
    479Unused credit lines, including unused portions of equity lines of credit
    
    
    33,909
    
    
    
    37,410Other loan commitments
    
    
    4,026
    
    
    
    3,996
 Commitments to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a fee by the
customer. Since many of the commitments are expected to expire without being drawn upon,
the total commitment amounts do not necessarily represent future cash requirements. The
Bank evaluates each customers credit-worthiness on a case-by-case basis. The amount of
collateral obtained, if any, is based on managements credit evaluation of the borrower.  9.
    Premises and Equipment  A summary of premises and equipment and their estimated useful lives used for
depreciation purposes is as follows: EstimatedUseful Life(In
thousands) At December 31,
    
    2004
    
    
    2003
    
    
    (In Years)Premises:Land
    
    $
    2,392
    
    
    $
    2,392
    
    
    
    Buildings
    
    
    6,003
    
    
    
    5,917
    
    
    
    25-45Building and leasehold improvements
    
    
    2,527
    
    
    
    2,487
    
    
    
    2-30Equipment
    
    
    5,139
    
    
    
    5,069
    
    
    
    2-1516,061
    
    
    
    15,865Less: accumulated depreciation and amortization
    
    
    9,597
    
    
    
    8,922Total premises and equipment, net
    
    $
    6,464
    
    
    $
    6,943
 The Bank is obligated under a number of noncancelable operating leases for various banking offices.
These operating leases expire at various dates through 2014 with options for renewal. Rental
expenses for the years ended December 31, 2004, 2003 and 2002 amounted to $294 thousand, $274
thousand, and $277 thousand, respectively. 48




---



##### 



9.
    Premises and Equipment(continued)The minimum rental commitments, with initial or remaining terms of one year or more
exclusive of operating costs and real estate taxes to be paid by the Bank under these leases, as of
December 31, 2004, are as follows: (In thousands) Years ending December 31,
    
    Payments2005
    
    $
    2962006
    
    
    2452007
    
    
    2182008
    
    
    2192009
    
    
    142Later years
    
    
    331Total
    
    $
    1,451
  10.
    DepositsDeposits are summarized as follows: (In thousands) At December 31,
    
    2004
    
    
    2003Amount
    
    
    Rate
    
    
    Amount
    
    
    RateDemand and NOW:NOW accounts
    
    $
    58,991
    
    
    
    0.33
    %
    
    $
    56,108
    
    
    
    0.37
    %Demand accounts
    
    
    28,662
    
    
    
    
    
    
    
    28,948
    
    
    
    Total demand and NOW
    
    
    87,653
    
    
    
    0.22
    
    
    
    85,056
    
    
    
    0.24Savings:Savings accounts
    
    
    549,657
    
    
    
    1.52
    
    
    
    595,575
    
    
    
    1.64Money market accounts
    
    
    11,656
    
    
    
    0.97
    
    
    
    12,256
    
    
    
    0.45Total savings
    
    
    561,313
    
    
    
    1.51
    
    
    
    607,831
    
    
    
    1.62Time certificates of deposit:Fixed rate certificates
    
    
    145,249
    
    
    
    2.29
    
    
    
    129,210
    
    
    
    2.00Variable rate certificates
    
    
    55,250
    
    
    
    3.06
    
    
    
    60,411
    
    
    
    1.68Total time certificates of deposit
    
    
    200,499
    
    
    
    2.51
    
    
    
    189,621
    
    
    
    1.89Total deposits
    
    $
    849,465
    
    
    
    1.61
    %
    
    $
    882,508
    
    
    
    1.55
    %
  The maturity distribution and related rate structure of the Banks time certificates of deposit at December 31, 2004 follows: (In thousands) At December 31,
    
    2004AverageAmount
    
    
    Interest RateDue within 3 months
    
    $
    35,287
    
    
    
    2.18
    %Due within
36 months
    
    
    30,324
    
    
    
    2.01Due within 612 months
    
    
    38,847
    
    
    
    2.27Due within 12 years
    
    
    59,431
    
    
    
    2.72Due within 23 years
    
    
    26,133
    
    
    
    3.05Due within 35 years
    
    
    9,575
    
    
    
    3.35Thereafter
    
    
    902
    
    
    
    3.61Total
    
    $
    200,499
    
    
    
    2.51
    %
 49




---



##### 



10.
    Deposits (continued)At December 31, 2004 and 2003, the Bank had individual time certificates of deposit of $100 thousand or more maturing
as follows: (In thousands) At December 31,
    
    2004
    
    
    2003Due within 3 months
    
    $
    8,662
    
    
    $
    4,605Due within
36 months
    
    
    7,380
    
    
    
    5,442Due within 612 months
    
    
    10,010
    
    
    
    13,792Due within 12 years
    
    
    17,219
    
    
    
    10,374Due within 23 years
    
    
    9,538
    
    
    
    5,221Due within 35 years
    
    
    3,589
    
    
    
    3,198Thereafter
    
    
    302
    
    
    
    1,279Total
    
    $
    56,700
    
    
    $
    43,911
  11.
    Fair Value of Financial InstrumentsThe Bank is required to disclose estimated fair values for its financial instruments.
Fair value estimates, methods, and assumptions are set forth below for the Banks financial instruments.Cash and Due from Banks, Short-Term Investments and Accrued Interest ReceivableThe carrying amounts for these financial instruments approximate fair value because of
the short-term nature of these financial instruments.Interest-Bearing Deposits in BanksThe carrying amounts of the interest-bearing deposits in banks reported in the balance
sheet at December 31, 2004 and 2003 approximate fair value.SecuritiesThe fair value of investment securities is based principally on quoted market prices
and dealer quotes.Statement 107 specifies that fair values should be calculated based on the value of one unit
without regard to any premium or discount that may result from concentrations of ownership of a financial
instrument, possible tax ramifications, or estimated transaction costs.The carrying amount and estimated fair values of the Companys investment securities are as
follows: (In thousands) At December 31,
    
    2004
    
    
    2003Carrying
    
    
    Calculated
    
    
    Carrying
    
    
    CalculatedAmount
    
    
    Fair Value
    
    
    Amount
    
    
    Fair ValueSecurities available for sale
    
    $
    443,753
    
    
    $
    443,753
    
    
    $
    429,229
    
    
    $
    429,229Securities held to maturity
    
    
    4,877
    
    
    
    4,883
    
    
    
    
    
    
    
    Trading securities
    
    
    59,013
    
    
    
    59,013
    
    
    
    72,633
    
    
    
    72,633Total securities
    
    $
    507,643
    
    
    $
    507,649
    
    
    $
    501,862
    
    
    $
    501,862
  LoansFair values are estimated for portfolios of loans with similar financial characteristics.
Loans are segregated by type such as residential mortgage, commercial real estate, consumer and
commercial.The fair values of residential and commercial real estate, and certain consumer loans are
calculated by discounting scheduled cash flows through the estimated maturity using estimated
market discount rates that reflect the credit and interest rate risk inherent in the loan. The
estimate of maturity is based on the Banks historical experience with repayments for each loan
classification, modified, as required, by an estimate of the effect of current economic and lending
conditions. For variable rate commercial loans and certain variable rate consumer loans, including
home equity lines of credit, carrying value approximates fair value. Assumptions regarding credit
risk, cash flows, and discount rates are judgmentally determined using available market
information. 50




---



##### 



11.
    Fair Value of Financial Instruments (continued)The following table presents information for loans: (In thousands) At December 31,
    
    2004
    
    
    2003Carrying
    
    
    Calculated
    
    
    Carrying
    
    
    CalculatedAmount
    
    
    Fair Value
    
    
    Amount
    
    
    Fair ValueReal estate:Residential:Variable
    
    $
    21,529
    
    
    $
    21,059
    
    
    $
    22,949
    
    
    $
    22,991Fixed
    
    
    203,054
    
    
    
    205,432
    
    
    
    217,344
    
    
    
    220,972Commercial:Variable
    
    
    1,614
    
    
    
    1,593
    
    
    
    1,593
    
    
    
    1,605Consumer
    
    
    9,892
    
    
    
    9,871
    
    
    
    10,981
    
    
    
    11,015Commercial
    
    
    109
    
    
    
    91
    
    
    
    139
    
    
    
    114Total loans
    
    
    236,198
    
    
    
    238,046
    
    
    
    253,006
    
    
    
    256,697Allowance for loan losses
    
    
    (1,307
    )
    
    
    
    
    
    
    (1,554
    )
    
    
    Net loans
    
    $
    234,891
    
    
    $
    238,046
    
    
    $
    251,452
    
    
    $
    256,697
  DepositsThe fair value of deposits with no stated maturity, such as demand deposits, NOW accounts,
savings accounts, and money market accounts for purposes of this disclosure, is equal to the amount
payable on demand as of December 31, 2004 and 2003. The fair value of certificates of deposit is
based on the discounted value of contractual cash flows. The discount rate is estimated using the
rates currently offered for deposits of similar remaining maturities. (In thousands)At December 31,
    
    2004
    
    
    2003Carrying
    
    
    Estimated
    
    
    Carrying
    
    
    EstimatedAmount
    
    
    Fair Value
    
    
    Amount
    
    
    Fair ValueDemand accounts
    
    $
    28,662
    
    
    $
    28,662
    
    
    $
    28,948
    
    
    $
    28,948NOW accounts
    
    
    58,991
    
    
    
    58,991
    
    
    
    56,108
    
    
    
    56,108Savings accounts
    
    
    549,657
    
    
    
    549,657
    
    
    
    595,575
    
    
    
    595,575Money market accounts
    
    
    11,656
    
    
    
    11,656
    
    
    
    12,256
    
    
    
    12,256Time certificates of deposit
    
    
    200,499
    
    
    
    200,274
    
    
    
    189,621
    
    
    
    190,655Total deposits
    
    
    849,465
    
    
    
    849,240
    
    
    
    882,508
    
    
    
    883,542Escrow deposits of borrowers
    
    
    1,074
    
    
    
    1,074
    
    
    
    1,139
    
    
    
    1,139Total
    
    
    $850,539
    
    
    $
    850,314
    
    
    $
    883,647
    
    
    $
    884,681
  The fair value estimates and the carrying amounts above do not include the benefit that results
from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing
funds in the market.Commitments to Extend CreditThe fair value of commitments to extend credit is estimated using the fees currently charged
to enter into similar agreements, taking into account the remaining terms of the agreements and the
present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also
considers the difference between current levels of interest rates and the committed rates.The Bank estimates the fair value of the cost to terminate commitments to advance funds on
construction loans and for residential mortgage loans in the pipeline at December 31, 2004 and 2003
to be immaterial. Unused credit lines, including unused portions of equity lines of credit, are at
floating interest rates and therefore there is no fair value adjustment. The Banks other loan
commitments approximate fair value. 51




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##### 



11.
    Fair Value of Financial Instruments (continued)LimitationsFair value estimates are made at a specific point in time, based on relevant market
information and information about the financial instrument. These estimates do not reflect any
premium or discount that could result from offering for sale at one time the Banks entire
holdings of a particular financial instrument. Because no active market exists for a portion of
the Banks financial instruments, fair value estimates are based on judgments regarding future
expected loss experience, current economic conditions, risk characteristics of various financial
instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore
cannot be determined with precision. Changes in assumptions could significantly affect the
estimates.Fair value estimates are determined without attempting to estimate the value of anticipated
future business and the value of assets and liabilities that are not considered financial
instruments. For example, the Bank has a trust department that contributes fee income annually.
The trust department is not considered a financial instrument, and its value has not been
incorporated into the fair value estimates. Other significant assets and liabilities that are
not considered financial assets or liabilities include deferred tax liabilities, premises and
equipment and goodwill. In addition, the tax ramifications related to the realization of the
unrealized gains and losses can have a significant effect on fair value estimates and have not
been considered in any of the estimates.12.
    Income TaxesIncome tax expense (benefit) was allocated as follows: (In thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Current income tax expense:Federal
    
    $
    3,606
    
    
    $
    3,702
    
    
    $
    5,210State
    
    
    264
    
    
    
    291
    
    
    
    438Total current tax expense
    
    
    3,870
    
    
    
    3,993
    
    
    
    5,648Deferred income tax expense (benefit):Federal
    
    
    23
    
    
    
    175
    
    
    
    (132
    )State
    
    
    5
    
    
    
    61
    
    
    
    (42
    )Total deferred tax expense (benefit)
    
    
    28
    
    
    
    236
    
    
    
    (174
    )Total income tax expense
    
    $
    3,898
    
    
    $
    4,229
    
    
    $
    5,474
  Income tax expense attributable to income from operations for the years ended December 31, differed from the amounts
computed by applying the federal income tax rate of 35 percent as a result of the following: (In thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Computed expected income tax expense at statutory rate
    
    $
    3,947
    
    
    
    4,232
    
    
    $
    5,351Increase (reduction) in income taxes resulting from:Reduction in federal income tax rate
    
    
    (98
    )
    
    
    (97
    )
    
    
    (101
    )State and local income taxes, net of federal benefit
    
    
    175
    
    
    
    229
    
    
    
    257Dividends received deduction
    
    
    (40
    )
    
    
    (54
    )
    
    
    (57
    )Dividends paid to ESOP deduction
    
    
    (73
    )
    
    
    (67
    )
    
    
    (34
    )Other
    
    
    (13
    )
    
    
    (14
    )
    
    
    58Income tax expense
    
    $
    3,898
    
    
    $
    4,229
    
    
    $
    5,474Effective income tax rate
    
    
    34.56
    %
    
    
    34.97
    %
    
    
    35.81
    %
 52




---



##### 



12.
    Income Taxes (continued)At December 31, 2004 and 2003, the Bank had gross deferred tax assets and gross deferred tax liabilities as follows: (In thousands) Years ended December 31,
    
    2004
    
    
    2003Deferred tax assets:Loan losses
    
    $
    792
    
    
    $
    914Deferred loan fees, net
    
    
    11
    
    
    
    7Deferred compensation and pension cost
    
    
    745
    
    
    
    715Depreciation
    
    
    37
    
    
    
    29Purchase accounting
    
    
    179
    
    
    
    263Other
    
    
    95
    
    
    
    48Gross deferred tax asset
    
    
    1,859
    
    
    
    1,976Deferred tax liabilities:Unrealized gains on securities available for sale
    
    
    1,156
    
    
    
    2,555Other unrealized securities gains
    
    
    106
    
    
    
    106Other
    
    
    9
    
    
    
    98Gross deferred tax liability
    
    
    1,271
    
    
    
    2,759Net deferred tax asset (liability)
    
    $
    588
    
    
    $
    (783
    )
  Based on the Companys historical and current pretax earnings, management believes it is
more likely than not that the Company will realize the gross deferred tax asset existing at
December 31, 2004. The primary sources of recovery of the gross federal deferred tax asset are
federal income taxes paid in 2004, 2003 and 2002 that are available for carryback and the
expectation that the existing net deductible temporary differences will reverse during periods
in which the Company generates net taxable income. Since there is no carryback provision for
state income tax purposes, management believes the existing net deductible temporary differences
which give rise to the gross deferred state income tax asset will reverse during periods in
which the Company generates net taxable income. There can be no assurance, however, that the
Company will generate any earnings or any specific level of continuing earnings.As a result of the Tax Reform Act of 1996, the special tax bad debt provisions were amended
to eliminate the reserve method. However, the tax effect of the pre-1988 bad debt reserve amount
of approximately $7.3 million remains subject to recapture in the event that the Bank pays
dividends in excess of its reserves and profits.13.
    Earnings per ShareThe following is a calculation of earnings per share for the years indicated: Years Ended December 31,
    
    2004
    
    
    2003
    
    
    2002(In thousands except share data)
    
    Basic
    
    
    Diluted
    
    
    Basic
    
    
    Diluted
    
    
    Basic
    
    
    DilutedNet income
    
    $
    7,380
    
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    7,863
    
    
    $
    9,814
    
    
    $
    9,814Average shares outstanding
    
    
    4,408,293
    
    
    
    4,408,293
    
    
    
    4,439,394
    
    
    
    4,439,394
    
    
    
    4,708,783
    
    
    
    4,708,783Dilutive stock options
    
    
    
    
    
    
    93,244
    
    
    
    
    
    
    
    105,200
    
    
    
    
    
    
    
    124,675Unallocated Employee Stock
Ownership Plan (ESOP) shares
not committed to be released
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,957
    )
    
    
    (10,957
    )Weighted average shares outstanding
    
    
    4,408,293
    
    
    
    4,501,537
    
    
    
    4,439,394
    
    
    
    4,544,594
    
    
    
    4,697,826
    
    
    
    4,822,501Earnings per share (in dollars)
    
    $
    1.67
    
    
    $
    1.64
    
    
    $
    1.77
    
    
    $
    1.73
    
    
    $
    2.09
    
    
    $
    2.04
 53




---



##### 



14.
    Stockholders EquityThe Company may not declare or pay cash dividends on its shares of common stock if the
effect thereof would cause its stockholders equity to be reduced below or to otherwise violate
legal or regulatory requirements. Substantially all of the Companys retained earnings are
unrestricted at December 31, 2004.The Bank is a Federal Deposit Insurance Corporation insured
institution subject to the FDIC regulatory capital requirements. The FDIC regulations require
all FDIC insured institutions to maintain minimum levels of Tier I capital. Highly rated banks
(i.e., those with a composite rating of 1 under the CAMELS rating system) are required to
maintain a minimum leverage ratio of Tier I capital to total average assets of at least 3.00%.
An additional 100 to 200 basis points are required for all but these most highly rated
institutions. The Bank is also required to maintain a minimum level of risk-based capital. Under
the risk-based capital standards, FDIC insured institutions must maintain a Tier I capital to
risk-weighted assets ratio of 4.00% and are generally expected to meet a minimum total
qualifying capital to risk-weighted assets ratio of 8.00%. The risk-based capital guidelines
take into consideration risk factors, as defined by the regulators, associated with various
categories of assets, both on and off the balance sheet. Under the guidelines, capital strength
is measured in two tiers which are used in conjunction with risk adjusted assets to determine
the risk-based capital ratios. Tier II capital components include supplemental capital
components such as qualifying allowance for loan losses, qualifying subordinated debt and up to
45 percent of the pretax net unrealized holding gains on certain available for sale equity
securities. Tier I capital plus the Tier II capital components are referred to as total
qualifying capital.The capital ratios of the
Company and its principal subsidiary
Massbank set
forth below currently exceed the minimum ratios for well capitalized banks as defined by
federal regulators.As of December 31, 2004, the most recent notification from the FDIC categorized the Bank as
well capitalized under the regulatory framework for prompt corrective action. To be categorized
as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and
Tier I leverage ratios as set forth in the following table. There are
no conditions or events
since that notification that management believes would cause a change in the Banks
categorization. (In thousands)
    
    
    
    
    
    
    
    
    
    For Capital
    
    
    To Be WellAt December 31, 2004
    
    Actual
    
    
    Adequacy Purposes
    
    
    Capitalized(1)Amount
    
    
    Ratio
    
    
    Amount
    
    
    Ratio
    
    
    Amount
    
    
    RatioTier I Capital (to Average Assets):Massbank Corp. (consolidated)
    
    $
    107,168
    
    
    
    11.15
    %
    
    $
    28,829
    
    
    
    3.00
    %
    
    
    N/A
    
    
    
    Massbank (the Bank)
    
    
    102,501
    
    
    
    10.67
    
    
    
    28,828
    
    
    
    3.00
    
    
    $
    48,047
    
    
    
    5.00
    %Tier I Capital (to Risk-Weighted Assets):Massbank Corp. (consolidated)
    
    
    107,168
    
    
    
    39.16
    
    
    
    10,947
    
    
    
    4.00
    
    
    
    N/A
    
    
    
    Massbank (the Bank)
    
    
    102,501
    
    
    
    37.48
    
    
    
    10,938
    
    
    
    4.00
    
    
    
    16,408
    
    
    
    6.00Total Capital (to Risk-Weighted Assets):Massbank Corp. (consolidated)
    
    
    109,464
    
    
    
    40.00
    
    
    
    21,893
    
    
    
    8.00
    
    
    
    N/A
    
    
    
    Massbank (the Bank)
    
    
    104,797
    
    
    
    38.32
    
    
    
    21,877
    
    
    
    8.00
    
    
    
    27,346
    
    
    
    10.00
   (1)This column presents the minimum amounts and ratios that a financial institution must have to be
categorized as well capitalized. (In thousands)
    
    
    
    
    
    
    
    
    
    For Capital
    
    
    To Be WellAt December 31, 2003
    
    Actual
    
    
    Adequacy Purposes
    
    
    Capitalized(1)Amount
    
    
    Ratio
    
    
    Amount
    
    
    Ratio
    
    
    Amount
    
    
    RatioTier I Capital (to Average Assets):Massbank Corp. (consolidated)
    
    $
    105,876
    
    
    
    10.57
    %
    
    $
    30,054
    
    
    
    3.00
    %
    
    
    N/A
    
    
    
    Massbank (the Bank)
    
    
    101,908
    
    
    
    10.17
    
    
    
    30,054
    
    
    
    3.00
    
    
    $
    50,090
    
    
    
    5.00
    %Tier I Capital (to Risk-Weighted Assets):Massbank Corp. (consolidated)
    
    
    105,876
    
    
    
    34.56
    
    
    
    12,254
    
    
    
    4.00
    
    
    
    N/A
    
    
    
    Massbank (the Bank)
    
    
    101,908
    
    
    
    33.29
    
    
    
    12,246
    
    
    
    4.00
    
    
    
    18,369
    
    
    
    6.00Total Capital (to Risk-Weighted Assets):Massbank Corp. (consolidated)
    
    
    108,466
    
    
    
    35.40
    
    
    
    24,509
    
    
    
    8.00
    
    
    
    N/A
    
    
    
    Massbank (the Bank)
    
    
    104,498
    
    
    
    34.13
    
    
    
    24,492
    
    
    
    8.00
    
    
    
    30,615
    
    
    
    10.00
   (1)This column presents the minimum amounts and ratios that a financial institution must have to be
categorized as well capitalized. 54




---



##### 



15.
    Employee BenefitsPension PlanThe Bank sponsors a noncontributory defined benefit pension plan that covers all
employees who meet specified age and length of service requirements, which is administered by
the Savings Banks Employees Retirement Association (SBERA). The plan provides for benefits to
be paid to eligible employees at retirement based primarily upon their years of service with the
Bank and compensation levels near retirement. Contributions to the plan reflect benefits
attributed to employees service to date, as well as service expected to be earned in the future.
Pension plan assets consist principally of equity securities; mutual
funds  bonds, mutual funds
  equities, and all assets mutual funds; and money market funds and cash.The following table sets forth the plans funded status and amounts recognized in the
Companys consolidated financial statements for the plan years ended October 31, 2004, 2003, and
2002, the plans latest valuation dates: (In thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Actuarial present value of vested benefits
    
    $
    7,260
    
    
    $
    6,548
    
    
    $
    5,929Total accumulated benefit obligation
    
    
    7,280
    
    
    
    6,617
    
    
    
    5,969Change in benefit obligation:Projected benefit obligation at beginning of year
    
    $
    8,389
    
    
    $
    7,645
    
    
    $
    7,009Service cost
    
    
    430
    
    
    
    386
    
    
    
    386Interest cost
    
    
    524
    
    
    
    516
    
    
    
    493Amendments
    
    
    
    
    
    
    
    
    
    
    129Actuarial loss (gain)
    
    
    456
    
    
    
    91
    
    
    
    (173
    )Benefits paid
    
    
    (311
    )
    
    
    (249
    )
    
    
    (199
    )Projected benefit obligation at end of year
    
    $
    9,488
    
    
    $
    8,389
    
    
    $
    7,645Change in plan assets:Fair value of plan assets at beginning of year
    
    $
    7,038
    
    
    $
    5,963
    
    
    $
    6,804Actual return on plan assets
    
    
    740
    
    
    
    902
    
    
    
    (643
    )Employer contribution
    
    
    367
    
    
    
    420
    
    
    
    Benefits paid
    
    
    (311
    )
    
    
    (249
    )
    
    
    (199
    )Other
    
    
    
    
    
    
    2
    
    
    
    1Fair value of plan assets at end of year
    
    $
    7,834
    
    
    $
    7,038
    
    
    $
    5,963Deficiency of plan assets over projected benefit obligation
    
    $
    (1,654
    )
    
    $
    (1,351
    )
    
    $
    (1,682
    )Certain changes in the items shown are not recognized as they occur,
but are amortized systematically
over subsequent periods.
Unrecognized amounts to be amortized and the amounts included in the
consolidated balance sheets are shown below:Unrecognized net actuarial loss
    
    $
    (712
    )
    
    $
    (459
    )
    
    $
    (915
    )Transition asset
    
    
    64
    
    
    
    84
    
    
    
    106Past service cost
    
    
    (114
    )
    
    
    (121
    )
    
    
    (129
    )Accrued benefit cost
    
    
    (892
    )
    
    
    (855
    )
    
    
    (744
    )Deficiency of plan assets over projected benefit obligation
    
    $
    (1,654
    )
    
    $
    (1,351
    )
    
    $

    (1,682
    )Assumptions used in determining the actuarial present value of
the projected benefit obligation were as follows:Discount rate
    
    
    5.75
    %
    
    
    6.25
    %
    
    
    6.75
    %Rate of compensation increase
    
    
    4.00
    %
    
    
    4.00
    %
    
    
    4.00
    %Assumptions used to develop the
net periodic benefit cost data were:Discount rate
    
    
    6.25
    %
    
    
    6.75
    %
    
    
    7.00
    %Expected return on plan assets
    
    
    7.75
    %
    
    
    7.75
    %
    
    
    7.75
    %Rate of compensation increase
    
    
    4.00
    %
    
    
    4.00
    %
    
    
    4.50
    %Components of net periodic pension expense:Service cost
    
    $
    430
    
    
    $
    385
    
    
    $
    386Interest cost
    
    
    524
    
    
    
    516
    
    
    
    494Expected return on plan assets
    
    
    (545
    )
    
    
    (462
    )
    
    
    (527
    )Transition obligation
    
    
    (21
    )
    
    
    (21
    )
    
    
    (21
    )Past service cost
    
    
    7
    
    
    
    7
    
    
    
    Recognized net actuarial (gain) loss
    
    
    8
    
    
    
    107
    
    
    
    (4
    )Net periodic pension expense
    
    $
    403
    
    
    $
    532
    
    
    $
    328
 55




---



##### 



15.
    Employee Benefits(continued)The approximate composition of pension plan assets as of the end of the plan years ended October 31, 2004 and 2003 is as follows: Years ended October 31,
    
    2004
    
    
    2003Asset Category:Cash and money market funds
    
    
    2
    %
    
    
    21
    %Equity securities
    
    
    51
    %
    
    
    47
    %Mutual funds
- equities
    
    
    15
    %
    
    
    8
    %Mutual funds
- bonds
    
    
    23
    %
    
    
    24
    %Mutual funds
- all assets
    
    
    9
    %
    
    
    100
    %
    
    
    100
    %
  The expected long-term rate of return on plan assets is based on prevailing yields on high quality
fixed income investments increased by a premium of 3%  5% for equity investments.The Bank expects to contribute $364 thousand to its pension plan in 2005.The investment policies and strategies for the Banks pension plan are as follows:
Massbank (the Bank) is a member of the Savings Banks Employees Retirement Association
(SBERA) within which the Bank maintains a Defined Benefit pension plan. SBERA offers a common and
collective trust as the underlying investment structure for pension plans participating in the
Association. The target allocation mix for the common and collective trust portfolio calls for an
equity-based investment deployment range from 55% to 75% of total portfolio assets. The remainder
of the portfolio is allocated to fixed income. The approximate investment allocation of the
portfolio is shown in the table above. The Trustees of SBERA, through the Associations Investment
Committee, select investment managers for the common and collective trust portfolio. A professional
investment advisory firm is retained by the Investment Committee to provide allocation analysis,
performance measurement and to assist with manager searches. The overall investment objective is to
diversify equity investments across a spectrum of investment types (e.g., small cap, large cap,
international, etc.) and styles (e.g., growth, value, etc.).The Bank expects to make benefit payments for the plan years ending October 31, as follows: (In thousands) Years ending October 31,
    
    Payments2005
    
    $
    9262006
    
    
    6552007
    
    
    7482008
    
    
    4902009
    
    
    1,4452010
    
    
    523
 Payments2011
    
    
    1,3672012
    
    
    1,0582013
    
    
    1,1542014
    
    
    1,9192015
    
    
    1,102
  Profit Sharing and Incentive Compensation Bonus PlansThe Banks Profit Sharing and Incentive Compensation Bonus Plans provide for payments to
employees under certain circumstances based upon a year-end measurement of the Companys net income
and attainment of individual goals and objectives by certain key officers. There were no profit
sharing or incentive compensation bonus distributions in 2004 and 2003 because the criteria for
making such distributions were not met. Because some of the target goals and individual goals and
objectives were met in 2002, bonuses were awarded to officers and non-officer employees of the Bank
in the amount of $67 thousand. There were no profit sharing distributions in 2002 because the
criteria for making such distributions were not met.The Board of Directors approved a holiday distribution to all officers, excluding the CEO, and
non-officer employees in 2004 in the amount of $47 thousand. In 2003, a holiday distribution was
made to non-officer employees in the amount of $44 thousand.Employee Stock Ownership PlanThe Bank has an Employees Stock Ownership Plan (ESOP) for the benefit of each employee
who has completed at least 1,000 hours of service with the Company in the previous twelve months.
Under the plan, the ESOP has borrowed funds from a third party bank to invest in the Companys
common stock. The balance of the ESOP loan was repaid in 2002.Shares of the Companys common stock purchased with the loan proceeds were held in a suspense
account. As the loan was repaid, a proportionate number of shares were released for allocation to
plan participants, annually. In 2004 and 2003, the Bank contributed $145,000 and $161,000,
respectively to the ESOP to invest in the Companys common stock. These shares were allocated to
plan participants, on a pro rata basis, based on compensation.At December 31, 2004, the
ESOP held 209,321 shares of the Companys common stock which have
been allocated to plan participants and no unallocated shares.Dividends on allocated shares held by the ESOP are allocated to plan participants
proportionately based on the number of shares in the participants allocated accounts.The Companys total expense applicable to the ESOP amounted to $205 thousand, $135 thousand
and $373 thousand for the years ended December 31, 2004, 2003 and 2002, respectively. 56




---



##### 



15.
    Employee Benefits (continued)Employee AgreementsThe Bank has entered into employment agreements with certain executive officers which
provide that the officer will receive a minimum amount of annual compensation from the Bank for
a specified period. The agreements also provide for the continued payment of compensation to
the officer for a specified period after termination under certain circumstances, including if
the officers termination follows a change of control, generally defined to mean a person or
group attaining ownership of 25% or more of the shares of the Company.Executive Supplemental Retirement AgreementsThe Bank maintains executive supplemental retirement agreements for certain executive
officers. These agreements provide retirement benefits designed to supplement benefits
available through the Banks retirement plan for employees. The Company made contributions of
$52 thousand, $50 thousand and $59 thousand to a rabbi trust for the benefits payable under the
agreements in 2004, 2003 and 2002.Directors Deferred Compensation PlanIn 1988, the Company established a deferred compensation plan for its directors. The
plan allows the Companys directors to defer receipt of all or a portion of their compensation

until: (1) their attaining the age of 72, or (2) their termination as a director of the
Company. In 2000, the plan was amended to allow the directors compensation to be invested in
Company stock held in an irrevocable trust. At December 31, 2004, the trust held 25,804 shares
of Massbank Corp. stock. The shares are considered outstanding in the computation of
earnings per share and book value per share.Stock Option PlanEffective April 20, 2004, the Board of Directors adopted and the shareholders approved
the Corporations 2004 Stock Option and Incentive Plan (the 2004 Plan). This new plan
replaced the Corporations 1994 Stock Incentive Plan, which expired in January 2004. The 2004
Plan provides for awards of incentive stock options, non-qualified stock options, stock
appreciation rights, a limited number of restricted stock awards and cash replacement awards.
The total number of shares of common stock that can be issued under this plan is 400,000
shares, subject to adjustment for stock splits, stock dividends and similar events. Of this
amount, no more than 100,000 shares of common stock may be issued as awards of restricted stock
under the 2004 Plan. Under the 2004 Plan, the Corporation may not grant stock options with an
exercise price less than 100% of the fair market value of the Corporations common stock on the
date of grant. The maximum option term is ten years.As of December 31, 2004, there were 104,942 non-qualified stock options and 195,145
incentive stock options outstanding to purchase shares under the 1994 and 2004 plans.A summary of the status of the Companys fixed stock option plan as of December 31, 2004,
2003 and 2002, and changes during the years ended on those dates is presented below. All share
information presented has been adjusted for stock splits. Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Weighted
    
    
    
    
    
    
    Weighted
    
    
    
    
    
    
    WeightedShares
    
    
    Average
    
    
    Shares
    
    
    Average
    
    
    Shares
    
    
    AverageUnder
    
    
    Exercise
    
    
    Under
    
    
    Exercise
    
    
    Under
    
    
    ExerciseFixed Options
    
    Option
    
    
    Price
    
    
    Option
    
    
    Price
    
    
    Option
    
    
    PriceOutstanding at beginning of year
    
    
    318,334
    
    
    $
    20.94
    
    
    
    376,122
    
    
    $
    19.27
    
    
    
    475,651
    
    
    $
    17.09Granted
    
    
    30,250
    
    
    
    42.76
    
    
    
    22,600
    
    
    
    28.56
    
    
    
    32,250
    
    
    
    27.63Exercised
    
    
    (48,097
    )
    
    
    13.22
    
    
    
    (78,138
    )
    
    
    14.90
    
    
    
    (130,277
    )
    
    
    13.26Forfeited
    
    
    (400
    )
    
    
    42.90
    
    
    
    (2,250
    )
    
    
    29.50
    
    
    
    (1,502
    )
    
    
    28.55Outstanding at end of year
    
    
    300,087
    
    
    $
    24.35
    
    
    
    318,334
    
    
    $
    20.94
    
    
    
    376,122
    
    
    $
    19.27Options exercisable at year-end
    
    
    300,087
    
    
    
    
    
    
    
    318,334
    
    
    
    
    
    
    
    376,122
  The following table summarizes information about fixed stock options outstanding and exercisable at December 31, 2004: At December 31, 2004
    
    Options Outstanding
    
    
    Options ExercisableWeighted Avg.
    
    
    Weighted Avg.
    
    
    
    
    
    
    Weighted Avg.Range of
    
    Number
    
    
    Remaining
    
    
    Exercise
    
    
    Number
    
    
    ExerciseExercise Prices
    
    Outstanding
    
    
    Contractual Life
    
    
    Price
    
    
    Exercisable
    
    
    Price$11.56 to $16.38
    
    
    47,487
    
    
    0.8 years
    
    $
    14.55
    
    
    
    47,487
    
    
    $
    14.5519.00 to 20.67
    
    
    102,250
    
    
    3.9 years
    
    
    19.82
    
    
    
    102,250
    
    
    
    19.8225.00 to 29.60
    
    
    120,300
    
    
    4.9 years
    
    
    27.47
    
    
    
    120,300
    
    
    
    27.4734.50 to 42.90
    
    
    30,050
    
    
    9.0 years
    
    
    42.72
    
    
    
    30,050
    
    
    
    42.72$11.56 to $42.90
    
    
    300,087
    
    
    4.3 years
    
    $
    24.35
    
    
    
    300,087
    
    
    $
    24.35
 57




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##### 



16.
    Shareholder Rights PlanThe Company has in effect a Shareholder Rights Plan, pursuant to which the Board of
Directors authorized the issuance of one preferred stock purchase right for each share of common
stock of the Company outstanding. Under the Plan, the Rights automatically become part of and
trade with the Companys shares of common stock. Although the Rights are not
exercisable initially, they become exercisable if a person becomes an acquiring person by
acquiring 11% or more of the Companys common stock or if a person commences a tender offer that
could result in that person owning 11% or more of the common stock of
Massbank Corp.
In the event that a person becomes an acquiring person, each holder of a Right (other than the
acquiring person) would be entitled to acquire such number of shares of preferred stock which
are equivalent to
Massbank Corp. common stock having a value of twice the exercise
price of the Right. The exercise price of a Right initially shall be $136.00 per one
one-thousandth of a share of the Companys preferred stock. If
Massbank Corp. is
acquired in a merger or other business combination transaction after any such event, each holder
of a Right would be entitled to purchase, at the then-current exercise price, shares of the
acquiring companys common stock having a value of twice the exercise price of the Right. The
Rights will expire on January 19, 2010, but may be redeemed at the option of the Board of
Directors for $0.01 per Right at any time prior to the time at which any person becomes an
acquiring person or until the expiration date of the Shareholder Rights Plan.17.
    Parent Company Financial StatementsThe following are the condensed financial statements for
Massbank Corp. (the
Parent Company) only: Balance Sheets(In thousands except share data) At December 31,
    
    2004
    
    
    2003Assets:Cash
    
    $
    18
    
    
    $
    5Interest-bearing deposits in banks
    
    
    4,229
    
    
    
    3,742Investment in subsidiaries
    
    
    105,348
    
    
    
    106,959Due from subsidiaries
    
    
    196
    
    
    
    Income tax receivable, net
    
    
    187
    
    
    
    209Deferred income tax asset, net
    
    
    21
    
    
    
    28Other assets
    
    
    29
    
    
    
    1Total assets
    
    $
    110,028
    
    
    $
    110,944Liabilities:Other liabilities
    
    $
    13
    
    
    $
    17Total liabilities
    
    
    13
    
    
    
    17Stockholders Equity(Notes 12, 14, 15 and 16):Preferred stock, par value $1.00 per share; 2,000,000 shares authorized, none issued
Common stock, par value $1.00 per share; 10,000,000 shares
authorized, 7,736,430 and 7,688,333 shares issued, respectively
    
    
    7,736
    
    
    
    7,688Additional paid-in capital
    
    
    55,313
    
    
    
    54,417Retained earnings
    
    
    102,003
    
    
    
    99,038165,052
    
    
    
    161,143Treasury stock at cost, 3,354,703 and 3,280,880 shares, respectively
    
    
    (56,794
    )
    
    
    (54,177
    )Accumulated other comprehensive income
    
    
    1,757
    
    
    
    3,961Shares held in rabbi trust at cost
2,254 and 3,000 shares, respectively
    
    
    (59
    )
    
    
    (72
    )Deferred compensation obligation
    
    
    59
    
    
    
    72Total stockholders equity
    
    
    110,015
    
    
    
    110,927Total liabilities and stockholders equity
    
    $
    110,028
    
    
    $
    110,944
 58




---



##### 



17.
    Parent Company Financial Statements (continued) Statements of Income(In thousands) Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Income:Dividends received from subsidiaries
    
    $
    7,100

    
    
    $
    9,300
    
    
    $
    11,000Interest and dividend income
    
    
    18
    
    
    
    15
    
    
    
    76Total interest and dividend income
    
    
    7,118
    
    
    
    9,315
    
    
    
    11,076Non-interest expense
    
    
    179
    
    
    
    166
    
    
    
    172Income before income taxes
    
    
    6,939
    
    
    
    9,149
    
    
    
    10,904Income tax benefit
    
    
    108
    
    
    
    93
    
    
    
    40Income before equity in undistributed earnings of
subsidiaries
    
    
    7,047
    
    
    
    9,242
    
    
    
    10,944Equity in undistributed earnings of subsidiaries
    
    
    333
    
    
    
    (1,379
    )
    
    
    (1,130
    )Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814
  The Parent Company only Statements of Changes in Stockholders Equity are identical to the
consolidated statements and therefore are not presented here. Statements of Cash Flows(In thousands)Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002Cash flows from operating activities:Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814Adjustments to reconcile net income to net cash provided by
operating activities:Equity in undistributed earnings of subsidiaries
    
    
    (333
    )
    
    
    1,379
    
    
    
    1,130Decrease (increase) in current income tax receivable, net
    
    
    22
    
    
    
    151
    
    
    
    (164
    )Decrease (increase) in deferred income tax asset, net
    
    
    7
    
    
    
    (6
    )
    
    
    (6
    )Increase in other assets
    
    
    (28
    )
    
    
    
    
    
    
    (Decrease) increase in other liabilities
    
    
    (4
    )
    
    
    (1,095
    )
    
    
    1,098Increase in amount due from subsidiaries
    
    
    (196
    )
    
    
    
    
    
    
    (Decrease) increase in amount due to subsidiaries
    
    
    
    
    
    
    (42
    )
    
    
    (246
    )Net cash provided by operating activities
    
    
    6,848
    
    
    
    8,250
    
    
    
    11,626Cash flow from financing activities:Payments to acquire treasury stock
    
    
    (2,617
    )
    
    
    (8,097
    )
    
    
    (7,230
    )Purchase of company stock for deferred compensation plan,
net of distributions
    
    
    13
    
    
    
    (13
    )
    
    
    (16
    )(Decrease) increase in deferred compensation obligation
    
    
    (13
    )
    
    
    13
    
    
    
    16Options exercised, including tax benefits
    
    
    684
    
    
    
    1,253
    
    
    
    1,874Dividends paid on common stock
    
    
    (4,415
    )
    
    
    (4,068
    )
    
    
    (4,139
    )Tax benefit resulting from dividends paid on unallocated
shares held by the ESOP
    
    
    
    
    
    
    
    
    
    
    4Net cash used in financing activities
    
    
    (6,348
    )
    
    
    (10,912
    )
    
    
    (9,491
    )Net increase (decrease) in cash and cash equivalents
    
    
    500
    
    
    
    (2,662
    )
    
    
    2,135Cash and cash equivalents at beginning of year
    
    
    3,747
    
    
    
    6,409
    
    
    
    4,274Cash and cash equivalents at end of year
    
    $
    4,247
    
    
    $
    3,747
    
    
    $
    6,409
  During the years ended December 31,2004,2003 and 2002, the Company made cash payments for income taxes
of $20 thousand, $32 thousand and $40 thousand, respectively, and no payments for interest.In addition, the Company made cash payments to the state of Delaware for franchise taxes in
the amount of $48 thousand, $38 thousand and $38 thousand during the years ended December 31,
2004,2003 and 2002, respectively. 59




---



##### 



18.
    Ten-Year Statistical Summary (Unaudited) (In thousands except per share data)Years ended December 31,
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000
    
    
    1999
    
    
    1998
    
    
    1997
    
    
    1996
    
    
    1995Net income
    
    $
    7,380
    
    
    $
    7,863
    
    
    $
    9,814
    
    
    $
    10,759
    
    
    $
    11,111
    
    
    $
    11,311
    
    
    $
    10,914
    
    
    $
    10,167
    
    
    $
    9,427
    
    
    $
    8,759Diluted earnings per share
    
    
    1.64
    
    
    
    1.73
    
    
    
    2.04
    
    
    
    2.24
    
    
    
    2.25
    
    
    
    2.17
    
    
    
    1.98
    
    
    
    1.85
    
    
    
    1.72
    
    
    
    1.56Cash dividends paid per share
    
    
    1.00
    
    
    
    0.92
    
    
    
    0.88
    
    
    
    0.84
    
    
    
    0.79
    
    
    
    0.74
    
    
    
    0.68
    
    
    
    0.59
    
    
    
    0.46
    
    
    
    0.36

1/2Book value per share, at year-end
    
    
    25.11
    
    
    
    25.17
    
    
    
    25.45
    
    
    
    24.34
    
    
    
    22.83
    
    
    
    20.43
    
    
    
    21.05
    
    
    
    19.38
    
    
    
    17.17
    
    
    
    16.56Return on average assets
    
    
    0.75
    %
    
    
    0.78
    %
    
    
    0.99
    %
    
    
    1.13
    %
    
    
    1.20
    %
    
    
    1.20
    %
    
    
    1.17
    %
    
    
    1.12
    %
    
    
    1.08
    %
    
    
    1.04
    %Return on average equity
    
    
    6.71
    %
    
    
    7.08
    %
    
    
    8.39
    %
    
    
    9.53
    %
    
    
    10.93
    %
    
    
    10.66
    %
    
    
    10.05
    %
    
    
    10.51
    %
    
    
    10.65
    %
    
    
    10.65
    %
  19.
    Quarterly Data (Unaudited) Years ended December 31,
    
    2004
    
    
    2003(In thousands except
    
    4th
    
    
    3rd
    
    
    2nd
    
    
    1st
    
    
    4th
    
    
    3rd
    
    
    2nd
    
    
    1stper
share data)
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    QuarterInterest and dividend income
    
    $
    8,679
    
    
    $
    8,436
    
    
    $
    8,121
    
    
    $
    8,345
    
    
    $
    8,690
    
    
    $
    9,226
    
    
    $
    9,860
    
    
    $
    10,361Interest expense
    
    
    3,304
    
    
    
    3,225
    
    
    
    3,096
    
    
    
    3,104
    
    
    
    3,483
    
    
    
    3,622
    
    
    
    4,136
    
    
    
    4,613Net interest income
    
    
    5,375
    
    
    
    5,211
    
    
    
    5,025
    
    
    
    5,241
    
    
    
    5,207
    
    
    
    5,604
    
    
    
    5,724
    
    
    
    5,748Provision (credit) for loan losses
    
    
    (55
    )
    
    
    (74
    )
    
    
    (51
    )
    
    
    (62
    )
    
    
    (52
    )
    
    
    (450
    )
    
    
    
    
    
    
    Net interest income after
provision (credit) for loan losses
    
    
    5,430
    
    
    
    5,285
    
    
    
    5,076
    
    
    
    5,303
    
    
    
    5,259
    
    
    
    6,054
    
    
    
    5,724
    
    
    
    5,748Gains on securities, net
    
    
    287
    
    
    
    182
    
    
    
    186
    
    
    
    574
    
    
    
    335
    
    
    
    72
    
    
    
    192
    
    
    
    40Other non-interest income
    
    
    361
    
    
    
    267
    
    
    
    342
    
    
    
    287
    
    
    
    346
    
    
    
    271
    
    
    
    400
    
    
    
    266Non-interest expense
    
    
    3,200
    
    
    
    2,978
    
    
    
    2,964
    
    
    
    3,160
    
    
    
    3,204
    
    
    
    3,133
    
    
    
    3,229
    
    
    
    3,049Income before income taxes
    
    
    2,878
    
    
    
    2,756
    
    
    
    2,640
    
    
    
    3,004
    
    
    
    2,736
    
    
    
    3,264
    
    
    
    3,087
    
    
    
    3,005Income tax expense
    
    
    992
    
    
    
    945
    
    
    
    906
    
    
    
    1,055
    
    
    
    941
    
    
    
    1,127
    
    
    
    1,101
    
    
    
    1,060Net income
    
    $
    1,886
    
    
    $
    1,811
    
    
    $
    1,734
    
    
    $
    1,949
    
    
    $
    1,795
    
    
    $
    2,137
    
    
    $
    1,986
    
    
    $
    1,945Earnings per share (in dollars):(1)Basic
    
    $
    0.43
    
    
    $
    0.41
    
    
    $
    0.39
    
    
    $
    0.44
    
    
    $
    0.41
    
    
    $
    0.49
    
    
    $
    0.45
    
    
    $
    0.43Diluted
    
    
    0.42
    
    
    
    0.40
    
    
    
    0.39
    
    
    
    0.43
    
    
    
    0.40
    
    
    
    0.48
    
    
    
    0.44
    
    
    
    0.42Weighted average common
shares outstanding:(1)Basic
    
    
    4,392
    
    
    
    4,398
    
    
    
    4,416
    
    
    
    4,427
    
    
    
    4,397
    
    
    
    4,378
    
    
    
    4,428
    
    
    
    4,557Diluted
    
    
    4,477
    
    
    
    4,483
    
    
    
    4,502
    
    
    
    4,545
    
    
    
    4,523
    
    
    
    4,490
    
    
    
    4,531
    
    
    
    4,637
   (1)Computation of earnings per share is further described in Note 1. 60




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##### 



Massbank Corp. and Subsidiaries Stockholder DataYears ended December 31, 2004 and 2003Massbank Corp.s common stock is currently traded on the Nasdaq Stock Market
under the symbol MASB. At December 31, 2004 there were 4,381,727 shares outstanding and 655
shareholders of record. Shareholders of record do not reflect the number of persons or entities who
hold their stock in nominee or street name.The following table includes the quarterly ranges of high and low closing sales prices for the
common stock, as reported by Nasdaq, and dividends declared per share for the periods indicated. Price per Share
    
    
    CashDividendsHigh
    
    
    Low
    
    
    DeclaredYear ended December 31,
    
    2004Fourth Quarter
    
    $
    38.41
    
    
    $
    36.50
    
    
    $
    0.25Third Quarter
    
    
    37.39
    
    
    
    34.25
    
    
    
    0.25Second Quarter
    
    
    41.99
    
    
    
    32.05
    
    
    
    0.25First Quarter
    
    
    43.48
    
    
    
    38.79
    
    
    
    0.25
 Year ended December 31,
    
    2003Fourth Quarter
    
    $
    44.27
    
    
    $
    37.23
    
    
    $
    0.23Third Quarter
    
    
    37.72
    
    
    
    31.91
    
    
    
    0.23Second Quarter
    
    
    36.20
    
    
    
    27.47
    
    
    
    0.23First Quarter
    
    
    28.90
    
    
    
    27.50
    
    
    
    0.23
 61




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##### 



Massbank Branch Offices d/b/a Massbank of Reading* 123 Haven Street
Reading, MA 01867
(781) 942-8188
(978) 446-9200 Massbank of Chelmsford 291 Chelmsford Street
Chelmsford, MA 01824
(978) 256-3751 17 North Road
Chelmsford, MA 01824
(978) 256-3733 Massbank of Dracut 45 Broadway Road
Dracut, MA 01826
(978) 441-0040 Massbank of Everett 738 Broadway
Everett, MA 02149
(617) 387-5115 Massbank of Lowell 50 Central Street
Lowell, MA 01852
(978) 446-9200 755 Lakeview Avenue
Lowell, MA 01850
(978) 446-9216 Massbank of Medford 4110 Mystic Valley Parkway
Wellington Circle Plaza
Medford, MA 02155
(781) 395-4899 Massbank of Melrose
476 Main Street
Melrose, MA 02176
(781) 662-0100 27 Melrose Street
Towers Plaza
Melrose, MA 02176
(781) 662-0165 Massbank of Stoneham 240 Main Street
Stoneham, MA 02180
(781) 662-0177 Massbank of Tewksbury 1800 Main Street
Tewksbury, MA 01876
(978) 851-0300 Massbank of Westford 203 Littleton Road
Westford, MA 01886
(978) 692-3467 Massbank of Wilmington
370 Main Street
Wilmington, MA 01887
(978) 658-4000 219 Lowell Street
Luccis Plaza
Wilmington, MA 01887
(978) 658-5775 *Main Office 62




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##### 



Corporate
Information Massbank Corp.
123 Haven Street
Reading, MA 01867
(781) 662-0100
(978) 446-9200
FAX (781) 942-1022 Savings and Mortgage
24-Hour-Rate Lines
(781) 662-0154
(978) 446-9285 Notice of Shareholders Meeting The Annual Meeting of the
Shareholders of Massbank Corp.
will be held at 10:00 A.M.
on Tuesday, April 19, 2005 at the
Sheraton Ferncroft Resort
50 Ferncroft Road
Danvers, MA 01923 Trademark Massbank and its logo are
registered trademarks of
the Company Form 10-K Shareholders may obtain without
charge a copy of the Companys
2004 Form 10-K. Written requests
should be addressed to:
Shareholder ServicesMassbank Corp.
159 Haven Street
Reading, MA 01867 Dividend Reinvestment and
Stock Purchase Plan Shareholders may obtain a brochure
containing a detailed description of
the plan by writing to:
Shareholder ServicesMassbank Corp.
159 Haven Street
Reading, MA 01867 Transfer Agent American Stock Transfer &
Trust Company
59 Maiden Lane
New York, NY 10038
(800) 937-5449
(877) 777-0800
Website address:
www.amstock.com Independent Registered
Public Accounting Firm KPMG LLP
99 High Street
Boston, MA 02110 Legal Counsel Goodwin Procter LLP
Exchange Place
Boston, MA 02109 63




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Officers
and Directors Massbank Corp. Officers Gerard H. BrandiChairman, President and
Chief Executive Officer Reginald E. CormierSenior Vice President, Treasurer and
Chief Financial Officer Robert S. CummingsSecretary Donna H. WestAssistant Secretary Board of Directors *Mathias B. BedellRetired, Bedell Brothers Insurance
Agency, Inc. *Gerard H. Brandi Chairman, President and
Chief Executive Officer,Massbank Corp.
 Allan S. BufferdTreasurer,
Massachusetts Institute of Technology Kathleen M. CamilliPresident
Camilli Economics, LLC Peter W. CarrRetired, Guilford Transportation
Industries Alexander S. CostelloTeacher, Brooks School *Robert S. CummingsSenior Counsel,
Nixon Peabody LLP *Stephen E. MarshallRetired, C.H. Cleaves Insurance
Agency, Inc. Nancy L. PettinelliExecutive Director,
Visiting Nurse Association *Herbert G. SchurianCertified Public Accountant *Dr. Donald B. StackhouseRetired, Dental Health Concepts *Member, Executive Committee
Member, Audit Committee Officers
and Directors Massbank Officers Gerard H. BrandiChairman, President and
Chief Executive Officer Donald R. WashburnSenior Vice President, Lending Donna H. WestSenior Vice President,
Community Banking Reginald E. CormierSenior Vice President, Treasurer
and Chief Financial Officer David F. CarrollVice President, Operations William F. RiversVice President, Operations Richard J. FlanniganVice President and
Senior Trust Officer Thomas J. QueeneyVice President and
Senior Trust Officer Carol A. AxelrodLoan Officer Kathleen M. BaldassariAssistant Treasurer Kenneth R. BerardAssistant Treasurer David M. BiancoAssistant Treasurer Andrea S. BradfordAssistant Vice President Ernest G. Campbell, Jr.Collections Officer Marianne J. CarpenterAssistant Vice President Lisa A. DiCiccoTrust Operations Officer Claudeia F. DowningAssistant Treasurer Karen L. FlammiaAssistant Vice President Scott M. ForbesMortgage Origination Officer Rachael E. GarneauAssistant Treasurer Martin J. HeneghanAssistant Controller Brian W. HurleyAssistant Vice President Anne M. LeeDirector of Human Resources Kenneth A. MassonAssistant Vice President,
Marketing Laura M. OConnorAssistant Treasurer Erik C. OlsonAuditor Joseph P. OreficeInformation Technology Officer Karen L. ORourkeAssistant Treasurer Charles E. SamourSecurity Officer Melanie M. SullivanAssistant Treasurer Margaret E. WhiteAssistant Treasurer Patricia A. WittsAssistant Treasurer Michael J. WoodsAssistant Vice President Board
of Directors and Executive Committee Mathias B. Bedell
Gerard H. Brandi, Chairman
Robert S. Cummings, Clerk
Stephen E. Marshall
Herbert G. Schurian
Dr. Donald B. Stackhouse
Donna H. West 64