Associated Banc-Corp 10-K 2008
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Commission file number: 0-5519
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (920) 491-7000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes o No þ
As of June 30, 2007, (the last business day of the registrants most recently completed second fiscal quarter) the aggregate market value of the voting stock held by nonaffiliates of the registrant was approximately $4,084,920,000. This excludes approximately $65,023,000 of market value representing the outstanding shares of the registrant owned by all directors and officers who individually, in certain cases, or collectively, may be deemed affiliates. This includes approximately $237,758,000 of market value representing 5.73% of the outstanding shares of the registrant held in a fiduciary capacity by the trust company subsidiary of the registrant.
As of January 31, 2008, 127,325,756 shares of common stock were outstanding.
Statements made in this document and in documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of managements plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements may be identified by the use of words such as believe, expect, anticipate, plan, estimate, should, will, intend, or similar expressions.
Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, could affect the future financial results of Associated Banc-Corp and could cause those results to differ materially from those expressed in forward-looking statements contained or incorporated by reference in this document. These factors, many of which are beyond Associated Banc-Corps control, include the following:
These factors should be considered in evaluating the forward-looking statements, and you should not place undue reliance on such statements. Forward-looking statements speak only as of the date they are made. Associated Banc-Corp undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Associated Banc-Corp (individually referred to herein as the Parent Company and together with all of its subsidiaries and affiliates, collectively referred to herein as the Corporation, Associated, we, us, or our) is a bank holding company registered pursuant to the Bank Holding Company Act of 1956, as amended (the BHC Act). We were incorporated in Wisconsin in 1964 and were inactive until 1969 when permission was received from the Board of Governors of the Federal Reserve System (the FRB or Federal Reserve) to acquire three banks. At December 31, 2007, we owned one nationally chartered commercial bank headquartered in Wisconsin, serving local communities within our three-state footprint (Wisconsin, Illinois, and Minnesota) and, measured by total assets held at December 31, 2007, were the second largest commercial bank holding company headquartered in Wisconsin. At December 31, 2007, we owned one nationally chartered trust company headquartered in Wisconsin, serving clients throughout our footprint. We also owned 28 limited purpose banking and nonbanking subsidiaries located in Arizona, California, Illinois, Minnesota, Nevada, Vermont, and Wisconsin, that are closely related or incidental to the business of banking.
We provide our subsidiaries with leadership, as well as financial and managerial assistance in areas such as corporate development, auditing, marketing, legal/compliance, human resources management, risk management, facilities management, security, purchasing, credit administration, asset and liability management and other treasury-related activities, budgeting, accounting and other finance support.
Responsibility for the management of the subsidiaries remains with their respective boards of directors and officers. Services rendered to the subsidiaries by us are intended to assist the management of these subsidiaries to expand the scope of services offered by them. At December 31, 2007, our bank subsidiary provided services through 295 locations in approximately 180 communities.
Through our banking subsidiary and various nonbanking subsidiaries, we provide a broad array of banking and nonbanking products and services to individuals and businesses in the communities we serve. We organize our business into two reportable segments: Banking and Wealth Management. Our banking and wealth management activities are conducted predominantly in Wisconsin, Minnesota, and Illinois, and are primarily delivered through branch facilities in this tri-state area, as well as supplemented through loan production offices, supermarket branches, a customer service call center and 24-hour phone-banking services, an interstate Automated Teller Machine (ATM) network, and internet banking services. See also Note 20, Segment Reporting, of the notes to consolidated financial statements within Part II, Item 8, Financial Statements and Supplementary Data. As disclosed in Note 20, the banking segment represented approximately 90% of total revenues in 2007, as defined in the note. Our profitability is significantly dependent on the net interest income, noninterest income, the level of the provision for loan losses, noninterest expense, and related income taxes of our banking segment.
Banking consists of lending and deposit gathering (as well as other banking-related products and services) to businesses, governments, and consumers, and the support to deliver, fund, and manage such banking services. We offer a variety of loan and deposit products to retail customers, including but not limited to: home equity loans and lines of credit, residential mortgage loans and mortgage refinancing, education loans, personal and installment loans, checking, savings, money market deposit accounts, IRA accounts, certificates of deposit, and safe deposit boxes. As part of our management of originating and servicing residential mortgage loans, nearly all of our long-term, fixed-rate residential mortgage loans are sold in the secondary market with servicing rights retained. Loans, deposits, and related banking services to businesses (including small and larger businesses, governments/municipalities, metro or niche markets, and companies with specialized lending needs such as floor plan lending or asset-based lending) primarily include, but are not limited to: business checking and other business deposit products, business loans, lines of credit, commercial real estate financing, construction loans, letters of credit, revolving credit arrangements, and to a lesser degree business credit cards and equipment and machinery leases. To further support business customers and correspondent financial institutions, we provide safe deposit and night depository services, cash management, international banking, as well as check clearing, safekeeping, and other banking-based services.
Lending involves credit risk. Credit risk is controlled and monitored through active asset quality management including the use of lending standards, thorough review of potential borrowers, and active asset quality administration. Credit risk management is discussed under Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, sections Critical Accounting Policies, Loans, Allowance for Loan Losses, and Nonperforming Loans, Potential Problem Loans, and Other Real Estate Owned, and under Part II, Item 8, Note 1, Summary of Significant Accounting Policies, and Note 4, Loans, of the notes to consolidated financial statements. Also see Item 1A, Risk Factors.
The wealth management segment provides products and a variety of fiduciary, investment management, advisory and corporate agency services to assist customers in building, investing, or protecting their wealth. Customers include individuals, corporations, small businesses, charitable trusts, endowments, foundations, and institutional investors. The wealth management segment is comprised of a) a full range of personal and business insurance products and services (including life, property, casualty, credit and mortgage insurance, fixed annuities, and employee group benefits consulting and administration); b) full-service investment brokerage, variable annuities, and discount and on-line brokerage; and c) trust/asset management, investment management, administration of pension, profit-sharing and other employee benefit plans, personal trusts, and estate planning. See also Note 20, Segment Reporting, of the notes to consolidated financial statements within Part II, Item 8, Financial Statements and Supplementary Data. As disclosed in Note 20, the wealth management segment represented approximately 10% of total revenues in 2007, as defined in the note.
We are not dependent upon a single or a few customers, the loss of which would have a material adverse effect on us. No material portion of our business is seasonal.
At December 31, 2007, we had approximately 5,110 full-time equivalent employees. None of our employees are represented by unions.
The financial services industry is highly competitive. We compete for loans, deposits, and financial services in all of our principal markets. We compete directly with other bank and nonbank institutions located within our markets, internet-based banks, with out-of-market banks and bank holding companies that advertise or otherwise serve our markets, money market and other mutual funds, brokerage houses, and various other financial institutions. Additionally, we compete with insurance companies, leasing companies, regulated small loan companies, credit unions, governmental agencies, and commercial entities offering financial services products. Competition involves efforts to obtain new deposits, the scope and type of services offered, interest rates paid on deposits and charged on loans, as well as other aspects of banking. We also face direct competition from members of bank holding company systems that have greater assets and resources than ours.
Financial institutions are highly regulated both at the federal and state levels. Numerous statutes and regulations affect the business of the Corporation.
As a registered bank holding company under the BHC Act, we are regulated and supervised by the FRB. Our nationally chartered bank subsidiary and our nationally chartered trust subsidiary are supervised and examined by the Office of the Comptroller of the Currency (the OCC). All of our subsidiaries that accept insured deposits are subject to examination by the Federal Deposit Insurance Corporation (the FDIC).
We are subject to various regulatory capital requirements administered by the federal banking agencies noted above. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. Our capital amounts and classification are also subject to judgments by the regulators regarding qualitative components, risk weightings, and other factors. We have consistently maintained regulatory capital ratios at or above the well capitalized standards. For further detail on capital and capital ratios see discussion under Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, sections, Liquidity and Capital, and under Part II, Item 8, Note 18, Regulatory Matters, of the notes to consolidated financial statements.
Under the risk-based capital requirements for bank holding companies, the minimum requirement for the ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital (as defined below) is to be composed of common stockholders equity, retained earnings, qualifying perpetual preferred stock (in a limited amount in the case of cumulative preferred stock), minority interests in the equity accounts of consolidated subsidiaries, and qualifying trust preferred securities, less goodwill and certain intangibles (Tier 1 Capital). The remainder of total capital may consist of qualifying subordinated debt and redeemable preferred stock, qualifying cumulative perpetual preferred stock and allowance for loan losses (Tier 2 Capital, and together with Tier 1 Capital, Total Capital). At December 31, 2007, our Tier 1 Capital ratio was 9.06% and Total Capital ratio was 10.92%.
The Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These requirements provide for a minimum leverage ratio of Tier 1 Capital to adjusted average quarterly assets (Leverage Ratio) equal to 3% for bank holding companies that meet specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a leverage ratio of at least 4%. Our Leverage Ratio at December 31, 2007, was 7.83%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a tangible tier 1 leverage ratio (deducting all intangibles) in evaluating proposals for expansion or to engage in new activity. The Federal Reserve has not advised us of any specific minimum leverage ratio or tier 1 leverage ratio applicable to us.
Our commercial national bank subsidiary is subject to similar capital requirements adopted by the OCC. The OCC has not advised our subsidiary bank of any specific minimum leverage ratios applicable to it. The risk-based capital requirements identify concentrations of credit risk and certain risks arising from non-traditional activities, and the management of those risks, as important factors to consider in assessing an institutions overall capital adequacy. Other factors taken into consideration by federal regulators include: interest rate exposure; liquidity, funding and market risk; the quality and level of earnings; the quality of loans and investments; the effectiveness of loan and investment policies; and managements overall ability to monitor and control financial and operational risks, including the risks presented by concentrations of credit and non-traditional activities.
In December 2006, the federal banking agencies issued a notice of proposed rulemaking seeking comment on various possible changes to the existing risk-based capital requirements. 71 F.R. 77446. These rules, referred to as Basel IA, would apply to the majority of U.S. banks that would not be subject to the proposed more advanced capital adequacy rules, known as Basel II. The notice suggests that most U.S. domestic institutions would be able to choose to remain under the existing Basel I risk-based capital system. Proposed modifications to the Basel I system under Basel IA would include: (i) expanding the number of risk-weightings from 4 to 8, with the highest being 200%; (ii) expanding the use of external credit ratings as an indicator of credit risk for externally-rated exposures; (iii) expanding the range of collateral and guarantors that may qualify an exposure for a lower risk-weighting; (iv) using loan-to-value ratios (and possibly, credit assessments and other broad measures of credit risk) for assigning risk weightings for residential mortgages; (v) imposing a capital charge for certain short-term commitments; (vi) assessing a risk-based capital charge to reflect the risks in securitizations backed by revolving retail exposures with early amortization provisions; (vii) removing the 50% limit on the risk-weighting for credit equivalent amounts of derivatives; and (viii) a possible reduction of the risk-weight for small loans to business. We would be subject to the Basel IA rules upon their adoption and are evaluating the effect on our capital requirements if these rules are adopted in their proposed form. The proposal has been criticized by industry participants, and we can make no prediction as to if or when the proposal will be adopted.
As a bank holding company, we are required to obtain prior Federal Reserve approval before acquiring more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association. In determining whether to approve a proposed bank acquisition, federal bank regulators will consider, among other factors, the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institutions record of addressing the credit needs of the communities it serves, including the needs of low and moderate income neighborhoods, consistent with the safe and sound operation of the bank, under the Community Reinvestment Act (CRA).
The Parent Company is a legal entity separate and distinct from its banking and other subsidiaries. A substantial portion of its revenue comes from dividends paid to us by our national bank subsidiary. The OCCs prior approval is required if the total of all dividends declared by a national bank in any calendar year will exceed the sum of that banks net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits national banks from paying dividends that would be greater than the banks undivided profits after deducting statutory bad debt in excess of the banks allowance for loan losses.
Under the foregoing dividend restrictions and restrictions applicable to our nonbanking subsidiaries, as of December 31, 2007, our subsidiaries could pay additional dividends of $65 million to us, without obtaining affirmative governmental approvals. This amount is not necessarily indicative of amounts that may be available in future periods. In 2007, our subsidiaries paid $273 million in cash dividends to us.
We and our banking subsidiary are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank or bank holding company that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The appropriate federal regulatory authorities have indicated that paying dividends that deplete a banks capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings.
The Gramm-Leach-Bliley Act of 1999 significantly amended the BHC Act. The amendments, among other things, allow certain qualifying bank holding companies that elect treatment as financial holding companies to engage in activities that are financial in nature and that explicitly include the underwriting and sale of insurance. The Parent Company thus far has not elected to be treated as a financial holding company. Bank holding companies that have not elected such treatment generally must limit their activities to banking activities and activities that are closely related to banking.
The BHC Acts provisions governing the scope and manner of the FRBs supervision of bank holding companies, the manner in which activities may be found to be financial in nature or closely related to banking, and the extent to which state laws on insurance will apply to insurance activities of banks and bank subsidiaries were amended. The FRB has issued regulations implementing these provisions. The BHC Act, as amended, allows for the expansion of activities by banking organizations and permits consolidation among financial organizations generally. Under the BHC Act, we are required to act as a source of financial strength to each of our subsidiaries pursuant to which we may be required to commit financial resources to support such subsidiaries in circumstances when, absent such requirements, we might not otherwise do so. Under the BHC Act, we are generally prohibited from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any company that is not a bank or bank holding company. The BHC Act also requires the prior approval of the FRB to enable us to acquire direct or indirect ownership or control of more than 5% of any class of voting shares of any bank or bank holding company. The BHC Act further regulates our activities, including requirements and limitations relating to capital, transactions with officers, directors and affiliates, securities issuances, dividend payments, inter-affiliate liabilities, extensions of credit, and expansion through mergers and acquisitions.
The federal regulatory authorities have broad authority to enforce the regulatory requirements imposed on us. In particular, the provisions of the Federal Deposit Insurance Act (FDIA), and its implementing regulations carry greater enforcement powers. Under the FDIA, all commonly controlled FDIC insured depository institutions may be held liable for any loss incurred by the FDIC resulting from a failure of, or any assistance given by the FDIC to, any commonly controlled institutions. Pursuant to certain provisions of the FDIA, the federal regulatory agencies have broad powers to take prompt corrective action if a depository institution fails to maintain certain capital levels. Prompt corrective action may include, without limitation, restricting our ability to pay dividends, restricting acquisitions or other activities, and placing limitations on asset growth. At this time, our capital levels are above the levels at which federal regulatory authorities could invoke their authority to initiate any manner of prompt corrective action.
Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Riegle-Neal Act), an adequately capitalized and managed bank holding company may acquire banks in states other than its home state without regard to the permissibility of such acquisitions under state law, but remain subject to state requirements that a bank has been organized and operating for a period of time. Subject to certain other restrictions, the Riegle-Neal Act also authorizes banks to merge across state lines to create interstate branches. The Riegle-Neal Amendments Act of 1997 and the Regulatory Relief Act of 2006 provides further guidance on the application of host state laws to any branch located outside the host state.
The FDIC maintains the Deposit Insurance Fund (DIF) by assessing depository institutions an insurance premium on a quarterly basis. The amount of the assessment is a function of the institutions risk category and assessment base. An institutions risk category is determined according to its supervisory ratings and capital levels, and is used to determine the institutions assessment rate. The assessment rate for the lowest risk category (Risk Category I) is calculated according to a formula, which relies on supervisory ratings and either certain financial ratios or long-term debt ratings. An insured banks assessment base is determined by the balance of its insured deposits. This system is risk-based and allows banks to pay less assessments to the FDIC as their capital level and supervisory
ratings improve. By the same token, if these indicators deteriorate, the institution will have to pay higher assessments to the FDIC.
Under the FDIA, the FDIC Board has the authority to set the annual assessment rate range for the Risk Category I (and the assessment rate for the other categories), within certain regulatory limits, in order to maintain the DIF reserve ratio at 1.25%, which is the FDICs current target ratio. One-time deposit insurance premium assessment credits were authorized pursuant to the Federal Deposit Insurance Reform Act of 2005. In May 2007, the Corporations national bank subsidiary was notified of its assessment credit. The assessment credit was applied automatically to reduce deposit insurance assessments beginning with the assessment due in June 2007. The amount calculated as the assessment credit for the Corporations national bank subsidiary was approximately $16 million.
DIF-insured institutions pay a Financing Corporation (FICO) assessment in order to fund the interest on bonds issued in the 1980s in connection with the failures in the thrift industry. For the first quarter of 2008, the FICO assessment is equal to 1.14 basis points for each $100 in domestic deposits. These assessments will continue until the bonds mature in 2019.
The FDIC is authorized to terminate a depository banks deposit insurance upon a finding by the FDIC that the banks financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the banks regulatory agency. The termination of deposit insurance for our national bank subsidiary could have a material adverse effect on our earnings, operations and financial condition.
Under federal law, deposits and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the liquidation or other resolution of such an institution by any receiver.
Our national bank subsidiary is subject to periodic CRA review by our primary federal regulators. The CRA does not establish specific lending requirements or programs for financial institutions and does not limit the ability of such institutions to develop products and services believed best-suited for a particular community. Note that an institutions CRA assessment can be used by its regulators in their evaluation of certain applications, including a merger or the establishment of a branch office.
Associated Bank, National Association, underwent a CRA examination by the Comptroller of the Currency in November 2003, for which it received a Satisfactory rating.
Financial institutions, such as our national bank subsidiary, are required by statute and regulation to disclose its privacy policies. In addition, such financial institutions must appropriately safeguard its customers nonpublic, personal information.
In 2001, Congress enacted the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the Patriot Act). The Patriot Act is designed to deny terrorists and criminals the ability to obtain access to the United States financial system and has significant implications for depository institutions, brokers, dealers, and other businesses involved in the transfer of money. The Patriot Act mandates financial services companies to implement additional policies and procedures with respect to additional measures designed to address any or all of the following matters: customer identification programs, money laundering, terrorist financing, identifying and reporting suspicious activities and currency transactions, currency crimes, and cooperation between financial institutions and law enforcement authorities.
The laws and regulations to which we are subject are constantly under review by Congress, the federal regulatory agencies, and the state authorities. These laws and regulations could be changed drastically in the future, which
could affect our profitability, our ability to compete effectively, or the composition of the financial services industry in which we compete.
On October 1, 2007, the US Department of Defense (the DOD) regulations implementing the John Warner National Defense Authorization Act for fiscal year 2007 became effective. The regulations impose certain restrictions on provisions found in agreements for consumer credit products provided to covered borrowers (generally defined as active duty service members and their dependents) by creditors, which term includes our national bank subsidiary. The regulations impose a new Military Annual Percentage Rate (MAPR) that must be calculated and provided to covered borrowers. The MAPR is capped at 36%.
Our national bank subsidiary must comply with Sections 23A and 23B of the Federal Reserve Act containing certain restrictions on its transactions with affiliates. In general terms, these provisions require that transactions between a banking institution or its subsidiaries and such institutions affiliates be on terms as favorable to the institution as transactions with non-affiliates. In addition, these provisions contain certain restrictions on loans to affiliates, restricting such loans to a percentage of the institutions capital. A covered affiliate, for purposes of these provisions, would include us and any other company that is under our common control.
Certain transactions with our directors, officers or controlling persons are also subject to conflicts of interest regulations. Among other things, these regulations require that loans to such persons and their related interests be made on terms substantially the same as for loans to unaffiliated individuals and must not create an abnormal risk of repayment or other unfavorable features for the financial institution.
Our earnings and growth, as well as the earnings and growth of the banking industry, are affected by the credit policies of monetary authorities, including the FRB. An important function of the Federal Reserve is to regulate the national supply of bank credit in order to combat recession and curb inflationary pressures. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, changes in reserve requirements against member bank deposits, and changes in the Federal Reserve discount rate. These means are used in varying combinations to influence overall growth of bank loans, investments, and deposits, and may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
In view of changing conditions in the national economy and in money markets, as well as the effect of credit policies by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, and loan demand, or their effect on our business and earnings or on the financial condition of our various customers.
We file annual, quarterly, and current reports, proxy statements, and other information with the SEC. These filings are available to the public on the Internet at the SECs web site at www.sec.gov. Shareholders may also read and copy any document that we file at the SECs public reference rooms located at 100 F Street, NE, Washington, DC 20549. Shareholders may call the SEC at 1-800-SEC-0330 for further information on the public reference room.
Our principal Internet address is www.associatedbank.com. We make available free of charge on or through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. In addition, shareholders may request a copy of any of our filings (excluding exhibits) at no cost by writing, telephoning, faxing, or e-mailing us using the following information: Associated Banc-Corp, Attn: Shareholder Relations, 1200 Hansen Road, Green Bay, WI 54304; phone 920-431-8034; fax 920-431-8037; or e-mail to firstname.lastname@example.org. Our Code of Ethics for Directors and Executive Officers, Corporate Governance Guidelines, Code of Ethics for Directors and Executive Officers, and Board of Directors committee charters
are all available on our website, www.associatedbank.com/About Us/Investor Relations/Corporate Governance. We will disclose on our website amendments to or waivers from our Code of Ethics in accordance with all applicable laws and regulations. Information contained on any of our websites is not deemed to be a part of this Annual Report.
An investment in Associateds common stock is subject to risks inherent to our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below, together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors. See also, Special Note Regarding Forward-Looking Statements.
If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.
Our Stock Price can be Volatile Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors including, among other things:
General market fluctuations, industry factors, and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, or credit loss trends, could also cause our stock price to decrease regardless of operating results.
Our Articles of Incorporation, Bylaws, and Certain Banking Laws may have an Anti-Takeover Effect Provisions of our articles of incorporation, bylaws, and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions may prohibit a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.
An Investment in Our Common Stock is not an Insured Deposit Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund, or by any other public or private entity. An investment in our common stock is inherently risky for the reasons described in this Risk Factors section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.
Our Profitability Depends Significantly on Economic Conditions in the States within which We do Business Our success depends on the general economic conditions of the specific local markets in which we operate. Local economic conditions have a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, on the value of the collateral securing loans, and the stability of our deposit funding
sources. A significant decline in general local economic conditions, caused by inflation, recession, unemployment, changes in securities markets or other factors could impact local economic conditions and, in turn, have a material adverse effect on our financial condition and results of operations.
The Earnings of Financial Services Companies are Significantly Affected by General Business and Economic Conditions Our operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the United States economy, all of which are beyond our control. A deterioration in economic conditions could result in an increase in loan delinquencies and nonperforming assets, decreases in loan collateral values, and a decrease in demand for our products and services, among other things, any of which could have a material adverse impact on our financial condition and results of operations.
Our Earnings are Significantly Affected by the Fiscal and Monetary Policies of the Federal Government and Its Agencies The policies of the Federal Reserve impact us significantly. The Federal Reserve regulates the supply of money and credit in the United States. Its policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments we hold. Those policies determine to a significant extent our cost of funds for lending and investing. Changes in those policies are beyond our control and are difficult to predict. Federal Reserve policies can also affect our borrowers, potentially increasing the risk that they may fail to repay their loans. For example, a tightening of the money supply by the Federal Reserve could reduce the demand for a borrowers products and services. This could adversely affect the borrowers earnings and ability to repay its loan, which could have a material adverse effect on our financial condition and results of operation.
We Operate in a Highly Competitive Industry and Market Area We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and internet banks within the various markets in which we operate. We also face competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory, and technological changes and continued consolidation. Banks, securities firms, and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.
Our ability to compete successfully depends on a number of factors, including, among other things:
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Consumers may Decide not to Use Banks to Complete Their Financial Transactions Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank
deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as disintermediation, could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Severe Weather, Natural Disasters, Acts of War or Terrorism, and Other External Events could Significantly Impact Our Business Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Our Financial Condition and Results of Operations could be Negatively Affected if We Fail to Grow or Fail to Manage Our Growth Effectively Our business strategy includes significant growth plans. We intend to continue pursuing a profitable growth strategy. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in significant growth stages of development. We cannot assure you that we will be able to expand our market presence in our existing markets or successfully enter new markets or that any such expansion will not adversely affect our results of operations. Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations and could adversely affect our ability to successfully implement our business strategy. Also, if we grow more slowly than anticipated, our operating results could be materially adversely affected.
Our ability to grow successfully will depend on a variety of factors including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth. While we believe we have the management resources and internal systems in place to successfully manage our future growth, there can be no assurance growth opportunities will be available or growth will be successfully managed.
Acquisitions May Disrupt Our Business and Dilute Stockholder Value We regularly evaluate merger and acquisition opportunities and conduct due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, negotiations may take place and future mergers or acquisitions involving cash, debt, or equity securities may occur at any time. We seek merger or acquisition partners that are culturally similar, have experienced management, and possess either significant market presence or have potential for improved profitability through financial management, economies of scale, or expanded services.
Acquiring other banks, businesses, or branches involves potential adverse impact to our financial results and various other risks commonly associated with acquisitions, including, among other things:
We Continually Encounter Technological Change The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
New Lines of Business or New Products and Services May Subject Us to Additional Risk From time to time, we may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services, we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business and/or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business and/or new products or services could have a material adverse effect on our business, results of operations and financial condition.
Negative Publicity could Damage Our Reputation Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business. Negative public opinion could adversely affect our ability to keep and attract customers and expose us to adverse legal and regulatory consequences. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, regulatory compliance, mergers and acquisitions, and disclosure, sharing or inadequate protection of customer information, and from actions taken by government regulators and community organizations in response to that conduct. Because we conduct most of our business under the Associated Bank brand, negative public opinion about one business could affect our other businesses.
Unauthorized Disclosure of Sensitive or Confidential Client or Customer Information, Whether Through a Breach of Our Computer Systems or Otherwise, could Severely Harm Our Business As part of our business, we collect, process and retain sensitive and confidential client and customer information on our behalf and on behalf of other third parties. Despite the security measures we have in place, our facilities and systems, and those of our third party service providers, may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors, or other similar events. Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information, whether by us or by our vendors, could severely damage our reputation, expose us to the risk of litigation and liability, disrupt our operations and have a material adverse effect on our business.
Ethics or Conflict of Interest Issues could Damage Our Reputation We have established a Code of Conduct and related policies and procedures to address the ethical conduct of business and to avoid potential conflicts of interest. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our related controls and procedures or failure to comply with the established Code of Conduct and Related Party Transaction Policies and Procedures could have a material adverse effect on our reputation, business, results of operations, and/or financial condition.
We are Subject to Lending Concentration Risks As of December 31, 2007, approximately 66% of our loan portfolio consisted of commercial, financial, and agricultural, real estate construction, commercial real estate loans, and lease financing (collectively, commercial loans). Commercial loans are generally viewed as having more inherent risk of default than residential mortgage loans or retail loans. Also, the commercial loan balance per borrower is typically larger than that for residential mortgage loans and retail loans, inferring higher potential losses on an individual loan basis. Because our loan portfolio contains a growing number of commercial loans with balances over a $25 million internal threshold, the deterioration of one or a few of these loans could cause a significant increase in nonperforming loans. An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in the provision for loan losses, and an increase in loan charge offs, all of which could have a material adverse effect on our financial condition and results of operations.
Changes in Economic and Political Conditions could Adversely Affect Our Earnings, as Our Borrowers Ability to Repay Loans and the Value of the Collateral Securing Our Loans Decline Our success depends, to a certain extent, upon economic and political conditions, local and national, as well as governmental monetary policies. Conditions such as inflation, recession, unemployment, changes in interest rates, money supply and other factors beyond our control may adversely affect our asset quality, deposit levels and loan demand and, therefore, our earnings. Because we have a significant amount of real estate loans, decreases in real estate values could adversely affect the value of property used as collateral. Adverse changes in the economy may also have a negative effect on the ability of our borrowers to make timely repayments of their loans, which could have an adverse impact on our earnings. Consequently, any decline in the economy in our market area could have a material adverse effect on our financial condition and results of operations.
Our Allowance for Loan Losses may be Insufficient All borrowers carry the potential to default and our remedies to recover (seizure and/or sale of collateral, legal actions, guarantees, etc.) may not fully satisfy money previously lent. We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, which represents managements best estimate of probable credit losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance for loan losses reflects managements continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks using existing qualitative and quantitative information, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of additional loan charge offs, based on judgments different than those of management. An increase in the allowance for loan losses results in a decrease in net income, and possibly risk-based capital, and may have a material adverse effect on our financial condition and results of operations.
We are Subject to Environmental Liability Risk Associated with Lending Activities A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected propertys value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
Lack of System Integrity or Credit Quality Related to Funds Settlement could Result in a Financial Loss We settle funds on behalf of financial institutions, other businesses and consumers and receive funds from clients, card issuers, payment networks and consumers on a daily basis for a variety of transaction types. Transactions facilitated by us include debit card, credit card and electronic bill payment transactions, supporting consumers, financial institutions and other businesses. These payment activities rely upon the technology infrastructure that facilitates the verification of activity with counterparties and the facilitation of the payment. If the continuity of operations or integrity of processing were compromised this could result in a financial loss to us due to a failure in payment facilitation. In addition, we may issue credit to consumers, financial institutions or other businesses as part of the funds settlement. A default on this credit by a counterparty could result in a financial loss to us.
Financial Services Companies Depend on the Accuracy and Completeness of Information about Customers and Counterparties In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.
Liquidity is Essential to Our Businesses Our liquidity could be impaired by an inability to access the capital markets or unforeseen outflows of cash. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us. Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger unfavorable contractual obligations.
We Rely on Dividends from Our Subsidiaries for most of Our Revenue Our Parent Company is a separate and distinct legal entity from its banking and other subsidiaries. A substantial portion of its revenue comes from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on our common stock, repurchase our common stock, and to pay interest and principal on our Parent Companys debt. Various federal and/or state laws and regulations limit the amount of dividends that our national bank subsidiary and certain nonbank subsidiaries may pay to the Parent Company. Also, the Parent Companys right to participate in a distribution of assets upon a subsidiarys liquidation or reorganization is subject to the prior claims of the subsidiarys creditors. In the event our national bank subsidiary is unable to pay dividends to the Parent Company, the Parent Company may not be able to service debt, pay obligations, or pay dividends on our common stock. The inability to receive dividends from our national bank subsidiary could have a material adverse effect on our business, financial condition, and results of operations.
We are Subject to Interest Rate Risk Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but such changes could also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the average duration of our mortgage-backed securities portfolio and other interest-earning assets. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies, including the limited use of derivatives as hedging instruments, to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected, prolonged change in market interest rates could have a
material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet.
The Impact of Interest Rates on Our Mortgage Banking Business can be Large and Complex Changes in interest rates can impact our mortgage related revenues. A decline in mortgage rates generally increases the demand for mortgage loans as borrowers refinance, but also generally leads to accelerated payoffs. Conversely, in a constant or increasing rate environment, we would expect fewer loans to be refinanced and a decline in payoffs. Although we use models to assess the impact of interest rates on mortgage related revenues, the estimates of revenues produced by these models are dependent on estimates and assumptions of future loan demand, prepayment speeds and other factors which may differ from actual subsequent experience.
Changes in Interest Rates could also Reduce the Value of Our Mortgage Servicing Rights and Earnings We have a portfolio of mortgage servicing rights. A mortgage servicing right (MSR) is the right to service a mortgage loan (i.e, collect principal, interest, escrow amounts, etc.) for a fee. We acquire MSRs when we originate mortgage loans and keep the servicing rights after we sell or securitize the loans or when we purchase the servicing rights to mortgage loans originated by other lenders. We carry MSRs at the lower of amortized cost or estimated fair value. Fair value is the present value of estimated future net servicing income, calculated based on a number of variables, including assumptions about the likelihood of prepayment by borrowers.
Changes in interest rates can affect prepayment assumptions and, thus, fair value. When interest rates fall, borrowers are more likely to prepay their mortgage loans by refinancing them at a lower rate. As the likelihood of prepayment increases, the fair value of our MSRs can decrease. Each quarter we evaluate our MSRs for impairment based on the difference between carrying amount and fair value at quarter end. If temporary impairment exists, we establish a valuation allowance through a charge to earnings for the amount the carrying amount exceeds fair value. We also evaluate our MSRs for other-than-temporary impairment. If we determine that other-than-temporary impairment exists, we will recognize a direct write-down of the carrying value of the MSRs.
We are Subject to Extensive Government Regulation and Supervision We, primarily through Associated Bank, National Association, and certain nonbank subsidiaries, are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors funds, federal deposit insurance funds, and the banking system as a whole, not shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy, and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations, and policies for possible changes. Changes to statutes, regulations, or regulatory policies, including changes in interpretation or implementation of statutes, regulations, or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer, and/or increase the ability of nonbanks to offer competing financial services and products, among other things. Failure to comply with laws, regulations, or policies could result in sanctions by regulatory agencies, civil money penalties, and/or reputation damage, which could have a material adverse effect on our business, financial condition, and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
We are Subject to Examinations and Challenges by Tax Authorities We are subject to federal and state income tax regulations. Income tax regulations are often complex and require interpretation. Changes in income tax regulations could negatively impact our results of operations. In the normal course of business, we are routinely subject to examinations and challenges from federal and state tax authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we have engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. These tax positions may relate to tax compliance, sales and use, franchise, gross receipts, payroll, property and income tax issues, including tax base, apportionment and tax credit planning. The challenges made by tax authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have a material adverse effect on our financial condition and results of operations.
We are Subject to Claims and Litigation Pertaining to Fiduciary Responsibility From time to time, customers make claims and take legal action pertaining to the performance of our fiduciary responsibilities. Whether customer claims and legal action related to the performance of our fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to us, they may result in significant financial liability and/or adversely affect the market perception of us and our products and services, as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
We may be a Defendant in a Variety of Litigation and Other Actions, Which may have a Material Adverse Effect on our Financial Condition and Results of Operation We may be involved from time to time in a variety of litigation arising out of our business. Our insurance may not cover all claims that may be asserted against us, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. Should the ultimate judgments or settlements in any litigation exceed our insurance coverage, they could have a material adverse effect on our financial condition and results of operation. In addition, we may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms, if at all.
Changes in Our Accounting Policies or in Accounting Standards could Materially affect how We Report Our Financial Results and Condition Our accounting policies are fundamental to understanding our financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results. Some of our accounting policies are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions.
From time to time the Financial Accounting Standards Board (FASB) and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report our results of operations and financial condition. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts.
Our Internal Controls may be Ineffective Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations, and financial condition.
Impairment of Goodwill or Other Intangible Assets could Require Charges to Earnings, which could Result in a Negative Impact on Our Results of Operations Under current accounting standards, goodwill and certain other intangible assets with indeterminate lives are no longer amortized but, instead, are assessed for impairment periodically or when impairment indicators are present. Assessment of goodwill and such other intangible assets could result in circumstances where the applicable intangible asset is deemed to be impaired for accounting purposes. Under such circumstances, the intangible assets impairment would be reflected as a charge to earnings in the period during which such impairment is identified.
We may not be able to Attract and Retain Skilled People Our success depends, in large part, on our ability to attract and retain skilled people. Competition for the best people in most activities engaged in by us can be intense and we may not be able to hire sufficiently skilled people or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our markets, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.
Loss of Key Employees may Disrupt Relationships with Certain Customers Our business is primarily relationship-driven in that many of our key employees have extensive customer relationships. Loss of a key employee with such customer relationships may lead to the loss of business if the customers were to follow that
employee to a competitor. While we believe our relationship with our key producers is good, we cannot guarantee that all of our key personnel will remain with our organization. Loss of such key personnel, should they enter into an employment relationship with one of our competitors, could result in the loss of some of our customers.
Because the Nature of the Financial Services Business Involves a High Volume of Transactions, We Face Significant Operational Risks We operate in many different businesses in diverse markets and rely on the ability of our employees and systems to process a high number of transactions. Operational risk is the risk of loss resulting from our operations, including but not limited to, the risk of fraud by employees or persons outside our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements, and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, we could suffer financial loss, face regulatory action and suffer damage to our reputation.
We Rely on Other Companies to Provide Key Components of Our Business Infrastructure Third party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business. Replacing these third party vendors could also entail significant delay and expense.
Revenues from Our Investment Management and Asset Servicing Businesses are Significant to Our Earnings Generating returns that satisfy clients in a variety of asset classes is important to maintaining existing business and attracting new business. Administering or managing assets in accordance with the terms of governing documents and applicable laws is also important to client satisfaction. Failure in either of the foregoing areas can expose us to liability.
Our Information Systems May Experience an Interruption or Breach in Security We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security or operational integrity of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, we cannot assure you that any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
The Potential for Business Interruption Exists Throughout Our Organization Integral to our performance is the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and the vast array of associates and key executives in our day-to-day and ongoing operations. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes, but is not limited to, operational or technical failures, ineffectiveness or exposure due to interruption in third party support as expected, as well as, the loss of key individuals or failure on the part of key individuals to perform properly.
Our headquarters are located in the Village of Ashwaubenon, Wisconsin, in a leased facility with approximately 30,000 square feet of office space. We entered into a five-year lease with one consecutive five-year extension and are 4 years into the five-year extension.
At December 31, 2007, our bank subsidiary occupied 295 offices in approximately 180 different communities within Illinois, Minnesota, and Wisconsin. The main office of Associated Bank, National Association, is owned. Most bank subsidiary branch offices are freestanding buildings that provide adequate customer parking, including drive-through facilities of various numbers and types for customer convenience. Some bank branch offices are in supermarket locations or in retirement communities. In addition, we own other real property that, when considered in aggregate, is not material to our financial position.
In the ordinary course of business, the Corporation may be named as defendant in or be a party to various pending and threatened legal proceedings. Since it may not be possible to formulate a meaningful opinion as to the range of possible outcomes and plaintiffs ultimate damage claims, management cannot estimate the specific possible loss or range of loss that may result from these proceedings. Management believes, based upon current knowledge, that liabilities arising out of any such current proceedings will not have a material adverse effect on the consolidated financial position, results of operations or liquidity of the Corporation.
There were no matters submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2007.
Information in response to this item is incorporated by reference to the discussion of dividend restrictions in Note 10, Stockholders Equity, of the notes to consolidated financial statements included under Item 8 of this document. The Corporations common stock is traded on The Nasdaq Stock Market LLC under the symbol ASBC.
The approximate number of equity security holders of record of common stock, $.01 par value, as of February 15, 2008, was 13,200. Certain of the Corporations shares are held in nominee or street name and the number of beneficial owners of such shares is approximately 35,300.
Payment of future dividends is within the discretion of the Board of Directors and will depend, among other factors, on earnings, capital requirements, and the operating and financial condition of the Corporation. At the present time, the Corporation expects that dividends will continue to be paid in the future. The amount of the annual dividend was $1.22 and $1.14 for 2007 and 2006, respectively.
The Corporation did not purchase any common stock during the fourth quarter of 2007. For a detailed discussion of the common stock repurchase authorizations and repurchases during 2007 and 2006, see section Capital included under Item 7 of this document and Note 10, Stockholders Equity, of the notes to consolidated financial statements included under Item 8 of this document.
The following represents selected market information of the Corporation for 2007 and 2006.
Set forth below is a line graph (and the underlying data points) comparing the yearly percentage change in the cumulative total shareholder return (change in year-end stock price plus reinvested dividends) on Associateds common stock with the cumulative total return of the Nasdaq Bank Index and the S&P 500 Index for the period of five fiscal years commencing on January 1, 2003, and ending December 31, 2007. The Nasdaq Bank Index is prepared for Nasdaq by the Center for Research in Securities Prices at the University of Chicago. The graph assumes that the value of the investment in Common Stock and for each index was $100 on December 31, 2002. Historical stock price performance shown on the graph is not necessarily indicative of the future price performance.
The Stock Price Performance Graph shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Statement on Form 10-K into any filing under the Securities Act or under the Exchange Act, except to the extent Associated specifically incorporates this information by reference, and shall not otherwise be deemed filed under such Acts.
TABLE 1: EARNINGS SUMMARY AND SELECTED FINANCIAL DATA
(In thousands, except per share data)
The following discussion is managements analysis to assist in the understanding and evaluation of the consolidated financial condition and results of operations of the Corporation. It should be read in conjunction with the consolidated financial statements and footnotes and the selected financial data presented elsewhere in this report.
The detailed financial discussion that follows focuses on 2007 results compared to 2006. Discussion of 2006 results compared to 2005 is predominantly in section 2006 Compared to 2005.
Management continually evaluates strategic acquisition opportunities and other various strategic alternatives that could involve the sale or acquisition of branches or other assets, or the consolidation or creation of subsidiaries. Therefore, the financial discussion that follows may refer to the effect of the Corporations business combination activity, detailed under section, Business Combinations, and Note 2, Business Combinations, of the notes to consolidated financial statements. The Corporations 2007 acquisition modestly impacted financial results between the annual periods, as 2007 included seven months of operating results of First National Bank of Hudson (First National Bank), a $0.4 billion community bank at acquisition, while the acquisition had no impact on 2006 financial results.
The Corporation is a bank holding company headquartered in Wisconsin, providing a diversified range of banking and nonbanking financial services to individuals and businesses primarily in its three-state footprint (Wisconsin, Illinois and Minnesota). The Corporation, principally through its wholly owned banking subsidiary, provides a wide range of services, including business and consumer loan and depository services, as well as other traditional banking services. Principally through its nonbanking subsidiaries, the Corporations wealth business provides a variety of products and services to supplement the banking business including insurance, brokerage, and trust/asset management.
The Corporations primary sources of revenue are net interest income (predominantly from loans and deposits, and also from investment securities and other funding sources), and noninterest income, particularly fees and other revenue from financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace as well.
During 2007, the Corporation made meaningful progress on key strategies in an otherwise challenging banking and economic environment. Investments in the management team were made, the quality of our earnings was improved (i.e., increasing earnings potential from core banking and wealth businesses), and risks in our balance sheet were minimized.
The executive management team was enhanced with the addition of Lisa Binder as President and Chief Operating Officer in January 2007, providing added depth and expertise. Resources were allocated into higher growth markets, such as Milwaukee and Madison, Wisconsin, Chicago, Illinois, and Minneapolis, Minnesota (including our acquisition of First National Bank with 8 locations in the rapidly growing Greater Twin Cities area). We sold $224 million of deposits in lower-growth markets over the second half of 2007, and consolidated several branches. These efforts position us for improved balance sheet and revenue growth potential in our markets in 2008, during which extreme competition and challenging operating and rate environments are anticipated to continue.
In 2007, the Corporation continued to actively manage its balance sheet. The wholesale funding reduction strategy completed during 2006 aided a 12% decline in average wholesale funding balances and a 9% decline in average investments between the years. In addition to the branch deposit sales already noted, the Corporation also completed the January 2007 sale of $0.3 billion of lower-yielding residential mortgage loans, reduced its average mortgage portfolio serviced for others by 16% through bulk servicing sales, managed nonperforming and targeted distressed commercial loans, and repurchased approximately 4 million shares of common stock. The Corporation continually evaluates risks/rewards of its balance sheet, mortgage portfolio serviced for others, and other banking products, services and locations, for opportunities to redeploy capital.
2007 presented unique asset quality issues for the industry (including the effects of general economic conditions such as rising energy prices, the fall of the dollar, and rumors of inflation or recession; softening commercial and residential real estate markets; pervasive subprime lending issues; and waning consumer confidence) and for the Corporation (including elevated net charge offs during the second half of 2007 and higher nonperforming loan levels since mid-2006 compared to the Corporations longer-term historical experience). The Corporation responded by tightening underwriting guidelines and aggressively managing risks of the commercial and retail portfolios. While these actions kept commercial nonperforming loans minimally changed between year-end 2007 and 2006, nonperforming loans were up 14% (i.e., up $20 million to $163 million at year end 2007), led by consumer-based credits which were particularly impacted by negative economic conditions on these borrowers and rapid deterioration in the housing markets especially in the second half of 2007.
The 2007 operating and rate environments were challenging, and, as a result, net income for 2007 was $286 million ($31 million or 10% lower than 2006), diluted earnings per share were $2.23 ($0.15 or 6% lower than 2006), net interest income was $644 million on a margin of 3.60% (compared to $670 million on a margin of 3.62% for 2006), and the provision for loan losses was $35 million with net charge offs to average loans of 0.27% (compared to a provision of $19 million and a net charge off ratio of 0.12% for 2006). Changes in and resolutions of certain tax matters favorably impacted 2006 net income by approximately $12 million and 2006 diluted earnings per share by approximately $0.09.
The shrinking of the average balance sheet (with average earning assets down $0.6 billion or 3% versus 2006) impacted net interest income in absolute terms (down $26 million or 4%), but helped to maintain the net interest margin at 3.60% for 2007 (down only 2 basis points from 2006), as loans (which, on average, earn more than investments) grew to represent 81% of average earning assets (versus 80% for 2006), and wholesale funding balances (which, on average, cost more than deposits) fell to represent 28% of average interest-bearing liabilities (versus 31% for 2006).
Increasing net interest income from profitable growth in loans and deposits constitute the Corporations greatest opportunities for 2008 earnings growth. Yet, these are also subject to various risks, such as competitive pricing pressures that are expected to continue in 2008, softening loan markets (particularly commercial real estate in our footprint), future changes in customer behavior relative to loan and deposit products and in light of general economic conditions, and challenges to deposit growth (as noted below). While there was some normalization and steepening of the yield curve during 2007, there are still significant rate environment and competitive challenges that may cause continued downward pressure on the net interest margin for 2008.
Total deposits declined $0.3 billion or 2% between year-end 2007 and 2006, as strategically we sold $224 million of deposits in 19 branches from lower-growth markets during the second half of 2007 and relied less on brokered CDs (down $228 million between year ends), offset partly by $0.3 billion in deposits added from the First National Bank at acquisition. On average, these items were relatively neutral, with average deposits up $0.1 billion or 1% over 2006. Deposit growth remains a key to improving net interest income and the quality of earnings in 2008. Competition for deposits remains high. Challenges to deposit growth include a cyclical decline in deposits historically experienced during the first quarter, price increases on deposit products given the rate environment, other competitive pricing pressures, along with customer preference for higher-costing deposit products or non-deposit investment alternatives.
Total loans increased $0.6 billion (4%) between year-end 2007 and 2006, with $0.3 billion added from First National Bank at acquisition and organic growth coming primarily in the fourth quarter of 2007. On average, loans declined $0.2 billion (2%) when considering the timing of the January 2007 sale of $0.3 billion of residential mortgages, the June 2007 acquisition, the exiting of distressed commercial loans previously mentioned, and the strong fourth quarter organic growth.
As mentioned earlier, asset quality measures deteriorated during 2007. While not immune to deteriorating credit conditions and declining real estate values, the Corporation worked commercial credit risks aggressively during 2007, such that the $20 million (14%) increase in nonperforming loans between year-end 2006 and 2007 was principally due to consumer-based credits. At December 31, 2007, the allowance for loan losses to total loans ratio of 1.29% was deemed adequate by management, covering 123% of nonperforming loans, compared to 1.37% at December 31, 2006, covering 143% of nonperforming loans. The provision for loan losses was $35 million for 2007, with net charge offs to average loans of 0.27% (compared to a provision of $19 million and a net charge off
ratio of 0.12% for 2006). For 2008, we anticipate that net charge offs and provision for loan losses will remain elevated compared to our longer-term historical levels. We cannot predict the duration of asset quality stress for 2008, given uncertainty as to the magnitude and scope of economic stress in our markets, on our customers, and on underlying real estate values (residential and commercial).
Noninterest income of $345 million in 2007 was up $49 million (17%) over 2006, primarily from growth in core fee-based revenues (up $20 million or 9%, and defined as trust service fees, service charges on deposit accounts, card-based and other nondeposit fees, and retail commissions), as well as asset sale and investment securities net gains (up $19 million combined, predominantly from deposit premiums and fixed asset gains related to the branch deposit sales), and higher net mortgage banking income (up $8 million, led by gains on bulk sales of mortgage servicing in 2007). Core fee-based revenues benefited in 2007 from a combination of higher volumes, improved pricing, and the improved stock market on new and retained business. Core fee-based revenues are expected to improve in 2008, with growth from cross selling of services, product offerings and pricing.
Noninterest expense of $535 million grew $39 million (8%) over 2006. Personnel expenses were $303 million, up $20 million or 7% versus 2006, with a $2 million increase in stock awards expense, $8 million (4%) higher base salaries and commissions (principally due to merit increases), $3 million more on transitional costs (including signing/retention bonuses, severance, and overtime/temporary help), $4 million higher performance-based bonuses (as 2006 scaled back discretionary pay to a greater degree than in 2007), and $2 million more in fringe benefits expense. On average, there was no change in full time equivalent employees between 2007 and 2006, as severance plans that started in fourth quarter 2006 were effected through the first part of 2007, offsetting increases from the June 2007 acquisition and new hires. Nonpersonnel noninterest expenses on an aggregate basis were up $19 million or nearly 9% over 2006, primarily due to generally rising costs, greater marketing for business generation, higher foreclosure related and loan collection costs, increased placement/relocation expense, and higher third party deposit network service costs. The efficiency ratio (defined as noninterest expense divided by total revenue, with total revenue calculated as the sum of taxable equivalent net interest income plus noninterest income, excluding net asset and securities gains) was 53.92% for 2007 and 50.31% for 2006. Noninterest expense will increase in 2008 as employment costs rise, particularly considering planned merit increases, higher variable incentives expected to be earned, health benefits, and stock awards expense, as well as system conversion costs and elevated levels of foreclosure and loan collection costs that are likely to continue. The Corporation is expecting to complete a conversion of its core banking platform in mid-2008 to provide operational and other benefits. Significant risks related to this conversion effort include: potential for related internal and external costs to exceed expectations, potential for disruption of operations, and potential for negative customer impact. Although management has implemented processes and oversight to manage and control such risks, unexpected difficulties may arise.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, mortgage servicing rights valuation, derivative financial instruments and hedging activities, and income taxes.
The consolidated financial statements of the Corporation are prepared in conformity with U.S. generally accepted accounting principles and follow general practices within the industries in which it operates. This preparation requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Management believes the following policies are both important to the portrayal of the Corporations financial condition and results and require subjective or complex judgments and, therefore, management considers the following to be critical accounting policies. The critical accounting policies are discussed directly with the Audit Committee of the Corporations Board of Directors.
Allowance for Loan Losses: Managements evaluation process used to determine the adequacy of the allowance for loan losses is subject to the use of estimates, assumptions, and judgments. The evaluation process combines several factors: managements ongoing review and grading of the loan portfolio, consideration of historical loan loss and delinquency experience, trends in past due and nonperforming loans, risk characteristics of the various classifications of loans, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance for loan losses, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require that certain loan balances be charged off when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. The Corporation believes the allowance for loan losses is adequate as recorded in the consolidated financial statements. See Note 1, Summary of Significant Accounting Policies, and Note 4, Loans, of the notes to consolidated financial statements and section Allowance for Loan Losses.
Mortgage Servicing Rights Valuation: The fair value of the Corporations mortgage servicing rights asset is important to the presentation of the consolidated financial statements since the mortgage servicing rights are carried on the consolidated balance sheet at the lower of amortized cost or estimated fair value. Mortgage servicing rights do not trade in an active open market with readily observable prices. As such, like other participants in the mortgage banking business, the Corporation relies on an internal discounted cash flow model to estimate the fair value of its mortgage servicing rights. The use of an internal discounted cash flow model involves judgment, particularly of estimated prepayment speeds of underlying mortgages serviced and the overall level of interest rates. Loan type and note rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. The Corporation periodically reviews the assumptions underlying the valuation of mortgage servicing rights. In addition, the Corporation consults periodically with third parties as to the assumptions used and to determine that the Corporations valuation is consistent with the third party valuation. While the Corporation believes that the values produced by its internal model are indicative of the fair value of its mortgage servicing rights portfolio, these values can change significantly depending upon key factors, such as the then current interest rate environment, estimated prepayment speeds of the underlying mortgages serviced, and other economic conditions. To better understand the sensitivity of the impact on prepayment speeds to changes in interest rates, if mortgage interest rates moved up 50 basis points (bp) at December 31, 2007 (holding all other factors unchanged), it is anticipated that prepayment speeds would have slowed and the modeled estimated value of mortgage servicing rights could have been $2.1 million higher than that determined at December 31, 2007 (leading to more valuation allowance recovery and an increase in mortgage banking, net). Conversely, if mortgage interest rates moved down 50 bp, prepayment speeds would have likely increased and the modeled estimated value of mortgage servicing rights could have been $1.7 million lower (leading to adding more valuation allowance and a decrease in mortgage banking, net). The proceeds that might be received should the Corporation actually consider a sale of some or all of the mortgage servicing rights portfolio could differ from the amounts reported at any point in time. The Corporation believes the mortgage servicing rights asset is properly recorded in the consolidated financial statements. See Note 1, Summary of Significant Accounting Policies, and Note 5, Goodwill and Intangible Assets, of the notes to consolidated financial statements and section Noninterest Income.
Derivative Financial Instruments and Hedge Activities: In various aspects of its business, the Corporation uses derivative financial instruments to modify exposures to changes in interest rates and market prices for other financial instruments. Derivative instruments are required to be carried at fair value on the balance sheet with changes in the fair value recorded directly in earnings. To qualify for and maintain hedge accounting, the Corporation must meet formal documentation and effectiveness evaluation requirements both at the hedges inception and on an ongoing basis. The application of the hedge accounting policy requires strict adherence to documentation and effectiveness testing requirements, judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings, and measurement of changes in the fair value of hedged items. If in the future derivative financial instruments used by the Corporation no longer qualify for hedge accounting, the impact on the consolidated results of operations and reported earnings could be significant. When hedge accounting is discontinued, the Corporation would continue to carry the derivative on the balance sheet at its fair value; however, for a cash flow derivative, changes in its fair value would be recorded in earnings instead of through other
comprehensive income, and for a fair value derivative, the changes in fair value of the hedged asset or liability would no longer be recorded through earnings. Effective in second quarter 2005, the Corporation determined that the hedge accounting applied to certain interest rate swaps and an interest rate cap needed to be changed under the requirements of Statement of Financial Accounting Standard (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133). Consequently, the Corporation recorded a $6.7 million loss in other income effective for the quarter ended June 30, 2005, which after tax was a $4.0 million reduction to net income, or $0.03 to both basic and diluted earnings per share in that quarter. Certain derivative instruments that lost hedge accounting treatment were terminated in the third quarter of 2005 at a net gain of $1.0 million recorded in other income. Prior to March 31, 2006, the Corporation had been using the short cut method of assessing hedge effectiveness for a fair value hedge with $175 million notional balance, hedging a long-term, fixed-rate subordinated debenture. Effective March 31, 2006, the Corporation de-designated the hedging relationship under the short cut method and re-designated the hedging relationship under a long-haul method utilizing the same instruments. In December 2006, the Corporation terminated all swaps hedging long-term, fixed-rate commercial loans for a net gain of approximately $0.8 million. In September 2007, the Corporation entered into an interest rate swap accounted for as a cash flow hedge, which hedges the interest rate risk in the cash flows of a long-term, variable-rate FHLB advance. The Corporation continues to evaluate its future hedging strategies. See also Note 1, Summary of Significant Accounting Policies, and Note 15, Derivative and Hedging Activities, of the notes to consolidated financial statements and section Interest Rate Risk.
Income Taxes: The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgment concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from managements current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. The Corporation believes that tax assets and liabilities are adequate and properly recorded in the consolidated financial statements. See Note 1, Summary of Significant Accounting Policies, and Note 13, Income Taxes, of the notes to consolidated financial statements and section Income Taxes.
The Corporations business combination activity is detailed in Note 2, Business Combinations, of the notes to consolidated financial statements. All the Corporations business combinations since 2002 were accounted for under the purchase method of accounting; thus, the results of operations of the acquired institutions prior to their respective consummation dates were not included in the accompanying consolidated financial statements. In each acquisition, the excess cost of the acquisition over the fair value of the net assets acquired were allocated to the identifiable intangible assets, if any, with the remainder then allocated to goodwill.
In 2007 there was one completed business combination: First National Bank: On June 1, 2007, the Corporation consummated its acquisition of 100% of the outstanding shares of First National Bank, a $0.4 billion community bank headquartered in Woodbury, Minnesota. The consummation of the transaction included the issuance of approximately 1.3 million shares of common stock and $46.5 million in cash. With the addition of First National Banks eight locations, the Corporation expanded its presence in the Greater Twin Cities area. At acquisition, First National Bank added approximately $0.3 billion to both loans and deposits. In June 2007, the Corporation also completed its conversion of First National Bank onto its centralized operating systems and merged it into its banking subsidiary, Associated Bank, National Association.
In 2005 there was one completed business combination: State Financial Services Corporation (State Financial): On October 3, 2005, the Corporation consummated its acquisition of 100% of the outstanding shares of State Financial. Based on the terms of the agreement, the consummation of the transaction included the issuance of approximately 8.4 million shares of the Corporations common stock and $11 million in cash. As of the acquisition date, State Financial was a $2 billion financial services company based in Milwaukee, Wisconsin, with 29 banking branches in southeastern Wisconsin and northeastern Illinois, providing commercial and retail banking products. During the fourth quarter of 2005, the Corporation integrated and converted State Financial onto its centralized operating systems and merged State Financial into its banking subsidiary, Associated Bank, National Association.
As described in Part I, Item I, section Services, and in Note 20, Segment Reporting, of the notes to consolidated financial statements, the Corporations primary reportable segment is banking. Banking consists of lending and deposit gathering (as well as other banking-related products and services) to businesses, governments, and consumers and the support to deliver, fund, and manage such banking services. The Corporations wealth management segment provides products and a variety of fiduciary, investment management, advisory, and Corporate agency services to assist customers in building, investing, or protecting their wealth, including insurance, brokerage, and trust/asset management.
Note 20, Segment Reporting, of the notes to consolidated financial statements, indicates that the banking segment represents 90% of total revenues in 2007, as defined. The Corporations profitability is predominantly dependent on net interest income, noninterest income, the level of the provision for loan losses, noninterest expense, and taxes of its banking segment. The consolidated discussion therefore predominantly describes the banking segment results. The critical accounting policies primarily affect the banking segment, with the exception of income tax accounting, which affects both the banking and wealth management segments (see section Critical Accounting Policies).
The contribution from the wealth management segment compared to consolidated net income and total revenues (as defined and disclosed in Note 20, Segment Reporting, of the notes to consolidated financial statements) was 7% and 10%, respectively, for 2007, compared to 6% and 10%, respectively, for 2006, and 5% and 9%, respectively, for 2005. Wealth management segment revenues were up $6 million (5%) between 2007 and 2006, and up $9 million (10%) between 2006 and 2005. Wealth management segment expenses were up $2 million (3%) between 2007 and 2006, and up $7 million (12%) between 2006 and 2005. Wealth management segment assets (which consist predominantly of cash equivalents, investments, customer receivables, goodwill and intangibles) were up $15 million (16%) between year-end 2007 and 2006, and up $5 million (5%) between year-end 2006 and 2005. The $6 million increase in wealth management segment revenues between 2007 and 2006 was attributable principally to higher trust service fees, while the $2 million increase in expenses between 2007 and 2006 was primarily attributable to higher personnel expense. The $15 million increase in wealth management segment assets from 2006 to 2007 was comprised largely of higher levels of cash equivalents and investments. The major components of wealth management revenues are trust fees, insurance fees and commissions, and brokerage commissions, which are individually discussed in section Noninterest Income. The major expenses for the wealth management segment are personnel expense (between 71% and 72% of expense for 2007, 2006, and 2005), as well as occupancy, processing, and other costs, which are covered generally in the consolidated discussion in section Noninterest Expense. See also Note 5, Goodwill and Intangible Assets, of the notes to consolidated financial statements for additional disclosure.
The Corporations recent acquisition activity impacts financial results modestly between the annual periods, as 2007 includes seven months operating results of the First National Bank acquisition. The First National Bank acquisition had no impact on 2006 financial results.
The Corporation recorded net income of $285.8 million for the year ended December 31, 2007, a decrease of $30.9 million or 9.8% from 2006. Basic earnings per share for 2007 were $2.24, a 6.7% decrease from 2006 basic earnings per share of $2.40. Earnings per diluted share were $2.23, a 6.3% decrease from 2006 diluted earnings per share of $2.38. Earnings of 2006 benefited from changes in and resolutions of certain tax matters, positively impacting 2006 diluted earnings per share by approximately $0.09. Return on average assets was 1.38% for 2007 compared to 1.50% for 2006. Return on average equity was 12.68% and 13.89% for 2007 and 2006, respectively. Cash dividends of $1.22 per share paid in 2007 increased by 7.0% over 2006. Key factors behind these results are discussed below.
INCOME STATEMENT ANALYSIS
Net interest income in the consolidated statements of income (which excludes the taxable equivalent adjustment) was $643.8 million in 2007 compared to $669.5 million in 2006. The taxable equivalent adjustments (the adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that income been subject to a taxation using a 35% tax rate) of $27.3 million and $26.2 million for 2007 and 2006, respectively, resulted in fully taxable equivalent net interest income of $671.1 million in 2007 and $695.8 million in 2006.
Net interest income is the primary source of the Corporations revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities, repricing frequencies, and the use of interest rate swaps and caps.
Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (net free funds), principally noninterest-bearing demand deposits and stockholders equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt loans and investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.
Table 2 provides average balances of earning assets and interest-bearing liabilities, the associated interest income and expense, and the corresponding interest rates earned and paid, as well as net interest income, interest rate spread, and net interest margin on a taxable equivalent basis for the three years ended December 31, 2007. Tables 3 through 5 present additional information to facilitate the review and discussion of taxable equivalent net interest income, interest rate spread, and net interest margin.
The Corporation had an initiative that began in October 2005 and completed in the third quarter of 2006, to use cash flows from maturing or sold investments to substantially reduce wholesale funding and repurchase common stock when opportunistic, toward improving the net interest margin, the balance sheet position, and the quality of earnings. In support of this initiative, the Corporation sold investment securities in the first quarter of 2006 and reduced wholesale funding during 2006. This initiative also impacts the average balance variances between 2007 and 2006.
Taxable equivalent net interest income of $671.1 million for 2007 was $24.7 million or 3.6% lower than 2006. The decrease in taxable equivalent net interest income was a function of unfavorable interest rate changes (as the impact of changes in the interest rate environment and product pricing reduced taxable equivalent net interest income by $20.0 million) and unfavorable volume variances (as balance sheet changes in both volume and mix reduced taxable equivalent net interest income by $4.7 million). Rate changes on earning assets increased interest income by $21.1 million, while changes in rates on interest-bearing liabilities raised interest expense by $41.1 million, for a net unfavorable rate impact of $20.0 million. The change in mix and volume of earning assets reduced taxable equivalent net interest income by $23.7 million, while the reduction in and composition of interest-bearing liabilities reduced taxable equivalent net interest income by $19.0 million, for a net unfavorable volume impact of $4.7 million. See additional discussion in section Interest Rate Risk.
The net interest margin for 2007 was 3.60%, compared to 3.62% in 2006. The 2 bp compression in net interest margin was attributable to a 7 bp decrease in interest rate spread (the net of a 27 bp increase in the cost of interest-bearing liabilities and a 20 bp increase in the yield on earning assets), partially offset by 5 bp higher contribution from net free funds (as higher rates on interest-bearing liabilities in 2007 increased the value of noninterest-bearing deposits).
The Federal Reserve raised interest rates by 100 bp during the first half of 2006, followed by a fourteen month stretch with no rate changes. In the last four months of 2007, the Federal Reserve lowered interest rates by 100 bp. At December 31, 2007, the Federal Funds rate was 4.25%, 100 bp lower than 5.25% at December 31, 2006. On average, the Federal funds rate was 4.95% for 2007, 2 bp lower than 2006, and the prime rate was 8.05% for 2007, 9 bp higher than the previous year. These interest rate conditions, along with higher levels of nonaccrual loans and competitive pricing pressures, resulted in lower spreads on loans and higher rates on deposits between the years.
For 2007, the yield on earning assets of 6.99% was 20 bp higher than 2006. The yield on securities and short-term investments increased 27 bp (to 5.35%), aided by the sale of $0.7 billion of a pool of lower-yielding investment securities in March 2006. See Note 3, Investment Securities, of the notes to consolidated financial statements and section, Investment Securities Portfolio, for additional information on the March 2006 investment securities sale. Loan yields increased 15 bp (to 7.37%), benefiting from the January 2007 sale of $0.3 billion of lower-yielding residential mortgage loans, higher yields on home equity and other retail loans, and with commercial loan yields
moderated by competitive pricing pressures, higher levels of nonaccrual loans, and lower recoveries of nonaccrual interest in 2007. Overall, earning asset rate changes added $21.1 million to interest income, the combination of $14.0 million higher interest on loans and $7.1 million higher interest on securities and short-term investments.
The cost of interest-bearing liabilities of 3.98% in 2007 was 27 bp higher than 2006, unfavorably impacted by the rise in the cost of each source of funds. The average cost of interest-bearing deposits was 3.55% in 2007, 32 bp higher than 2006, given competitive pricing and a continuing shift by customers to higher priced deposit products. The cost of wholesale funding (comprised of short-term borrowings and long-term funding) increased 30 bp to 5.06% for 2007, with short-term borrowings up 6 bp (similar to the change in the average Federal Funds rate) and long-term funding up 56 bp (as lower-costing debt matured, renewed, or repriced during the first half of 2007 before interest rates began to fall). The interest-bearing liability rate changes resulted in $41.1 million higher interest expense, with $30.6 million attributable to interest-bearing deposits and $10.5 million due to wholesale funding.
Year-over-year changes in the average balance sheet were predominantly a function of the Corporations wholesale funding reduction strategy. In conjunction with this initiative (which began in fourth quarter 2005 and completed in third quarter 2006), cash from maturing or sold investments was not reinvested, but used to reduce wholesale funding and repurchase stock. As a result, average earning assets of $18.6 billion in 2007 were $0.6 billion (3%) lower than 2006, led by a $348 million decrease in average securities and short-term investments. Average loans were down $237 million, with a $468 million decrease in residential mortgage (due primarily to the January 2007 sale of $0.3 billion of lower-yielding residential mortgage loans) and a $50 million decline in retail loans, partially offset by a $281 million increase in commercial loans (notably, commercial and industrial). As a percentage of average earning assets, loans increased from 80% for 2006 to 81% for 2007, and average securities and short-term investments experienced a corresponding decrease. Taxable equivalent interest income in 2007 decreased $23.7 million due to earning asset volume changes, with $15.5 million of the decrease attributable to securities and short-term investments and $8.2 million attributable to loans.
Average interest-bearing liabilities of $15.9 billion in 2007 were down $0.5 billion (3%) versus 2006, attributable to lower wholesale funding balances. Average interest-bearing deposits grew $0.1 billion and average noninterest-bearing demand deposits (a principal component of net free funds) increased by $26 million. Given the growth in total deposits and the decrease in earning assets, average wholesale funding decreased by $0.6 billion, the net of a $0.7 billion decrease in long-term funding and a $0.1 billion increase in short-term borrowings. As a percentage of total average interest-bearing liabilities, interest-bearing deposits, short-term borrowings, and long-term funding were 72%, 17%, and 11%, respectively, for 2007, compared to 69%, 16%, and 15%, respectively, for 2006. In 2007, interest expense decreased $19.0 million due to volume changes, with a $27.8 million decline from lower volumes of wholesale funding, partially offset by an $8.8 million increase due to growth in interest-bearing deposits.
TABLE 2: Average Balances and Interest Rates (interest and rates on a taxable equivalent basis)
TABLE 3: Rate/Volume Analysis(1)
TABLE 4: Interest Rate Spread and Interest Margin (on a taxable equivalent basis)
TABLE 5: Selected Average Balances
The provision for loan losses in 2007 was $34.5 million, compared to $19.1 million and $13.0 million for 2006 and 2005, respectively. Net charge offs were $40.4 million for 2007, compared to $19.0 million for 2006 and $12.7 million for 2005. Net charge offs as a percent of average loans were 0.27%, 0.12%, and 0.09% for 2007, 2006, and 2005, respectively. At December 31, 2007, the allowance for loan losses was $200.6 million (including $3.0 million at acquisition from First National Bank, a community bank with a 1.01% allowance for loan losses to total loans ratio at acquisition). In comparison, the allowance for loan losses was $203.5 million at December 31, 2006, and $203.4 million at December 31, 2005 (including $13.3 million at acquisition from State Financial, a commercial bank with a 1.34% allowance for loan losses to total loans ratio at acquisition). The ratio of the allowance for loan losses to total loans was 1.29%, 1.37%, and 1.34% at December 31, 2007, 2006, and 2005, respectively. Nonperforming loans at December 31, 2007, were $163 million, compared to $142 million at December 31, 2006, and $99 million at December 31, 2005, representing 1.05%, 0.96%, and 0.65% of total loans, respectively.
The provision for loan losses is predominantly a function of the methodology and other qualitative and quantitative factors used to determine the adequacy of the allowance for loan losses which focuses on changes in the size and character of the loan portfolio, changes in levels of impaired and other nonperforming loans, historical losses and delinquencies on each portfolio category, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other factors which could affect potential credit losses. See additional discussion under sections, Allowance for Loan Losses, and Nonperforming Loans, Potential Problem Loans, and Other Real Estate Owned.
Noninterest income was $344.8 million for 2007, up $49.3 million or 16.7% over 2006. Core fee-based revenue (as defined in Table 6 below) was $252.9 million for 2007, an increase of $19.9 million or 8.5% over 2006. Net mortgage banking income was $22.8 million compared to $14.8 million for 2006. All other noninterest income categories combined were $69.2 million, up $21.5 million compared to 2006. Fee income (defined in Table 6 below) as a percentage of total revenue (defined as taxable equivalent net interest income plus fee income) was 32.4% for 2007 compared to 29.5% for 2006.
TABLE 6: Noninterest Income
Trust service fees for 2007 were $42.6 million, up $5.1 million (13.7%) from 2006. The change was primarily the result of an improved stock market on new and retained business resulting in growth in assets under management, as well as changes to the pricing structure implemented in the fourth quarter of 2006. The market value of assets under management at December 31, 2007, was $6.1 billion compared to $5.8 billion at December 31, 2006.
Service charges on deposit accounts were $101.0 million, $9.4 million (10.3%) higher than 2006. The increase was due to higher nonsufficient funds / overdraft fees (attributable to higher volumes, processing changes, and a moderate fee increase in fourth quarter 2006), and, to a lesser degree, an increase in account service charges.
Card-based and other nondeposit fees were $47.6 million for 2007, an increase of $4.9 million (11.5%) from 2006, principally due to higher card-use volumes which increased inclearing and other card-related fees. Retail commissions (which include commissions from insurance and brokerage product sales) were $61.6 million for 2007, up $0.4 million (0.6%) compared to 2006. Within retail commissions, insurance commissions were unchanged at $44.4 million for both 2007 and 2006, while the increase in brokerage and variable annuity commissions (up $2.7 million to $11.4 million on a combined basis for 2007) were greater than the decline in fixed annuity commissions (down $2.3 million to $5.8 million for 2007).
Net mortgage banking income for 2007 was $22.8 million, up $7.9 million (53.7%) compared to 2006. Net mortgage banking income consists of gross mortgage banking income less mortgage servicing rights expense. Gross mortgage banking income (which includes servicing fees, the gain or loss on sales of mortgage loans to the secondary market and related fees, and the gain or loss on bulk servicing sales) was $39.5 million in 2007, an increase of $6.6 million (20.0%) compared to 2006. Since year-end 2006, the residential mortgage portfolio serviced for others (the servicing portfolio) included a $0.3 billion addition from the June 2007 acquisition of First National Bank, and a $2.7 billion reduction from two bulk servicing sales. In late March 2007, the Corporation sold approximately $2.3 billion of its servicing portfolio at an $8.4 million gain, while in late September 2007 approximately $0.4 billion of the servicing portfolio was sold at a $0.2 million gain. The Corporation periodically considers such bulk servicing sales to effectively manage earnings volatility risks. As a result, net gains on loan and servicing sales were up $10.0 million, with 2007 including the $8.6 million servicing sale gains, while 2006 included a $2.1 million unfavorable market valuation adjustment on the transfer of $0.3 billion of residential mortgage loans to loans held for sale in the fourth quarter of 2006. Servicing fees were down $3.4 million (15.2%), a function of the reduced servicing portfolio (down 16% on average from 2006) but aided partly by sub-servicing fees earned until transfer of the sold servicing. Secondary mortgage production was $1.48 billion for 2007, 8% higher than $1.37 billion for 2006.
Mortgage servicing rights expense includes both the base amortization of the mortgage servicing rights asset and increases or decreases to the valuation allowance associated with the mortgage servicing rights asset. Mortgage servicing rights expense is affected by the size of the servicing portfolio, as well as changes in the estimated fair value of the mortgage servicing rights asset. Mortgage servicing rights expense was $16.7 million for 2007 compared to $18.1 million for 2006, with $2.3 million lower base amortization (in line with the lower average servicing portfolio), partially offset by $1.0 million lower valuation reserve recovery (with a $1.4 million valuation recovery in 2007 compared to a $2.3 million valuation recovery in 2006). As mortgage interest rates rise, prepayment speeds are usually slower and the value of the mortgage servicing rights asset generally increases, requiring less valuation reserve.
Mortgage servicing rights, net of any valuation allowance, are carried in other intangible assets, net, on the consolidated balance sheets at the lower of amortized cost or estimated fair value. At December 31, 2007, the net mortgage servicing rights asset was $51.2 million, representing 80 bp of the $6.4 billion portfolio of residential mortgage loans serviced for others, compared to a net mortgage servicing rights asset of $66.6 million, representing 80 bp of the $8.3 billion mortgage portfolio serviced for others at December 31, 2006. Mortgage servicing rights are considered a critical accounting policy given that estimating their fair value involves an internal discounted cash flow model and assumptions that involve judgment, particularly of estimated prepayment speeds of the underlying mortgages serviced and the overall level of interest rates. See section Critical Accounting Policies, as well as Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements for the Corporations accounting policy for mortgage servicing rights and Note 5, Goodwill and Intangible Assets, of the notes to consolidated financial statements for additional disclosure.
BOLI income was $17.4 million, up $1.3 million from 2006, principally due to higher average BOLI balances between the years (up 9%). Other income was $28.0 million, an increase of $1.4 million (5.4%) versus 2006, with small to moderate increases in various revenues (such as ATM fees, international banking, and check processing revenues), partially offset by a $1.2 million decline in net derivatives gains, as 2006 included an $0.8 million net gain on the termination of all swaps hedging long-term, fixed-rate commercial loans.
Asset sale gains were $15.6 million for 2007 compared to $0.3 million for 2006, with 2007 including a $1.3 million gain on the sale of $32 million in student loans in March 2007, as well as $11.5 million in deposit premium and $2.5 million gain on fixed assets related to the sale of $224 million in deposits of 19 branches during the second half of 2007. Investment securities net gains for 2007 were $8.2 million, including gross gains of $9.1 million on the sales of equity securities, partially offset by a $0.9 million other-than-temporary impairment write-down on a common stock security. Investment securities net gains for 2006 were $4.7 million, including gains of $22.5 million on the sales of equity securities, partially offset by losses of $15.8 million (predominantly from the March 2006 sale of $0.7 billion of investment securities as part of the Corporations 2006 initiative to reduce wholesale funding) as well as a $2.0 million other-than-temporary impairment write-down on the Corporations holding of preferred stock securities. For additional data see section, Investment Securities Portfolio, and Note 1, Summary of Significant Accounting Policies, and Note 3, Investment Securities, of the notes to consolidated financial statements.
Noninterest expense for 2007 was $534.9 million, an increase of $38.7 million or 7.8% over 2006. Personnel expense for 2007 was up $20.0 million or 7.1%, while collectively all other noninterest expenses were up $18.7 million or 8.8% compared to 2006.
TABLE 7: Noninterest Expense
Personnel expense (which includes salary-related expenses and fringe benefit expenses) was $303.4 million for 2007, up $20.0 million (7.1%) over 2006. Salary-related expenses increased $17.6 million (7.9%), with $2.3 million of the increase attributable to higher expense for stock options and restricted stock grants, as granting and vesting actions by the Corporation in 2005 afforded lower expense during 2006. The remaining $15.3 million increase in salary-related expenses included higher base salaries and commissions (up $8.4 million or 4.2%, including merit increases between the years), higher performance-based bonuses (up $4.2 million, as 2006 scaled back discretionary pay to a greater degree in response to the Corporations 2006 performance results), $1.5 million higher signing/retention bonuses (of which $0.7 million was related to the June 2007 acquisition of First National Bank), $0.5 million higher severance costs, and $0.7 million increased overtime/temporary help. Fringe benefit expenses increased $2.4 million (3.9%), primarily related to the increase in salary expense and higher 401k plan expense (given plan design changes starting in 2007), offset partly by lower pension plan expense (aided by returns on higher plan assets between the years). Average full-time equivalent employees were 5,114 for 2007, essentially unchanged from 5,115 for 2006, as severance plans that started in fourth quarter 2006 were effected through the first part of 2007, offsetting increases from the June 2007 acquisition and new hires.
Occupancy expense of $46.7 million for 2007 was higher than 2006 (up $2.8 million or 6.5%) due to the rise in underlying costs such as rent, maintenance and insurance. Equipment, data processing, and stationery and supplies expenses were minimally changed year over year. Business development and advertising of $19.8 million was up $2.9 million (17.4%) and postage was up (4.2%), due to normal inflationary cost increases and greater marketing for business generation. Other intangible asset amortization expense decreased $1.8 million (20.1%), attributable to the full amortization of certain intangible assets during 2006, more than offsetting increases from the June 2007 acquisition. Legal and professional expense of $11.8 million decreased modestly, down $0.9 million (6.9%). Other expense of $82.0 million increased $14.9 million (22.1%) over 2006, across various categories, but largely due to $4.6 million higher third party deposit network service costs, $3.7 million higher foreclosure-related and loan collection costs, $1.5 million higher card-based expense (in line with the increase in card-related fees), and a $2.3 million reserve for unfavorable litigation losses related to Visa, Inc. (Visa) anti-trust matters (to which the Corporation and other Visa member banks have direct and potential obligations to share in with Visa).
Income tax expense for 2007 was $133.4 million compared to $133.1 million for 2006. The Corporations effective tax rate (income tax expense divided by income before taxes) was 31.8% in 2007 and 29.6% in 2006. The effective
tax rate for 2006 benefited from the resolution of certain multi-jurisdictional tax issues for certain years and changes in exposure of uncertain tax positions, both resulting in the reduction of tax liabilities and income tax expense.
See Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements for the Corporations income tax accounting policy and section Critical Accounting Policies. Income tax expense recorded in the consolidated statements of income involves interpretation and application of certain accounting pronouncements and federal and state tax codes, and is, therefore, considered a critical accounting policy. The Corporation undergoes examination by various taxing authorities. Such taxing authorities may require that changes in the amount of tax expense or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. See Note 13, Income Taxes, of the notes to consolidated financial statements for more information.
The Corporations growth comes predominantly from loans and investment securities. See sections Loans and Investment Securities Portfolio. The Corporation has generally financed its growth through increased deposits and issuance of debt (see sections, Deposits, Other Funding Sources, and Liquidity), as well as retention of earnings and the issuance of common stock, particularly in the case of certain acquisitions (see section Capital).
Total loans were $15.5 billion at December 31, 2007, an increase of $0.6 billion or 4.3% from December 31, 2006, with $0.3 billion added from First National Bank at acquisition and organic growth momentum coming primarily in the fourth quarter of 2007. Commercial loans were $10.3 billion, up $690 million or 7.2%, and represented 66% of total loans at the end of 2007, compared to 64% at year-end 2006. Retail loans grew $30 million or 1.0% to represent 20% of total loans compared to 21% at December 31, 2006, while residential mortgage loans decreased $85 million or 3.9% to represent 14% of total loans versus 15% for the prior year. The Corporation does not have a significant volume of nontraditional or subprime loan products.
TABLE 8: Loan Composition
Commercial loans are generally viewed as having more inherent risk of default than residential mortgage or retail loans. Also, the commercial loan balance per borrower is typically larger than that for residential mortgage and retail loans, inferring higher potential losses on an individual customer basis. Commercial loan growth through most of 2007 was muted partly as the Corporation purposefully adhered to risk/reward pricing disciplines (particularly in commercial real estate), and aggressively managed risks of certain targeted performing and nonperforming commercial loans, with growth momentum returning primarily in the fourth quarter.
Commercial, financial, and agricultural loans accounted for the majority of growth between year-end 2007 and 2006. Commercial, financial, and agricultural loans were $4.3 billion at the end of 2007, up $604 million or 16.4% since year-end 2006, and comprised 28% of total loans outstanding, up from 24% at the end of 2006. The commercial, financial, and agricultural loan classification primarily consists of commercial loans to middle market companies and small businesses. Loans of this type are in a diverse range of industries. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrowers operations or on the value of underlying collateral, if any. Within the commercial, financial, and agricultural classification, loans to finance agricultural production totaled less than 0.5% of total loans for all periods presented.
Commercial real estate primarily includes commercial-based loans that are secured by multifamily properties and nonfarm/nonresidential real estate properties. Commercial real estate totaled $3.6 billion at December 31, 2007, down $154 million or 4.1% from December 31, 2006, and comprised 23% of total loans outstanding versus 25% at year-end 2006. Commercial real estate loans involve borrower characteristics similar to those discussed for commercial loans and real estate construction projects. Loans of this type are mainly for business and industrial properties, multifamily properties, and community purpose properties. Loans are primarily made to customers based in Wisconsin, Illinois, and Minnesota. Credit risk is managed in a similar manner to commercial loans and real estate construction by employing sound underwriting guidelines, lending to borrowers in local markets and businesses, periodically evaluating the underlying collateral, and formally reviewing the borrowers financial soundness and relationship on an ongoing basis.
Real estate construction loans grew $214 million or 10.4% to $2.3 billion, representing 14% of the total loan portfolio at the end of 2007, compared to $2.0 billion or 14% at the end of 2006. Loans in this classification are primarily short-term interim loans that provide financing for the acquisition or development of commercial real estate, such as multifamily or other commercial development projects. Real estate construction loans are made to developers and project managers who are well known to the Corporation, have prior successful project experience, and are well capitalized. Projects undertaken by these developers are carefully reviewed by the Corporation to ensure that they are economically viable. Loans of this type are primarily made to customers based in the Corporations tri-state market in which the Corporation has a thorough knowledge of the local market economy. The credit risk associated with real estate construction loans is generally confined to specific geographic areas but is also influenced by general economic conditions. The Corporation controls the credit risk on these types of loans by making loans in familiar markets to developers, underwriting the loans to meet the requirements of institutional investors in the secondary market, reviewing the merits of individual projects, controlling loan structure, and monitoring project progress and construction advances.
Retail loans totaled $3.1 billion at December 31, 2007, up $30 million or 1.0% compared to 2006, and represented 20% of the 2007 year-end loan portfolio versus 21% at year-end 2006. Loans in this classification include home equity and installment loans. Home equity consists of home equity lines and residential mortgage junior liens, while installment loans consist of educational loans, as well as short-term and other personal installment loans. Individual borrowers may be required to provide related collateral or a satisfactory endorsement or guaranty from another person, depending on the specific type of loan and the creditworthiness of the borrower. Credit risk for these types of loans is generally greatly influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral. Risks of loss are generally on smaller average balances per loan spread over many borrowers. Once charged off, there is usually less opportunity for recovery on these smaller retail loans. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.
Residential mortgage loans totaled $2.1 billion at the end of 2007, down $85 million or 3.9% from the prior year and comprised 14% of total loans outstanding versus 15% at year-end 2006. Residential mortgage loans include conventional first lien home mortgages and the Corporation generally limits the maximum loan to 80% of collateral value. As part of its management of originating and servicing residential mortgage loans, nearly all of the Corporations long-term, fixed-rate residential real estate mortgage loans are sold in the secondary market with servicing rights retained.
Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early
identification of potential problems, an adequate allowance for loan losses, and sound nonaccrual and charge off policies.
An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. Credit risk is controlled by detailed underwriting procedures, comprehensive loan administration, and periodic review of borrowers outstanding loans and commitments. Borrower relationships are formally reviewed and graded on an ongoing basis for early identification of potential problems. Further analyses by customer, industry, and geographic location are performed to monitor trends, financial performance, and concentrations.
The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas within our primary three-state area. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At December 31, 2007, no significant concentrations existed in the Corporations portfolio in excess of 10% of total loans.
Credit risks within the loan portfolio are inherently different for each loan type. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and on-going review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, aids in the management of credit risk and minimization of loan losses. Credit risk management for each loan type is discussed briefly in the section entitled Loans.
The allowance for loan losses represents managements estimate of an amount adequate to provide for probable credit losses in the loan portfolio at the balance sheet date. To assess the adequacy of the allowance for loan losses, an allocation methodology is applied by the Corporation which focuses on evaluation of several factors, including but not limited to: evaluation of facts and issues related to specific loans, managements ongoing review and grading of the loan portfolio, consideration of historical loan loss and delinquency experience on each portfolio category, trends in past due and nonperforming loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Assessing these factors involves significant judgment. Therefore, management considers the allowance for loan losses a critical accounting policy see section Critical Accounting Policies and further discussion in this section. See also managements allowance for loan losses accounting policy in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans, of the notes to consolidated financial statements for additional allowance for loan losses disclosures. Table 8 provides information on loan growth and composition, Tables 10 and 11 provide additional information regarding activity in the allowance for loan losses, and Table 12 provides additional information regarding nonperforming loans and assets.
At December 31, 2007, the allowance for loan losses was $200.6 million, compared to $203.5 million at December 31, 2006 and $203.4 million at December 31, 2005. The allowance for loan losses to total loans
was 1.29%, 1.37%, and 1.34% at December 31, 2007, 2006 and 2005, respectively, and the allowance for loan losses covered 123%, 143% and 206% of nonperforming loans at December 31, 2007, 2006 and 2005, respectively. Changes in the allowance for loan losses are shown in Table 10. Credit losses, net of recoveries, are deducted from the allowance for loan losses. A direct increase to the allowance for loan losses comes from acquisitions. Finally, the provision for loan losses, a charge against earnings, is recorded to bring the allowance for loan losses to a level that, in managements judgment, is adequate to absorb probable losses in the loan portfolio. With the deterioration of credit quality during 2007, rising net charge off and nonperforming loans ratios, and managements assessment of the adequacy of the allowance for loan losses, the provision for loan losses of $34.5 million for 2007 was higher than the 2006 provision of $19.1 million and 2005 provision of $13.0 million.
Asset quality was under stress during 2007 with the Corporation experiencing elevated net charge offs (particularly during the second half of 2007) and higher nonperforming loan levels since mid-2006 compared to the Corporations historical trends. Industry issues impacting asset quality in 2007 included general economic factors such as rising energy prices, the fall of the dollar, and rumors of inflation or recession; softening commercial and residential real estate markets; pervasive subprime lending issues; and waning consumer confidence. The Corporation has been tightening underwriting guidelines over the past two years. While not immune to deteriorating credit conditions and declining real estate values, the Corporation managed commercial credit risks aggressively during 2007, such that the $20.2 million (14%) increase in nonperforming loans between year-end 2006 and 2007 was principally due to consumer-based credits.
Net charge offs were $40.4 million or 0.27% of average loans for 2007, compared to $19.0 million or 0.12% of average loans for 2006, and $12.7 million or 0.09% of average loans for 2005 (see Table 10). The increase in net charge offs between 2007 and 2006 was primarily due to a sizable increase in commercial charge offs (primarily related to several specific larger commercial credits), and due to a general rise in home equity and residential mortgage net charge offs.
For 2007, 60% of net charge offs came from commercial loans (and commercial loans represent 66% of total loans at year-end 2007), compared to 22% for 2006 and 21% for 2005, a result of the sizable increase in commercial charge offs in 2007 and with higher commercial recoveries driving the net charge off amounts for 2006 and 2005 to a greater degree than the gross charge offs. For 2007, retail loans (which represent 20% of total loans at year-end 2007) accounted for 35% of net charge offs, down from 70% for 2006 and 67% for 2005. Residential mortgages (representing 14% of total loans at year-end 2007) accounted for 5% of 2007 net charge offs, compared to 8% and 12% for 2006 and 2005, respectively. Gross charge offs of retail and residential mortgage loans have been rising over the past three years, as economic conditions, such as rising energy, health and other costs and a weakening housing market, have been impacting the consumers borrowing behavior and ability to pay back debt, while recoveries on these loans have remained relatively low. In absolute terms, the $21.4 million increase in net charge offs between 2007 and 2006 was primarily due to commercial net charge offs (up $19.8 million, including a singular $6 million fully charged off commercial credit), with smaller increases to retail (up $1.0 million) and residential mortgage (up $0.6 million). Loans charged off are subject to continuous review, and specific efforts are taken to achieve maximum recovery of principal, accrued interest, and related expenses.
TABLE 10: Loan Loss Experience