The First Bancorp, Inc. Annual Report 2008

Plain-text annual report

A N N U A L R E P O R T 2 0 0 8 First Light As the sun peaks over our spruce-lined shores, a new day dawns along the coast of Maine. While much of the country is still asleep, a lobsterman heads out on Penobscot Bay; a runner begins her morning jog on the carriage roads of Acadia; and, at 7 a.m. sharp, customers of The First are banking at drive- up windows all along the coast, from Wiscasset to Calais. Here in Maine, we make the most of dawn’s early light. And here at The First Bancorp, we are proud to report that your company was on the rise again in 2008, shining brightly on the financial industry’s larger, wavering horizon. On the following pages, we invite you to read our President’s letter, our Chief Financial Officer’s letter, and the articles that appear in between which we have written to help you gain a better understanding of the financial crisis our country is facing. Message from the President 2 Dear Shareholder: I am pleased to report that 2008 was another year of record earnings for The First Bancorp, Inc. Especially satisfying was the fact that these earnings were achieved in a year with the economy in a recession, the housing market collapsing and a financial crisis that engulfed the banking industry. 2008 was both a tumultuous and a highly volatile year for the financial sector with economic conditions not seen in many decades. In this annual report we will share with you our results and articulate the underlying reasons for another successful year at The First. In addition, we have included several background articles on important topics that will help clarify what led to the financial crisis and what steps have been taken to address the issues. Record Earnings Net income of $14,034,000 was an increase of $933,000 or 7.1% over the $13,101,000 earned in 2007. Earnings per share on a fully diluted basis were $1.44, up $0.10 or 7.5% from the $1.34 reported for the year ended December 31, 2007. The First Bancorp certainly stands out in comparison to other financial institutions that are announcing large losses or a fairly significant decline in earnings. There are a number of factors that led to this exceptional result for the Company. One of the major contributors was the $99.3 million growth in earning assets. The Company’s loan portfolio increased by $59.1 million or 6.4% during the course of the year and we increased the Bank’s investment portfolio by $40.7 million or 18.4%. This growth, combined with a decrease in interest costs, resulted in a strong increase in net interest income from $31.8 million in 2007 to $37.7 million in 2008 – a $5.9 million or 18.4% increase. As previously mentioned, this excellent result in net interest income was driven by a combination of growth in earning assets and a substantial reduction in funding costs brought to fruition by declining interest rates. The net interest margin also improved from 3.13% in 2007 to 3.33% in 2008. The Bank’s balance sheet was liability sensitive at the end of 2007, which meant that as interest rates declined, the cost of funding our loans and investments declined at a more rapid pace than the decrease in yields on our loans and investments. This $5.9 million increase in net interest income was the single most contributing factor to the $933,000 improvement in net income. When we mention interest rates we are referring to the Federal Funds Target Rate which is set by the Federal Open Market Committee (FOMC) of the Federal Reserve Bank. As of December 31, 2007, this rate was 4.25%, which was down 1.00% from the June 2006 high of 5.25%. As the economy continued to weaken during 2008 and the financial crisis worsened, the FOMC dramatically lowered this target rate by 4.00% to 0.25% as of yearend. This was an unprecedented low, well below the 1.00% bottom in June 2003 during the post 9/11 rate cycle. The prime lending rate, which is widely used as the base for business loans and home equity loans, averages 3.00% above the Fed Funds Target Rate and ended 2008 at 3.25%. The last time that the Prime rate was this low was over 50 years ago in 1955, making today’s rates historically low for the modern economy. According to economic theory, low interest rates spur economic growth and decreasing rates is a move to either prevent a recession or minimize the depth and length of a recession. Net interest income grew from $31.8 million in 2007 to $37.7 million in 2008 – a $5.9 million or 18.4% increase. �� 3 We continue to have a strong lending focus and culture which has helped us grow the portfolio in weak economic times. Efficiency Ratio loans on the books of $59.1 million. The categories with the largest increases were commercial real estate, which One of the performance metrics The First Bancorp prides contributed $52.8 million to the growth, and residential itself on is the efficiency ratio – a measure of the cost of real estate, which was up $10.0 million. The growth in operations in relationship to operating revenues. The lower these portfolios was offset by a net decline in general the figure, the more efficiently the company performs. business loans and consumer loans of $5.2 million. We This ratio improved from 50.16% in 2007 to an industry- continue to have a strong lending focus and culture which leading level of 46.07% in 2008. This is the best it has been has helped us grow the portfolio in weak economic times in the history of the Company. On a national basis, The without compromising our loan underwriting standards First Bancorp had the 60th-best efficiency ratio of the 500 nor our loan pricing approach. Generating good quality largest bank holding companies in the United States in the loans and operating efficiently have been the keys to our third quarter of 2008. Operating as efficiently as possible success over the past 15 years. has been a major focus of the Company for the past 15 years and is made possible by the great buy-in from all of Investments: Another source of revenue growth for the the employees and the effective utilization of technology. Company is the investment portfolio which increased Asset Growth by $40.7 million in 2008. The primary investments purchased were municipal securities and U.S. agency securities, all of which carry low exposure to credit risk. Loans: Despite a weak economy and relatively slack At the same time, the Company decreased its corporate loan demand, the Company still posted a net increase in bond holdings by $10.3 million, and the $5.7 million in �� remaining corporate bonds represent only 2.2% of the investment portfolio. Our goal is to have minimal credit risk in the portfolio which is the reason for the reduction in corporate bonds. Revenues from interest and dividends on investments were $13.3 million, an increase of $2.2 million or 19.3% over 2007. Asset Quality While the weaknesses in the national and global economies have not impacted coastal Maine as much as other parts of �� the country, we nevertheless experienced deterioration in the asset quality of our loan portfolio. Net charge offs in �� 4 We continue to have a strong lending focus and culture which has helped us grow the portfolio in weak economic times. 2008 were $2.7 million compared to $1.0 million in 2007. long-standing approach to working with our borrowers One borrowing relationship contributed $1.1 million to and our strong loan underwriting standards helps alleviate the loan losses in 2008, with the balance being spread some of the payment problems on customers’ bank loans across the portfolios similarly to our past experience. This and in the end minimizes actual loan losses. $2.7 million in net losses is 0.28% of average loans in 2008 which is higher than our results in the most recent decade Another downside of a recession is the amount of but is still relatively low compared to most banks across foreclosed properties the Bank ends up owning. As of the country. Our average loss rate over the past 20 years December 31, 2008, these totaled $2.4 million, up $1.6 is 0.22%. Without the $1.1 million attributable to the million from the $0.8 million at the end of 2007. This is a one relationship, the loss ratio would have been 0.17%, relatively modest level, however, given the loan portfolio which is in line with our ten-year historical average of is nearly $1.0 billion. 0.16%. We have an excellent track record of managing our loan portfolio to minimize losses, and the last time As previously mentioned, the Company’s allowance for loan losses were at this level was during the late 1980s loan losses increased by $2.0 million in 2008, ending and early 1990s. In addition to covering the actual losses the year at $8.8 million. The allowance is a figure that posted in 2008, the $4.7 million provision made to the represents an amount sufficient to absorb probable losses allowance for loan losses in 2008 resulted in a $2.0 million in the loan portfolio in the short term. A number of net increase in the allowance. With a weakening economy factors are taken into consideration in arriving at the and an increase in our level of non-performing loans, we appropriate level for the allowance, such as historical felt it prudent to add to the reserve. losses, delinquency trends, a specific review of individual In addition to loan losses being up, the level of non- performing assets to total assets stood at 1.31% as of yearend 2008, a significant increase over the 0.56% level of December 31, 2007. This increase is clearly attributable to the impact the weakened economy is having on our borrowers. Small businesses are seeing revenue and sales decline and some are now struggling to meet their obligations. A number of consumers have either lost their jobs or seen a reduction in hours worked and/or overtime, thereby creating strained finances resulting in payment issues on their loans. This, unfortunately, is very common and expected in these recessionary cycles. We feel our �� 5 The Company ended the year comfortably above the well-capitalized threshold. loans and general economic conditions. The two most increasingly important and critical for every bank, important elements are the historical losses and the specific irrespective of its performance. The bank regulatory loan reviews. As of December 31, 2008, the allowance for agencies place a strong emphasis on a bank’s capital ratios loan losses stood at 0.90% of total loans outstanding. which they see as a buffer to absorb losses. The more capital a bank has, the more comfortable the regulators Our historical loss factor over the past 20 years is 0.22%, are. In these recessionary times it is no longer viewed as so at 0.90%, this represents coverage for more than four acceptable to only be well-capitalized – the new measure years of potential losses. The First has a high concentration bank regulators are looking for is to have the bank be in residential real estate loans, comprising 46.6% of the super-capitalized. total loan portfolio. This loan category has a much lower level of losses in comparison to other loan types. For The Company ended the year comfortably above the example, in 2008 the loss ratio for residential mortgages well-capitalized threshold but felt the prudent course was was 0.04% compared to 0.28% for the portfolio as a to increase the bank capital to levels well whole. We have avoided writing any subprime loans and above the minimum requirements. In what is commonly referred to as “no documentation loans” which have been the two types of loans that are currently defaulting on a large scale across the country. In addition, the Company does not have a credit card loan portfolio or a portfolio of what is referred to as dealer consumer loans. These loan categories generally carry more risk and therefore higher losses. Given all of the above factors management feels comfortable with the $8.8 million allowance level as of December 31, 2008. Bank Capital In challenging economic times bank capital becomes 6 exploring different sources of capital and availability, it became clear that the least expensive option and the one least dilutive to common shareholders was to participate in the U.S. Treasury’s Capital Purchase Program. The Company did so to the tune of $25.0 million, receiving the capital in early January 2009. On page 10 of this report is a detailed article on the Capital Purchase The Company ended the year comfortably above the well-capitalized threshold. Program and a more detailed explanation as to the Market Value of The First Bancorp Shares reasons for our participation. With our total capital ratio now at 13.97% based upon risk-based assets on December One of the biggest highlights of our successful 31, 2008, we feel very comfortable going forward and performance in 2008 was the market appreciation of working through this economic recession regardless of First Bancorp shares. In an era when all indices were how long it may last or how deep it may go. down in the 30% range, our stock went from $14.64 on Cash Dividend December 31, 2007 to $19.89 per share on December 31, 2008, and posted a total return of 43.7% for the year. For a good part of the year, our stock price was up The Company has a long history of paying out a good despite most of the market, especially financial stocks, portion of our earnings in the form of cash dividends. In 2008, the dividends declared amounted to 52.76% of our net income and was the fifteenth consecutive year of dividend increases and provided the highest payout over this period. In comparison, in 1994 the payout was 15.36% of earnings. We recognize that a strong dividend yield is not only an attractive component for investing in The First Bancorp, but is also a source of current income that a number of shareholders rely on. In 2008 the dividend represented being down. As a comparison, the KBW Regional Bank Index had a total return of -18.5% and the broad market S&P 500 had a total return of -36.9%. Over the past five years the total return of FNLC shares has been 43.93% with a compound annual growth rate of 7.56%. This compares to a negative total return of 15.16% for the S&P 500 and a negative 0.42% for the NASD Bank Index. a 10.9% increase over the 2007 dividend and produced a In June, The First Bancorp was added to the Russell 2000 yield of 3.92% based on the $19.89 year end closing price and Russell 3000 indices. Being part of these indices has – especially attractive in the low interest rate environment resulted in much more volatility in our stock as larger that exists. We still feel it is both prudent and good practice volumes of shares may be traded in a day based on investors for the Company to continue to distribute a good portion flowing funds into or out of index funds. Inclusion in the of our annual earnings to our shareholders in the form of Russell 3000 Index is based on the market capitalization cash dividends and believe our longstanding track record of the top 3,000 stocks that are publicly traded, therefore supports that view. we do not make the decision to belong or not belong. On 7 the whole it appears that despite the volatility this added the insurance coverage from $100,000 to $250,000. The 2009 will likely be a year of even greater uncertainty than 2008. liquidity for our shares is a positive. FDIC also was proactive in informing the public that the The First Bancorp, Inc. insurance fund was solvent and they had access to the full resources of the U.S. Government should additional monies be needed to cover losses from failed banks. Please At the April 2008 shareholder meeting, the name of the see the article on page 13 for more detail on this topic. Company was changed from “First National Lincoln Corporation” to “The First Bancorp, Inc.”. The rational The Financial Crisis for the new name reflects the expansion of the Company’s physical presence and the Bank’s customer base beyond 2008 was a year that will be remembered as one of the Lincoln County communities. Since the introduction of most challenging periods since the Great Depression. The The First Bancorp, we have been very pleased with the problems first surfaced in the summer of 2007 and were results. The synergy of referring to the Bank as The First related primarily to problems with subprime mortgage and the Company as The First Bancorp has developed loans. From that point forward, the problems in housing effectively. We feel a much broader base of customers and carried over into the entire financial system. There were shareholders now realize that both entities are one and several points during the year when the crisis and concerns the same. On a go forward basis, we are confident that the about a systemic failure of the financial markets became brand identity of the Company and the Bank will become critical. The Federal Reserve began aggressively lowering much stronger as well. FDIC Insurance the Fed Funds Target Rate in March 2008 after the near- collapse of Bear Stearns, which ended up being sold to J.P. Morgan with the help of the Federal Reserve Bank. The markets seemed to have calmed down after that as As the financial crisis worsened and the media became the Federal Reserve also provided the investment banks more and more obsessed with perceived problems in access to the Fed Discount Window. The housing market banking industry, the importance of FDIC insurance has continued to decline, however, resulting in more losses in heightened. Especially confusing to the general public was mortgage-backed securities, more questions on the value the reference to Wall Street investment firms such as Bear of those securities and the losses the banks holding these Stearns and Lehman Brothers as banks. These companies securities would have to recognize. Please see the article were not banks, were not approved to accept FDIC- on page 16 for more detail on this topic. insured deposits, and were not regulated like a bank. The reference in the media, however, created an increased level The next pivotal event was in September 2008 when of anxiety for all bank customers. Fortunately, the FDIC over the course of a few days, the investment bank took decisive action to alleviate this concern by increasing 8 Lehman Brothers filed bankruptcy and 80% of AIG 2009 will likely be a year of even greater uncertainty than 2008. (American International Group) was acquired by the salability of real estate has been impacted as well. As U.S. Government to keep it from failing. As a result, the borrowers default on mortgage loans, foreclosures have financial markets seized up even more and for the most increased as the owners are unable to sell their homes. part were on a downward spiral. The financial crisis was With a weak buyers market, there is little interest in the not limited to just the United States as similar major foreclosure sales which drives the values of homes down financial problems surfaced globally. The Federal Reserve, further, fueling the downward spiral. the U.S. Government and the FDIC collectively instituted aggressive actions to stabilize the financial markets, free up We are optimistic that in 2009 the housing market will the flow of funds and calm people’s concerns about the somehow stabilize and the financial markets, in turn, will safety of their money held in banks and money market begin to improve. The economy, however, is likely to mutual funds. As 2008 came to a close, solving the financial remain weak for most of 2009, even if the housing market crisis was a top priority as the economy continued to stabilizes. For the Company, this will be another year worsen. The housing slide in home sales and prices did not with a strong focus on asset quality. At the same time, we show any improvement and the unemployment rate and expect to still find good lending opportunities and will job losses continued to increase at an alarming rate. continue to take advantage of them when they present What Will 2009 Look Like? themselves. We continue to keep a watchful eye on our expenses and anticipate that the interest rate environment will be stable at these historically low levels. 2009 will likely be a year of even greater uncertainty than 2008 was. As I write this letter in the first quarter of Despite the economic turmoil of the past two years, The 2009, the unemployment rate has continued to increase First Bancorp has prospered and we are optimistic that and is expected to reach levels not seen in many years. 2009 will be another successful year. On behalf of the On a daily basis, the news media reports additional major Board of Directors and our employees, we thank you for layoffs, the economy shows continued weakness, the auto your support and confidence in The First. industry is under severe strains and the housing crisis still has not been contained. All of these components are Sincerely, interconnected with multiple ideas and opinions on what the best steps need to be taken to resolve them. The problems brought about from subprime mortgage Daniel R. Daigneault lending have carried over into the entire housing market, President & Chief Executive Officer impacting the value of real estate across the country. Not only have housing values declined, but the actual 9 U.S. TREASURY CAPITAL PURCHASE PROGRAM In the fall of 2008, the financial crisis worsened to the point where there was grave concern that some of the major financial institutions in the United States might fail and the financial markets would cease to function. For months, various steps had been taken by the Federal Reserve Bank to calm the financial markets without any great success and, in October, at the request of the Bush Administration and the Federal Reserve, the U.S. Congress enacted the Emergency Economic Stabilization Act. The Act allowed the Secretary of the Treasury to establish the Troubled Asset Relief Program (TARP), and one of its initial priorities was to have the U.S. Government purchase troubled assets directly from financial institutions at an agreed upon price. The theory was that taking troubled assets off the institutions’ books would make the markets more liquid and place the affected financial institutions in a better position to lend more money to businesses and consumers. This approach was not implemented, however, as its execution proved to be more complex than anticipated and the pricing of the toxic assets was a major roadblock. 10 What is the Capital Purchase Program? The same legislation, however, also authorized a Capital Purchase Program (CPP) with a goal of “stabilizing the financial system by increasing the capital in U.S. banks and then restoring confidence so credit can flow to consumers and businesses.” This voluntary program for qualifying healthy banks is designed to allow the U.S. Treasury to inject capital into the banking system by buying senior preferred stock issued by the banks. Out of the $700 billion that was authorized by Congress under the Emergency Economic Stabilization Act, $250 billion was set aside for this program. The amount any one bank could receive was limited to 3.00% of its risk based assets, and the $250 billion provided sufficient funds for all banks in the United States to participate. The attractiveness to banks was the relatively low cost of 5.00% for tier-1 bank capital, as well as the ease of participation and the short time frame which the funds would be available. The goal is to stabilize the financial system by increasing the capital in U.S. banks and then restoring confidence so credit can flow to consumers and businesses. Sources of Capital Banks – especially community banks like The First Bancorp – have limited options to raise additional capital. One option that has been utilized by banks over the past ten years is the issuance of Trust Preferred Pooled Securities. This form of bank capital generally carried an interest rate in the 9% range and was, at one time, readily available to healthy banks on relatively short notice. The financial crisis and credit crunch in late summer 2008 essentially wiped out this market and the availability of capital from this source became non-existent. The other option for capital is the issuance of additional common stock, which is much more expensive and dilutive to the holdings of existing shareholders. The cost of common stock is calculated on the targeted rate of return on tangible equity (ROE). The First Bancorp has a targeted ROE of 15.0%, which we have achieved over the past fifteen years. If we wanted to raise $25.0 million in equity, we would have to issue approximately 1.5 million new shares of common stock. These new shares would dilute the ownership of the current shareholders by 13% -- a fairly significant level. Cost of Capital In order to provide a 15.0% ROE on this higher capital base, the earnings after tax would need to increase by $3.7 million, or 26.4%, over the $14.0 million earned by the Company in 2008. In contrast, the senior preferred stock sold to the government under Capital Purchase Program has a 5.0% cost for the first five years, which would require readily a much more attainable increase in after- 11 Community banks like The First have, on average, outstanding loans equal to ten times their tangible capital. tax earnings of $1.25 million, or 8.9%, to cover the incremental costs. The CPP also required participating banks to issue warrants to the Treasury giving it the right to purchase from the company a number of common shares equal to 15% of the amount of the senior preferred stock. For The First Bancorp, this totaled 225,904 shares, or 2.33% of our outstanding shares. So the dilutive factor is 2.33%, versus 13.00% had the same amount of capital been raised by the issuance of common stock. Under the CPP program, the Treasury does not have any voting rights and the preferred stock can be repaid at the bank’s option and with the approval of the bank’s regulator. Importance of Bank Capital Why would a healthy bank participate in this program? The amount of capital a bank has is a critical driver in determining the amount of money that can be loaned to customers or invested. Community banks like The First have, on average, outstanding loans equal to ten times their tangible capital, meaning that $25.0 million of new capital supports up to $250 million in net new loans. Equally important, however, is that capital is viewed by banking regulators as the backstop for problem loans. Regulators look very carefully at the ratio of criticized loans to a bank’s tangible capital. If that ratio gets too high they may require the bank to raise additional capital and/or reduce the level of non-performing assets in a short time period. An accelerated sell-off of problem loans could result in increased loan losses, business failures and increased unemployment. With excess capital made available through the CPP, healthy banks are in a much better position to work with struggling customers and modify loan terms, change payment structures or take other reasonable steps to allow businesses a better chance of surviving the economic recession, and help consumers stay in and keep their homes. The Capital Purchase Program has noble goals and, if implemented effectively, will be a successful program for the U.S. Treasury and participating banks. For a further discussion of the importance of capital for banks, please see the letter from our Chief Financial Officer on page 20. ■ 12 The Importance of FDIC Insurance One of the basic foundations of our nation’s financial system is confidence, and as financial intermediaries, banks rely on confidence to make their business work. The basic model for a bank is very simple: bring in funding, primarily from depositors, and use it to make loans or purchase investments. What makes this work is the confidence that the Federal Deposit Insurance Corporation (FDIC) provides to depositors: they will get all of their money back, when they need it, which is especially important during times of financial turbulence. What is the FDIC? The FDIC is the U.S. Government agency that provides deposit insurance and guarantees the safety of checking accounts, savings accounts, certificates of deposit and retirement accounts – up to certain limits. While we have all heard of the FDIC and have seen “Member FDIC” signage in banks and in bank advertising, the concept of insuring bank deposits is relatively new. Prior to the twentieth century, there was no bank guarantee fund 13 In 2008, the deposit insurance coverage limit increased from $100,000 to $250,000 and the insurance coverage for non-interest-bearing checking accounts is now unlimited. at a national level to protect depositors during the occasional bank panic or failure. Over time, a number of deposit security measures were adopted at the state level, and when the Federal Reserve was founded in 1913, the government chose to be a “lender of last resort” which would keep troubled banks afloat rather than provide guarantees on bank deposits. The Great Depression put an enormous strain on the banking system, however, and in 1933, the United States experienced a bank panic that saw the closing of over 4,000 banks. While the federal government stepped in to merge weaker banks with stronger ones, it was months before depositors saw even a portion of their funds that were deposited in the failed banks. At the height of this crisis, President Roosevelt signed the Banking Act of 1933 establishing the Federal Deposit Insurance Corporation – initially intended to be a temporary measure to raise the confidence of U.S. depositors in the banking system. When FDIC deposit insurance went into effect in January of 1934, the initial insurance coverage level was $2,500. Later that year, the coverage was increased to $5,000, and with the passing of The Banking Act of 1935, deposit insurance coverage and the FDIC itself were made permanent. Over the years, the insurance level has been increased several times until it reached $100,000 in 1980, where it remained until 2008. In 1950, Congress expanded the FDIC’s role and authorized the agency to also examine banks on a regular basis to determine how well each bank is run and the level of risk it places on the deposit insurance fund. Today the FDIC insures more than $4.3 trillion in deposits in over 8,000 U.S. banks and thrifts. It employs 4,500 people nationwide and is managed by a five person board of directors, all of whom are appointed by the President and confirmed by the Senate. How is the FDIC funded? The short answer to this question is that the FDIC is funded by banks themselves though premiums that are assessed based upon a bank’s level of deposits. It also receives a small amount of revenue from the investment of the fund’s assets in U.S. Treasury securities. Over the years, however, the costs to the FDIC-member banks have gone up dramatically and this increase was not based solely on regular deposit premiums. By law, the FDIC has to maintain reserves at a specified target, currently 1.25% of insured deposits, and if the Fund falls below this target, deposit insurance premiums paid by banks are increased. In other words, when a bank fails, the remaining healthy banks pay the cost of replenishing the fund, not the U.S. taxpayer. Until the 1980s, only regular banks were insured by the FDIC. Savings and loan institutions, or thrifts, were insured by a similar but separate agency, the Federal Savings and Loan Insurance Corporation (FSLIC). During the S&L debacle in the late 1980s, FSLIC became insolvent and was recapitalized with $8.0 billion of bonds issued by the Financing Corporation (FICO), to be repaid with funds from the Federal Home Loan Bank System and premiums from FSLIC- insured banks. The recapitalization plan proved to be inadequate, however, and in 1989 Congress established a new fund – the Savings Association Insurance Fund (SAIF) – which was administered by the FDIC. At this point, FICO bond payments were expected to come 14 $250.000 out of insurance premiums paid by the FSLIC-insured banks for their coverage by the SAIF fund. additional coverage is also expected to be temporary and end on December 31, 2009. It soon became apparent that the SAIF revenues would not be able to cover the SAIF bond payments as the projected annual deposit growth rate of 7% proved to be overly optimistic. This led Congress to pass the Deposit Insurance Funds Act of 1996 requiring regular banks, which had previously not been involved in the S&L problems, to assist with repayment of the FICO bonds. Beginning in 1996, regular banks were required to pay a FICO bond assessment equal to one-fifth of the amount that the FSLIC-insured banks were paying until 1999 when the SAIF fund and Bank Insurance Fund (BIF) were merged into one – the Deposit Insurance Fund (DIF) – after which the assessments were equally shared by all. Changes to FDIC Coverage in 2008 With a high level of instability in the financial markets in 2008, Congress passed the Emergency Economic Stabilization Act (EESA) to shore up depositor confidence in the banking industry. First, the deposit insurance coverage limit was increased from $100,000 to $250,000. This is expected to be temporary and revert to $100,000 on December 31, 2009 (excluding retirement accounts which were already insured up to $250,000 and will remain at that level.) The second major change is that insurance coverage for non- interest-bearing checking accounts is now unlimited, however this is optional for financial institutions. The First is participating, so all non-interest bearing checking accounts in our Bank, regardless of how they are owned, are insured to the balance on deposit. This services consumers, In addition to providing insurance coverage and examining banks, the FDIC also provides many educational including for informational booklets and an interactive website that helps consumers learn about deposit insurance. Consumers can also use an online calculator to determine that best way to structure their accounts for maximum FDIC coverage. The FDIC is backed by the full faith and credit of the United States government and since its inception no one has lost a penny of insured deposits as the result of a bank failure. The Cost to Us So what does this mean to The First in terms of real dollars? At the end of 2008 our FDIC insurance premium assessment (based on our total deposits) was approximately $550,000 per year and our FICO Assessment was $100,000 per year, for a total annual premium of $650,000. As noted above, when a bank fails, the cost of this falls to the remaining healthy banks, and as a result of the increasing level of bank failures in 2008, we expect our total deposit insurance premium in 2009 to be at least $1.5 million. The FDIC has also proposed a one- time special assessment to be levied on all FDIC-insured banks in 2009 to help replenish the fund. While increased FDIC coverage will prove to be beneficial to depositors and is necessary in these challenging economic times, this comes at a cost to FDIC-member banks, even if those banks are very healthy and well- capitalized like The First, with little risk of failure. ■ 15 WALL The roots of the current financial crisis go very deep and are centered on the traditional home mortgage, which, until recently, had been considered one of the safest, most secure and least risky loans. Mortgages are typically written for repayment over 20 to 30 years and may have a fixed interest rate for the entire period or one that may adjust periodically based on a change in an agreed upon index, such as the rate on the one-year U.S. Treasury. The borrower makes a monthly payment that includes both interest and repayment of principal. Because of the pride most Americans traditionally take in their homes, conventional wisdom and experience have shown that borrowers tend not to risk their homes and, in general, when paying debt, the mortgage gets paid first. If these were such low-risk loans, then how could they be at the heart of today’s mess? The simple answer is greed and self-deception. Take a low- interest rate environment and a huge demand for home ownership, combine these with the belief that home prices would continue to climb, and the stage was set for the mortgage meltdown that we have seen over the past two years. While most mortgages that were made in this decade were based on sound underwriting standards, a hybrid product – the subprime mortgage – ultimately is behind our situation today. This is a story that starts on Main Street and ends on Wall Street. There is a lot of jargon used these days to describe the various contributors to the mortgage meltdown. To help understand what the most commonly used terms mean, we have assembled the following glossary and chronology that takes us from the simple, safe, low-risk home mortgage of Main Street to what is now described as the toxic waste of Wall Street and the effect it is having on the financial system. Fannie, Freddie and Ginnie Many of the banks on Main Street that originate mortgages do not want to hold these long-term fixed-rate instruments on their balance sheets 16 STREET because they pose too much interest rate risk. As a result, three entities were created between 1968 and 1970 to broaden home ownership in the United States by making mortgage financing more readily and widely available. Fannie Mae (Federal National Mortgage Association or FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation or FHLMC) are both Government Sponsored Enterprises (GSEs) – for-profit corporations created through Congressional legislation but owned by shareholders. Ginnie Mae (Government National Mortgage Association or GNMA), however, is a part of the U.S. Department of Housing and Urban Development and thus is backed by the full faith and credit of the U.S. Government. MBS Fannie, Freddie and Ginnie work in a similar fashion – they buy mortgages from regular banks and mortgage origination companies (such as Countrywide) and then sell the majority of them to other investors. Rather than selling them as individual mortgages, however, a number of mortgages are put together to create a pool of mortgages, and then pieces of the pool are sold to different investors – usually in $1,000 units – as a Mortgage-Backed Security (MBS). One important characteristic of an MBS is that Fannie, Freddie and Ginnie provide a credit guarantee, so an MBS has a AAA rating and has virtually no credit risk for the investor. CMO MBS investors receive a principal and interest payment every month based upon the payments from the mortgages which make up the pool. Since mortgages give the borrower the ability to repay part or all of the loan at any time, however, the MBS investor does not know exactly how long it will be until the investment is completely repaid. Enter the Collateralized Mortgage Obligation (CMO) – a marvel of Wall Street financial engineering that is designed to bring a much higher degree of repayment certainty than an MBS. A CMO is typically a The Alchemy of Transforming Simple Home Mortgages Into Toxic Assets 17 behemoth financial structure that is created by pooling many MBS pools and then dividing them into tranches, or slices, each with a different time period for repayment. With the good comes the bad, though … to create a tranche with more certain repayment characteristics, a backstop tranche with total repayment uncertainty is also created to make this happen. These backstop tranches typically have much higher yields and much greater risk, and they were the toxic waste of Wall Street that was sold in the early 1990s to unsuspecting local governments, such as Orange County, California, which had no idea what they were purchasing. ABS Since Wall Street is very creative, putting together pools didn’t stop with regular mortgages. Today you can purchase an Asset Backed Security (ABS), a pool made up of a variety of underlying financial instruments, including commercial loans, auto loans, student loans, financing receivables, or credit card debt, to name a few. Investors like these because pooling together the underlying loans reduced the overall risk and these were sometimes enhanced with an added credit guarantee. 18 Subprime Mortgage In good financial times, potential risks and memories of past problems are easy to ignore, and in the early to middle part of this decade, economic conditions were ripe for such avoidance. The economy was doing well, housing demand and prices were skyrocketing, and everyone wanted to get in on home ownership before it was too late. Enter the Subprime Mortgage, a loan generally made by mortgage originators (not regular banks) to borrowers with little or no demonstrated ability to repay or with marginal credit, typically characterized by a FICO score of 620 or below. Many of these loans were made with an initial low rate that would adjust upward after a few years, at which time it was presumed that the borrower would have higher income to afford the higher payments or would sell the home and book a tidy profit. The problem is that many of these subprime mortgages were made to borrowers who didn’t have the ability to repay even at the low initial rate, let alone the higher rate that some of the loans reset to after one to two years. CDO Once again, enter the financial engineers of Wall Street. After such great success in creating and selling the MBS, the CMO and the ABS, putting together pools of subprime mortgage was seen as the logical next step. In the same way that the CMO provided predictability for the timing of repayment of principal, the Collateralized Debt Obligation (CDO) was designed to remove credit risk for the investor in pools of subprime mortgages. Once again, this was done by creating good tranches, in this case with little or no credit risk, balanced by higher- yielding bad tranches, which were designed to take most or all of the credit risk. While the good tranches had AAA ratings from the credit agencies, there was a fatal flaw in the design: the assumptions and models used to quantify the potential default of subprime mortgages grossly underestimated the actual rate. The result was that the bad tranches were quickly wiped out as mortgages defaulted and suddenly the AAA-rated tranches were experiencing losses that were never anticipated. CDS Just as most people purchase insurance to protect against an untimely event beyond their control such as a home fire, auto accident or early death, investors can purchase insurance against the credit default of a borrower: the its current fair value. For banks, this is typically seen in the investment portfolio when the partial or full repayment of a security is uncertain, resulting in the security being classified as “other-than-temporarily-impaired.” When this occurs, the difference between the carrying value and fair value of the security is recorded in the company’s statement of income. Credit Default Swap (CDS). Like a typical insurance policy, regular payments are made by the policy owner for the term of the policy or until a specified event occurs: with a CDS this is typically a loan or bond default or a declaration of bankruptcy. If that event occurs, an agreed- upon sum is paid to the policy owner. In good economic times, the perceived potential for default or bankruptcy was low, so banks and insurance companies were willing to write a CDS for a relatively low premium, thinking it would be easy income with little risk. In the past two years, however, that has not been the case, and the amount of CDS payouts have crippled many underwriters, such as the insurance giant AIG. And to make matters worse, a CDS could be written for speculative purposes, betting against a company even if one had no financial interest in it. We have never originated subprime mortgages and none of the securities we Mark-to-Market own have subprime mortgages as their underlying collateral. decades, For companies have accounted for their assets using historical cost – the actual price paid for an asset, less any accumulated depreciation. Since the early 1990s, however, the Securities and Exchange the Financial Commission and Accounting Standards Board (which establishes the accounting rules in the United States), have pushed to change from historical cost accounting to Mark-to-Market or fair value accounting. While this has been touted as in the best interest of the investor, it may not always be the case. For example, when markets seize up and no one is willing to buy anything at any price, as they did in the third and fourth quarters of 2008, what is the true value of an asset? In this case, fair value accounting can mislead the investor about the true value of a company, since the asset would be priced at its liquidation value at that moment in time, not at its true value assuming the company has the ability to ride out current economic problems and await the market’s rebound. Impairment A component of fair value accounting is Impairment – a charge against current earnings to write down an asset to The Situation Today While it has taken nearly forty years, what started as a way to expand home ownership and allow more people to live the American dream is now on a much different path. As the economy weakened, people became more conservative and began spending less. This, in turn, led to fewer jobs and more foreclosures. With less demand and more houses for sale, home prices suddenly began to fall after rising for so long. At this point in the cycle, borrowers with subprime mortgages had loans that were repricing upward and they were unable to sell their loans, homes or refinance their which put them in default. Investors then saw huge losses on securities that were supposedly of the highest quality, which ultimately led to the writedown of billions and billions of dollars by large banks and brokerage firms holding the CDOs collateralized by subprime mortgages. How This Affects The First The First Bancorp has always operated on Main Street, not Wall Street. We maintain a conservative credit culture with high underwriting standards, which is why we have never originated any subprime mortgages. This culture extends to the investment portfolio as well, where none of the securities we own have subprime mortgages as their underlying collateral. Our securities available for sale portfolio carries all investments at fair value, and as of December 31, 2008, none of our investment securities were classified as other-than-temporarily impaired. While staying with our principles may have seemed overly conservative to some in the past, today it is obvious that it was the best course to have taken. ■ 19 Message From the Chief Financial Officer Dear Shareholder: It is certainly a challenging time for the banking industry and we have devoted much of this year’s annual report to help you better understand what has led to the current economic situation and how The First Bancorp is navigating through it. In 2008, our record earnings were driven by excellent growth in earning assets, wider margins due to declining rates, controlled operating expenses and a strong focus on asset quality. The Importance of Capital The basic business of banking is pretty simple – we bring in money from deposits and other borrowings (our liabilities) and then lend it or invest it (our assets). There is a third section of the balance sheet however: shareholders’ equity or the bank’s own stake in the game. In order for a bank to remain in business, shareholders’ equity or bank capital must be a minimum percentage of assets to be considered “well-capitalized” by the FDIC. Since some assets on a bank’s balance sheet have more risk than others, capital ratios are calculated in two ways: with total assets as shown and then after adjusting these assets for credit risk. To calculate “risk-weighted assets,” U.S. Treasury securities are weighted at 0% of their carrying value, Government Agency securities at 10%, municipal securities at 20%, residential mortgages at 50% and all other loans at 100%. Risk-weighted assets are typically quite lower than total assets at most banks. For The First Bancorp, as of December 31, 2008 our total assets were $1.325 billion while our risk- weighted assets were only $877.7 million. 20 In challenging times such as these, having ample capital is critical and enables a bank to better ride out the economic storm. There are three capital ratios used by the banking In challenging times such as these, having ample capital is regulators. The first is total capital (after adjusting for critical and enables a bank to better ride out the economic intangibles) as a percentage of average assets for the storm. But banking regulators look at more than the ratio quarter, which is known as leverage capital. The second of bank capital to assets – they also evaluate the level of is total capital as a percentage of risk-weighted assets, or problem loans to bank capital. If this ratio rises above 50% tier-1 risk-based capital. The third is total capital plus the of bank capital, the regulators may step in and push a bank allowance for loan losses as a percentage of risk-weighted to reduce its level of problem loans. This can be done in assets, which is known as total risk-based capital. To be two ways – by encouraging the borrower to refinance considered well-capitalized, a bank’s leverage capital must elsewhere or sometimes to foreclose on the loan, which be at least 5.0%, tier-1 risk-based capital at least 6.0%, and happened frequently in the early 1990s. It is one of the total risk-based capital at least 10.0%. As of December 31, factors which made that economic recession even worse. 2008, the Company’s actual ratios were 7.07%, 10.11% and 11.13%, respectively. Although The First Bancorp comfortably met the well- capitalized threshold of 10.0% of risk-weighted assets How does a bank add to its capital? Retained earnings as of December 31, 2008, the Board and Management is the most common way, however a bank can also issue felt that carrying additional bank capital would be new stock to increase capital levels. And what reduces prudent given current economic conditions. This was capital? Dividends are the most common use of capital, the primary reason for choosing to participate in the and a bank can also use capital to repurchase its own stock. But in the same way that earnings add to capital, losses reduce bank capital – which is the reason regulators require a bank to have a minimum ratio of capital to its assets. This is the buffer that allows a bank to absorb losses while depositors’ dollars remain safe. �� Capital Purchase Program, under which we received a $25 million preferred stock investment from the U.S. Treasury. Based upon our December 31, 2008 assets, leverage capital increased from 7.07% to 9.06% after the preferred stock investment, tier-1 risk-based capital went from 10.11% to 12.96%, and total-risked-based capital increased from 11.13% to 13.97%. 21 The challenge we face is determining the opportune time to extend liabilities. The Capital Purchase Program has, unfortunately, been The table below shows the composition of the incorrectly maligned by the media. It is not a bailout, investment portfolio at December 31, 2008. All and it has been structured to make money for the U.S. of the mortgage-backed securities in the portfolio taxpayer, not to cost the taxpayer. More importantly, were issued by either Fannie Mae, Freddie Mac, though, it is intended to strengthen the capital position or Ginnie Mae and we had no collateralized debt of the banks and stimulate the flow of funding to the obligations secured by subprime mortgages – the banking system, which is expected, in turn, to increase toxic securities which were a prime contributor the level of bank lending. to the current economic situation. Corporate debt The First’s investment portfolio as of December 31, 2008 U.S. Treasury and agency $110,513,000 Mortgage-backed securities State and municipal Corporate securities FHLB stock FRB stock Other equity securities 61,696,000 71,240,000 4,127,000 14,031,000 662,000 263,000 42.1% 23.5% 27.1% 1.6% 5.3% 0.3% 0.1% Total $262,532,000 100.0% securities rated below investment grade totaled $2.4 million and had an estimated fair value of $1.4 million. Management has evaluated these securities for other-than temporary impairment, and in the Company’s opinion, none of these holdings warranted other-than-temporary classification as of December 31, 2008. Management considered several factors in making this determination, including: Our Investment Portfolio • All three companies were current on their interest payments to bondholders. During 2008, the Company increased its investment • The securities are issued by auto-related companies. portfolio by $40.7 million or 18.4% and also saw interest The U.S. Government and President Obama have income from investments increase by $2.2 million or 19.3%. publicly stated the importance of helping the U.S. We have always sought to minimize the amount of credit auto industry and preserving jobs. risk in the portfolio, and during the fourth quarter we • The Company has both the intent and the ability to reduced the level of corporate securities by $10.7 million. It continue to hold these securities. has been our long-standing position that the predominant • The securities are in the available-for-sale portfolio, risk we take in the investment portfolio is interest rate risk, and the decline in market value is recognized on the not credit risk, and paring back the level of holdings of Company’s balance sheets as an unrealized loss to corporate debt securities is consistent with that view. equity in accordance with SFAS 115. 22 The challenge we face is determining the opportune time to extend liabilities. Liquidity Management Since the middle of 2008 we have strengthened our liquidity position, and as of December 31, 2008, the Bank Unlike most other businesses, a bank does not manage cash had primary sources of liquidity of $188.4 million, or flow. Why? Because cash is the raw material which a bank 14.5% of its assets compared to $84.5 million, or 7.07% of turns into its product – either loans or investments. Instead, its assets as of December 31, 2007. In Management’s view, a bank needs to manage its liquidity or its access to sources this is adequate and can meet the growth and liquidity of funding, since almost all of the money it lends or invests needs of the Bank. come from deposits or borrowed funds, not from bank capital or shareholders’ equity. The key to liquidity management at a bank is to have multiple sources to go to. While local deposits are our largest single source of funding, it is difficult to raise a significant amount of local deposits in a short period of time. As a result, The First Bancorp uses a liability-based approach to liquidity management and has a variety of wholesale or non-local funding sources which it can tap quickly and easily. These include the Federal Home Loan Bank of Boston, repurchase agreements with brokerage firms, lines of credit from two correspondent banks and non-local certificates of deposit �� from brokers and online networks. Management evaluates Managing Interest Rate Risk our liquidity position on a daily basis and is prepared to move from one source to another based on available pricing The increase in earnings in 2008 was a direct result of and overall liquidity needs. the $5.9 million or 18.4% increase in net interest income over 2007. While this was partly attributable to growth in One of the major reasons that the financial markets came close earning assets, a greatly improved net interest margin was to seizing up in September was liquidity – or lack thereof. also a major contributor to this increase. With huge uncertainty about what a bank might have on its balance sheet, other banks became extremely cautious about The management of interest rate risk is the major factor in a which banks they would loan money to and for how much bank’s net interest margin – the spread earned between the or for how long. Access to this short-term liquidity is the income on loans and investments and the cost of deposits lifeblood of the global financial system, and when these funds and borrowings, expressed as a percentage of average stopped flowing, the financial crisis deepened quickly. earning assets. With a balance sheet made up of tens of 23 Given our strong capital position, conservative credit culture, ample liquidity, and limited interest rate risk, we feel we are in a much better position to weather this economic storm than many other banks. �� thousands of accounts with various maturities or repricing at different intervals, when interest rates change, not everything changes at the same time or by the same amount. This can lead to the net interest margin widening or contracting. � � � � � � � � � � � � � � � � � � � � � � The First Bancorp started 2008 with a liability-sensitive balance sheet. This means that we had more �� opportune time to extend liabilities – before rates begin to increase but not too soon should rates remain flat for an extended period. As President Daigneault noted in his letter, we expect 2009 to be a challenging year for the banking industry. Given our strong capital position, conservative credit culture, ample liquidity, and limited interest liabilities repricing in the short-term than assets, which is a rate risk, we feel that The First Bancorp is in a much better good position to be in with a declining rate environment. position to weather this economic storm than many other The 3.25% drop in prime rate and the Fed Funds target rate banks – especially the large money center banks and the during the year led to our margin increasing from 3.13% in super-regionals. We are a true community bank and have 2007 to 3.33% in 2008. stayed true to our focus of serving our customers and communities. This has served us very well in the past, and Management’s goal in managing the balance sheet is to I am confident that this approach will continue to serve us have a modest level of interest rate risk at most. Given well in the future. that interest rates are now at unprecedented lows, our objective is to reduce liability sensitivity so that liabilities reprice less quickly. The preferred way to do this is by extending the maturity of liabilities, however this comes at a cost since longer liabilities typically have a higher F. Stephen Ward rate of interest. The challenge we face is determining the Executive Vice President & Chief Financial Officer 24 Selected Financial Data The First Bancorp, Inc. and Subsidiary Dollars in thousands, except for per share amounts Summary of Operations Interest Income Interest Expense Net Interest Income Provision for Loan Losses Non-Interest Income Non-Interest Expense Net Income Per Common Share Data Net Income Basic Diluted Cash Dividends (Declared) Book Value Market Value Financial Ratios Return on Average Equity Return on Average Tangible Equity Return on Average Assets Average Equity to Average Assets Average Tangible Equity to Average Assets Net Interest Margin (Tax-Equivalent) Dividend Payout Ratio (Declared) Allowance for Loan Losses/Total Loans Non-Performing Loans to Total Loans Non-Performing Assets to Total Assets Efficiency Ratio (Tax-equivalent) At Year End Total Assets Total Loans Total Investment Securities Total Deposits Total Borrowings Total Shareholders’ Equity Market price per common share of stock during 2008 2008 $ 71,372 33,669 37,703 4,700 9,646 22,994 14,034 Years ended December 31, 2007 2006 2005 2004 $ 71,721 39,885 31,836 1,432 10,145 22,183 13,101 $ 64,204 33,589 30,615 1,325 10,306 22,439 12,295 $ 50,431 $ 30,528 9,024 21,504 880 4,667 13,371 8,509 18,848 31,583 200 9,034 22,518 12,843 $ 1.45 1.44 0.765 12.09 19.89 $ 1.34 1.34 0.69 11.58 14.64 $ 1.25 1.25 0.61 10.98 16.72 $ 1.32 1.30 0.53 10.52 17.58 $ 1.16 1.14 0.45 7.18 17.45 12.02% 15.75 1.10 9.14 6.98 3.33 52.76 0.90 1.27 1.31 46.07 11.89% 15.89 1.13 9.53 7.13 3.13 51.49 0.74 0.31 0.56 50.16 11.63% 15.75 1.14 9.81 7.24 3.24 48.80 0.76 0.42 0.32 52.12 12.98% 17.81 1.36 10.44 7.61 3.84 40.15 0.79 0.40 0.30 52.89 979,273 262,532 925,736 272,074 117,181 $1,325,744 $1,223,250 $1,104,869 $1,042,209 772,338 183,981 713,964 215,189 $ 103,452 High $23.05 838,145 180,549 805,235 179,862 $ 107,327 920,164 221,815 781,280 316,719 $112,453 17.10% 17.36 1.41 8.22 8.27 3.94 38.62 0.99 0.34 0.25 48.78 $ 634,238 478,332 126,827 369,844 207,206 $ 52,815 Low $12.84 25 Consolidated Balance Sheets The First Bancorp, Inc. and Subsidiary As of December 31, Assets Cash and cash equivalents Securities available for sale Securities to be held to maturity, fair value of $229,460,000 at December 31, 2008, and $181,132,000 at December 31, 2007 Loans held for sale Loans Less allowance for loan losses Net loans Accrued interest receivable Premises and equipment, net Other real estate owned Goodwill Other assets Total assets Liabilities Demand deposits NOW deposits Money market deposits Savings deposits Certificates of deposit under $100,000 Certificates of deposit $100,000 or more Total deposits Borrowed funds Other liabilities Total liabilities Commitments and contingent liabilities (notes 13, 15, 19 and 20) Shareholders’ equity Common stock, one cent par value Additional paid-in capital Retained earnings Accumulated other comprehensive (loss) income Net unrealized (loss) gain on securities available for sale, net of tax benefit of $441,000 in 2008 and net of tax of $234,000 in 2007 Net unrealized loss on post-retirement benefit costs, net of tax benefit of $146,000 in 2008 and $147,000 in 2007 Total shareholders’ equity Total liabilities and shareholders’ equity Common stock Number of shares authorized Number of shares issued Number of shares outstanding Book value per share 2007 (restated for change in accounting principle) 2008 $ 16,856,000 27,765,000 $ 17,254,000 40,461,000 234,767,000 1,298,000 979,273,000 8,800,000 970,473,000 5,783,000 16,028,000 2,428,000 27,684,000 22,662,000 $1,325,744,000 $ 68,399,000 108,188,000 129,333,000 82,867,000 246,152,000 290,797,000 925,736,000 272,074,000 10,753,000 1,208,563,000 181,354,000 1,817,000 920,164,000 6,800,000 913,364,000 6,585,000 16,481,000 827,000 27,684,000 17,423,000 $ 1,223,250,000 $ 60,637,000 101,680,000 124,033,000 86,611,000 301,364,000 106,955,000 781,280,000 316,719,000 12,798,000 1,110,797,000 97,000 44,117,000 74,057,000 97,000 44,762,000 67,432,000 (819,000) 436,000 (271,000) 117,181,000 $ 1,325,744,000 (274,000) 112,453,000 $ 1,223,250,000 18,000,000 9,696,397 9,696,397 $12.09 18,000,000 9,732,493 9,732,493 $11.58 The accompanying notes are an integral part of these consolidated financial statements 26 Consolidated Statements of Income The First Bancorp, Inc. and Subsidiary Years ended December 31, Interest and dividend income Interest and fees on loans (includes tax-exempt income of $1,245,000 in 2008, $1,179,000 in 2007, and $975,000 in 2006) Interest on deposits with other banks Interest and dividends on investments (includes tax-exempt income of $2,820,000 in 2008, $2,685,000 in 2007, and $2,703,000 in 2006) Total interest and dividend income Interest expense Interest on deposits Interest on borrowed funds Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Non-interest income Fiduciary and investment management income Service charges on deposit accounts Net securities gains Mortgage origination and servicing income Other operating income Total non-interest income Non-interest expense Salaries and employee benefits Occupancy expense Furniture and equipment expense Net securities losses Amortization of core deposit intangible Other operating expenses Total non-interest expense Income before income taxes Income tax expense Net income Earnings per common share Basic earnings per share Diluted earnings per share Cash dividends declared per share Weighted average number of shares outstanding Incremental shares $ 1.34 1.34 0.690 9,787,287 25,731 The accompanying notes are an integral part of these consolidated financial statements $ 1.45 1.44 0.765 9,701,379 18,952 2008 2007 2006 $58,079,000 3,000 $60,585,000 - $54,585,000 64,000 13,290,000 71,372,000 11,136,000 71,721,000 9,555,000 64,204,000 23,000,000 10,669,000 33,669,000 37,703,000 4,700,000 33,003,000 1,475,000 2,837,000 - 145,000 5,189,000 9,646,000 29,745,000 10,140,000 39,885,000 31,836,000 1,432,000 30,404,000 1,737,000 2,740,000 2,000 589,000 5,077,000 10,145,000 11,333,000 1,518,000 2,005,000 89,000 283,000 7,766,000 22,994,000 19,655,000 5,621,000 $ 14,034,000 11,037,000 1,438,000 1,944,000 - 283,000 7,481,000 22,183,000 18,366,000 5,265,000 $13,101,000 25,804,000 7,785,000 33,589,000 30,615,000 1,325,000 29,290,000 1,951,000 2,752,000 18,000 503,000 5,082,000 10,306,000 10,826,000 1,421,000 2,124,000 - 283,000 7,785,000 22,439,000 17,157,000 4,862,000 $12,295,000 $ 1.25 1.25 0.610 9,816,307 49,476 27 Consolidated Statements of Changes in Shareholders’ Equity The First Bancorp, Inc. and Subsidiary Balance at December 31, 2005 Net income Net unrealized loss on securities available for sale, net of tax benefit of $3,000 Initial application of Statement No. 158, net of tax benefit of $190,000 Comprehensive income Cash dividends declared Equity compensation expense Payment to repurchase common stock Proceeds from sale of common stock Tax benefit of disqualifying disposition of stock option shares Balance at December 31, 2006 Net income Net unrealized loss on securities available for sale, net of tax benefit of $100,000 Unrecognized actuarial gain for post-retirement benefits, net of taxes of $42,000 Comprehensive income Cash dividends declared Equity compensation expense Payment to repurchase common stock Proceeds from sale of common stock Balance at December 31, 2007 (as previously stated) Change in accounting for split dollar life insurance arrangements Balance at December 31, 2007 (restated) Net income Net unrealized loss on securities available for sale, net of tax benefit of $675,000 Unrecognized actuarial gain for post-retirement benefits, net of taxes of $1,000 Comprehensive income Cash dividends declared Equity compensation expense Payment to repurchase common stock Proceeds from sale of common stock Tax benefit of disqualifying disposition of stock option shares Balance at December 31, 2008 Number of common shares outstanding Common stock Additional paid-in capital 9,832,777 $ 99,000 $47,718,000 - - - Accumulated other comprehensive income (loss) Total shareholders’ equity $ 734,000 $103,452,000 12,295,000 - Retained earnings $54,901,000 12,295,000 - - - - (38,000) (38,000) - - - - (179,176) 117,191 - - - - (1,000) - - - - 60,000 (3,051,000) 860,000 - 9,770,792 - - 98,000 - - 45,587,000 - - 12,295,000 (5,983,000) - - - 85,000 61,298,000 13,101,000 (352,000) (390,000) - - - - (352,000) 11,905,000 (5,983,000) 60,000 (3,052,000) 860,000 - 344,000 - 85,000 107,327,000 13,101,000 - - - - (260,000) (260,000) - - - - (109,860) 71,561 - - - - (1,000) - - - - 59,000 (1,686,000) 802,000 - 13,101,000 (6,752,000) - - - 78,000 (182,000) - - - - 78,000 12,919,000 (6,752,000) 59,000 (1,687,000) 802,000 9,732,493 $ 97,000 $ 44,762,000 $67,647,000 $ 162,000 $112,668,000 - - - (215,000) - (215,000) 9,732,493 - $ 97,000 $ 44,762,000 - - $67,432,000 14,034,000 $ 162,000 $112,453,000 14,034,000 - - - - - - (88,764) 52,668 - - - - - - - - - (1,255,000) (1,255,000) - - - 37,000 (1,414,000) 732,000 - 14,034,000 (7,416,000) - - - 3,000 (1,252,000) - - - - 3,000 12,782,000 (7,416,000) 37,000 (1,414,000) 732,000 - 9,696,397 - - $ 97,000 $ 44,117,000 7,000 $74,057,000 7,000 $ (1,090,000) $117,181,000 - The accompanying notes are an integral part of these consolidated financial statements 28 Consolidated Statements of Cash Flows The First Bancorp, Inc. and Subsidiary 2008 2007 2006 $14,034,000 $13,101,000 $12,295,000 For the years ended December 31, Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Change in deferred income taxes Provision for loan losses Loans originated for resale Proceeds from sales of loans Net (gain) loss on sale of other real estate owned Net (gain) loss on sale of premises and equipment Equity compensation expense Net (gain) loss on sale or call of securities Net change in other assets and accrued interest receivable Net change in other liabilities Amortization of investment in limited partnership Net accretion of discounts on investments Net acquisition amortization Provision for losses on other real estate owned Net cash provided by operating activities Cash flows from investing activities Proceeds from sales of securities available for sale Proceeds from maturities, payments, calls of securities available for sale Proceeds from maturities, payments, calls of securities held to maturity Proceeds from sales of other real estate owned Purchases of securities available for sale Investment in limited partnership Purchases of securities to be held to maturity Net increase in loans Capital expenditures Proceeds from sale of premises and equipment Net cash used in investing activities Cash flows from financing activities Net increase (decrease) in transaction and savings accounts Net increase in certificates of deposit Advances on long-term borrowings Repayments on long-term borrowings Net increase (decrease) in short-term borrowings Payments to repurchase common stock Proceeds from sale of common stock Dividends paid Net cash provided by financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Interest paid Income taxes paid Non-cash transactions: Transfer from loans to other real estate owned Net decrease in unrealized gain on securities available for sale 1,232,000 (1,039,000) 4,700,000 (19,199,000) 19,718,000 - 17,000 37,000 89,000 (1,627,000) (1,933,000) 84,000 (5,475,000) 239,000 - 10,877,000 1,224,000 (464,000) 1,432,000 (24,081,000) 22,724,000 20,000 (34,000) 59,000 (2,000) (926,000) 486,000 - (2,996,000) 228,000 56,000 10,827,000 14,192,000 3,551,000 106,450,000 - (6,836,000) (1,700,000) 179,000 8,883,000 90,261,000 978,000 (4,983,000) - (154,618,000) (133,008,000) (83,804,000) (63,410,000) (2,108,000) (796,000) 282,000 - (103,167,000) (123,320,000) 15,826,000 128,651,000 50,000,000 - (94,622,000) (1,414,000) 732,000 (7,281,000) 91,892,000 (398,000) 17,254,000 $16,856,000 $34,558,000 7,111,000 (24,102,000) 231,000 100,000,000 (62,000,000) 98,880,000 (1,687,000) 802,000 (6,565,000) 105,559,000 (6,934,000) 24,188,000 $17,254,000 $39,265,000 5,919,000 1,400,000 (424,000) 1,325,000 (17,435,000) 16,975,000 (10,000) - 60,000 (18,000) (1,444,000) 2,542,000 - (253,000) 252,000 269,000 15,534,000 218,000 9,801,000 20,040,000 561,000 (58,000) - (26,339,000) (68,961,000) (872,000) 339,000 (65,271,000) (11,415,000) 102,837,000 30,000,000 - (65,304,000) (3,052,000) 860,000 (5,983,000) 47,943,000 (1,794,000) 25,982,000 $24,188,000 $32,934,000 4,443,000 The accompanying notes are an integral part of these consolidated financial statements 29 1,601,000 1,930,000 737,000 360,000 1,964,000 41,000 Notes to Consolidated Financial Statements Nature of Operations The First Bancorp, Inc. (the “Company”) through its wholly-owned subsidiary, The First, N.A. (“the Bank”), provides a full range of banking services to individual and corporate customers from fourteen offices in coastal Maine. First Advisors, a division of the Bank, provides investment management, private banking and financial planning services. At the Company’s Annual Meeting of Shareholders on April 30, 2008, the Company’s name was changed to The First Bancorp, Inc. from First National Lincoln Corporation. Note 1. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of the Company and the Bank. All intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates in Preparation of Financial Statements In preparing the financial statements in accordance with accounting principles generally accepted in the United States of America, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the balance sheet and revenues and expenses for the reporting period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of mortgage servicing rights, and goodwill. Investment Securities Investment securities are classified as available for sale or held to maturity when purchased. There are no trading account securities. Securities available for sale consist primarily of debt securities which Management intends to hold for indefinite periods of time. They may be used as part of the Bank’s funds management strategy, and may be sold in response to changes in interest rates or prepayment risk, changes in liquidity needs, or for other reasons. They are accounted for at fair value, with unrealized gains or losses adjusted through shareholders’ equity, net of related income taxes. Securities to be held to maturity consist primarily of debt securities which Management has acquired solely for long-term investment purposes, rather than for purposes of trading or future sale. For securities to be held to maturity, Management has the intent and the Bank has the ability to hold such securities until their respective maturity dates. Such securities are carried at cost adjusted for the amortization of premiums and accretion of discounts. Investment securities transactions are accounted for on a settlement date basis; reported amounts would not be materially different from those accounted for on a trade date basis. Gains and losses on the sales of investment securities are determined using the amortized cost of the security. Loans Held for Sale Loans held for sale consist of residential real estate mortgage loans and are carried at the lower of aggregate cost or market value, as determined by current investor yield requirements. Loans Loans are generally reported at their outstanding principal balances, adjusted for chargeoffs, the allowance for loan losses and any deferred fees or costs to originate loans. Loan commitments are recorded when funded. Loan Fees and Costs Loan origination fees and certain direct loan origination costs are deferred and recognized in interest income as an adjustment to the loan yield over the life of the related loans. The unamortized net deferred fees and costs are included on the balance sheets with the related loan balances, and the amortization is included with the related interest income. Allowance for Loan Losses Loans considered to be uncollectible are charged against the allowance for loan losses. The allowance for loan losses is maintained at a level determined by Management to be adequate to absorb probable losses. This allowance is increased by provisions charged to operating expenses and recoveries on loans previously charged off. Arriving at an appropriate level of allowance for loan losses necessarily involves a high degree of judgment. In determining the appropriate level of allowance for loan losses, Management takes into consideration several factors, including reviews of individual non- performing loans and performing loans listed on the watch report requiring periodic evaluation, loan portfolio size by category, recent loss experience, delinquency trends and current economic conditions. Loans more than 30 days past 30 due are considered delinquent. Impaired loans, including restructured loans, are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral if the loan is collateral dependent. Management takes into consideration impaired loans in addition to the above mentioned factors in determining the appropriate level of allowance for loan losses. Goodwill and Identified Intangible Assets Intangible assets include the excess of the purchase price over the fair value of net assets acquired (goodwill) from the acquisition of FNB Bankshares in 2005 as well as the core deposit intangible related to the same acquisition. The core deposit intangible is amortized on a straight-line basis over ten years. Amortization expense for 2008, 2007 and 2006 was $283,000 and the amortization expense for each year until fully amortized will be $283,000. The straight-line basis is used because the Company does not expect significant run off in the core deposits acquired. The Company annually evaluates goodwill, and periodically evaluates other intangible assets for impairment on the basis of whether these assets are fully recoverable from projected, undiscounted net cash flows of the acquired company. At December 31, 2008, the Company determined goodwill and other intangible assets were not impaired. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period the change is enacted. Accrual of Interest Income and Expense Interest on loans and investment securities is taken into income using methods which relate the income earned to the balances of loans and investment securities outstanding. Interest expense on liabilities is derived by applying applicable interest rates to principal amounts outstanding. Recording of interest income on problem loans, which includes impaired loans, ceases when collectibility of principal and interest within a reasonable period of time becomes doubtful. Cash payments received on non-accrual loans, which includes impaired loans, are applied to reduce the loan’s principal balance until the remaining principal balance is deemed collectible, after which interest is recognized when collected. As a general rule, a loan may be restored to accrual status when payments are current and repayment of the remaining contractual amounts is expected or when it otherwise becomes well secured and in the process of collection. Premises and Equipment Premises, furniture and equipment are stated at cost, less accumulated depreciation. Depreciation expense is computed by straight-line and accelerated methods over the asset’s estimated useful life. Other Real Estate Owned (OREO) Real estate acquired by foreclosure or deed in lieu of foreclosure is transferred to OREO and recorded at the lower of cost or fair market value, less estimated costs to sell, based on appraised value at the date actually or constructively received. Loan losses arising from the acquisition of such property are charged against the allowance for loan losses. Subsequent provisions to reduce the carrying value of a property are recorded to the allowance for OREO losses and a charge to operations on a specific property basis. Earnings Per Share Basic earnings per share data are based on the weighted average number of common shares outstanding during each year. Diluted earnings per share gives effect to the stock options outstanding, determined by the treasury stock method. Post-Retirement Benefits The cost of providing post-retirement benefits is accrued during the active service period of the employee or director. Comprehensive Income Comprehensive income includes net income and other comprehensive income (loss),which is comprised of the change in unrealized gains and losses on securities available for sale, net of tax, and unrealized gains and (loss) related to post- retirement benefit costs, net of tax, is disclosed in the consolidated statements of changes in shareholders’ equity. Segments The First Bancorp, Inc., through the branches of its subsidiary, The First, N.A., provides a broad range of financial services to individuals and companies in coastal Maine. These services include demand, time, and savings deposits; lending; credit card servicing; ATM processing; and investment management and trust services. Operations are 31 managed and financial performance is evaluated on a corporate-wide basis. Accordingly, all of the Company’s banking operations are considered by Management to be aggregated in one reportable operating segment. Loan Servicing Servicing rights are recognized when they are acquired through sale of loans. Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing rights are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. Stock Options The Company established a shareholder-approved stock option plan in 1995, under which the Company may grant options to its employees for up to 600,000 shares of common stock. The Company believes that such awards align the interests of its employees with those of its shareholders. Only incentive stock options may be granted under the plan. The exercise price of each option grant is determined by the Options Committee of the Board of Directors, and in no instance shall be less than the fair market value on the date of the grant. An option’s maximum term is ten years from the date of grant, with 50% of the options granted vesting two years from the date of grant and the remaining 50% vesting five years from date of grant. As of January 16, 2005, all options under this plan had been granted. The Company applies the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment”, to stock-based employee compensation for fiscal years beginning on or after January 1, 2006. As a result, $37,000, $59,000 and $60,000 in compensation cost was included in the Company’s financial statements for 2008, 2007 and 2006, respectively. The unrecognized compensation cost to be amortized over a weighted average remaining vesting period of 2.0 years is $74,000 for 21,000 options granted in 2005. The weighted average fair market value per share was $4.41 for options granted in 2005. The fair market value was estimated using the Black-Scholes option pricing model and the following assumptions: quarterly dividends of $0.12, risk-free interest rate of 4.20%, volatility of 25.81%, and an expected life of ten years. Volatility is based on the actual volatility of the Company’s stock during the quarter in which the options were granted. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve at the time of the option grant. The following table summarizes the status of the Company’s non-vested options as of December 31, 2008. Number of Shares Weighted Average Grant Date Fair Value Non-vested at December 31, 2007 Granted in 2008 Vested in 2008 Forfeited in 2008 Non-vested at December 31, 2008 21,000 - - - 21,000 $4.41 - - - $4.41 During 2008, 13,000 options were exercised, with total proceeds paid to the Company of $84,000. The excess of the fair value of the stock issued upon exercise over the exercise price was $115,000. A summary of the status of the Company’s Stock Option Plan as of December 31, 2008, and changes during the year then ended, is presented below. Number of Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value Outstanding at December 31, 2007 Granted in 2008 Vested in 2008 Exercised in 2008 Forfeited in 2008 Outstanding at December 31, 2008 Exercisable at December 31, 2008 89,500 - - (13,000) - 76,500 55,500 $ 12.28 - - 6.43 - $ 13.27 $ 11.49 4.1 3.4 $ 506,000 $ 466,000 32 Note 2. Cash and Cash Equivalents For the purposes of reporting consolidated cash flows, cash and cash equivalents include cash on hand, amounts due from banks and federal funds sold. At December 31, 2008 the Company had a contractual clearing balance of $500,000 and a reserve balance requirement of $706,000 at the Federal Reserve Bank, which are satisfied by both cash on hand at branches and balances held at the Federal Reserve Bank of Boston. The Company maintains a portion of its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant risk with respect to these accounts. Note 3. Investment Securities The following tables summarize the amortized cost and estimated fair value of investment securities at December 31, 2008 and 2007: As of December 31, 2008 Securities available for sale Mortgage-backed securities State and political subdivisions Corporate securities Federal Home Loan Bank stock Federal Reserve Bank stock Other equity securities Securities to be held to maturity U.S. Treasury and agency Mortgage-backed securities State and political subdivisions Corporate securities As of December 31, 2007 Securities available for sale Mortgage-backed securities State and political subdivisions Corporate securities Federal Home Loan Bank stock Federal Reserve Bank stock Other equity securities Securities to be held to maturity U.S. Treasury and agency Mortgage-backed securities State and political subdivisions Corporate securities Amortized Cost Unrealized Gains Unrealized Losses Fair Value (Estimated) $ 900,000 8,571,000 4,566,000 14,031,000 662,000 295,000 $ 29,025,000 $110,513,000 60,774,000 62,330,000 1,150,000 $234,767,000 $ 22,000 339,000 - - - 2,000 $ 363,000 $ 74,000 640,000 952,000 - $1,666,000 $ - - (1,589,000) - - (34,000) $(1,623,000) $(5,871,000) (297,000) (684,000) (121,000) $(6,973,000) $ 922,000 8,910,000 2,977,000 14,031,000 662,000 263,000 $ 27,765,000 $104,716,000 61,117,000 62,598,000 1,029,000 $229,460,000 Amortized Cost Unrealized Gains Unrealized Losses Fair Value (Estimated) $ 1,309,000 10,524,000 14,393,000 12,569,000 662,000 334,000 $ 39,791,000 $ 95,009,000 30,786,000 53,914,000 1,645,000 $ 181,354,000 $ 40,000 331,000 638,000 - - 5,000 $ 1,014,000 $ 189,000 219,000 731,000 9,000 $ 1,148,000 $ (27,000) - (304,000) - - (13,000) $ (344,000) $ (935,000) (354,000) (81,000) - $ (1,370,000) $ 1,322,000 10,855,000 14,727,000 12,569,000 662,000 326,000 $ 40,461,000 $ 94,263,000 30,651,000 54,564,000 1,654,000 $ 181,132,000 33 The following table summarizes the contractual maturities of investment securities at December 31, 2008: Due in 1 year or less Due in 1 to 5 years Due in 5 to 10 years Due after 10 years Equity securities Securities available for sale Fair Value Amortized (Estimated) Cost Securities to be held to maturity Amortized Cost Fair Value (Estimated) $ 1,063,000 5,251,000 5,935,000 1,788,000 14,988,000 $29,025,000 $ 935,000 4,408,000 6,162,000 1,304,000 14,956,000 $27,765,000 $ 935,000 7,210,000 21,856,000 204,766,000 - $234,767,000 $ 936,000 7,369,000 22,199,000 198,956,000 - $229,460,000 At December 31, 2008, securities with a fair value of $153,560,000 were pledged to secure borrowings from the Federal Home Loan Bank of Boston, public deposits, repurchase agreements, and for other purposes as required by law. This compares to securities with a fair value of $139,108,000, as of December 31, 2007 pledged for the same purpose. Gains and losses on the sale of securities available for sale are computed by subtracting the amortized cost at the time of sale from the security’s selling price, net of accrued interest to be received. The following table shows securities gains and losses for 2008, 2007 and 2006: Proceeds from sales Gross gains Gross losses Net gain (loss) Related income taxes 2008 $14,192,000 $ 123,000 (212,000) $ (89,000) $ (31,000) 2007 $179,000 $ 2,000 - $ 2,000 $ 1,000 2006 $218,000 $ 18,000 - $ 18,000 $ 6,000 Management reviews securities with unrealized losses for other than temporary impairment. Federal Home Loan Bank stock and Federal Reserve Bank stock have been evaluated for impairment. As of December 31, 2008, there were 97 securities with unrealized losses held in the Company’s portfolio. These securities were temporarily impaired as a result of changes in interest rates reducing their fair market value, of which 29 had been temporarily impaired for 12 months or more. At the present time, there have been no material changes in the credit quality of these securities resulting in other than temporary impairment. Information regarding securities temporarily impaired as of December 31, 2008 is summarized below: As of December 31, 2008 U.S. Treasury and agency Mortgage-backed securities State and political subdivisions Corporate securities Other equity securities Less than 12 months Fair Value Unrealized Losses 12 months or more Fair Value Unrealized Losses Total Fair Value Unrealized Losses $64,951,000 $(4,610,000) $10,043,000 $(1,261,000) (187,000) 12,498,000 (111,000) 13,592,000 (1,523,000) 1,821,000 (34,000) - $74,994,000 $(5,871,000) (297,000) 16,032,000 15,757,000 (684,000) (1,710,000) 3,530,000 (34,000) 32,000 $92,862,000 $(5,480,000) $17,483,000 $(3,116,000) $110,345,000 $(8,596,000) 3,534,000 2,165,000 1,709,000 32,000 (110,000) (573,000) (187,000) - As of December 31, 2007, there were 74 securities with unrealized losses held in the Company’s portfolio. These securities were temporarily impaired as a result of changes in interest rates reducing their fair market value, of which 50 had been temporarily impaired for 12 months or more. Information regarding securities temporarily impaired as of December 31, 2007 is summarized below: 34 As of December 31, 2007 U.S. Treasury and agency Mortgage-backed securities State and political subdivisions Corporate securities Other equity securities Note 4. Loan Servicing Fair Value $ 37,356,000 - 1,658,000 2,529,000 11,000 $ 41,554,000 Less than 12 months Total 12 months or more Fair Value Fair Value Unrealized Losses Unrealized Losses Unrealized Losses $ (719,000) $ 13,575,000 $ (216,000) $ 50,931,000 $ (935,000) (381,000) (381,000) (81,000) (60,000) (304,000) (122,000) (13,000) (13,000) $ (792,000) $ 76,527,000 $ (1,714,000) 17,844,000 2,559,000 930,000 65,000 $ (922,000) $ 34,973,000 17,844,000 4,217,000 3,459,000 76,000 - (21,000) (182,000) - At December 31, 2008 and 2007, the Bank serviced loans for others totaling $168,242,000 and $168,001,000, respectively. Net gains from the sale of loans totaled $249,000 in 2008, $333,000 in 2007, and $222,000 in 2006. In 2008, mortgage servicing rights of $201,000 were capitalized or acquired, and amortization for the year totaled $366,000. After deducting for an impairment reserve of $368,000 at December 31, 2008, mortgage servicing rights had a fair value of $311,000, which is included in other assets. In 2007, mortgage servicing rights of $325,000 were capitalized or acquired, and amortization for the year totaled $471,000. After deducting for an impairment reserve of $11,000 at December 31, 2007, mortgage servicing rights had a fair value of $832,000, which is included in other assets. SFAS No. 156, “Accounting for Servicing of Financial Assets”, requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. Servicing assets and servicing liabilities are reported using the amortization method or the fair value measurement method. In evaluating the carrying values of mortgage servicing rights, the Company obtains third party valuations based on loan level data including note rate, type and term of the underlying loans. The model utilizes several assumptions, the most significant of which is loan prepayments, calculated using a three-month moving average of weekly prepayment data published by the Public Securities Association (PSA) and modeled against the serviced loan portfolio, and the discount rate to discount future cash flows. As of December 31, 2008, the prepayment assumption using the PSA model was 549, which translates into an anticipated prepayment rate of 32.95%. The discount rate is the quarterly average ten-year U.S. Treasuries plus 9.42%. Other assumptions include delinquency rates, foreclosure rates, servicing cost inflation, and annual unit loan cost. All assumptions are adjusted periodically to reflect current circumstances. Amortization of mortgage servicing rights, as well as write-offs due to prepayments of the related mortgage loans, are recorded as a charge against mortgage servicing fee income. Note 5 – Derivative Financial Instruments During 2007, the Bank purchased an interest rate protection agreement (cap) as a cash flow hedge to eliminate the cash flow exposure of interest rate movements on money-market deposits. The premium paid for the cap is amortized over its life. Any cash payments received are recorded as an adjustment to net interest income. The Bank documents its risk management strategy and hedge effectiveness at the inception of and during the term of the hedge. The cap is designated and qualifies as a cash flow hedge, and thus is recorded at fair value. SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, provides that a cash flow hedge is effective to the extent the variability in its cash flows offsets the variability in the cash flows of the hedged item, in this case the increase in cost of money market deposits. Management has determined that the hedge relationship is 100 percent effective. The amortized cost of the cap was $24,000 and $51,000 at December 31, 2008 and 2007, respectively, and is recorded on the balance sheet. This approximates the fair value of the derivative, and as a result, no unrealized gain or loss, net of applicable income taxes, is recorded in other comprehensive loss in the statement of changes in shareholders’ equity for the year ended December 31, 2008 and 2007. 35 Note 6. Loans The following table shows the composition of the Company’s loan portfolio as of December 31, 2008 and 2007: As of December 31, Real estate loans Residential Commercial Commercial and industrial loans State and municipal loans Consumer loans Residential construction loans Total loans 2008 2007 $ 455,753,000 172,492,000 245,224,000 36,279,000 67,642,000 1,883,000 $ 979,273,000 $ 442,407,000 119,675,000 251,489,000 34,785,000 66,539,000 5,269,000 $ 920,164,000 Loan balances include net deferred loan costs of $1,369,000 in 2008 and $1,303,000 in 2007. Pursuant to collateral agreements, qualifying first mortgage loans, which were valued at $356,964,000 and $349,797,000 in 2008 and 2007, respectively, were used to collateralize borrowings from the Federal Home Loan Bank of Boston. At December 31, 2008 and 2007, loans on non-accrual status totaled $12,449,000 and $2,867,000, respectively. As of December 31, 2008, 2007 and 2006, interest income which would have been recognized on these loans, if interest had been accrued, was $489,000, $283,000, and $396,000, respectively. Loans past due greater than 90 days which are accruing interest totaled $4,980,000 at December 31, 2008 and $2,287,000 at December 31, 2007. The Company continues to accrue interest on these loans because it believes collection of principal and interest is reasonably assured. Transactions in the allowance for loan losses for the years ended December 31, 2008, 2007 and 2006 were as follows: For the years ended December 31, Balance at beginning of year Provision charged to operating expenses Loans charged off Recoveries on loans Net loans charged off Balance at end of year 2008 $ 6,800,000 4,700,000 11,500,000 (2,941,000) 241,000 (2,700,000) $ 8,800,000 2007 $ 6,364,000 1,432,000 7,796,000 (1,337,000) 341,000 (996,000) $ 6,800,000 2006 $ 6,086,000 1,325,000 7,411,000 (1,313,000) 266,000 (1,047,000) $ 6,364,000 Information regarding impaired loans is as follows: As of December 31, Average investment in impaired loans Interest income recognized on impaired loans, all on cash basis 2008 2007 2006 $ 6,199,000 $ 2,427,000 $ 3,391,000 24,000 163,000 99,000 As of December 31, Balance of impaired loans Less portion for which no allowance for loan losses is allocated Portion of impaired loan balance for which an allowance for loan losses is allocated Portion of allowance for loan losses allocated to the impaired loan balance 2008 $ 12,449,000 (4,805,000) 2007 $ 2,867,000 (1,589,000) $ 7,644,000 $ 1,278,000 $ 1,957,000 $ 560,000 36 Loans to directors, officers and employees totaled $37,876,000 at December 31, 2008 and $34,510,000 at December 31, 2007. A summary of loans to directors and executive officers, which in the aggregate exceed $60,000, is as follows: For the years ended December 31, Balance at beginning of year New loans Repayments Balance at end of year 2008 2007 $ 20,886,000 $ 18,695,000 10,021,000 (7,830,000) $ 23,896,000 $ 20,886,000 12,245,000 (9,235,000) Note 7. Premises and Equipment Premises and equipment are carried at cost and consist of the following: As of December 31, Land Land improvements Buildings Equipment Less accumulated depreciation 2008 $ 3,556,000 636,000 13,788,000 6,348,000 24,328,000 8,300,000 $ 16,028,000 2007 $ 3,837,000 602,000 13,115,000 6,082,000 23,636,000 7,155,000 $ 16,481,000 Note 8. Other Real Estate Owned The following summarizes other real estate owned: As of December 31, Real estate acquired in settlement of loans 2008 $ 2,428,000 2007 $ 827,000 Changes in the allowance for losses from other real estate owned were as follows: For the years ended December 31, Balance at beginning of year Losses charged to allowance Provision charged to operating expenses Balance at end of year 2008 $ 325,000 - - $ 325,000 2007 $ 269,000 - 56,000 $ 325,000 2006 $ - - 269,000 $ 269,000 Note 9. Goodwill On January 14, 2005, the Company completed the acquisition of FNB Bankshares (“FNB”) of Bar Harbor, Maine, and its subsidiary, The First National Bank of Bar Harbor. As part of the acquisition, the Company issued 2.35 shares of its common stock to the shareholders of FNB in exchange for each of the 1,048,814 shares of the common stock outstanding of FNB. The total value of the transaction was $47,955,000, and all of the voting equity interest of FNB was acquired in the transaction. The transaction was accounted for as a purchase and the excess of purchase price over the fair value of net tangible assets acquired equaled $27,559,000 and was recorded as goodwill, none of which was deductible for tax purposes. The portion of the purchase price related to the core deposit intangible is being amortized over its expected economic life, and goodwill is evaluated annually for possible impairment under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. 37 Note 10. Income Taxes The current and deferred components of income tax expense (benefit) were as follows: For the years ended December 31, Federal income tax Current Deferred State franchise tax 2008 2007 2006 $ 6,415,000 (1,039,000) 5,376,000 245,000 $ 5,621,000 $ 5,500,000 (464,000) 5,036,000 229,000 $ 5,265,000 $ 5,075,000 (424,000) 4,651,000 211,000 $ 4,862,000 The actual tax expense differs from the expected tax expense (computed by applying the applicable U.S. Federal corporate income tax rate to income before income taxes) as follows: For the years ended December 31, Expected tax expense Non-taxable income State franchise tax, net of federal tax benefit Tax credits, net of amortization Other 2008 $ 6,879,000 (1,364,000) 159,000 (100,000) 47,000 $ 5,621,000 2007 $ 6,428,000 (1,244,000) 149,000 - (68,000) $ 5,265,000 2006 $ 6,005,000 (1,209,000) 137,000 - (71,000) $ 4,862,000 Deferred tax assets and liabilities are classified as other assets and other liabilities in the consolidated balance sheets. No valuation allowance is deemed necessary for the deferred tax asset. Items that give rise to the deferred income tax assets and liabilities and the tax effect of each at December 31, 2008 and 2007 are as follows: Allowance for loan losses Other real estate owned Assets related to FNB acquisition Accrued pension and post-retirement Unrealized loss on securities available for sale Other assets Total deferred tax asset Net deferred loan costs Depreciation Unrealized gain on securities available for sale Mortgage servicing rights Core deposit intangible Liabilities related to FNB acquisition Other liabilities Total deferred tax liability Net deferred tax asset 2008 $3,080,000 114,000 9,000 1,139,000 441,000 75,000 4,858,000 (578,000) (1,422,000) - (109,000) (600,000) (32,000) (35,000) (2,776,000) $2,082,000 2007 $2,328,000 114,000 24,000 1,087,000 - 120,000 3,673,000 (529,000) (1,490,000) (234,000) (291,000) (699,000) (52,000) (8,000) (3,303,000) $370,000 At December 31, 2008, the Company held an investment in a limited partnership with related New Market Tax Credits. This investment is carried at cost and amortized on the effective yield method. The tax credit from this investment is estimated at $154,000 for the year ended December 31, 2008, and is recorded as a reduction of income tax expense. Amortization of the investment in the limited partnership for the year ended December 31, 2008 totaled $84,000 and is recognized as a component of income tax expense in the consolidated statements of income. The carrying value of this investment at December 31, 2008 amounts to $1,616,000, which is recorded in other assets. The Company's total exposure to this limited partnership at December 31, 2008 was $5,516,000, which is comprised of the Company's equity investment in the limited partnership and the balance of a participated loan receivable. 38 Note 11. Certificates of Deposit At December 31, 2008, the scheduled maturities of certificates of deposit are as follows: Year of Maturity 2009 2010 2011 2012 2013 Less than $100,000 $211,889,000 28,694,000 2,633,000 1,141,000 1,795,000 $246,152,000 Greater than $100,000 $272,597,000 12,268,000 3,074,000 1,553,000 1,305,000 $290,797,000 All Certificates of Deposit $484,486,000 40,962,000 5,707,000 2,694,000 3,100,000 $536,949,000 Interest on certificates of deposit of $100,000 or more was $6,905,000, $11,885,000, and $11,210,000 in 2008, 2007 and 2006, respectively. Note 12. Borrowed Funds Borrowed funds consist of advances from the Federal Home Loan Bank of Boston (FHLB), Treasury Tax & Loan Notes, and securities sold under agreements to repurchase with municipal and commercial customers. Pursuant to collateral agreements, FHLB advances are collateralized by all stock in FHLB, qualifying first mortgage loans, U.S. Government and Agency securities not pledged to others, and funds on deposit with FHLB. As of December 31, 2008, the Bank’s total FHLB borrowing capacity was $317,796,000, of which $102,612,000 was unused and available for additional borrowings. All FHLB advances as of December 31, 2008, had fixed rates of interest until their respective maturity dates. Under the Treasury Tax & Loan Note program, the Bank accumulates tax deposits made by customers and is eligible to receive Treasury Direct investments up to an established maximum balance. Securities sold under agreements to repurchase include U.S. Treasury and Agency securities and other securities. Repurchase agreements have maturity dates ranging from one to 365 days. The Bank also has in place $15.0 million in credit lines with correspondent banks which are currently not in use. Borrowed funds at December 31, 2008 and 2007 have the following range of interest rates and maturity dates: As of December 31, 2008 Federal Home Loan Bank Advances 2009 2010 2011 2012 2013 2014 and thereafter Treasury Tax & Loan Notes (rate at December 31, 2008 was 0.00%) Repurchase agreements Municipal and commercial customers 0.36% 4.43% - - - 0.00% - 5.00% 5.41% 4.39% 3.49% 3.89% variable 1.49% - 4.75% $80,227,000 50,000,000 - 10,000,000 10,000,000 70,184,000 220,411,000 2,864,000 48,799,000 $272,074,000 39 As of December 31, 2007 Federal Home Loan Bank Advances 2008 2009 2010 2011 2012 2013 and thereafter Treasury Tax & Loan Notes (rate at December 31, 2007 was 3.59%) Repurchase agreements Municipal and commercial customers 3.00% 4.79% 4.43% 0.00% - - - - - 4.94% $ 156,460,000 27,000,000 5.00% 50,000,000 5.41% - 10,000,000 30,191,000 273,651,000 1,961,000 4.39% 3.89% variable 2.71% - 5.02% 41,107,000 $316,719,000 Note 13. Employee Benefit Plans 401(k) Plan The Bank has a defined contribution plan available to substantially all employees who have completed six months of service. Employees may contribute up to $15,500 of their compensation if under age 50 and $20,500 if over age 50, and the Bank may provide a match to employee contributions not to exceed 3.0% of compensation depending on contribution level. Subject to a vote of the Board of Directors, the Bank may also make a profit-sharing contribution to the Plan. Such contribution equaled 2.0% of each eligible employee’s compensation in 2008, 2007, and 2006. The expense related to the 401(k) plan was $356,000, $338,000, and $315,000 in 2008, 2007, and 2006, respectively. Supplemental Retirement Plan The Bank also sponsors an unfunded, non-qualified supplemental retirement plan for certain officers. The agreement provides supplemental retirement benefits payable in installments over 20 years upon retirement or death. The costs for this plan are recognized over the service periods of the participating officers. The expense of this supplemental plan was $164,000 in 2008, $153,000 in 2007,and $149,000 in 2006. As of December 31, 2008 and 2007, the accrued liability of this plan was $1,265,000 and $1,157,000, respectively. Post-Retirement Benefit Plans The Bank sponsors two post-retirement benefit plans. One plan currently provides a subsidy for health insurance premiums to certain retired employees and a future subsidy for seven active employees who were age 50 and over in 1996. These subsidies are based on years of service and range between $40 and $1,200 per month per person. The other plan provides life insurance coverage to certain retired employees. The Bank also provides health insurance for retired directors. None of these plans are pre-funded. In December 2003, the federal Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) was signed into law. The Act included two features to Medicare (Medicare Part D) that could affect the measurement of the accumulated post-retirement benefit obligation and net periodic postretirement benefit costs: a subsidy to plan sponsors that is based on 28% of an individual beneficiary’s annual prescription drug costs between $250 and $5,000, and the opportunity for a retiree to obtain a prescription drug benefit under Medicare. During 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” The FSP addresses employers’ accounting for the effects of the Act and was effective for the Company in 2004. The accounting for the Act will depend on the Company’s assessment as to whether the prescription drug benefits available under its plan are actuarially equivalent to Medicare Part D, among other factors. The Company’s Plan has not been actuarially determined to be equivalent to Medicare Part D. Accordingly, the impact of applying the FSP has not been reflected in the consolidated financial statements. 40 The following tables set forth the accumulated post-retirement benefit obligation, funded status, and net periodic benefit cost: At December 31, Change in benefit obligations Benefit obligation at beginning of year: Service cost Interest cost Benefits paid Actuarial (gain) loss Benefit obligation at end of year: Funded status Benefit obligation at end of year Accrued benefit cost 2008 2007 2006 $ 1,949,000 19,000 134,000 (155,000) 43,000 $ 1,990,000 $ 2,005,000 20,000 136,000 (144,000) (68,000) $ 1,949,000 $ 1,705,000 13,000 125,000 (157,000) 319,000 $ 2,005,000 $(1,990,000) $(1,990,000) $(1,949,000) $ (2,005,000) $(1,949,000) $ (2,005,000) For the years ended December 31, Components of net periodic benefit cost Service cost Interest cost Amortization of unrecognized transition obligation Amortization of prior service credit Amortization of accumulated losses Net periodic benefit cost Weighted average assumptions as of December 31 Discount rate 2008 2007 2006 $ 19,000 134,000 29,000 (3,000) 21,000 $ 200,000 $ 20,000 136,000 29,000 (3,000) 26,000 $ 208,000 $ 13,000 125,000 29,000 (3,000) 4,000 $ 168,000 7.0% 7.0% 7.0% The above discount rate assumption was used in determining both the accumulated benefit obligation as well as the net benefit cost. The measurement date for benefit obligations was as of year-end for all years presented. The estimated amount of benefits to be paid in 2009 is $157,000. For years ending 2010 through 2013 the estimated amount of benefits to be paid is $163,000, $169,000, $185,000 and $183,000 respectively, and the total estimated amount of benefits to be paid for years ended 2014 through 2018 is $850,000. Plan expense for 2009 is estimated to be $175,000. In 2006, the Company adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” On initial application, a $352,000 adjustment was recognized in the Statement of Changes in Shareholders’ Equity as a component of accumulated other comprehensive income. Amounts not yet reflected in net periodic benefit cost and included in accumulated other comprehensive income are as follows: At December 31, Unamortized prior service credit Unamortized net actuarial loss Unrecognized transition obligation Deferred tax benefit at 35% Net unrecognized post-retirement benefits included in accumulated other comprehensive income 2008 $ 1,000 (297,000) (121,000) (417,000) 146,000 2007 $ 5,000 (276,000) (150,000) (421,000) 147,000 Portion to Be Recognized in Income in 2009 $ - - 29,000 29,000 (10,000) $(271,000) $(274,000) $ 19,000 41 Note 14. Shareholders’ Equity The Company has reserved 700,000 shares of its common stock to be made available to directors and employees who elect to participate in the stock purchase or savings and investment plans. During 2006, the number of shares set aside for these plans was increased by the Board of Directors from 480,000 to 700,000. As of December 31, 2008, 463,382 shares had been issued pursuant to these plans, leaving 236,618 shares available for future use. The issuance price is based on the market price of the stock at issuance date. Sales of stock to directors and employees amounted to 17,425 in 2008, 17,828 shares in 2007, and 17,410 shares in 2006. In 2001, the Company established a dividend reinvestment plan to allow shareholders to use their cash dividends for the automatic purchase of shares in the Company. When the plan was established, 600,000 shares were registered with the Securities and Exchange Commission, and as of December 31, 2008, 134,388 shares have been issued, leaving 465,612 shares for future use. Participation in this plan is optional and at the individual discretion of each shareholder. Shares are purchased for the plan from the Company at a price per share equal to the average of the daily bid and asked prices reported on the NASDAQ System for the five trading days immediately preceding, but not including, the dividend payment date. Sales of stock under the Dividend Reinvestment Plan amounted to 22,243 shares in 2008, 20,233 shares in 2007, and 17,031 shares in 2006. Note 15. Off-Balance-Sheet Financial Instruments and Concentrations of Credit 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. These financial instruments include commitments to originate loans, commitments for unused lines of credit, and standby letters of credit. The instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. Commitments for unused lines are agreements to lend to a customer provided 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. 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 creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on Management’s credit evaluation of the borrower. The Bank did not incur any losses on its commitments in 2008, 2007 or 2006. Standby letters of credit are conditional commitments issued by the Bank to guarantee a customer’s performance to a third party, with the customer being obligated to repay (with interest) any amounts paid out by the Bank under the letter of credit. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments and standby letters of credit is represented by the contractual 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. At December 31, the Bank had the following off-balance-sheet financial instruments, whose contract amounts represent credit risk: As of December 31, Unused lines, collateralized by residential real estate Other unused commitments Standby letters of credit Commitments to extend credit Total 2008 2007 $ 55,370,000 $ 55,694,000 56,904,000 2,594,000 15,098,000 $145,789,000 $ 130,290,000 75,236,000 2,687,000 12,496,000 The Bank grants residential, commercial and consumer loans to customers principally located in the Mid-Coast and Down East regions of Maine. Collateral on these loans typically consists of residential or commercial real estate, or personal property. Although the loan portfolio is diversified, a substantial portion of borrowers’ ability to honor their contracts is dependent on the economic conditions in the area, especially in the real estate sector. 42 Note 16. Earnings Per Share The following tables provide detail for basic earnings per share (EPS) and diluted earnings per share for the years ended December 31, 2008, 2007 and 2006: For the year ended December 31, 2008 Net income as reported Basic EPS: Income available to common shareholders Effect of dilutive securities: incentive stock options Diluted EPS: Income available to common shareholders plus assumed conversions For the year ended December 31, 2007 Net income as reported Basic EPS: Income available to common shareholders Effect of dilutive securities: incentive stock options Diluted EPS: Income available to common shareholders plus assumed conversions For the year ended December 31, 2006 Net income as reported Basic EPS: Income available to common shareholders Effect of dilutive securities: incentive stock options Diluted EPS: Income available to common shareholders plus assumed conversions Income (Numerator) Shares (Denominator) Per-Share Amount $ 14,034,000 14,034,000 9,701,379 18,952 $ 1.45 $ 14,034,000 9,720,331 $ 1.44 $ 13,101,000 $ 13,101,000 9,787,287 25,731 $ 1.34 $ 13,101,000 9,813,018 $ 1.34 $ 12,295,000 $ 12,295,000 9,816,307 49,476 $ 1.25 $ 12,295,000 9,865,783 $ 1.25 All earnings per share calculations have been made using the weighted average number of shares outstanding for each year. All of the dilutive securities are incentive stock options granted to certain key members of Management. The dilutive number of shares has been calculated using the treasury method, assuming that all granted options were exercisable at each year end. Note 17 – Fair Value Disclosures Certain assets and liabilities are recorded at fair value to provide additional insight into the Company’s quality of earnings. Some of these assets and liabilities are measured on a recurring basis while others are measured on a nonrecurring basis, with the determination based upon applicable existing accounting pronouncements. For example, securities available for sale and derivative financial instruments are recorded at fair value on a recurring basis. Other assets, such as, mortgage servicing rights, loans held for sale, and impaired loans, are recorded at fair value on a nonrecurring basis using the lower of cost or market methodology to determine impairment of individual assets. Under Statement of Financial Accounting No. 157, Fair Value Measurements, the Company groups assets and liabilities which are recorded at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with level 1 considered highest and level 3 considered lowest). A brief description of each level follows. Level 1 – Valuation is based upon quoted prices for identical instruments in active markets. Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 3 – Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Valuation techniques include use of discounted cash flow models and similar techniques. The most significant instruments that the Company fair values include securities and derivative instruments, all of which fall into Level 2 in the fair value hierarchy. The securities in the available for sale portfolio are priced by independent providers. In obtaining such valuation information from third parties, the Company has evaluated their 43 valuation methodologies used to develop the fair values in order to determine whether the valuations are representative of an exit price in the Company’s principal markets. The Company’s principal markets for its securities portfolios are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets. Derivative instruments are priced by independent providers using observable market assumptions with adjustments based on widely accepted valuation techniques. A discounted cash flow analysis on the expected cash flows of each derivative reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves, implied volatilities, and credit valuation adjustments. Assets and Liabilities Recorded at Fair Value on a Recurring Basis Securities Available for Sale. Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices for similar assets, if available. If quoted prices are not available, fair values are measured using matrix pricing models, or other model-based valuation techniques requiring observable inputs other than quoted prices such as yield curves, prepayment speeds, and default rates. Recurring Level 1 securities would include U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Recurring Level 2 securities include federal agency securities, mortgage-backed securities, collateralized mortgage obligations, municipal bonds and corporate debt securities. Derivative Financial Instruments. Substantially all derivative financial instruments held by the Company are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value based upon pricing for similar derivative instruments if they were purchased today. The Company classifies derivative financial instruments held or issued for risk management as recurring Level 2. The following table presents the balances of assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2008. In thousands of dollars Securities available for sale Derivative financial instruments Total Assets Level 1 $ - - $ - At December 31, 2008 Level 2 Level 3 $ 27,765 $ - - $ 27,789 $ - 24 Total $ 27,765 24 $ 27,789 Assets and Liabilities Recorded at Fair Value on a Non-Recurring Basis Mortgage Servicing Rights. Mortgage servicing rights represent the value associated with servicing residential mortgage loans. Servicing assets and servicing liabilities are reported using the amortization method or the fair value measurement method. In evaluating the carrying values of mortgage servicing rights, the Company obtains third party valuations based on loan level data including note rate, type and term of the underlying loans. As such, the Company classifies mortgage servicing rights as nonrecurring Level 2. Loans Held for Sale. Mortgage loans held for sale are recorded at the lower of carrying value or market value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies mortgage loans held for sale as nonrecurring Level 2. Other Real Estate Owned. Real estate acquired through foreclosure is recorded at the lower of carrying value or market value. The fair value of other real estate owned is based on property appraisals and an analysis of similar properties currently available. As such, the Company records other real estate owned as nonrecurring Level 2. Impaired Loans. A loan is considered to be impaired when it is probable that all of the principal and interest due under the original underwriting terms of the loan may not be collected. Impairment is measured based on the fair value of the underlying collateral. The Company measures impairment on all nonaccrual loans for which it has established specific reserves as part of the specific allocated allowance component of the allowance for loan losses. As such, the Company records impaired loans as nonrecurring Level 2. The following table includes assets measured at fair value on a nonrecurring basis that have had a fair value adjustment since their initial recognition as of March 31, 2008. Other real estate owned is presented net of an allowance for losses of $325,000. Impaired loans are presented net of their related specific allowance for loan losses of $1,957,000. 44 In thousands of dollars Mortgage servicing rights Loans held for sale Other real estate owned Impaired loans Total Assets Level 1 $ - - - - $ - At December 31, 2008 Level 2 $ 311 1,298 2,428 10,492 $ 14,529 Level 3 $ - - - - $ - Total $ 311 1,298 2,428 10,492 $ 14,529 SFAS No. 107, “Disclosures about the Fair Value of Financial Instruments,” requires disclosures of fair value information about financial instruments, whether or not recognized in the balance sheet, if the fair values can be reasonably determined. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques using observable inputs when available. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company. The estimated fair values for financial instruments as of December 31, 2008 and 2007 were as follows: Financial assets Cash and cash equivalents Securities available for sale Securities to be held to maturity Loans held for sale Loans (net of allowance for loan losses) Cash surrender value of life insurance Accrued interest receivable Interest rate cap Financial liabilities Deposits Borrowed funds Accrued interest payable December 31, 2008 December 31, 2007 Carrying amount Estimated fair value Carrying amount Estimated fair value $ 16,856,000 $ 16,856,000 27,765,000 229,460,000 1,298,000 994,560,000 9,148,000 5,783,000 24,000 27,765,000 234,767,000 1,298,000 970,473,000 9,148,000 5,783,000 24,000 $ 17,254,000 40,461,000 181,354,000 1,817,000 913,364,000 8,804,000 6,585,000 51,000 $17,254,000 40,461,000 181,132,000 1,817,000 908,190,000 8,804,000 6,585,000 51,000 $ 925,736,000 272,074,000 1,322,000 $ 904,926,000 290,336,000 1,322,000 $ 781,280,000 $687,739,000 317,288,000 2,212,000 316,719,000 2,212,000 The fair value estimates, methods, and assumptions for the Company’s financial instruments are set forth below. Cash and Cash Equivalents The carrying values of cash equivalents, due from banks and federal funds sold approximate their relative fair values. Investment Securities The fair values of investment securities are estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Fair values are 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. If these considerations had been incorporated into the fair value estimates, the aggregate fair value could have been changed. The carrying values of restricted equity securities approximate fair values. 45 Loans Fair values are estimated for portfolios of loans with similar financial characteristics. The fair values of performing loans are calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest risk inherent in the loan. The estimates of maturity are based on the Company’s historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions, and the effects of estimated prepayments. Fair values for significant non-performing loans are based on estimated cash flows and are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information. Management has made estimates of fair value using discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, Management has no basis to determine whether the fair value presented above would be indicative of the value negotiated in an actual sale. Cash Surrender Value of Life Insurance The fair value is based on the actual cash surrender value of life insurance policies. Accrued Interest Receivable The fair value estimate of this financial instrument approximates the carrying value as this financial instrument has a short maturity. It is the Company’s policy to stop accruing interest on loans for which it is probable that the interest is not collectible. Therefore, this financial instrument has been adjusted for estimated credit loss. Deposits The fair value of deposits 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. The fair value estimates do not include the benefit that results from the low-cost funding provided by the deposits compared to the cost of borrowing funds in the market. If that value were considered, the fair value of the Company’s net assets could increase. Derivatives The fair values of derivatives are based on quotations received from securities dealers. Borrowed Funds The fair value of borrowed funds is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently available for borrowings of similar remaining maturities. Accrued Interest Payable The fair value estimate approximates the carrying amount as this financial instrument has a short maturity. Off-Balance-Sheet Instruments Off-balance-sheet instruments include loan commitments. Fair values for loan commitments have not been presented as the future revenue derived from such financial instruments is not significant. Limitations Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These values do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on Management’s 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 based on existing on- and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Other significant assets and liabilities that are not considered financial instruments include the deferred tax asset, premises and equipment, and other real estate owned. In addition, 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. 46 Note 18. Other Operating Income and Expense Other operating income and other operating expense include the following items greater than 1% of revenues. For the years ended December 31, Other operating income Merchant discount fees ATM income Other operating expense Merchant interchange fees 2008 2007 2006 $ 2,433,000 1,156,000 $ 2,528,000 971,000 $ 2,507,000 771,000 $ 2,358,000 $ 2,427,000 $ 2,393,000 Note 19. Regulatory Capital Requirements The ability of the Company to pay cash dividends to its shareholders depends primarily on receipt of dividends from its subsidiary, the Bank. The subsidiary may pay dividends to its parent out of so much of its net income as the Bank’s directors deem appropriate, subject to the limitation that the total of all dividends declared by the Bank in any calendar year may not exceed the total of its net income of that year combined with its retained net income of the preceding two years and subject to minimum regulatory capital requirements. The amount available for dividends in 2009 will be 2009 earnings plus retained earnings of $12,279,000 from 2008 and 2007. The payment of dividends by the Company is also affected by various regulatory requirements and policies, such as the requirements to maintain adequate capital. In addition, if, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), that authority may require, after notice and hearing, that such bank cease and desist from that practice. The Federal Reserve Bank and the Comptroller of the Currency have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve Bank, the Comptroller and the Federal Deposit Insurance Corporation have issued policy statements which provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. In addition to the effect on the payment of dividends, failure to meet minimum capital requirements can also result in mandatory and discretionary actions by regulators that, if undertaken, could have an impact on the Company’s operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measurements of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of Tier 1 capital and Tier 2 or total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2008, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2008, the most recent notification from the Office of the Comptroller of the Currency classified 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 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since this notification that Management believes have changed the institution’s category. The actual and minimum capital amounts and ratios for the Bank are presented in the following table: 47 As of December 31, 2008 Tier 2 capital to risk-weighted assets Tier 1 capital to risk-weighted assets Tier 1 capital to average assets As of December 31, 2007 Tier 2 capital to risk-weighted assets Tier 1 capital to risk-weighted assets Tier 1 capital to average assets Actual $97,454,000 11.10% $88,554,000 10.09% $88,554,000 6.90% $88,775,000 10.99% $81,875,000 10.13% $81,875,000 6.99% For capital adequacy purposes To be well-capitalized under prompt corrective action provisions $70,243,000 8.00% $35,122,000 4.00% $51,311,000 4.00% $64,628,000 8.00% $32,314,000 4.00% $46,883,000 4.00% $87,804,000 10.00% $52,682,000 6.00% $64,139,000 5.00% $80,785,000 10.00% $48,471,000 6.00% $58,604,000 5.00% The actual and minimum capital amounts and ratios for the Company, on a consolidated basis, are presented in the following table: As of December 31, 2008 Tier 2 capital to risk-weighted assets Tier 1 capital to risk-weighted assets Tier 1 capital to average assets As of December 31, 2007 Tier 2 capital to risk-weighted assets Tier 1 capital to risk-weighted assets Tier 1 capital to average assets Note 20. Legal Contingencies Actual $97,649,000 11.13% $88,749,000 10.11% $88,749,000 7.07% $89,470,000 11.07% $82,570,000 10.21% $82,570,000 7.22% For capital adequacy purposes To be well-capitalized under prompt corrective action provisions $70,218,000 8.00% $35,109,000 4.00% $50,204,000 4.00% $64,667,000 8.00% $32,334,000 4.00% $45,771,000 4.00% n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a Various legal claims also arise from time to time in the normal course of business which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements. 48 Note 21. Condensed Financial Information of Parent Condensed financial information for The First Bancorp, Inc. exclusive of its subsidiary is as follows: Balance Sheets As of December 31, Assets Cash and cash equivalents Dividends receivable Investments Investment in subsidiary Premises and equipment Goodwill Other assets Total assets Liabilities and shareholders’ equity Dividends payable Other liabilities Total liabilities Shareholders’ equity Common stock Additional paid-in capital Retained earnings Accumulated other comprehensive loss Net unrealized loss on available for sale securities, net of tax benefit of $11,000 in 2008 and $3,000 in 2007 Net unrealized loss on post-retirement benefit costs, net of tax benefit of $146,000 in 2008 and $147,000 in 2007 Total accumulated other comprehensive loss Total shareholders’ equity Total liabilities and shareholders’ equity 2008 2007 $ 213,000 $ 369,000 1,750,000 171,000 84,163,000 350,000 27,559,000 67,000 $ 114,429,000 1,800,000 123,000 89,323,000 - 27,559,000 64,000 $ 119,082,000 $ 1,891,000 10,000 1,901,000 $ 1,752,000 10,000 1,762,000 97,000 44,117,000 73,259,000 97,000 44,762,000 68,088,000 (21,000) (6,000) (271,000) (292,000) 117,181,000 $ 119,082,000 (274,000) (280,000) 112,667,000 $ 114,429,000 Statements of Income For the years ended December 31, Investment income Other income Other expense Loss before Bank earnings Equity in earnings of Bank Remitted Unremitted Net income 2008 $ 11,000 - 136,000 (125,000) 2007 $ 28,000 26,000 179,000 (125,000) 2006 $ 36,000 - 120,000 (84,000) 7,281,000 6,878,000 $ 14,034,000 7,825,000 5,401,000 $ 13,101,000 7,485,000 4,894,000 $ 12,295,000 49 Statements of Cash Flows For the years ended December 31, Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Net realized loss on sale of securities Equity compensation expense (Increase) decrease in other assets Increase (decrease) in other liabilities Gain on sale of real estate Unremitted earnings of Bank Net cash provided by operating activities Cash flows from investing activities: Proceeds from maturities and calls of investments Capital expenditures Net cash used in investing activities Cash flows from financing activities: Proceeds from sale of real estate Payments to purchase common stock Proceeds from sale of common stock Dividends paid Net cash used in financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Note 22. New Accounting Pronouncements 2008 2007 2006 $ 14,034,000 $ 13,101,000 $ 12,295,000 2,000 24,000 37,000 (38,000) 278,000 - (6,878,000) 7,459,000 - - - 1,000 - 59,000 (134,000) (73,000) (27,000) (5,401,000) 7,526,000 251,000 (350,000) (99,000) 2,000 - 60,000 386,000 (619,000) - (4,894,000) 7,230,000 - - - 348,000 (1,414,000) 732,000 (7,281,000) (7,615,000) (156,000) 369,000 $ 213,000 250,000 (1,687,000) 802,000 (6,565,000) (7,200,000) 227,000 142,000 $ 369,000 - (3,052,000) 860,000 (5,983,000) (8,175,000) (945,000) 1,087,000 $ 142,000 In September 2006, FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. In February 2008, FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, Effective Date of FASB Statement No. 157, which delays the effective date for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. Although this Statement does not require any new fair value measurements, it has expanded our fair value disclosures. In October 2008, the FASB issued FSP FAS No. 157-3, “Determining the Fair Value of a Financial Asset when the Market for that Asset is not Active.” FSP FAS No. 157-3 amended SFAS No. 157 by incorporating an example to illustrate key considerations in determining the fair value of a financial asset in an inactive market. The FSP was effective upon issuance. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which gives entities the option to measure eligible financial assets and financial liabilities at fair value on an instrument-by-instrument basis. The election to use the fair value option is available when an entity first recognizes a financial asset or financial liability. Subsequent changes in fair value must be recorded in earnings. SFAS No. 159 contains provisions to apply the fair value option to existing eligible financial instruments at the date of adoption. This statement is effective as of the beginning of an entity’s first fiscal year after November 15, 2007. The Company did not take the fair value option under SFAS No. 159 for any financial assets or financial liabilities. Effective January 1, 2008, the Company adopted the provisions of Emerging Issues Task Force (EITF) 06-10: Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements. The EITF states that an employer should recognize a liability for the postretirement benefit related to a collateral assignment split-dollar life insurance 50 arrangement. The Company recognized the effect of applying EITF 06-10 as a change in accounting principle through a cumulative-effect adjustment to retained earnings. The cumulative effect of the change on retained earnings on the consolidated balance sheet was $215,000 to retained earnings. In December 2007, FASB issued Statement No. 160, “Non-controlling Interests in Consolidated Financial Statements – an amendment of ARB No. 51” (SFAS No.160). This statement applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding non-controlling interest in one or more subsidiaries or that deconsolidate a subsidiary. This statement amends ARB No. 51 to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning after December 15, 2009. The Company does not expect it will have a material effect on its financial condition or results of operations. In March 2008, FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (SFAS No. 161). This statement requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improves the transparency of financial reporting. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. The Company is currently evaluating the impact of SFAS No. 161 but does not expect it will have a material effect on its financial condition or results of operations. In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the Company’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes, and prescribes a minimum recognition threshold and measurement attributed for the financial statement recognition and measurement of a tax provision taken or expected to be taken in a tax return. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2007. The Company implemented FIN 48 during 2008 and it did not have a material impact on the Company’s financial statements. Note 23. Subsequent Events On January 9, 2009, the Company received $25 million from a preferred stock investment by the U.S. Treasury under the Capital Purchase Program (the “CPP Shares”) at a purchase price of $1,000 per share. The CPP Shares call for cumulative dividends at a rate of 5.0% per year for the first five years, and at a rate of 9.0% per year in following years, payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year. Incident to such issuance, the Company issued to the U.S. Treasury warrants (the “Warrants”) to purchase up to 225,904 shares of the Company’s common stock at a price per share of $16.60 (subject to adjustment). The CPP Shares and the related Warrants (and any shares of common stock issuable pursuant to the Warrants) are freely transferable by Treasury to third parties and the Company has filed a registration statement with the Securities and Exchange Commission to allow for possible resale of such securities. The CPP Shares qualify as Tier 1 capital on the Company’s books for regulatory purposes and rank senior to the Company’s common stock and senior or at an equal level in the Company’s capital structure to any other shares of preferred stock the Company may issue in the future. The impact on the Company’s capital ratios as of December 31, 2008, is shown in the following table: Total capital to risk-weighted assets Tier 1 capital to risk-weighted assets Tier 1 capital to average assets As of December 31, 2008 Historical as Presented Pro-Forma as Approved 11.13% 10.11% 7.07% 13.97% 12.96% 9.06% The Company may redeem the CPP Shares during the first three years only with the proceeds the Company receives from the sale for cash of other Tier 1 qualifying perpetual preferred or common stock that results in aggregate gross proceeds to the Company of not less than 25% of the issue price of the CPP Shares. After three years, the Company could redeem the CPP Shares at its option, in whole or in part, at any time using any funds available to the Company. Any redemption would be subject to the prior approval of the Federal Reserve Bank of Boston. The CPP Shares would be “perpetual” preferred stock, which means that neither Treasury nor any subsequent holder would have a right to require that the Company redeem any of the shares. During the first three years following the Company’s sale of the CPP Shares, the Company will be required to obtain Treasury’s consent to increase the dividend per share paid on the Company’s common stock unless the Company had redeemed the CPP Shares in full or Treasury had transferred all of the CPP Shares to other parties. Also during the 51 first three years following the Company’s sale of the CPP Shares, the Company would be required to obtain Treasury’s consent in order to repurchase any shares of its outstanding stock of any type (other than purchases of common stock or preferred stock ranking junior to the CPP Shares in the ordinary course of the Company’s business and consistent with the Company’s past practices in connection with a benefit plan) unless the Company had redeemed the CPP Shares in full or Treasury had transferred all of the CPP Shares to other parties. As a condition to Treasury’s purchase of the CPP Shares, during the time that Treasury holds any equity or debt instrument the Company issued, the Company will be required to comply with certain restrictions and other requirements relating to the compensation of the Company’s chief executive officer, chief financial officer and three other most highly compensated executive officers. These restrictions include a prohibition on severance payments to those executive officers upon termination of their employment and a $500,000 limit on the tax deductions the Company can take for compensation expense for each of those executive officers in a single year as well as a prohibition on bonus compensation to such officers other than limited amounts of long-term restricted stock. In conjunction with the sale of the CPP shares, the Company also issued warrants (“Warrants”) to Treasury giving it the right to purchase from the Company 225,904 shares of the Company’s common stock equal at a price of $16.60 per share. The Warrants have a term of ten years and could be exercised by Treasury or a subsequent holder at any time or from time to time during their term. To the extent they had not previously been exercised, the Warrants would expire after ten years. Treasury will not vote any shares of common stock it receives upon exercise of the Warrants, but that restriction would not apply to third parties to whom Treasury transferred the Warrants. The Warrants (and any common stock issued upon exercise of the Warrants) could be transferred to third parties separately from the CPP Shares. Note 24. Quarterly Information The following tables provide unaudited financial information by quarter for each of the past two years: Dollars in thousands Balance Sheets Cash Investments Net loans Other assets Total assets Deposits Borrowed funds Other liabilities Shareholders’ equity Total liabilities & equity Income Statements Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Non-interest income Non-interest expense Income before taxes Income taxes Net income Basic earnings per share Diluted earnings per share 52 2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 221,815 913,364 70,817 178,390 840,279 68,849 200,170 870,550 69,128 219,855 886,274 69,111 $ 21,103 $ 21,349 $ 27,339 $ 17,254 $ 15,837 $ 19,997 $ 21,667 $ 16,856 262,532 971,771 84,585 $1,108,621 $1,161,197 $1,202,579 $1,223,250 $1,248,208 $1,285,373 $1,311,157 $1,325,744 $ 824,761 $ 851,090 $ 811,395 $ 781,280 $ 826,477 $ 842,120 $ 918,856 $ 925,736 272,074 10,753 117,181 267,011 12,068 112,105 188,478 11,419 110,210 162,512 12,548 108,800 316,719 12,583 112,668 261,057 953,797 74,636 232,878 928,887 70,606 246,378 946,267 72,731 264,617 11,812 115,872 295,253 12,867 113,611 317,055 11,440 114,758 $1,108,621 $1,161,197 $1,202,579 $1,223,250 $1,248,208 $1,285,373 $1,311,157 $1,325,744 $ 16,948 $ 17,502 $ 18,538 $ 18,733 $ 18,330 $ 17,514 $ 17,891 $ 17,637 7,316 10,321 10,381 8,157 10,231 8,502 9,890 7,612 9,383 7,565 8,268 9,623 9,513 8,817 8,572 8,942 300 250 300 582 500 939 875 2,386 7,265 2,148 5,250 4,163 1,160 7,935 2,096 5,836 4,195 1,187 $ 3,003 $ 3,195 $ 3,414 $ 3,489 $ 3,591 $ 3,603 $ 3,832 $ 3,008 7,362 2,470 5,353 4,479 1,284 7,857 2,985 6,000 4,842 1,428 7,920 2,542 5,580 4,882 1,393 8,748 2,856 6,284 5,320 1,488 8,317 2,176 5,449 5,044 1,453 8,003 2,518 5,425 5,096 1,493 $ 0.30 $ 0.33 $ 0.35 $ 0.36 $ 0.37 $ 0.37 $ 0.40 $ 0.31 $ 0.30 $ 0.33 $ 0.35 $ 0.36 $ 0.37 $ 0.37 $ 0.39 $ 0.31 Report of Independent Registered Public Accounting Firm Berry, Dunn, McNeil & Parker The Shareholders and Board of Directors The First Bancorp, Inc. We have audited the accompanying consolidated balance sheets of The First Bancorp, Inc. and Subsidiary as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. We have also audited The First Bancorp, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The First Bancorp, Inc.’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We conducted our audits 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 the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. 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 U.S. 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 U.S. 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The First Bancorp, Inc. and Subsidiary as of December 31, 2008 and 2007, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, The First Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). As described in Note 22, the Company changed its method of accounting for split-dollar life insurance arrangements effective January 1, 2008, in accordance with EITF 06-10: Accounting for Collateral Assignment Split-Dollar Life Insurance Agreements. Portland, Maine March 13, 2009 53 Controls and Procedures As required by Rule 13a-15 under the Securities Exchange Act of 1934 (the “Exchange Act”), as of December 31, 2008, the end of the period covered by this report, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. In designing and evaluating the Company’s disclosure controls and procedures, the Company and its management recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and the Company’s management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Also, based on Management’s evaluation, there was no change in the Company’s internal control over financial reporting that occurred during the fiscal quarter ended December 31, 2008 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company reviews its disclosure controls and procedures, which may include its internal controls over financial reporting, on an ongoing basis, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that the Company’s systems evolve with its business. Management’s Annual Report on Internal Control over Financial Reporting The Management of the Company is responsible for the preparation and fair presentation of the financial statements and other financial information contained in this Form 10-K. Management is also responsible for establishing and maintaining adequate internal control over financial reporting and for identifying the framework used to evaluate its effectiveness. Management has designed processes, internal control and a business culture that foster financial integrity and accurate reporting. The Company’s comprehensive system of internal control over financial reporting was designed to provide reasonable assurances regarding the reliability of financial reporting and the preparation of the consolidated financial statements of the Company in accordance with generally accepted accounting principles. The Company’s accounting policies and internal control over financial reporting, established and maintained by Management, are under the general oversight of the Company’s Board of Directors, including the Board of Directors’ Audit Committee. Management has made a comprehensive review, evaluation, and assessment of the Company’s internal control over financial reporting as of December 31, 2008. The standard measures adopted by Management in making its evaluation are the measures in Internal Control – Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO”). Based upon its review and evaluation, Management concluded that, as of December 31, 2008, the Company’s internal control over financial reporting was effective and that there were no material weaknesses. Berry, Dunn, McNeil & Parker, an independent registered public accounting firm, which has audited and reported on the consolidated financial statements contained in this Form 10-K, has issued its written attestation report on Management’s assessment of the Company’s internal control over financial reporting which follows this report. Daniel R. Daigneault, President and Director (Principal Executive Officer) March 13, 2009 F. Stephen Ward , Treasurer and Chief Financial Officer (Principal Financial Officer, Principal Accounting Officer) March 13, 2009 54 Shareholder Information Common Stock Prices and Dividends The common stock of The First Bancorp, Inc. (ticker symbol FNLC) trades on the NASDAQ Global Select Market. The following table reflects the high and low prices of actual sales in each quarter of 2008 and 2007. Such quotations do not reflect retail mark-ups, mark- downs or brokers’ commissions. Annual Report on Form 10-K The Company’s Annual Report on Form 10-K to be filed with the Securities and Exchange Commission is available online at the Commission’s website: www.sec.gov. Shareholders may obtain a written copy, without charge, upon written request to the address listed below. 2008 2007 Low High Low High $15.74 $13.95 $16.84 $15.64 15.50 18.00 13.60 23.05 14.20 22.98 13.65 12.88 12.84 17.00 17.50 15.95 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter The last known transaction of the Company’s stock during 2008 was on December 31 at $19.89 per share. As of December 31, 2008, there are no warrants outstanding with respect to the Company’s common stock, and the Company has no securities outstanding which are convertible into common equity. The table below sets forth the cash dividends declared in the last two fiscal years: Date Declared March 22, 2007 June 21, 2007 September 19, 2007 December 20, 2007 March 20, 2008 June 19, 2008 September 18, 2008 December 18, 2008 Amount Per Share $0.165 $0.170 $0.175 $0.180 $0.185 $0.190 $0.195 $0.195 Date Payable April 30, 2007 July 31, 2007 October 31, 2007 January 31, 2008 April 30, 2008 July 31, 2008 October 31, 2008 January 30, 2009 Pending Legal Proceedings There are no material pending legal proceedings to which the Company or the Bank is the party or to which any of its property is subject, other than routine litigation incidental to the business of the Bank. None of these proceedings is expected to have a material effect on the financial condition of the Company or of the Bank. Annual Meeting The Annual Meeting of the Shareholders of The First Bancorp, Inc. will be held Wednesday, April 29, 2009 at 11:00 a.m. at The Samoset Resort, 220 Warrenton Street, Rockport, Maine 04856. Number of Shareholders The number of shareholders of record as of February 19, 2009 was approximately 3,353. Accessing Reports Online The First Bancorp, Inc.’s press releases, SEC filings and other reports or information issued by the Company are available at: www.TheFirstBancorp.com. In addition, all SEC filings are accessible at the Commission’s website: www.sec.gov. Corporate Headquarters Contact: F. Stephen Ward, Chief Financial Officer The First Bancorp, Inc. 223 Main Street, P.O. Box 940 Damariscotta, Maine 04543 207-563-3195; 1-800-564-3195 Transfer Agent Shareholder inquiries regarding change of address or title should be directed to: Shareholder Relations The First Bancorp, Inc. 223 Main Street, P.O. Box 940 Damariscotta, Maine 04543 207-563-3195; 1-800-564-3195 Independent Certified Public Accountants Berry, Dunn, McNeil & Parker 100 Middle Street, P.O. Box 1100 Portland, Maine 04104-1100 Corporate Counsel Pierce Atwood, Attorneys One Monument Square Portland, Maine 04101 Photography Credits All photographs contained in this report are copyright of the following photographers: Covers and page 1: Peter Ralston Pages 2, 6, and 20: Benjamin Magro. 55 Directors and Executive Officers Board of Directors The First, N.A. Management Executive Committee Stuart G. Smith, Chairman of the Board Katherine M. Boyd Daniel R. Daigneault Robert B. Gregory Tony C. McKim Carl S. Poole, Jr. Mark N. Rosborough David B. Soule, Jr. Bruce B. Tindal Directors of The First Bancorp also serve as Directors of The First, N.A. Daniel R. Daigneault President & Chief Executive Officer Tony C. McKim Executive Vice President & Chief Operating Officer Susan A. Norton Executive Vice President, Human Resources & Compliance F. Stephen Ward Executive Vice President & Chief Financial Officer Charles A. Wootton Executive Vice President & Senior Loan Officer Office Locations Bar Harbor Blue Hill Boothbay Harbor Calais Camden Damariscotta Eastport Ellsworth Northeast Harbor Rockland Rockport Southwest Harbor Waldoboro Wiscasset Office Locations Bar Harbor Damariscotta The First Bancorp Executive Officers Daniel R. Daigneault President & Chief Executive Officer Tony C. McKim Executive Vice President & Chief Operating Officer F. Stephen Ward Executive Vice President & Chief Financial Officer Charles A. Wootton Executive Vice President & Clerk 56 w w w . t h e f i r s t b a n c o r p . c o m

Continue reading text version or see original annual report in PDF format above