Associated Banc-Corp 10-K 2009
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Commission file number: 0-5519 and 001-31343
(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, 2008, (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 $2,417,296,000. 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 $140,468,000 of market value representing 5.71% of the outstanding shares of the registrant held in a fiduciary capacity by the trust company subsidiary of the registrant.
As of January 31, 2009, 127,899,500 shares of common stock were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
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, 2008, 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, 2008, were the second largest commercial bank holding company headquartered in Wisconsin. At December 31, 2008, we owned one nationally chartered trust company headquartered in Wisconsin. We also owned 27 limited purpose banking and nonbanking subsidiaries located in Arizona, Colorado, Illinois, Indiana, Iowa, Michigan, Minnesota, Missouri, 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, 2008, our bank subsidiary Associated Bank, National Association (Associated Bank), provided services through approximately 300 locations in approximately 160 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 2008, 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 real estate 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 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); full-service investment brokerage, variable annuities, and discount and on-line brokerage; and 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 2008, 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, 2008, we had approximately 5,140 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 retain current customers and to obtain new loans and 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, 2008, our Tier 1 Capital ratio was 11.91% and Total Capital ratio was 13.76%.
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, 2008, was 9.75%. 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.
On July 20, 2007, the federal banking agencies withdrew their previously announced Basel 1A proposal with respect to risk-based capital requirements. In so doing, the federal banking agencies published a revised capital requirements proposal applicable to all domestic banks, bank holding companies and savings associations (called the Basel II Standardized Approach) not otherwise subject to the Basel II advanced approaches rule. We are not subject to the Basel II advanced approaches rule. As proposed, according to the federal banking agencies, the revised rule would: (i) expand the use of credit ratings for determining risk weights; (ii) base risk weights for residential mortgages on loan-to-value ratios; (iii) expand the types of financial collateral and guarantees available to banks to offset credit risk; (iv) offer more risk-sensitive approaches for recognizing the benefits of mitigating credit risk; (v) increase the risk weight for certain short-term commitments; (vi) improve the risk sensitivity of the risk-based capital requirements for securitizations and equity investments; and (vii) institute a risk-based capital requirement for operational risk. Under the Basel II Standardized Approach, a covered entity would have to affirmatively opt in to use such approach by notifying its regulator at least 60 days before the beginning of the calendar quarter in which it first used the Basel II Standardized Approach; if such opt-in is not exercised, the entity would remain under the general risk-based capital rules. Elections to opt in to the Basel II Standardized Approach by a bank holding company would also apply to its subsidiary depository institutions. As of December 31, 2008, the Corporation did not intend to opt-in to the Basel II Standardized Approach. Comments on the proposal were due to the federal banking regulators on October 27, 2008.
Emergency Economic Stabilization Act of 2008
On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (EESA), giving the United States Department of the Treasury (UST) authority to take certain actions to restore liquidity and stability to the U.S. banking markets. Based upon its authority in the EESA, a number of programs to implement EESA have been announced. Those programs include the following:
During the time the UST holds securities issued pursuant to this program, participating financial institutions will be required to comply with certain provisions regarding executive compensation and corporate governance. Participation in this program also imposes certain restrictions upon an institutions dividends to common shareholders and stock repurchase activities. As described further herein, we elected to participate in the CPP and received $525 million pursuant to the program.
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.
On November 21, 2008, we sold 525,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the Senior Preferred Stock), to the UST pursuant to the CPP under the Troubled Asset Relief Program. While any Senior Preferred Stock is outstanding, we may pay dividends on our common stock, provided that all accrued and unpaid dividends for all past dividend periods on the Senior Preferred Stock are fully paid. Prior to the third anniversary of the USTs purchase of the Senior Preferred Stock, unless the Senior Preferred Stock has been redeemed or the UST has transferred all of the Senior Preferred Stock to third parties, the consent of the UST will be required for us to increase our common stock dividend from its current quarterly amount of $0.32 per share.
Under the foregoing dividend restrictions and restrictions applicable to our nonbanking subsidiaries, as of December 31, 2008, our subsidiaries could pay additional dividends of $50 million to us, without obtaining affirmative governmental approvals. This amount is not necessarily indicative of amounts that may be available in future periods. In 2008, our subsidiaries paid $133 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 lower 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. At December 31, 2008, Associated Banks risk category assignment required payment of approximately $0.15 per $100 of assessable deposits.
Under the FDIA, the FDIC Board has the authority to set the annual assessment rate range for the various risk categories within certain regulatory limits. Pursuant to this authority, risk-based assessment rates were uniformly increased 7 cents per $100 of assessable deposits by the FDIC Board in December 2008 for the first quarter of 2009. Under this rule, risk-based rates for the first quarter will range between 12 and 50 basis points (bp). This action is part of the Restoration Plan adopted by the FDIC in October 2008 as required by law and is intended to increase the reserve ratio to 1.15% within five years.
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 fourth 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 would 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 underwent a CRA examination by the Comptroller of the Currency on November 20, 2006, 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 banking subsidiary is also subject to a variety of other regulations with respect to the operation of its businesses, including but not limited to the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Electronic Funds Transfer Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Fair Debt Collection Practices Act, and the Fair Credit Reporting Act. Any change in these regulations or other applicable regulations.
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 email@example.com. Our Code of Ethics for Directors and Executive Officers, Corporate Governance Guidelines, 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, as Amended, Amended and Restated Bylaws, and Certain Banking Laws may have an Anti-Takeover Effect Provisions of our articles of incorporation, as amended, amended and restated 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, changes in housing market prices, 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, 2008, approximately 63% 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 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 and preferred 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 and preferred 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.
Our Agreements with the UST Under the CPP Impose Restrictions and Obligations on us that Limit our Ability to Increase Dividends, Repurchase our Common Stock or Preferred Stock and Access the Equity Capital Market In November 2008, we issued preferred stock and a warrant to purchase our common stock to the UST as part of the CPP under the Troubled Asset Relief Program (TARP). Prior to November 21, 2011, unless we have redeemed all of the preferred stock or the UST has transferred all of the preferred stock to a third party, the consent of the UST will be required for us to, among other things, increase our common stock dividend or repurchase our common stock or other preferred stock (with certain exceptions, including the repurchase of our common stock to offset share dilution from equity-based employee compensation awards). We have also granted registration rights and offering facilitation rights to the UST pursuant to which we have agreed to lock-up periods during which we would be unable to issue equity securities.
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 Have a Significant Impact on Revenues 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 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 Investment Securities, Goodwill, Other Intangible Assets, or Deferred Tax Assets could Require Charges to Earnings, which could Result in a Negative Impact on Our Results of Operations In assessing the impairment of investment securities, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issues, and the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. 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. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.
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.
New Requirements under EESA and Changes in the TARP CPP Regulations may Adversely Affect our Operations and Financial Condition Given the current international, national and regional economic climate, it is unclear what effect the provisions of the EESA will have with respect to our profitability and operations. In addition, the US government, either through the UST or some other federal agency, may also advance additional programs that could materially impact our profitability and operations.
Our headquarters are located in the Village of Ashwaubenon, Wisconsin, in a leased facility with approximately 30,000 square feet of office space. The space is subject to a two-year lease with one consecutive three-year extension.
At December 31, 2008, our bank subsidiary occupied approximately 300 offices in approximately 160 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, 2008.
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 January 26, 2009, was 13,600. Certain of the Corporations shares are held in nominee or street name and the number of beneficial owners of such shares is approximately 32,000.
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. The Board of Directors makes the dividend determination on a quarterly basis. The amount of the annual dividend was $1.27 and $1.22 for 2008 and 2007, respectively.
On November 21, 2008, we sold 525,000 shares of our Senior Preferred Stock to the UST pursuant to the CPP. While any Senior Preferred Stock is outstanding, we may pay dividends on our common stock, provided that all accrued and unpaid dividends for all past dividend periods on the Senior Preferred Stock are fully paid. Prior to the third anniversary of the USTs purchase of the Senior Preferred Stock, unless the Senior Preferred Stock has been redeemed or the UST has transferred all of the Senior Preferred Stock to third parties, the consent of the UST will be required for us to increase our common stock dividend from its current quarterly amount of $0.32 per share.
Following are the Corporations monthly common stock purchases during the fourth quarter of 2008. For a detailed discussion of the common stock repurchase authorizations and repurchases during 2008 and 2007, see section Capital included under Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, of this document and Part II, Item 8, Note 10, Stockholders Equity, of the notes to consolidated financial statements included under Item 8 of this document.
During the fourth quarter of 2008, the Corporation repurchased shares for minimum tax withholding settlements on equity compensation. The effect to the Corporation of this transaction was an increase in treasury stock and a decrease in cash of approximately $4,000 in the fourth quarter of 2008.
The following represents selected market information of the Corporation for 2008 and 2007.
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, 2004, and ending December 31, 2008. 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, 2003. 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 2008 results compared to 2007. Discussion of 2007 results compared to 2006 is predominantly in section 2007 Compared to 2006.
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 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 2008, 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 addressed. The economic environment during 2008 presented unique credit related issues that required managements focused attention. As a result, the Corporation established a team to focus on those issues and to strengthen the credit management process. The Corporation also made progress on a longer-term initiative to improve its management reporting and measurement by refining its risk-based measurement system. In addition, the Corporation successfully completed the conversion of its core banking platform in mid-2008 to improve operational and other benefits.
In November 2008, the Corporation sold $525 million of Senior Preferred Stock, bearing a 5% dividend for the first 5 years and 9% thereafter, and approximately 4 million related common stock warrants to the UST under the CPP. As a result, stockholders equity at December 31, 2008, included $508 million attributable to the Senior Preferred Stock net of the preferred stock discount, and net income available to common equity was reduced by $3 million due to the Senior Preferred Stock dividend and discount accretion that began in the fourth quarter of 2008. These funds also increased the Corporations equity and capital ratios and supported the Corporations investment in $1.7 billion of agency guaranteed mortgage-related investment securities during the fourth quarter of 2008.
Since mid-2007, and particularly during the second half of 2008, the banking industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in home prices and the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including investment securities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions, but more
recently in companies in a number of other industries and in the broader markets. The Corporations financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent on the business environment.
Given the market conditions noted above, 2008 continued to present unique asset quality issues for the industry (including the continued effects of weakening economic conditions; softening commercial and residential real estate markets; and waning consumer confidence) and for the Corporation (including elevated net charge offs and higher nonperforming loan levels compared to the Corporations longer-term historical experience). The Corporation responded during mid-2008 by establishing a cross-functional team of internal and external experts to constructively review and challenge the entire credit risk process in five key areas, including credit policy, credit governance, credit risk, problem loan management, and MIS reporting. At the conclusion of this project in late 2008, the Corporation created a road map for identified short and long-term improvements and is currently in the process of implementing the actionable items.
The 2008 operating and rate environments were challenging, and, as a result, net income available to common equity for 2008 was $165 million ($121 million or 42% lower than 2007), diluted earnings per common share were $1.29 ($0.94 or 42% lower than 2007), net interest income was $696 million on a margin of 3.65% (compared to $644 million on a margin of 3.60% for 2007), and the provision for loan losses was $202 million with net charge offs to average loans of 0.85% (compared to a provision of $35 million and a net charge off ratio of 0.27% for 2007).
Increasing net interest income from profitable growth in loans and deposits constitutes the Corporations greatest opportunity for 2009 earnings growth. Yet, this is also subject to various risks, such as competitive pricing pressures that are expected to continue in 2009, softening loan markets, 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 a continued steepening of the yield curve during 2008, short-term interest rates decreased significantly (400 bp) during 2008, and were at historically low levels at the end of 2008. This interest rate environment and competitive challenges may cause downward pressure on the net interest margin for 2009.
Total loans increased $0.8 billion (5%) between year-end 2008 and 2007, led by consumer-based loan growth (including $0.6 billion in home equity and $0.1 billion in residential mortgage), while commercial loan growth (up $0.1 billion) was tempered by the credit environment. On average, loans grew $0.9 billion (6%) primarily in commercial loans (up $0.6 billion) and home equity (up $0.5 billion), while all other consumer-based loans declined (down $0.2 billion).
Total deposits grew $1.2 billion (8%) between year-end 2008 and 2007, primarily attributable to higher network transaction deposits and brokered CDs. On average, total deposits were relatively unchanged, up $0.1 billion (1%) over 2007, primarily in noninterest-bearing demand deposits. Deposit growth remains a key to improving net interest income and the quality of earnings in 2009. Competition for deposits remains high. Challenges to deposit growth include a cyclical decline in deposits historically experienced during the first quarter, other competitive pricing pressures, along with customer preference for higher-costing deposit products or non-deposit investment alternatives.
As mentioned earlier, asset quality measures deteriorated during 2008. At December 31, 2008, the allowance for loan losses to total loans ratio of 1.63% was deemed adequate by management, covering 78% of nonperforming loans, compared to 1.29% at December 31, 2007, covering 123% of nonperforming loans. The provision for loan losses was $202 million for 2008, with net charge offs to average loans of 0.85% (compared to a provision of $35 million and a net charge off ratio of 0.27% for 2007). Based on current market conditions and our continuous monitoring of specific individual nonperforming and potential problem loans, we anticipate that net charge offs and provision for loan losses will remain elevated. We cannot predict the duration of asset quality stress for 2009, given uncertainty as to the magnitude and scope of economic weakness in our markets, on our customers, and on underlying real estate values (residential and commercial).
Noninterest income of $286 million in 2008 was down $59 million (17%) from 2007, primarily from other-than-temporary write-downs on investment securities (down $61 million, including other-than-temporary write-downs of $53 million in 2008 versus gains of $8 million on sales of common equity securities in 2007), a decline in net asset sale gains (down $17 million, predominantly from deposit premiums and fixed asset gains related to the
2007 branch deposit sales), and lower net mortgage banking income (down $8 million, led by a $7 million addition to the valuation reserve in 2008 compared to a $1 million recovery of the valuation reserve in 2007), partially offset by growth in most core fee-based revenue categories (up $15 million or 6%, and defined as trust service fees, service charges on deposit accounts, card-based and other nondeposit fees, and retail commissions). Most core fee-based revenue categories benefited in 2008 from a combination of higher volumes and improved pricing, while trust service fees were adversely impacted by weak stock market performance. For 2009, core fee-based revenues are expected to show moderate growth.
Noninterest expense of $557 million grew $23 million (4%) over 2007. Personnel expenses were $309 million, up $6 million or 2% versus 2007, with a $3 million increase in stock awards expense and $12 million (5%) higher base salaries, commissions, and incentives (principally due to merit increases), partially offset by a $1 million decline in transitional costs (including signing/retention bonuses, severance, and overtime/temporary help) and an $8 million decrease in fringe benefits expense. On average, there was minimal change in full time equivalent employees between 2008 and 2007 (from 5,114 for 2007 to 5,131 for 2008, an increase of 0.3%). Nonpersonnel noninterest expenses on an aggregate basis were up $17 million or 7% over 2007, primarily due to elevated foreclosure related and loan collection costs, increased legal and consultant expense, and higher weather-related occupancy 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 52.41% for 2008 and 53.92% for 2007. For 2009, the Corporation expects noninterest expense (exclusive of FDIC expense) will return to more stable levels and will remain relatively flat to up slightly (around 1%) compared to 2008. To support this outcome, the Corporation has undertaken a series of initiatives to focus on nonpersonnel-related expenses for efficiencies, and FDIC expense will increase approximately $20 million due to changes in deposit insurance coverage.
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 of operations 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 classified differently or 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 bp at December 31, 2008 (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 $2.5 million higher than that determined at December 31, 2008 (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 $2.4 million lower (leading to adding more valuation allowance and a decrease in mortgage banking, net). Due to the significant volatility and reduction in mortgage loan interest rates near year-end, the fair value of the Corporations mortgage servicing rights could continue to change at future measurement dates even though mortgage interest rates stay at their year-end levels. 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. 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 the tax assets and liabilities are adequate and properly recorded in the consolidated financial statements. The Corporation has established a valuation allowance relating to certain state deferred tax assets at December 31, 2008. However, there is no guarantee that the tax benefits associated with the remaining deferred tax assets will be fully realized. We have concluded that it is more likely than not that such tax benefits will be realized. 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 of Hudson (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.
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 2008, 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 12% and 10%, respectively, for 2008, compared to 7% and 10%, respectively, for 2007, and 6% and 10%, respectively, for 2006. Wealth management segment revenues were down $2 million (2%) between 2008 and 2007, and up $6 million (5%) between 2007 and 2006. Wealth management segment expenses were down $1 million (1%) between 2008 and 2007, and up $2 million (3%) between 2007 and 2006. Wealth management segment assets (which consist predominantly of cash equivalents, investments, customer receivables, goodwill and intangibles) were up $6 million (5%) between year-end 2008 and 2007, and up $15 million (16%) between year-end 2007 and
2006. The $2 million decrease in wealth management segment revenues between 2008 and 2007 was attributable principally to lower trust service fees, while the $1 million decrease in expenses between 2008 and 2007 was primarily attributable to lower nonpersonnel-related expenses. The $6 million increase in wealth management segment assets from 2007 to 2008 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 74% of expense for 2008, 2007, and 2006), 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 Corporation recorded net income of $168.5 million for the year ended December 31, 2008, a decrease of $117.3 million or 41.0% from 2007. Basic earnings per common share for 2008 were $1.30, a 42.0% decrease from 2007 basic earnings per common share of $2.24. Diluted earnings per common share were $1.29, a 42.2% decrease from 2007 diluted earnings per common share of $2.23. Earnings for 2008 were impacted by higher provision for loan losses (resulting from deterioration in the real estate markets and the economy) as well as other-than-temporary write-downs on investment securities. Return on average assets was 0.76% for 2008 compared to 1.38% for 2007. Return on average equity was 6.95% and 12.68% for 2008 and 2007, respectively. Cash dividends of $1.27 per common share paid in 2008 increased by 4.1% over 2007. 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 $696.1 million in 2008 compared to $643.8 million in 2007. 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 $27.7 million and $27.3 million for 2008 and 2007, respectively, resulted in fully taxable equivalent net interest income of $723.9 million in 2008 and $671.1 million in 2007.
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, 2008. 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.
Taxable equivalent net interest income of $723.9 million for 2008 was $52.8 million or 7.9% higher than 2007. The increase in taxable equivalent net interest income was a function of favorable volume variances (as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $35.3 million) and favorable interest rate changes (as the impact of changes in the interest rate environment and product pricing increased taxable equivalent net interest income by $17.5 million). The change in mix and volume of earning assets increased taxable equivalent net interest income by $82.3 million, while the change in volume and composition of interest-bearing liabilities decreased taxable equivalent net interest income by $47.0 million, for a net favorable volume impact of $35.3 million. Rate changes on earning assets reduced interest income by $230.8 million, while changes in rates on interest-bearing liabilities lowered interest expense by $248.3 million, for a net favorable rate impact of $17.5 million. See additional discussion in section Interest Rate Risk.
The net interest margin for 2008 was 3.65%, compared to 3.60% in 2007. The 5 bp improvement in net interest margin was attributable to a 28 bp increase in interest rate spread (the net of a 145 bp decrease in the cost of interest-bearing liabilities and a 117 bp decrease in the yield on earning assets), partially offset by 23 bp lower contribution from net free funds (due principally to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds).
While unchanged during the first eight months of 2007, the Federal Reserve lowered interest rates by 100 bp during the last four months of 2007 and by an additional 400 bp during 2008. At December 31, 2008, the Federal Funds rate was 0.25%, 400 bp lower than 4.25% at December 31, 2007. On average, the Federal funds rate was 1.75% for 2008, 320 bp lower than 2007, and the prime rate was 5.08% for 2008, 297 bp lower than the previous year.
For 2008, the yield on earning assets of 5.82% was 117 bp lower than 2007. Loan yields decreased 142 bp (to 5.95%), impacted by higher levels of nonaccrual loans, and commercial and retail loans in particular experienced lower yields (down 167 bp and 152 bp, respectively) given the repricing of adjustable rate loans and competitive pricing pressures in a declining rate environment. The yield on securities and short-term investments was minimally changed (down 9 bp to 5.26%). Overall, earning asset rate changes reduced interest income by $230.8 million, the combination of $228.2 million lower interest on loans and $2.6 million lower interest on securities and short-term investments.
The cost of interest-bearing liabilities of 2.53% in 2008 was 145 bp lower than 2007. The average cost of interest-bearing deposits was 2.32% in 2008, 123 bp lower than 2007, reflecting the lower rate environment, yet moderated by product-focused pricing to retain balances. The cost of wholesale funding (comprised of short-term borrowings and long-term funding) decreased 210 bp to 2.96% for 2008, with short-term borrowings down 283 bp (similar to the change in the average Federal Funds rate) and long-term funding down 14 bp. The interest-bearing liability rate changes resulted in $248.3 million lower interest expense, with $138.7 million attributable to interest-bearing deposits and $109.6 million due to wholesale funding.
Year-over-year changes in the average balance sheet were impacted by the June 2007 acquisition (which added $0.3 billion of both loans and deposits at June 1, 2007), branch sales ($0.2 billion of deposits) during the second half of 2007, and stronger loan growth beginning primarily in fourth quarter 2007 and continuing through 2008. As a result, average earning assets of $19.8 billion in 2008 were $1.2 billion (6%) higher than 2007. Average loans grew $948 million (6.3%), with a $580 million increase in commercial loans and a $461 million increase in retail loans, partially offset by a $93 million decrease in residential mortgage loans. Average investments grew $247 million as a
result of mortgage-related investment securities purchases during the fourth quarter of 2008. Taxable equivalent interest income in 2008 increased $82.3 million due to earning asset volume changes, with $69.5 million attributable to loans and $12.8 million of the decrease attributable to securities and short-term investments.
Average interest-bearing liabilities of $17.0 billion in 2008 were up $1.1 billion (7%) versus 2007, attributable to higher wholesale funding balances. Average interest-bearing deposits were flat, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $71 million. Given the growth in earning assets, average wholesale funding increased by $1.1 billion, the net of a $1.3 billion increase in short-term borrowings and a $0.2 billion decrease in long-term funding. As a percentage of total average interest-bearing liabilities, interest-bearing deposits, short-term borrowings, and long-term funding were 67%, 24%, and 9%, respectively, for 2008, compared to 72%, 17%, and 11%, respectively, for 2007. In 2008, interest expense increased $47.0 million due to volume changes, with a $48.4 million increase from higher volumes of wholesale funding, partially offset by a $1.4 million decrease due to a slight decline 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 2008 was $202.1 million, compared to $34.5 million and $19.1 million for 2007 and 2006, respectively. Net charge offs were $137.3 million for 2008, compared to $40.4 million for 2007 and $19.0 million for 2006. Net charge offs as a percent of average loans were 0.85%, 0.27%, and 0.12% for 2008, 2007, and 2006, respectively. At December 31, 2008, the allowance for loan losses was $265.4 million. In comparison, the allowance for loan losses was $200.6 million at December 31, 2007, and $203.5 million at December 31, 2006. The ratio of the allowance for loan losses to total loans was 1.63%, 1.29%, and 1.37% at December 31, 2008, 2007, and 2006, respectively. Nonperforming loans at December 31, 2008, were $341 million, compared to $163 million at
December 31, 2007, and $142 million at December 31, 2006, representing 2.09%, 1.05%, and 0.96% of total loans, respectively.
The provision for loan losses is predominantly a function of the Corporations reserving methodology and judgments as to 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 $285.7 million for 2008, down $59.1 million or 17.2% from 2007. Core fee-based revenue (as defined in Table 6 below) was $267.9 million for 2008, an increase of $15.0 million or 5.9% over 2007. Net mortgage banking income was $14.7 million compared to $22.8 million for 2007. Net losses on investment securities and asset sales were $54.2 million for 2008, an unfavorable change of $78.0 million versus 2007. All other noninterest income categories combined were $57.3 million, up $11.9 million compared to 2007. Fee income (defined in Table 6 below) as a percentage of total revenue (defined as taxable equivalent net interest income plus fee income) was 32.0% for 2008 compared to 32.4% for 2007.
TABLE 6: Noninterest Income
N/M = not meaningful
Trust service fees for 2008 were $38.4 million, down $4.2 million (9.9%) from 2007, primarily due to weaker stock market performance for 2008 versus 2007. The market value of assets under management at December 31, 2008, was $5.1 billion compared to $6.1 billion at December 31, 2007.
Service charges on deposit accounts were $118.4 million, $17.3 million (17.1%) higher than 2007. The increase was due to higher nonsufficient funds / overdraft fees (up $13.4 million, including a moderate fee increase late in first quarter 2008 and higher overdraft occurrences) and an increase in business service charges (up $4.0 million, aided by a lower earnings credit rate between the years).
Card-based and other nondeposit fees were $48.5 million for 2008, an increase of $1.0 million (2.1%) from 2007, 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 $62.6 million for 2008, up $0.9 million (1.5%) compared to 2007, led by increases in fixed annuity commissions (up $1.2 million to $7.0 million for 2008) and insurance commissions (up $0.7 million to $45.1 million), offset by lower brokerage and variable annuity commissions (down $1.0 million to $10.5 million on a combined basis for 2008).
Net mortgage banking income for 2008 was $14.7 million, down $8.1 million (35.5%) compared to 2007. 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 $37.6 million in 2008, a decrease of $1.9 million (4.8%) compared to 2007. This $1.9 million decrease between 2008 and 2007 is a combination of: $7.8 million higher gains on sales and related income (of which, $2.1 million was attributable to the January 2008 adoption of SAB 109 allowing the inclusion of the estimated fair value of future net cash flows related to servicing rights / servicing fees in the estimated fair value of certain mortgage derivatives and mortgage loans held for sale), offset by an $8.6 million decrease in bulk servicing sale gains (as 2007 included two bulk servicing sales totaling approximately $2.7 billion of the servicing portfolio, while there were no servicing sales during 2008) and a $1.1 million (6.0%) decrease in servicing fees between the years (impacted by the lower average servicing portfolio). Secondary mortgage production was $1.41 billion for 2008, 5% lower than $1.48 billion for 2007.
Mortgage servicing rights expense includes both the base amortization of the mortgage servicing rights asset and changes 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 the changes in the estimated fair value of the mortgage servicing rights asset. Mortgage servicing rights expense was $22.9 million for 2008 compared to $16.7 million for 2007, with an $8.2 million unfavorable change to the valuation reserve (including a $6.8 million addition to the valuation reserve in 2008 compared to a $1.4 million valuation recovery in 2007), partially offset by $2.0 million lower base amortization (in line with the lower average servicing portfolio resulting, in part, from the bulk servicing sales in 2007). 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. Conversely, as mortgage interest rates fall, prepayment speeds are usually faster and the value of the mortgage servicing rights asset generally decreases, requiring additional valuation reserve. Based on the current environment, there is downward pressure on the value of the mortgage servicing rights asset.
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, 2008, the net mortgage servicing rights asset was $45.6 million, representing 69 bp of the $6.6 billion portfolio of residential mortgage loans serviced for others, compared to a net mortgage servicing rights asset of $51.2 million, representing 80 bp of the $6.4 billion mortgage portfolio serviced for others at December 31, 2007. 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 $19.8 million, up $2.4 million from 2007, principally due to higher average BOLI balances between the years (up 13%), including $50 million of BOLI purchased during the fourth quarter of 2007. Other income was $37.5 million, an increase of $9.5 million (34.0%) versus 2007, including modest increases in ATM fees (up $0.8 million), an $0.8 million gain on an ownership interest divestiture, $2.1 million higher customer derivative revenue (higher fees given greater customer derivatives volume), and a $5.2 million in gains related to Visa, Inc. (Visa) matters.
During 2008, the Visa matters resulted in the Corporation recording a total gain of $5.2 million, which included a $3.2 million gain from the mandatory partial redemption of the Corporations Class B common stock in Visa Inc.
related to Visas initial public offering which was completed during first quarter 2008 and a $2.0 million gain (including a $1.5 million gain in the first quarter of 2008 and a $0.5 million gain in the fourth quarter of 2008) and a corresponding receivable (included in other assets in the consolidated balance sheets) for the Corporations pro rata interest in the litigation escrow account established by Visa from which settlements of certain covered litigation will be paid (Visa may add to this over time through a defined process which may involve a further redemption of the Class B common stock). In addition, the Corporation has a zero basis (i.e., historical cost/carryover basis) in the shares of unredeemed Visa Class B common stock which are convertible with limitations into Visa Class A common stock based on a conversion rate that is subject to change in accordance with specified terms (including provision of Visas retrospective responsibility plan which provides that Class B stockholders will bear the financial impact of certain covered litigation) and no sooner than the longer of three years or resolution of covered litigation. For additional discussion of Visa matters see section Contractual Obligation, Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities, and Note 14, Commitments, Off-Balance Sheet Arrangements, and Contingent Liabilities, of the notes to consolidated financial statements.
Asset sale losses were $1.7 million for 2008 (including a $1.2 million gain on the sale of third party administration business contracts and $2.4 million net losses on sales of other real estate owned), compared to asset sale gains of $15.6 million for 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). Net investment securities losses of $52.5 million for 2008 were attributable to other-than-temporary write-downs on the Corporations holding of various mortgage-related, debt, and equity securities (including a $31.1 million write-down on a non-agency mortgage-related security, a $13.2 million write-down on FHLMC and FNMA preferred stocks, a $6.8 million write-down on trust preferred debt securities pools, and a $1.4 million write-down on common equity securities). At December 31, 2008, the remaining carrying values of the specific securities with other-than-temporary write-downs were $32.9 million for the non-agency mortgage-related security, $0.2 million for the FHLMC and FNMA preferred stock securities combined, $3.9 million for the trust preferred debt securities pools, and $0.4 million for the common equity securities. 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 write-down on a common stock security. 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 2008 was $557.5 million, an increase of $22.6 million or 4.2% over 2007. Personnel expense for 2008 was up $6.1 million or 2.0%, while collectively all other noninterest expenses were up $16.5 million or 7.1% compared to 2007.
TABLE 7: Noninterest Expense
Personnel expense (which includes salary-related expenses and fringe benefit expenses) was $309.5 million for 2008, up $6.1 million (2.0%) over 2007. Average full-time equivalent employees were 5,131 for 2008, minimally changed from 5,114 for 2007. Salary-related expenses increased $13.9 million (5.8%). This increase was due to higher base salaries, commissions, and incentives (up $12.4 million or 5.5%, including merit increases between the years) and higher compensation cost related to the vesting of stock options and restricted stock grants (up $2.8 million), partially offset by lower signing bonuses, severance, and overtime/temporary help (down $1.3 million combined). Fringe benefit expenses decreased $7.8 million (12.1%), primarily from lower costs of premium-based benefits (down $8.3 million, aided by health care cost management, as well as differences in enrollment levels and participant plan choices), partially offset by higher other fringe and benefit plan expenses (up $0.5 million, primarily related to the increase in salary expense).
Occupancy expense of $50.5 million for 2008 was higher than 2007 (up $3.8 million or 8.1%), mostly due to higher snowplowing and utilities costs (given harsher winter weather between the periods), as well as increased rent and maintenance. Compared to 2007, equipment expense of $19.1 million was up $1.2 million (primarily repair and maintenance expense), while data processing of $30.5 million was down $1.2 million, with first quarter 2008 benefiting from a negotiated data processing vendor refund. Business development and advertising of $21.4 million was up $1.6 million (8.2%), and stationery and supplies of $7.7 million was up $0.9 million, all primarily due to normal inflationary cost increases and greater marketing for business generation. Other intangible asset amortization expense decreased $0.8 million (11.9%), attributable to the full amortization of certain intangible assets during 2007. Legal and professional expense of $14.6 million increased $2.7 million (23.0%), primarily due to higher legal and other professional consultant costs related to increased foreclosure activities, and other corporate activities and projects. Foreclosure / OREO expenses of $13.7 million increased $6.2 million, including a $4.0 million increase in OREO write-downs (with $3.0 million attributable to one property) and a general rise in foreclosure expenses (impacted by the overall deterioration of the real estate market). Other expense of $70.5 million increased $2.8 million (4.2%) over 2007, largely due to a $2.8 million increase to the reserve for losses on unfunded commitments.
Income tax expense for 2008 was $53.8 million compared to $133.4 million for 2007. The Corporations effective tax rate (income tax expense divided by income before taxes) was 24.2% in 2008 and 31.8% in 2007. The decline in the effective tax rate was primarily due to the decrease in income before taxes, as the level of permanent difference items (such as tax-exempt interest and dividends) while relatively consistent between years, had a proportionately greater impact on the effective tax rate based on lower pre-tax income. Additionally, the first quarter 2008 resolution
of certain tax matters and changes in the estimated exposure of uncertain tax positions, partially offset by the increase in valuation allowance related to certain deferred tax assets, resulted in the net reduction of previously recorded tax liabilities and income tax expense of approximately $4.4 million in the first quarter of 2008.
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 and preferred stock, particularly in the case of certain acquisitions (see section Capital).
Total loans were $16.3 billion at December 31, 2008, an increase of $0.8 billion or 4.9% from December 31, 2007, led by consumer-based loan growth (predominantly home equity), while commercial loan growth was tempered by the current credit environment and economic conditions. Commercial loans were $10.3 billion, relatively unchanged (up 0.5%), and represented 63% of total loans at the end of 2008, compared to 66% at year-end 2007. Retail loans grew $600 million or 19.3% to represent 23% of total loans compared to 20% at December 31, 2007, and residential mortgage loans increased $115 million or 5.4% to represent 14% of total loans (unchanged from 14% of total loans for 2007). During 2008, the Corporation strategically emphasized home equity growth, using strengthened underwriting standards and obtaining first-lien collateral positions on the vast majority of new production.
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 2008 was muted partly as the Corporation purposefully responded to the stricter credit environment (particularly in commercial real estate), and aggressively managed risks of certain targeted performing loans and took charge offs on nonperforming commercial loans.
Commercial, financial, and agricultural loans accounted for the majority of the commercial loan growth between year-end 2008 and 2007. Commercial, financial, and agricultural loans were $4.4 billion at the end of 2008, up $108 million or 2.5% since year-end 2007, and comprised 27% of total loans outstanding, down from 28% at the end of 2007. 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, 2008, down $69 million or 1.9% from December 31, 2007, and comprised 22% of total loans outstanding versus 23% at year-end 2007. 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 secured by commercial income properties or multifamily projects. Loans are primarily made to customers based in our core footprint (with over 90% of commercial real estate loan balances made to customers within our core footprint). Credit risk is managed in a similar manner to commercial loans and real estate construction by employing sound underwriting guidelines, lending primarily 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 were level at $2.3 billion, representing 13% of the total loan portfolio at the end of 2008, compared to 14% at the end of 2007. Loans in this classification are primarily short-term or interim loans that provide financing for the acquisition or development of commercial income properties, multifamily projects or residential development, both single family and condominium. Real estate construction loans are made to developers and project managers who are generally 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 core footprint in which the Corporation has a thorough knowledge of the local market economy (with approximately 90% of real estate construction loan balances made to customers within our core footprint). 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 $3.7 billion at December 31, 2008, up $600 million or 19.3% compared to 2007, and represented 23% of the 2008 year-end loan portfolio versus 20% at year-end 2007. Loans in this classification include home equity and installment loans. Home equity consists of home equity lines, as well as home equity loans, some of which are first lien positions, while installment loans consist of educational loans, as well as short-term and other personal installment loans. 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 $2.2 billion at the end of 2008, up $115 million or 5.4% from the prior year and comprised 14% of total loans outstanding at both year-end 2008 and year-end 2007. Residential mortgage loans include conventional first lien home mortgages and the Corporation generally limits the maximum loan to 80% of collateral value without credit enhancement. 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 core footprint. 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, 2008, 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, 2008, the allowance for loan losses was $265.4 million, compared to $200.6 million at December 31, 2007 and $203.5 million at December 31, 2006. The allowance for loan losses to total loans was 1.63%, 1.29%, and 1.37% at December 31, 2008, 2007 and 2006, respectively, and the allowance for loan losses covered 78%, 123% and 143% of nonperforming loans at December 31, 2008, 2007 and 2006, respectively. The Corporations estimate of the appropriate allowance for loan losses does not have a targeted reserve to nonperforming loan coverage ratio. Managements allowance methodology includes an impairment analysis on specifically identified commercial loans defined as impaired by the Corporation, as well as other qualitative and quantitative factors (including, but not limited to, historical trends, risk characteristics of the loan portfolio, changes in the size and character of the loan portfolio, and existing economic conditions) in determining the overall adequacy of the allowance for loan losses. 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 2008, rising net charge off and nonperforming loan ratios, and managements assessment of the adequacy of the allowance for loan losses, the provision for loan losses of $202.1 million for 2008 was higher than the 2007 provision of $34.5 million and 2006 provision of $19.1 million.
Asset quality was under stress during 2008 and 2007 with the Corporation experiencing elevated net charge offs (particularly during 2008 and 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 2008 and 2007 included general economic factors such as higher and more volatile 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. During this time period, the Corporation has continued to review its underwriting and risk-based pricing guidelines on the home equity and residential mortgage portfolios, to reduce potential exposure within these portfolio categories.
The Corporations underwriting and risk-based pricing guidelines for consumer-related real estate loans consist of a combination of both borrower FICO (credit score) and the loan-to-value (LTV) of the property securing the loan. Currently, for home equity products, the maximum acceptable LTV is 85% for customers with FICO scores exceeding 710, and 75% LTV for all other customers. The average FICO score for new home equity production in 2008 increased to 765, up from 750 in 2007, 739 in 2006, and 732 in 2005. Residential mortgage products continue to be underwritten using FHLMC and FNMA secondary marketing guidelines.
The Corporations current lending standards for commercial real estate and real estate construction lending is organized by property type and specifically addresses many criteria, including: maximum loan amounts, maximum LTV, requirements for pre-leasing and / or presales, minimum borrower equity, and maximum loan to cost. Currently, the maximum standard for LTV is 80%, with lower limits established for certain higher risk types, such as raw land which has a 50% LTV maximum. The Corporations LTV guidelines are generally more conservative than regulatory supervisory limits. In most cases, for real estate construction loans, the loan amounts used to determine LTV include interest reserves, which are built into the loans and sized to carry the projects through construction and lease up and / or sell out.
Gross charge offs were $145.8 million for 2008, $47.2 million for 2007, and $30.5 million for 2006, while recoveries for the corresponding periods were $8.5 million, $6.8 million, and $11.5 million, respectively. As a result, net charge offs were $137.3 million or 0.85% of average loans for 2008, compared to $40.4 million or 0.27% of average loans for 2007, and $19.0 million or 0.12% of average loans for 2006 (see Table 10). The increase in net charge offs was primarily due to larger specific commercial charge offs (including $69 million attributable to larger housing-related construction and other commercial credits (with a $9 million charge off on a $25 million nonperforming loan which was sold during the third quarter of 2008), and $16 million related to other larger
commercial real estate and other commercial credits), as well as a general rise in home equity and residential mortgage net charge offs (impacted by general economic conditions, such as higher energy and other costs, increasing unemployment rates, a weak housing market, and declines in home values).
For 2008, 79% of net charge offs came from commercial loans (and commercial loans represented 63% of total loans at year-end 2008), compared to 60% for 2007 and 22% for 2006, a result of the sizable increase in commercial charge offs in both 2008 and 2007, while higher commercial recoveries impacted the net charge off amounts for 2006. For 2008, retail loans (which represent 23% of total loans at year-end 2008) accounted for 19% of net charge offs, down from 35% for 2007 and 70% for 2006. Residential mortgages (representing 14% of total loans at year-end 2008) accounted for 2% of 2008 net charge offs, compared to 5% and 8% for 2007 and 2006, respectively. Gross charge offs of retail and residential mortgage loans have been rising over the past three years, as economic conditions, such as higher 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. 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