Capitol Bancorp 10-K 2013
Documents found in this filing:
F i n a n c i a l I n f o r m a t i o n
Table of Contents
(in $1,000s, except per share data)
Capitol's common stock was traded on the New York Stock Exchange (the "NYSE") under the symbol "CBC" prior to early 2011. On January 27, 2011, Capitol's common stock began being quoted through the facilities of OTC Markets Group under the symbol "CBCR." It is currently being categorized under the OTCQB tier, which identifies issuers that are registered and reporting with the Securities and Exchange Commission. Market quotations regarding the range of high and low bid prices of Capitol's common stock, as reported by the OTC Markets Group for 2012 and 2011, were as follows:
Below is a graph which summarizes the cumulative return earned by Capitol's shareholders over the last five years compared with the SNL (SNL Financial LC) Bank Pink >$500M Asset-Size Index (SNL) and the cumulative total return on the Russell 2000 Index (R-2000). This presentation assumes the initial value of an investment in Capitol's common stock and each index was $100 on December 31, 2007 and that any subsequent cash dividends were reinvested.
INFORMATION REGARDING CAPITOL'S COMMON STOCK—Continued
Beginning in September 2009, the payment of dividends became subject to prior approval of the Federal Reserve, Capitol's primary federal regulator (see subsequent discussion of certain regulatory matters in the section captioned "Management's Discussion and Analysis of Capitol's Business, Financial Condition and Results of Operations"). In the first quarter of 2009, Capitol paid a cash dividend of $0.05 per share. During 2008, Capitol paid quarterly cash dividends of $0.25 per share for the first quarter, $0.15 in the second quarter and $0.05 in the third and fourth quarters.
As of March 15, 2013, there were 8,598 holders of Capitol's common stock, based on information supplied to Capitol from its stock transfer agent and other sources.
At March 15, 2013, 41,177,479 shares of common stock were outstanding. Capitol's stock transfer agent is Computershare (formerly BNY Mellon Shareowner Services), 480 Washington Blvd., Jersey City, NJ 07310 (telephone 866-205-7090). The website for Computershare is http://www.computershare.com/investor.
Capitol has a direct purchase and dividend reinvestment plan, the Capitol Bancorp Limited Direct Purchase and Dividend Reinvestment Plan ("Capitol Bancorp Direct"), which offers a variety of convenient features including certain fee-free transactions, certificate safekeeping and other benefits. For a copy of the Capitol Bancorp Direct prospectus, informational brochure and enrollment materials, contact Computershare at 866-205-7090 or Capitol at 517-487-6555.
In addition to Capitol's common stock, trust-preferred securities of Capitol Trust I and Capitol Trust XII (each a subsidiary of Capitol) are quoted on the OTCQB tier of the OTC Markets Group under the symbol "CBCRP" and "CBCRO," respectively, commencing in late January 2011. Those trust-preferred securities have a liquidation amount of $10 per preferred security and are guaranteed by Capitol. Capitol Trust I consists of 1,349,398, 8.5% cumulative preferred securities scheduled to mature in 2027, which are currently callable and may be extended to 2036 if certain conditions are met. Capitol Trust XII consists of 3,031,066, 10.5% cumulative preferred securities scheduled to mature in 2038 and become callable in 2013. In 2009, Capitol commenced the deferral of interest payments on its various trust-preferred securities, as is permitted under the terms of the securities, to conserve cash and capital resources. Holders of the trust-preferred securities will continue to recognize current taxable income relating to the deferred interest payments. Payment of interest on the trust-preferred securities is subject to approval of the Federal Reserve (see subsequent discussion of certain regulatory matters in the section captioned "Management's Discussion and Analysis of Capitol's Business, Financial Condition and Results of Operations").
Capitol has filed with the U.S. Securities and Exchange Commission (the "SEC") all required certifications regarding the quality of Capitol's public disclosures upon filing of Capitol's 2012 Report on Form 10-K. Further, Capitol has filed certifications with the SEC in accordance with the Sarbanes-Oxley Act of 2002 as exhibits to Capitol's 2012 Report on Form 10-K.
A copy of Capitol's 2012 Annual Report on Form 10-K, without exhibits, will be available to holders of its common stock or trust-preferred securities without charge, upon written request. Form 10-K includes certain statistical and other information regarding Capitol and its business. Requests to obtain a copy of Form 10-K should be addressed to Investor Relations, Capitol Bancorp Limited, Capitol Bancorp Center, 200 N. Washington Square, Lansing, Michigan 48933.
Form 10-K and certain other periodic reports have been or will be filed with the SEC. The SEC maintains an Internet website that contains reports, proxy and information statements and other information regarding companies which file electronically (which includes Capitol). The SEC's website address is http://www.sec.gov. Capitol's filings with the SEC are also available at Capitol's website, http://www.capitolbancorp.com.
BDO USA, LLP
Grand Rapids, Michigan
DIRECT PURCHASE AND DIVIDEND REINVESTMENT PLAN
Capitol offers a direct purchase and dividend reinvestment plan, Capitol Bancorp Direct. Participation in Capitol Bancorp Direct is voluntary and shareholders and prospective investors are eligible. As a result of the Chapter 11 bankruptcy filing, purchases and sales through Capitol Bancorp Direct have been suspended until further notice. For further information regarding Capitol Bancorp Direct or for a copy of Capitol Bancorp Direct's prospectus, informational brochure and enrollment materials, please contact Computershare at 866-205-7090 or Capitol at 517-487-6555.
TRUST-PREFERRED SECURITIES TRADING INFORMATION
Preferred securities of Capitol Trust I and Capitol Trust XII (each a subsidiary of Capitol) are quoted on the OTC Markets Group under the trading symbols "CBCRP" and "CBCRO," respectively.
TRUST-PREFERRED SECURITIES TRUSTEE
Capitol Trust I: Bank of New York Mellon – Chicago, Illinois
Capitol Trust XII: M&T Trust Company of Delaware
Some of the statements contained in this annual report, including Capitol's consolidated financial statements, Management's Discussion and Analysis of Capitol's Business, Financial Condition and Results of Operations and in documents incorporated into this document by reference that are not historical facts, including, without limitation, statements of future expectations, projections of results of operations and financial condition, statements of future economic performance and other forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, are subject to known and unknown risks, uncertainties and other factors which may cause the actual future results, performance or achievements of Capitol and/or its subsidiaries and other operating units to differ materially from those contemplated in such forward-looking statements. The words "intend," "expect," "project," "estimate," "predict," "anticipate," "should," "could," "believe," "may," "might," and similar expressions also are intended to identify forward-looking statements. Important factors which may cause actual results to differ from those contemplated in such forward-looking statements include, but are not limited to:
· Capitol may not be able to successfully emerge from Chapter 11 bankruptcy and restructure its existing unsecured debt obligations;
· Capitol's ability to continue as a going concern;
· The availability and cost of capital and liquidity on favorable terms, if at all, which may depend in part on Capitol's asset quality, prospects and outlook;
· The risk that Capitol may not be able to complete its various proposed divestitures, mergers and consolidations of certain of its subsidiary banks or, if completed, realize the anticipated benefits of the proposed transactions;
CAUTIONS REGARDING FORWARD-LOOKING STATEMENTS—Continued
· The risk of additional future losses if the proceeds Capitol receives upon the liquidation of assets are less than the carrying value of such assets;
· Restrictions or limitations on access to funds from subsidiaries and potential obligations to contribute additional capital to Capitol's subsidiaries, which may restrict its ability to make payments on its obligations;
· Administrative or enforcement actions of banking regulators in connection with any material failure of Capitol or its subsidiary banks to comply with banking laws, rules or regulations or formal enforcement actions with regulatory agencies;
· The costs and effects of litigation, investigations, inquiries or similar matters, or adverse facts and developments related thereto;
· The possibility of the Federal Deposit Insurance Corporation ("FDIC") or an applicable state banking regulator seizing one or more of Capitol's subsidiary banks;
· The possibility of the FDIC assessing Capitol's banking subsidiaries for any cross-guaranty liability;
· Capitol's compliance with the terms of its written agreement with the Federal Reserve Bank, amendments thereto, or subsequent regulatory agreements;
· The current prohibition of Capitol's subsidiary banks to pay dividends to Capitol without prior written authorization from regulatory agencies;
· The risk that the realization of deferred tax assets may not occur;
· The risk that Capitol could have an "ownership change" under Section 382 of the Internal Revenue Code, which could impair its ability to timely and fully utilize its net operating losses for tax purposes and so-called built-in losses that may exist if such an "ownership change" occurs;
· The risks associated with the high concentration of commercial real estate loans within Capitol's consolidated loan portfolio, along with other credit risks associated with individual large loans;
· The concentration of Capitol's nonperforming assets by loan type in certain geographic regions and with affiliated borrowing groups;
· The overall adequacy of the allowance for loan losses to absorb the amount of actual losses inherent within the loan portfolio;
· The failure of assumptions underlying estimates for the allowance for loan losses and estimation of values of collateral or cash flow projections related to impaired loans;
· Capitol's ability to manage fluctuations in the value of its assets and liabilities and maintain sufficient capital and liquidity to support its operations;
· Fluctuations in the value of Capitol's investment securities;
CAUTIONS REGARDING FORWARD-LOOKING STATEMENTS—Continued
· Volatility of interest rate sensitive deposits and the uncertainties of future depositor activity regarding potentially uninsured deposits;
· The ability to successfully acquire deposits for funding and the pricing thereof;
· The continued availability of credit facilities provided by Federal Home Loan Banks to Capitol's banking subsidiaries;
· Management's ability to effectively manage interest rate risk and the impact of interest rates, in general, on the volatility of Capitol's net interest income;
· The ability to successfully execute strategies to increase noninterest income;
· The impact of possible future material impairment charges;
· Capitol's ability to adapt successfully to technological changes in order to compete effectively in the marketplace;
· Operational risks, including data processing system failures or fraud;
· The ability to retain senior management experienced in banking and financial services;
· A continuation of unprecedented volatility in the capital markets;
· The decline in commercial and residential real estate values and sales volume and the likely potential for continuing illiquidity in the real estate market;
· The uncertainties in estimating the fair value of developed real estate and undeveloped land relating to collateral-dependent loans and other real estate owned in light of decreased demand for such assets, falling prices and continuing illiquidity in the real estate market;
· The impact of negative developments and disruptions in the credit and lending markets on Capitol's business and the businesses of its customers, as well as on other banks and lending institutions with which Capitol has commercial relationships;
· Continued unemployment, the overall continued national economic weakness, rising commodity prices and the impact on Capitol's customers' savings rates and their ability to service debt obligations;
· Changes in the general economic environment, industry conditions, competition or other factors, either nationally or regionally, that could influence loan demand and repayment, deposit inflows and outflows, the quality of the loan portfolio and loan and deposit pricing;
· The effects of competition from other commercial banks, savings associations, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and mutual funds, and other financial institutions operating in Capitol's markets or elsewhere which provide similar services;
CAUTIONS REGARDING FORWARD-LOOKING STATEMENTS—Continued
· Changes in legislation or regulatory and accounting principles, policies, or guidelines affecting the business conducted by Capitol and/or its operating strategy;
· The impact on Capitol's financial results, reputation and business if it is unable to comply with all applicable federal and state regulations and applicable formal enforcement actions, consent orders, other regulatory actions and any related capital requirements;
· The effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Emergency Economic Stabilization Act of 2008, the implementation by the Department of the U.S. Treasury and federal banking regulators of a number of programs to address capital and liquidity issues within the banking system and additional programs that may apply to Capitol in the future, all of which may have significant effects on Capitol and the financial services industry;
· Governmental monetary and fiscal policies, as well as legislative and regulatory changes, that may result in the imposition of costs and constraints on Capitol through higher FDIC insurance premiums, significant fluctuations in market interest rates, increases in capital requirements and operational limitations;
· Acts of war or terrorism; and
· Other factors and other information contained in this document and in other reports and filings that Capitol makes with the SEC under the Securities Exchange Act of 1934, as amended, including, without limitation, under the caption "Risk Factors."
For a discussion of these and other risks that may cause actual results to differ from expectations, you should refer to the risk factors and other information in this Annual Report and Capitol's other periodic filings, including quarterly reports on Form 10-Q and current reports on Form 8-K, that Capitol files from time to time with the SEC. All written or oral forward-looking statements that are made by or are attributable to Capitol are expressly qualified by this cautionary notice. You should not place undue reliance on any forward-looking statements, since those statements speak only as of the date on which the statements are made. Capitol undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made to reflect the occurrence of new information or unanticipated events, except as may otherwise be required by law.
Management's Discussion and Analysis of Capitol's Business,
Financial Condition and Results of Operations
This section of the Annual Report is intended to discuss, from management's perspective, matters of importance regarding Capitol's operations, financial position and other matters which have a significant effect on Capitol, its business and its banks. This narrative includes comments about future events and other forward-looking statements, and readers are advised to carefully read the cautionary statement about forward-looking statements which is on page F-6 of this Annual Report.
Capitol operates community banks in a wide variety of markets in eight states, and operates in one business segment, community banking. Capitol's banks are staffed with banking professionals, serving customers who desire professional banking services delivered personally.
Financial Restructuring Plan
On June 22, 2012, Capitol announced the commencement of a voluntary restructuring plan designed to facilitate Capitol's objective of converting existing debt to equity and with the primary objectives of enhancing capital levels, improving liquidity and accelerating Capitol's return to profitability. The initiative includes the opportunity to preserve Capitol's substantial deferred tax assets.
Under the restructuring plan, which was approved by Capitol's board of directors and reviewed with Capitol's primary regulators, existing debt holders were asked to exchange their debt securities for both preferred and common stock of the Corporation (the "Exchange Offer"). Simultaneously, Capitol solicited votes from all debt and equity holders for a prepackaged plan of reorganization (the "Standby Plan") for Capitol and its affiliate, Financial Commerce Corporation ("FCC", formerly known as Michigan Commerce Bancorp Limited), to be commenced in the event that the Exchange Offer was not successful or Capitol believed the transactions contemplated by the Standby Plan to be in the best interests of all stakeholders. The Standby Plan contemplates the conversion of all current trust-preferred security holders, unsecured senior note holders, current preferred equity shareholders and current common equity shareholders into new classes of common stock, which will retain approximately 53% of the voting control and value of the restructured company. Capitol has also been actively seeking to identify external capital sources sufficient to restore all affiliate institutions to "well-capitalized" status in exchange for approximately 47% of the restructured Corporation, which is a critical component of the likelihood of success of the Standby Plan.
When the trust-preferred securities were originally issued, and until December 31, 2010, substantially all of those securities comprised a crucial element of Capitol's compliance with regulatory capital requirements because they were a material component of regulatory capital. As a result of Capitol's weakened financial condition and changes to banking regulations affecting its ability (as well as that of other bank holding companies in the United States) to include any portion of these securities in regulatory capital computations, none of these
securities are currently included in the Corporation's regulatory capital measurements. The restructuring initiatives will facilitate the conversion of Capitol's trust-preferred securities to equity and represent an efficient opportunity to strengthen the composition of Capitol's capital base by increasing its Tier 1 common and tangible common equity ratios, while also reducing the dividend and interest expense associated with these securities. By increasing its common equity component, and successfully completing the capital raise component of the plan, Capitol expects to have increased capital flexibility to continue to support its community banking platform, strategically take advantage of select market opportunities and implement its long-term strategies.
The Exchange Offer and voting on the Standby Plan expired on July 27, 2012. The results were overwhelmingly in support of the Standby Plan. All classes voted to accept the Standby Plan with all votes substantially exceeding the required thresholds for a successful solicitation. The conditions were not satisfied for the exchange offers to the existing debt holders.
Accordingly, on August 9, 2012, Capitol and FCC proceeded with filing a voluntary joint prepackaged bankruptcy petition (the "Joint Plan of Reorganization") in order to restructure its debt and streamline its capital structure. Capitol's banking subsidiaries were not part of the filing and continue to conduct business on an uninterrupted basis. Capitol was also granted a motion by the Court requiring that trading in the Corporation's senior notes, trust-preferred securities, preferred stock and common stock be restricted to preserve certain of its deferred tax assets.
The Joint Plan of Reorganization provides for the restructuring of Capitol's and FCC's liabilities in a manner designed to maximize recoveries to all creditors and to enhance the financial stability of the reorganized debtors while simultaneously raising new capital from outside investors which can be immediately deployed into the reorganized debtor's subsidiary banks, thus avoiding the disastrous consequences that would result from the seizure of any subsidiary bank. Specifically, the Joint Plan of Reorganization restructures Capitol's senior notes, trust-preferred securities, Series A preferred stock and common stock and leaves unimpaired the rights of all other claim holders. The Joint Plan of Reorganization also contemplates an equity infusion of at least $70 million and up to $115 million which would be pursuant to a separate equity commitment agreement to be entered into by Capitol and certain third-party investors prior to the date on which the Joint Plan of Reorganization becomes effective.
It is important at the outset to emphasize the limited dimensions of this process:
Financial Statement Impact of Emergence from Bankruptcy
Upon approval and exit from bankruptcy, Capitol's financial statements will be impacted significantly in accordance with "Fresh-Start Accounting" rules. Under these accounting and reporting rules:
Assuming completion of the Joint Plan of Reorganization by June 30, 2013, Capitol's consolidated financial statements as of that date will reflect the assets and liabilities of Capitol, inclusive of adjustments for fresh-start accounting. The consolidated financial statements will also include a Statement of Operations and a Statement of Comprehensive Income for (1) the period from January 1, 2013 until the date of emergence from bankruptcy and (2) the period from the date of emergence until June 30, 2013.
Each bank began as a single-location office, led by a bank president and a team of banking professionals with significant local experience, overseen by an independent board of directors composed of business leaders drawn from the local community. Generally, each bank has significant on-site authority to make decisions which directly affect the customer, such as credit approval and the pricing and structure of both loans and deposits. The philosophy of
banking as a profession is key to Capitol's model where its banks' customers seek relationships with banking professionals to meet their needs, as opposed to transaction-oriented financial institutions pushing financial products at customers and emphasizing market share.
With Capitol's customer-focused professional banking model, bank development on a national scale has been a natural extension of this business philosophy. Bank development consists of management and oversight of banks in which Capitol has a direct or indirect controlling interest and, through mid-2008, included formation of start-up banks. Capitol's banks were formed with a portion of their start-up capital provided by local investors in the communities of those banks.
Notably, 'market size' is not a strategic factor in Capitol's approach to community banking. Rather, the critical factor is 'people'. Capitol has recognized from its beginning that its banking focus is, and always will be, a people business. Its banks are small in market stature in relation to their competitors, emphasizing personalized banking relationships.
Capitol's community bank model, in a stable economic environment, is intended to maintain a scalable, low overhead structure focused on delivering return-on-equity results, while empowering its individual banks with operating autonomy in all areas impacting the customer relationship. Capitol's centralized 'back-office' functions, which support the banks, are capable of adjusting coverage in concert with the evolution of its banking subsidiaries.
Capitol's relationship with its banks is multidimensional as an investor, mentor and service provider. As an investor, Capitol closely monitors the financial performance of its bank subsidiaries. This mentoring role of providing assistance and guidance when and where necessary to help enhance bank performance is most important for its youngest affiliates where additional guidance is needed. As a service provider, Capitol provides efficient back-office support services which can be performed centrally for all of its banks and which do not involve a direct interface with the bank customer, such as:
Some of these functions are performed nationally from a single location, while others are performed regionally, where it is more efficient to have personnel located geographically based on their respective responsibilities in relation to the physical location of the banks.
Like many community banks, Capitol's banking affiliates have been impacted by the recent national recession and declines in real estate values. Capitol's consolidated financial position has been significantly adversely affected by large net losses in 2012, 2011 and 2010. The net losses resulted primarily from especially large provisions for loan losses and significantly elevated maintenance and collateral protection costs associated with foreclosed properties and other real estate owned. Those net losses resulted in an equity-deficit as of December 31, 2012 and 2011 and a regulatory-capital classification of less than "adequately-capitalized." In addition, numerous banking subsidiaries of Capitol have regulatory capital classifications as "undercapitalized" or "significantly-undercapitalized" at December 31, 2012, due to significant operating losses and capital infusions from Capitol in amounts insufficient to improve their regulatory classification and compliance with the terms of various regulatory enforcement actions between the banks and/or Capitol and their respective regulatory agencies.
Capitol and its affiliates continue ongoing capital preservation efforts, including expense reductions and infrastructure adjustments. For instance, Capitol has merged or divested 52 community banks since 2009. In 2010 through 2012, significant reductions in compensation costs were recognized through efforts which began in 2009 to combine certain banking subsidiaries and reduce staffing. To further streamline bank operations and reduce expenses, Capitol had also consolidated some of its individual bank charters regionally and has plans for potential further charter-consolidation activities in 2013.
In mid-2009, as part of its capital strategies and restructuring activities, Capitol announced plans to selectively divest some of its banks as a means to raise additional capital and redeploy capital resources to its remaining banks. Thirteen bank divestitures were completed prior to 2011, eight bank divestitures and one branch sale were completed during 2011 and four divestitures were completed in 2012. A few additional divestiture transactions have been announced and are expected to be completed in 2013, subject to regulatory approval and other contingencies.
These changes and structural matters are discussed in further detail later in this narrative.
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Total assets and revenues of each bank included in continuing operations within Capitol's market regions are summarized below as of and for the years ended December 31, 2012 and 2011 (in $1,000s):
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For 2012, the net loss attributable to Capitol approximated $25.5 million ($0.62 per share) compared to $45.4 million ($1.17 per share) in 2011 and $225.2 million ($11.16 per share) in 2010. As previously mentioned, Capitol incurred net losses related primarily to significant provisions for loan losses and costs associated with foreclosed properties and other real estate owned. Further, in 2010, a goodwill impairment charge of $55.8 million was recorded (excluding discontinued operations).
The table below presents operating results of each bank included in continuing operations without regard to Capitol's direct or indirect ownership percentage (in $1,000s) and, where applicable, the related rates of return on average equity and assets (none in 2010):
Operating losses were incurred in 2012 at banks located within all regions except the Great Lakes Region. The largest banking affiliate, Michigan Commerce Bank, returned to profitability in 2012 after experiencing significant losses in 2011 and 2010. Operating results of the Great Lakes-based group of banks amounted to net income of $479,000 in 2012, compared to a net loss of $21.6 million in 2011 and $82.8 million in 2010.
Capitol's other banks showed similar signs of improvement when compared to 2011 and 2010, despite most posting net losses in 2012. Losses continue to be primarily the result of compressed net interest margins, elevated costs associated with foreclosure activities and other real estate owned properties, and management of nonperforming loans.
Most of the amounts discussed in this narrative are based upon the "continuing operations" of Capitol and its consolidated banking subsidiaries. Results of operations for 2011 and 2010 in this report have been adjusted to reflect 2012 sales of banking subsidiaries as "discontinued operations" in order to present operating results on a comparable basis.
The principal revenue sources for Capitol's banks is interest income from loans, noninterest income comprised primarily of service charges on deposit accounts, fees on trust and wealth management accounts, fees on the origination of loans, and gains on the sale of residential mortgage and government-guaranteed commercial loans. Net interest income is the total of all interest income less interest expense and is an important measure used to help determine the amount of net operating revenue for financial institutions. Net operating revenue is the sum of net interest income and noninterest income.
Net interest income totaled $57.9 million in 2012, a 4.3% decrease from the $60.5 million reported in 2011. Net interest income also decreased during 2011 and 2010 by 6.4% and 13.0%, respectively. The declining trend in net interest income has resulted from a reduction in interest earning assets but has been mitigated somewhat by increased yield on average loans, decreased cost of average deposits and a reduction in nonperforming assets. The mitigating factors described above have caused net interest margin to gradually improve to 3.48% in 2012, as compared to 2.93% for 2011 and 2.50% for 2010. Beginning in the third quarter of 2012, consolidated net interest income and net interest margin also benefited from the suspension of interest accrual on trust-preferred securities. Continued reduction in nonperforming loans and normalization of on-balance sheet liquidity, if the risk profiles of the banks improve, should result in additional net interest margin improvement.
During 2012, net interest income exceeded the provision for loan losses by $56.4 million, a significant improvement compared to $24.9 million in 2011. During 2010, provision for loan losses exceeded net interest income by $77.6 million. The provision for loan losses approximated $1.5 million, $35.6 million and $142.2 million in 2012, 2011 and 2010, respectively. The provision for loan losses in 2012 decreased by $34.2 million, or 95.9%, from 2011. The decline is reflective of overall improvement in the loan portfolio's performance, as Capitol experienced signs of stabilizing real estate values and moderately improving levels of economic activity. The lower provision for loan losses is also a result of a $308.5 million decrease in the overall loan portfolio from December 31, 2011 to December 31, 2012 due to
tepid loan demand. The amount of the provision for loan losses is determined based on management's analysis of amounts necessary for the allowance for loan losses which is discussed in greater detail later in the Capitol's Financial Position section of this narrative.
Total consolidated net operating revenues decreased to approximately $74.8 million in 2012, compared to $100.5 million in 2011 and $85.6 million in 2010. Noninterest income for these years was $16.9 million, $40.0 million and $21.0 million, respectively. Noninterest income was influenced by the following infrequent events in 2011 and 2010; in 2011, Capitol recorded a $16.9 million gain on exchange of trust-preferred securities (see Note K to the consolidated financial statements). In 2010, Capitol realized a gain on exchange of promissory notes for common stock of $1.3 million. When excluding each of these gains, noninterest income decreased 27.0% in 2012 compared to 2011, and increased 17.3% in 2011 compared to 2010.
Service charges on deposit accounts remained stable at approximately $2.5 million in 2012, compared with $2.7 million in 2011 and $3.0 million in 2010. Revenue from trust and wealth management activities decreased about $288,000 in 2012, or 9%, compared to 2011, following a decrease of 23% in 2011 and 15% in 2010. Large decreases in this revenue source in 2011 and 2010 were the result of lower levels of client account balances in the midst of an uncertain economic environment and declines in the value of Capitol's common stock which is held in many fee-based accounts.
Due to the nature of other categories of noninterest income, including gain on the sales of government-guaranteed loans, the origination and sale of residential mortgage loans, and other service fee income, amounts can vary significantly from year to year depending on interest rates, business opportunities and other factors.
Noninterest expense totaled $98.0 million, $121.2 million and $151.3 million in 2012, 2011 and 2010, respectively, exclusive of goodwill impairment charges of $55.8 million in 2010 (none in 2012 and 2011). Such expenses decreased 19.2% in 2012 and 19.9% in 2011, exclusive of the charges related to goodwill impairment. As previously mentioned, in mid-2009 and continuing through 2012, as part of its capital strategies and restructuring activities, Capitol selectively divested of many of its banks as a means to redeploy capital resources to the remaining banks. These restructuring activities also necessitated adjustments to Capitol's infrastructure and resulted in operating expense reductions. Capitol continued to preserve capital in 2012 by undertaking additional cost containment measures and further downsizing of its infrastructure as 52 community banks were either merged or divested of since 2009. Salary and employee benefit expenses have decreased significantly as Capitol has made infrastructure and operational changes at both the bank and corporate level. Other components of noninterest expense associated with Capitol's infrastructure and operations, such as occupancy and equipment rental and maintenance costs, remained stable in 2012 but decreased in 2011, commensurate with bank mergers and divestitures. Primarily as a result of reduced nonperforming assets, costs associated with foreclosed properties and other real estate owned decreased $11.3 million in 2012 and $10.0 million in 2011.
After performing an annual review for potential goodwill impairment in the fourth quarter of 2010, Capitol concluded that all of its recorded goodwill (approximately $64.5 million, including $8.7 million from discontinued operations) was deemed to be impaired. Accordingly, such amount was written off as of December 31, 2010.
With the exception of 2010, which included the aforementioned goodwill impairment charge, the largest component of noninterest expense is salaries and employee benefits, which approximated $41.3 million, $46.8 million and $55.1 million in 2012, 2011 and 2010, respectively. Salaries and employee benefits decreased $5.4 million, or 11.6%, in 2012, $8.3 million, or 15.1%, in 2011 and $13.2 million, or 19.3%, in 2010. As previously mentioned, employee compensation costs decreased through employee attrition and as a result of Capitol's efforts to streamline staffing at its bank and corporate offices, as well as through the mergers of banking subsidiaries in Capitol's larger markets.
Occupancy costs fluctuated within a narrow range in 2012 and 2010 and decreased $2.1 million, or 18.0%, in 2011. Equipment rent, depreciation and maintenance expense decreased $1.7 million (24.1%) in 2012, $1.2 million (14.0%) in 2011 and $7.9 million (48.6%) in 2010, primarily related to certain lease-related costs incurred in 2009 which had resulted in an increase of about 77% in that year.
Costs associated with foreclosed properties and other real estate owned declined during 2012 to $17.0 million, compared to $28.3 million in 2011 and $38.3 million in 2010. The decrease in these costs was attributed primarily to a reduction in the overall level of other real estate owned, fewer and smaller valuation adjustments associated with other real estate owned due to the gradual stabilization in values in several geographical areas, and reduced holding costs. Since its peak in 2009 of over $102 million, the level of other real estate owned has declined to $81.0 million at December 31, 2012.
Prior to April 1, 2011, FDIC insurance premiums ranged from .07% to .78% of average domestic deposits, depending on an institution's risk classification and other factors. Effective April 1, 2011, banks were assessed FDIC insurance premiums based on net assets (defined by the FDIC for assessment purposes as quarter-to-date average daily total assets less the corresponding amount of Tier 1 capital) rather than based on average deposits. Currently, base assessment rates range from .05% to .35% of net assets and may be adjusted for certain factors. Future assessment rates and methodology are difficult to predict. Capitol's FDIC insurance premiums and other regulatory fees amounted to $6.3 million in 2012, a decrease of $2.5 million, or 28.5%, compared to 2011. These costs decreased $4.2 million during 2011 and increased $2.3 million during 2010. The recent reduction in costs resulted from a steady decline in both total deposits and assets.
The more significant elements of other noninterest expense consisted of the following (in $1,000s):
Professional fees related to management of problem loans declined in 2012. However, total professional fees, including attorney and accounting fees, increased in 2012 due largely to costs directly associated with the Corporation's research, planning, and implementation of its Exchange Offer and Standby Plan for financial restructuring incurred prior to the bankruptcy filing date. Professional and attorney fees related to the restructuring incurred after the bankruptcy filing date are included in reorganization items in the consolidated financial statements. Professional services fees declined in 2011 compared to 2010, due to lower levels of nonperforming assets, reduced foreclosures and fewer bank divestitures. With the exception of insurance expense, which increased in 2011 compared to 2010 due to increased other real estate owned property insurance costs, most other components of noninterest expense detailed above have declined for two consecutive years. The declining trend is commensurate with ongoing cost containment efforts, staffing reductions and streamlining of operations, as previously discussed. The largest decline was in directors' fees which decreased $631,000 in 2012 compared to 2011, primarily as a result of the election in early 2012 by Capitol's directors to waive payment of such fees.
In 2012, 2011 and 2010, an income tax benefit from continuing operations of $152,000, $3.3 million and $7.1 million, respectively, was recognized, related primarily to the intraperiod allocation of income tax expense associated with the gain on sale of bank subsidiaries and the reversal of related income tax valuation allowances associated with the sale of these bank subsidiaries included in discontinued operations. In 2011, Capitol recorded additional income tax expense in the amount of $6.5 million for a liability pertaining to expense deductions as a result of an Internal Revenue Service examination of a prior year. The examination concluded in 2012 and the liability was determined to be $6.4 million. A valuation allowance equal to deferred income tax assets was maintained at December 31, 2012 ($190.5 million), based on management's assessment of the realizability of such assets not meeting the requisite more-likely-than-not criteria. The valuation allowance for deferred income tax assets may reduce income tax expense requirements to the extent of Capitol's profitability in future periods.
Income from discontinued operations declined for the past two years due to fewer bank divestitures occurring in each year. Gain on sales of banks of $143,000, $5.5 million and $15.8 million were realized in 2012, 2011 and 2010, respectively. Pending bank divestiture activity is discussed later in this narrative.
Consolidated total assets decreased to $1.6 billion in 2012 from $2.2 billion at the end of 2011. The 2012 decrease in total assets resulted primarily from Capitol's previously mentioned divestitures of bank subsidiaries, infrastructure downsizing and ongoing efforts to deleverage its consolidated balance sheet through reductions in portfolio loans and borrowings.
Most of the amounts discussed in this narrative are based upon the "continuing operations" of Capitol and its consolidated bank subsidiaries. Asset and liability balances as of December 31, 2011 and 2010 have been adjusted to reflect recent sales of banking subsidiaries as "discontinued operations" in order to present Capitol's financial position on a comparable basis.
Key to the balance sheet of Capitol is an understanding of its capital position in terms of stated amounts (including any deficit amounts), regulatory capital levels and ratios and the regulatory classification of Capitol and its banking subsidiaries based upon those amounts and ratios, and liquidity (cash and cash equivalents) at December 31, 2012. Those important elements are discussed in a later section of this narrative, Liquidity, Capital Resources and Capital Adequacy.
Relative to Capitol's financial position, as shown on its consolidated balance sheet, the single largest asset category is portfolio loans. Accordingly, the narrative in this section is devoted primarily to loans and related aspects of asset quality.
Net portfolio loans (total portfolio loans after deducting the allowance for loan losses) approximated $1.1 billion at December 31, 2012 and $1.4 billion at December 31, 2011 (excluding discontinued operations). These amounts approximated 70.6% of total consolidated assets (excluding discontinued operations) at December 31, 2012 and 73.2% at December 31, 2011. The decrease in net portfolio loans during 2012 was the result of normal amortization of the loan portfolio and resolutions of troubled or adversely graded loans. The decline was consistent with Capitol's efforts to deleverage its balance sheet by its discontinued operations and to preserve liquidity and capital to the extent reasonably possible.
Capitol's banking subsidiaries have focused on offering commercial loans, consistent with their emphasis on lending to local entrepreneurs, professional service firms and other businesses. All of Capitol's banks use a common credit policy; however, credit decisions are made locally at the banks. Utilization of an enterprise-wide credit policy has several key benefits, such as providing procedural guidance to the banks in the following areas:
General underwriting policies on all construction, commercial real estate, and commercial and industrial loans include analyzing and documenting:
Additional lending requirements include regulatory loan-to-value guidelines, which are calculated based on current appraised value for loans that finance properties acquired by the borrower.
Variable-rate commercial loans are preferred in the current low interest rate environment. Most variable-rate commercial loans have stated minimum interest rates and are underwritten with ongoing evaluation, including stress testing the borrower's repayment ability in an increasing rate environment. Since substantially all residential mortgage loan origination volume is underwritten to secondary-market standards and sold into those markets without recourse, Capitol and its banks have no material exposure to hybrid loans such as option-ARMs or subprime credits.
As part of the banks' emphasis on commercial lending, commercial real estate has been sought as the primary source of collateral where possible. This emphasis on commercial real estate as collateral has been a consistent practice of Capitol and its banks from their earliest days of operation, based on the use of appropriate loan-to-value ratios at the time of loan origination, avoidance of large real estate development projects and the belief that, even in volatile economies, commercial real estate historically tends to experience substantially less loss potential than other types of business-asset collateral, such as receivables, inventory and equipment, which can completely evaporate during periods of severe operational stress for small business enterprises.
Market conditions and values of real estate as collateral had deteriorated significantly, as evidenced by adverse asset quality trends since 2007, resulting in large provisions for loan losses, charge-offs of uncollectible loans and materially negative valuation adjustments of other real estate owned. Other real estate owned arises from a foreclosure proceeding or acceptance of a deed in lieu of foreclosure. Those properties are held for sale at the lower of cost or fair value, less estimated costs to sell, and are reviewed periodically for subsequent impairment.
A loan may be deemed collateral-dependent when repayment is expected solely from liquidation of the loan's collateral. Many of the banking subsidiaries' collateral-dependent impaired loans are located in real estate markets that have been depressed relative to historical valuations, such as Michigan, Arizona, Georgia and Nevada. In those markets, historic appraisal data may reflect less useful information than in other real estate markets in estimating fair value because "comparable" sale transactions, generally used as important points of reference in such appraisals, have been infrequent, may not be "orderly" and may be the result of distressed or forced sale transactions. An increasing trend of non-distressed sales has been observed in these markets, providing comparable sale data which reflects owner-user or income driven valuations. Bank regulatory agencies require Capitol's banks to base their fair value estimates upon appraisal data in substantially all valuations of real estate. As of December 31, 2012 and 2011, such estimates of fair value for collateral-dependent loans and other real estate owned were based on appraisal data or other internal valuation techniques.
Updated appraisals are generally obtained when it has been determined that a loan has become collateral-dependent. Adjustments to the loan's carrying value (or requirements for an allocation of the allowance for loan losses) are made, when appropriate, after the review of an appraisal or evaluation. The timing of when a collateral-dependent loan should be classified as a nonperforming loan is contingent upon several factors, including the performance of the loan, the borrower's payment history and/or results of the bank's review of updated borrower financial information.
When a borrower's performance has deteriorated (for example, the borrower has become delinquent on required payments, the borrower's updated financial information received indicates adverse financial trends or sales/leasing activity is less than expected in the case of multi-unit properties), the loan will be downgraded and, if appropriate, an updated appraisal will be ordered for the loan if it is deemed collateral-dependent. Non-collateral dependent loans will be included within loss contingency pools, in conjunction with estimating the bank's requirements for its allowance for loan losses. Upon receipt and review of updated appraisal data and after any further fair value analysis is completed on those loans deemed to be collateral-dependent, the loans will be further evaluated for appropriate write-down. Negative differences between appraised value, less the estimated costs to sell, and the related carrying value of the loans are charged to the allowance for loan losses, as partial write-downs/charge-offs, on a timely basis. Occasionally, additional potential loss amounts may be included if circumstances exist which may further adversely impact fair value estimates. Internally-developed evaluations may be used when the amount of a loan is less than $250,000. Internally-prepared evaluations may also be used to estimate the current valuation changes
driven by current economic conditions. Updated fair value information is generally obtained at least annually for collateral-dependent loans and other real estate owned.
A potentially negative aspect of real estate as a primary source of collateral for commercial loans, among other things, is that when some commercial loans develop performance difficulties and reach nonperforming status (i.e., become 90 days past due), the resolution period will likely involve an extended period of time due to the foreclosure process, and may be further extended if real estate sales volume is weak or nonexistent. In contrast, a commercial loan secured by receivables, inventory or equipment, which becomes nonperforming, tends to have a higher loss potential due to the probable rapid dissipation of collateral value.
At December 31, 2012, the allowance for loan losses approximated $63.5 million, or 5.26%, of total portfolio loans outstanding, compared with $85.8 million, or 5.66%, at December 31, 2011. As stated earlier, the allowance is based on significant judgment and management's analysis of inherent losses in the loan portfolio at the balance-sheet date. The level of the allowance for loan losses in recent periods, and the percentage relationship to portfolio loans, remains high due to periods of volatile economic conditions. The decrease in 2012 was the result of the noted slow but stabilizing environment, most specifically for commercial and residential real estate.
As also discussed more extensively in the Critical Accounting Policies section, which appears later in this narrative, the use of estimates in determining the adequacy of the allowance for loan losses is extremely important to an understanding of Capitol's consolidated financial statements.
Capitol had 11 separately-chartered banks at year-end 2012. Each bank separately computes and documents the adequacy of its respective allowance for loan losses. The process of evaluating and determining the adequacy of the allowance for loan losses at each individual bank and on a consolidated basis is labor intensive and requires a high degree of judgment. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions.
The allowance for loan losses reflects management's judgment of probable loan losses inherent in the loan portfolio at the balance-sheet date. Management uses a disciplined process to establish the allowance for loan losses each quarter, which includes estimating the reserves needed for each segment of the loan portfolio, including loans analyzed individually and loans analyzed on a pooled basis, for probable future losses. Loans are also categorized based on the type of collateral which secures such loans. Additions to the allowance for loan losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses, and recoveries of previously charged-off amounts are credited to the allowance for loan losses.
The establishment of the allowance for loan losses relies on a consistent estimation process that requires multiple layers of management review and judgment, and factors in changes in economic conditions, loan volume and concentrations and collateral values, among other influences. The banks' allowance for loan losses is also dependent on, and sensitive to, risk ratings assigned to all loans, especially those that are individually evaluated, as well as economic assumptions and delinquency trends driving historical loss experience. Individual loan risk ratings are evaluated based on each lending relationship and situation by experienced senior credit officers and independently reviewed on a regular basis by both internal loan review officers and external regulatory examiners to confirm compliance with applicable internal and external standards. Furthermore, management closely monitors differences between estimated and actual incurred loan losses. This monitoring process includes periodic assessments by senior management of loan portfolios and the models used to estimate incurred losses in those portfolios.
To determine the balance of the allowance for loan losses, loans are pooled by class on the basis of collateral types. Losses are modeled using historical loss experience and, in some banks, an approach called migration analysis. Capitol uses internally developed models in this process that have recently been validated by independent accounting and consulting firms for conformity with regulatory and authoritative accounting guidance or independent internal sources. The models were independently validated and reviewed to ensure that their theoretical foundation, assumptions, data integrity, computational processes, reporting practices and end-user controls are appropriate and properly documented. Management exercises significant judgment to determine the estimation method and other additional inputs in the modeling process that fit the credit risk characteristics within each portfolio segment. Management must also use judgment in establishing additional input metrics which serve to adjust the historical loss experience for qualitative environmental factors. From time to time, events or economic factors may affect the loan portfolio, causing management to provide additional amounts to or, when appropriate, release balances from the allowance for loan losses account, although at the current time a release of reserves may be prohibited and could be subject to intense regulatory scrutiny and approval.
In addition, bank regulatory agencies have the authority to review the adequacy of the allowance for loan losses during their periodic examinations of the banks, and to require changes to the recorded allowance for loan losses, superseding management's judgment. Those changes or adjustments could involve directing the banks to increase their allowance for loan losses and the banks may be required to reflect the changes or adjustments retroactively. Such changes or adjustments may be required to be made long after management completed its process for the evaluation and documentation of the adequacy of the allowance for loan losses, based on information which was not available at the time that process was completed or based solely on their judgment.
In 2011, Capitol received regulatory guidance regarding the methodology used to determine the allowance for loan losses at its three largest banks. The guidance recommended that the banks' methodology be modified such that higher loss rates, in part derived from loan charge-off history on the substandard risk-rated loan pools, be applied to the "watch" rated loans as well as the "pass" (or acceptable credit quality) rated loan pool, the largest category of loans in the banks' portfolios. Corporate management, in frequent dialogue with the regulators concerning their guidance for determining the allowance for loan losses, evaluated other methodologies permissible in accordance with regulatory pronouncements and industry practices. As a result of the evaluation, Capitol began to phase in migration analysis effective December 31, 2011. Since that time, migration analyses have been used, at least in part, to conclude on the appropriate level for the allowance for loan losses at its three largest banks. The calculations are tailored to each individual bank in order to account for loss histories and market conditions within the markets served by the bank. The time periods for the loan portfolio look-back period were selected in such a manner as to capture losses incurred based on current economic conditions.
Over the past year, an independent professional accounting and consulting firm has validated the migration technique used by Capitol's largest banks for two accounting periods (December 31, 2011 and September 30, 2012). Based on management's analysis and judgment, and supported by the external firm's validation of the migration technique and the internal validation of the historical loss approach used at the smaller banks, the Corporation believes that the methodologies used in determining the allowance for loan losses meet both regulatory guidance and requirements under United States' generally accepted accounting principles ("U.S. GAAP"), and represents management's best estimate of probable incurred losses in the consolidated loan portfolio as of December 31, 2012.
At December 31, 2012, the Corporation's largest banking affiliate, Michigan Commerce Bank ("MCB"), tested the adequacy of its allowance for loan losses using multiple techniques which included a methodology developed by the regulatory agencies and the aforementioned migration analysis. The techniques applied had produced an allowance for loan losses level that resulted in excess reserves ranging from $20.9 million to $30.2 million at December 31, 2012, with the methodology developed by the regulators resulting in a $20.9 million excess reserve. Since it is currently operating under a Consent Order, written regulatory approval is required for MCB to release any portion of its $20.9 million in excess reserves and record a negative provision for loan losses; as such the Corporation has identified the $20.9 million portion of MCB's allowance for loan losses at December 31, 2012 as unallocated. On December 22, 2012, MCB formally requested regulatory approval to decrease the unallocated portion of its allowance for loan losses. This is the third time that MCB has requested regulatory approval for a reversal. MCB believes it has complied with all requirements deemed necessary by the regulators in order to be granted such approval, including the use of the methodology developed by the regulatory agencies in determining the excess. A negative provision in the amount suggested above would have a material impact on MCB's results of operations. Reversal of excess reserves could improve MCB's capital ratio calculation to "adequately-capitalized" or potentially "well-capitalized," dependent upon the amount of the reversal. The Bank has not yet received a response to its request.
The following table summarizes portfolio loans, the allowance for loan losses and nonperforming loans for each of the banks, regionally and on a consolidated basis, as of December 31 (in $1,000s):
Nonperforming loans approximated $131.4 million and $217.9 million at December 31, 2012 and 2011, or 10.9% and 14.4% of portfolio loans, respectively. Of the nonperforming loans at December 31, 2012, approximately 91% were real-estate secured, consistent with prior years. At December 31, 2012, the Michigan-based banks held about 47.1% ($61.9 million) of Capitol's total nonperforming loans compared to 45.3% ($98.6 million) as of December 31, 2011.
In part due to a continued elevated level of nonperforming loans, higher levels of allowances for loan losses have been established for banks located in the Southeast Region, the Great Lakes Region and the Nevada Region, approximating 7.06%, 6.20% and 3.72% of portfolio loans, respectively, for each of the regions on a combined basis as of December 31, 2012.
Nonperforming loans decreased $86.5 million or 39.7% during the year ended December 31, 2012 which followed a decrease of $67.5 million or 23.7% in the corresponding period of 2011. Nonperforming loans have decreased for ten consecutive quarters. Total nonperforming assets decreased $99.8 million for the year ended December 31, 2012 which followed a decrease of $72.2 million during 2011. Management believes the overall decreases demonstrate signs of stability in several of Capitol's key markets; however, there can be no assurance that future operating results will continue to reflect these recent trends.
At December 31, 2012, the "coverage ratio" of the allowance for loan losses to nonperforming loans (i.e., the allowance as a percentage of nonperforming loans) was 48.3%, compared to 39.4% at the beginning of the year. Management views the current level of the coverage ratio as being acceptable, inasmuch as many nonperforming loans already reflect partial write-downs based on the estimated fair value of the underlying real estate for collateral-dependent nonperforming loans. Comparison of the coverage ratio of the allowance to nonperforming loans is complicated by the accounting rules for loss recognition of impaired loans. For example, when an impaired, collateral-dependent loan is evaluated based on its fair value as of a particular balance-sheet date, any estimated shortfall is typically recognized as a charge to the allowance for loan losses. As a result, many nonperforming loans are carried at a written-down level and no allowance component may be necessary at the balance-sheet date.
Directional consistency in the allowance for loan losses, loan charge-offs (including partial write-downs resulting from impairment analyses, as discussed above) and asset quality is important in evaluating the allowance for loan losses. During 2012, impaired loans decreased 23.3% from $305.0 million at December 31, 2011 to $234.0 million at December 31, 2012. The amount of the allowance for loan losses allocable to impaired loans at December 31, 2012 of $16.5 million reflected a decrease of approximately 32.5% from the year-end 2011 amount of $24.4 million. This was due to an $83.1 million (38.9%) decrease in nonaccrual loans included within impaired loans at December 31, 2012 as compared to December 31, 2011. Impaired loans which do not have an allowance requirement include collateral-dependent loans for which direct write-downs (or charge-offs) have been made and, accordingly, no allowance requirement or allocation is necessary.
Included in total impaired loans as of December 31, 2012 and 2011 is $185.0 million and $204.3 million, respectively, of loans modified as troubled debt restructurings. These loans decreased $19.4 million in 2012 mostly related to charge-offs and payments received, including loans paid in full. Troubled debt restructurings increased approximately $100 million in 2011 compared to 2010, mostly due to substandard accruing loans that were renewed, which under the new guidance issued in 2011, constituted troubled debt restructurings.
The following table presents the activity within troubled debt restructurings for the year ended December 31, 2012 (in $1,000s):
Loan modifications or restructurings are accounted for as troubled debt restructurings if, for economic or legal reasons, it has been determined a borrower is experiencing financial difficulties and the bank grants a "concession" to the borrower that it would not otherwise consider. A troubled debt restructuring may involve a modification of terms, such as a reduction of the stated interest rate or loan balance, a reduction of accrued interest, an extension of the maturity date at an interest rate lower than a current market rate for a new loan with similar risk, or some combination thereof involving a concession to the borrower in order to facilitate repayment. Loans modified and classified as troubled debt restructurings are considered impaired loans. Such loans generally remain classified as impaired until the borrower has demonstrated timely payment performance for a period of time, pursuant to the modified terms of the loan, and the loan is renewed at an interest rate that is a market rate for loans with similar risk characteristics.
In addition to the identification of nonperforming loans involving borrowers with payment performance difficulties (i.e., nonaccrual loans and loans past-due 90 days or more), management utilizes an internal loan review process to identify other potential problem loans which may warrant additional monitoring or other attention. This loan review process is a continuous activity which periodically updates internal loan ratings. When originated, all loans are individually assigned a rating which grades the credits on a risk basis, based on the financial strength of the borrower and guarantors, as well as other factors, such as the nature of the borrower's business climate, local economic conditions and other subjective factors. The loan rating process is fluid and subjective.
Potential problem loans include loans which are generally performing as agreed; however, because of loan review's and/or lending staff's risk assessment, increased monitoring is deemed appropriate (i.e., "watch" and "substandard, accrual" loans). In addition, some loans with specific performance issues or other risk factors are assigned a more adverse rating, requiring closer management attention and the development of specific remedial action plans.
At December 31, 2012, problem loans (i.e., substandard, nonaccrual loans) and potential problem loans approximated $355.4 million, or 29.5%, of total consolidated portfolio loans, whereas problem and potential problem loans, excluding nonperforming loans, approximated $224.0 million, or 18.6%, of total consolidated loans. Such loans are an important component of management's ongoing and proactive loan review activities, which are designed to early-identify loans which warrant close monitoring at both the bank and corporate credit administration levels. It is important to note that these potential problem loans do not necessarily have significant loss exposure, but rather are identified by management in this manner to aid in loan administration and risk management. These loans are considered in management's evaluation of the adequacy of the allowance for loan losses.
There are several other asset categories. Loans held for sale ($2.1 million at December 31, 2011; none at December 31, 2012) are residential mortgages which are sold into the secondary market, generally within 30-60 days of closing (discussed in more detail in the following section of this narrative). A modest amount of investment securities are also reflected on the balance sheet ($18.4 million and $17.6 million at December 31, 2012 and 2011, respectively).
Other real estate owned approximated $81.0 million at December 31, 2012, a decrease from the year-end 2011 level of $94.3 million. Other real estate owned amounts stabilized in 2011 and 2010 after a dramatic increase in 2009, primarily in Michigan and Arizona, due to borrower difficulties, foreclosures and lack of sales activity which began to improve in 2012. Other real estate owned at December 31, 2012 consisted primarily of commercial properties. Over the past several years, weaknesses in real estate market conditions for commercial and residential properties has had negative implications on sales and valuation of other real estate owned, as well as on collateral-dependent impaired loans secured by real estate. In 2012, however, Capitol and its banking subsidiaries have observed signs of stabilizing real estate values and some sales activity, although economic conditions in some regions have not fully recovered.
The following table presents the activity within other real estate owned for the year ended December 31, 2012 (in $1,000s):
Foreclosure laws in Michigan generally favor borrowers rather than lenders and, accordingly, foreclosure and redemption periods (i.e., the number of months it takes for a financial institution to obtain clear title to freely market the real estate) take much longer than in many other states. Further, once the property is available to the bank for sale or liquidation, market conditions may not be conducive to rapid marketing or near-term sale of the properties.
In a volatile economic environment, financial institution liquidity is especially important. On-balance sheet liquidity for financial institutions typically consists of cash and cash equivalents and assets which may be quickly converted to cash, such as loans held for sale and investment securities available for sale. These assets totaled $345.3 million at year-end 2012, or about 21.3% of total assets, excluding discontinued operations, and $372.1 million, or about 19.1%, at year-end 2011, both of which marked high levels of liquidity compared to previous years when capital ratios were stronger and credit risk was lower. Liquidity can vary significantly on
a daily basis, based on customer activity and funding sources. The increased liquidity position at year-end 2012 is the result of management's ongoing efforts to manage risks, tepid loan demand in some markets and changes in consumer spending habits. Liquidity is important for financial institutions because of the need to meet depositor withdrawal requests and to fund loan and various other commitments. Management believes the banks' on-balance sheet liquidity positions at December 31, 2012, along with readily available off-balance sheet sources of funding, were adequate to meet each bank's anticipated and contingency funding needs.
Most of the investment securities portfolio, approximating $15.7 million at December 31, 2012 and $14.9 million at year-end 2011, has been classified as available for sale. During 2010, approximately $26 million of investment securities were sold primarily to facilitate changes in risk management strategies and liquidity needs. In 2012 and 2011, there were no significant sales of investment securities available for sale to meet liquidity needs or for other purposes.
Capitol did not maintain any loans held for sale as of December 31, 2012 but such assets approximated $2.1 million at year-end 2011. These are residential real estate mortgages originated by the banks and subsequently sold into the secondary market, rather than being held in the banks' portfolios. Mortgage loan origination volume in 2012 decreased to approximately $22.4 million, compared to $44.4 million in 2011 ($116.8 million in 2010). Future mortgage origination volume will depend in large part on interest rates, real estate values, the strength of residential real estate market conditions and secondary market risk tolerance.
The primary source of funds for Capitol's banks is deposits. The banks rely upon interest-bearing time deposits as a key part of their funding strategy. The banks also use noninterest-bearing deposits, or checking accounts, which reduce their cost of funds. Noninterest-bearing deposits were about 20.9% of total deposits at year-end 2012 (about 17.8% at year-end 2011). This ratio is significant inasmuch as a lower percentage of noninterest-bearing deposits has the effect of increasing a bank's funding costs and, accordingly, reducing net interest income.
Capitol's banks have eliminated substantially all brokered deposits other than a small amount of Certificate of Deposit Account Registry Service ("CDARs") reciprocal deposits, which stem from larger client deposits but are classified as brokered by the FDIC for technical reasons. At year-end 2012, brokered funding totaled approximately $4.6 million (0.3% of deposits), over $4.0 million of which was CDARs reciprocal. This was much lower than the $15.1 million, or 0.8%, in brokered funding reported at year-end 2011. In the past, deposits obtained from internet-based sources (which are not classified as brokered deposits) were used to replace some maturing brokered deposits. Such funding has steadily declined for more than a year and at year-end 2012 stood at $136 million, or 8.8% of total bank funding.
To supplement their funding sources, some of the banks have lines of credit with the Federal Home Loan Bank ("FHLB") system. At year-end 2012, a total of approximately $4.9 million was borrowed under FHLB facilities ($38.0 million at year-end 2011) and additional borrowing availability approximated $113.3 million. The $33.0 million decrease in the amount of FHLB borrowings is the result of Capitol's efforts to reduce debt obligations of its banking subsidiaries and deleverage its balance sheet. Borrowings under FHLB facilities are generally at short-term market rates of interest and, although the repayment dates can be extended, are generally outstanding for brief periods of time. The FHLB may accelerate due dates of these borrowings under certain circumstances, which could have an adverse impact on liquidity.
Capitol's longer term contractual obligations are disclosed in the notes to the accompanying consolidated financial statements. At December 31, 2012, such obligations consist principally of time deposits, debt and lease obligations and trust-preferred securities, which are summarized as follows (in $1,000s):
During 2008, Capitol completed a private offering of $14 million of promissory notes which were purchased by accredited investors. The promissory notes became callable in 2010, mature in 2013 and bear interest at 9%. In 2010, Capitol converted approximately $4.6 million of those notes into approximately 1.4 million shares of common stock in a private-placement transaction.
Loan commitments of Capitol's banks (stand-by letters of credit and unfunded loans) generally expire within one year. Other than the items set forth in the table above, there are no individually material contractual obligations, such as purchase obligations.
A significant source of capital in prior years was investments in start-up banks made by community investors, or noncontrolling interests, in those subsidiaries which are consolidated for financial reporting purposes. Total noncontrolling interests, included as a component of equity, amounted to an equity deficit of $10.2 million at year-end 2012, a net increase of $9.7 million from $563,000 at year-end 2011. The net increase in 2012 of the deficit balance of noncontrolling interests resulted from operating losses and bank divestitures.
Capitol has several bank development subsidiaries, each originally capitalized with two classes of common stock, voting and nonvoting. Capitol purchased all of the initial voting shares of common stock of these entities while the nonvoting shares were sold in private offerings to accredited investors, some of whom are related parties of Capitol. Those entities had been engaged in bank development activities, through Capitol, consisting of formation and investment in start-up banks and management of their investments in young banks. Bank start-up activities were suspended in mid-2008 when the regulatory and capital raising environment for new banks became unfavorable. Each of these entities bears a similar name, Capitol Development Bancorp Limited ("CDBL"), each numbered in their sequential formation, CDBL I through CDBL VIII.
CDBL I became wholly-owned by Capitol in 2006 and CDBL II became wholly-owned in February 2007. Both were subsequently merged with and into Capitol. CDBL III ceased to be a controlled subsidiary in 2009 and, accordingly, its consolidated financial position and results of operations were deconsolidated effective September 30, 2009. Effective December 31, 2009, Capitol increased its ownership in some of the CDBLs through the conversion of intercompany indebtedness to voting common stock of the CDBLs in order to maintain a controlling (>50%) interest in anticipation of conversion of those CDBLs' nonvoting shares to voting shares. In 2011, Capitol exchanged a portion of its ownership in one of its wholly-owned banks for CDBL III shares and increased its ownership of that CDBL.
Prior to 2009, Capitol raised a total of $167 million of capital through the issuance of trust-preferred securities. Most were obtained through private placements of pooled trust-preferred securities. Trust-preferred securities are long-term debt obligations which may be treated as elements of capital for regulatory purposes. When these securities were issued, all were included as an element of the Corporation's regulatory capital. Currently, none of those securities are included due to the Corporation's capital position. As noted in the accompanying financial statements, the trusts relating to Capitol's trust-preferred securities are classified as debt obligations on the consolidated balance sheet as of December 31, 2011 and are included in liabilities subject to compromise as of December 31, 2012. Future availability of trust-preferred securities as a near-term capital resource is unlikely, due to the instability of U.S. capital markets and recent bank regulatory reform pursuant to the July 2010 Dodd-Frank Act.
In April 2009, the Corporation commenced the deferral of interest payments on its various trust-preferred securities, as is permitted under the terms of the securities, in order to conserve cash and capital resources. The payment of interest may be deferred for periods up to five years. Capitol continued to accrue interest payable on such securities until the bankruptcy filing date. Capitol is prohibited from paying dividends on its common stock while interest is being deferred on the trust-preferred securities. Payment of interest on the trust-preferred securities is also not permitted without prior approval from the Federal Reserve (see subsequent discussion in the Certain Regulatory Matters section of this narrative). Holders of the trust-preferred securities recognize current taxable income relating to the deferred interest payments.
On January 31, 2011, Capitol accepted for exchange 1,180,602 of the 2,530,000 outstanding shares of trust-preferred securities of Capitol Trust I and 773,934 of the 1,454,100 outstanding shares of trust-preferred securities of Capitol Trust XII and, pursuant to the related exchange offer, issued approximately 19.5 million previously-unissued shares of Capitol's common stock. This exchange resulted in the retirement of approximately $19.5 million aggregate liquidation amount of the trust-preferred securities on a combined basis and eliminated approximately $3.4 million of accrued interest payable associated with the retired securities, which collectively increased Capitol's equity and regulatory capital by $21.9 million, including a gain on the transaction of approximately $16.9 million.
The stockholders' equity deficit attributable to Capitol approximated $133.9 million at year-end 2012, as compared to $108.1 million at year-end 2011. Capitol's equity deficit increased by $25.8 million in 2012 due to losses incurred from operations, although the losses were less significant than in 2011, attributed primarily to lower provisions for loan losses. The equity deficit at December 31, 2012, coupled with adverse classification of Capitol and many of its banks on the basis of their regulatory capital levels, among other things, raises some level of doubt as to Capitol's ability to continue as a going concern, as discussed in the Going Concern Considerations section of this narrative. Additionally, Capitol and many of its banking subsidiaries are operating under various formal enforcement actions and informal regulatory agreements (see subsequent discussion in the Certain Regulatory Matters section of this narrative).
In April 2010, Capitol completed an offering of 2.5 million shares of previously-unissued common stock and warrants for the purchase of 1.25 million additional shares of common stock, resulting in net proceeds approximating $6.8 million with a corresponding increase to Capitol's stockholders' equity. The warrants have an exercise price of $3.50 per warrant and expire in 2013.
On June 30, 2010, Capitol issued an aggregate 95,000 shares of its Series A Noncumulative Perpetual Preferred Stock. Of that aggregate issuance, 44,020 shares were issued to a consolidated subsidiary of Capitol and, accordingly, have been eliminated in consolidation. The remaining 50,980 shares were issued to a bank-development company which is an unconsolidated affiliate of Capitol. The liquidation preference of the shares issued is $100 per share, with an aggregate issuance of $9.5 million of which $4.4 million has been eliminated upon consolidation. The Series A Preferred Stock is nonvoting and callable at Capitol's option after 36 months from the date of issuance at $100 per share, plus any accrued dividends. Dividends on such shares are payable only when and if declared by Capitol's board of directors, based on an annual rate of 6%.
Capitol and each of its bank subsidiaries are subject to a complex series of regulatory rules and requirements which require specific levels of capital adequacy at both the bank level and on a consolidated basis. Under those rules and regulations, banks and bank holding companies are categorized as "well-capitalized" or "adequately-capitalized" using several ratio measurements, including a risk-weighting approach to assets and financial commitments. Similarly, banks may further be classified as "undercapitalized," "significantly-undercapitalized," or "critically-undercapitalized." These ratio measurements, in addition to certain other requirements, are
used by regulatory agencies to determine the level of regulatory intervention and enforcement applied to financial institutions.
The following table summarizes the amounts (in $1,000s) and related ratios of Capitol's consolidated regulatory capital position at December 31, 2012, and the amounts of "deficiency" that exist between the Corporation's current deficit position and levels required in order to be considered "adequately-capitalized":
Capitol's total risk-based capital ratios at December 31, 2012 and 2011 were materially and adversely impacted by the exclusion of approximately $167.3 million and $171.5 million, respectively, of previously-qualifying Tier 2 capital, inasmuch as Tier 2 capital is limited to 100% of Tier 1 capital, primarily trust-preferred securities and a portion of the allowance for loan losses. The Tier 1 capital deficit resulted mostly from operating losses. Capitol's Tier 1 capital will need to increase to a positive level in order to allow for the inclusion of trust-preferred securities in Tier 2 capital for regulatory capital computation purposes.
The preceding summary indicates that Capitol, on a consolidated basis, was classified as less than "adequately-capitalized" at December 31, 2012 for regulatory purposes. As indicated above, such classification is based upon certain stated ratio minimums at the "adequately-capitalized" level.
Several of Capitol's bank subsidiaries had capital levels resulting in classification as "undercapitalized" or "significantly-undercapitalized" at December 31, 2012. Banks and bank holding companies which are less than "adequately-capitalized" are subject to increased regulatory oversight, intervention, requirements and limitations. Regarding banks classified as "undercapitalized" or "significantly-undercapitalized," or otherwise noncompliant with formal enforcement actions and informal regulatory agreements, management is taking appropriate
action to improve such capital classifications and related compliance in the future, subject to the availability of capital and continued cooperation by regulatory agencies.
The following comparative analysis summarizes each bank's regulatory capital position as of December 31:
Footnotes to regulatory capital position:
Future regulatory capital compliance, classification and related ratios are difficult to predict and are subject to significant contingencies. There is also no assurance that regulatory agencies may not impose higher ratio thresholds at any time.
After the filing of the December 31, 2012 call reports, the FDIC sent letters to 1st Commerce Bank, Central Arizona Bank, Pisgah Community Bank and Sunrise Bank, indicating that the use of capital notes for the period ending December 31, 2012 was being disallowed and the banks were directed to re-file their call reports. The banks have appealed this determination and are awaiting a decision from the FDIC.
Subsequent to the letter directive, the FDIC conducted a visitation of the above-mentioned banks and determined that each bank was considered "critically-undercapitalized" as of the exam date. Capitol intends to inject the necessary capital into these bank affiliates to cure the capital deficiency as of March 31, 2013, but this potential transaction is subject to regulatory approval.
Proceeds from the sale of banks in 2012 have been deployed as additional capital in Capitol's remaining banks pursuant to requirements imposed by the FDIC. Capitol anticipates augmenting the capital levels of its less than "adequately-capitalized" bank subsidiaries further through allocation of proceeds from additional pending divestitures of certain bank subsidiaries. Management is pursuing various strategies to increase Capitol's Tier 1 capital, including raising capital through potential equity transactions and other initiatives, as discussed further on page F-43.
In September 2009, Capitol and its second-tier bank holding companies entered into an agreement with the Federal Reserve Bank of Chicago (the "Reserve Bank") under which Capitol agreed to refrain from the following actions without the prior written consent of the Reserve Bank: (i) declare or pay dividends; (ii) receive dividends or any other form of payment representing a reduction in capital from Michigan Commerce Bank, or from any of its subsidiary institutions that are subject to any restriction by the institution's federal or state regulator that limits the payment of dividends or other intercorporate payments; (iii) make any distributions of interest, principal, or other sums on subordinated debentures or trust-preferred securities; (iv) incur, increase or guarantee any debt; or (v) purchase or redeem any shares of the stock of Capitol, the second-tier bank holding companies, nonbank subsidiaries or any of the subsidiary banks that are held by shareholders other than Capitol.
In addition, Capitol agreed to: (i) submit to the Reserve Bank a written plan to maintain sufficient capital at Capitol on a consolidated basis and at Michigan Commerce Bank (as Capitol's largest bank subsidiary and a separate legal entity on a stand-alone basis); (ii) notify the Reserve Bank no more than 30 days after the end of any quarter in which Capitol's consolidated or Michigan Commerce Bank's capital ratios fall below the approved capital plan's minimum ratios as well as if any subsidiary institution's ratios fall below the minimum ratios required by the institution's federal or state regulator; (iii) review and revise its ALLL methodology for loans held by Capitol and submit to the Reserve Bank a written program for
maintenance of an adequate ALLL for loans held by Capitol; (iv) take all necessary actions to ensure each of its subsidiary institutions comply with Federal Reserve regulations; (v) refrain from increasing any fees or charging new fees to any subsidiary institution without the prior written consent of the Reserve Bank; (vi) submit to the Reserve Bank a written plan to enhance the consolidated organization's risk management practices, a strategic plan to improve the consolidated organization's operating results and overall condition, and cash flow projections; (vii) comply with laws and regulations regarding senior executive officer positions and severance payments; and (viii) provide quarterly reports to the Reserve Bank regarding these undertakings.
Many of Capitol's bank subsidiaries have entered into formal enforcement actions (as well as informal agreements) with their applicable regulatory agencies. Those enforcement actions provide for certain restrictions and other guidelines and/or limitations to be followed by the banks. The banks generally subject to such enforcement actions are noted as such in the regulatory capital summary appearing on page F-36 of this document. In all instances where Capitol or its banks are subject to formal enforcement actions or informal agreements, corporate and/or bank management, as the case may be, and their boards of directors are fully committed and working proactively towards achieving compliance with those enforcement actions and improving their entity's financial condition.
The FDIC may issue Prompt Corrective Action Notifications ("PCAN") to banking subsidiaries falling below the "adequately-capitalized" regulatory-capital classification, and subsequently may issue Prompt Correction Action Directives ("PCAD"). PCADs may be issued when a bank, which has previously received a PCAN, has submitted two consecutive capital restoration plans which have been rejected by the FDIC.
Capitol's banking subsidiaries which have received a PCAD are as follows (listed in descending order based on total assets):
These banks are striving to develop and implement capital restoration plans which may be acceptable to the FDIC. Typically a capital plan is not deemed acceptable by the FDIC until receipt of the planned capital funds is imminent.
On September 20, 2012, the State of New Mexico Regulation and Licensing Department, Financial Institutions Division (the "New Mexico FID") issued a written notice of its intention to take possession and control of Sunrise Bank of Albuquerque and its assets for the purpose of the reorganization or liquidation through receivership if certain findings of the New Mexico FID were not corrected by December 20, 2012. In the event that such a reorganization or
liquidation of Sunrise Bank of Albuquerque had taken place, the FDIC would have experienced losses in connection with such failure and such losses could have been assessed against the Corporation's other depository institution subsidiaries. Such liability would likely have had a material adverse effect on the financial condition of any assessed subsidiary institution and on the Corporation as the common parent. In February 2013, Capitol provided Sunrise Bank of Albuquerque with a $1 million capital injection to raise the Bank's capital level to 4.00% and thus satisfied the New Mexico FID mandate. The Bank continues to provide banking services in a normal manner, including maintaining FDIC insurance for its depositors. However, if the Bank's capital level falls below 4.00% in future quarters, the New Mexico FID may reissue a notice of intent to take possession.
Generally, banks are subject to cross-guaranty liability regarding other financial institutions the FDIC determines are commonly controlled by any multibank holding company. Pursuant to federal regulations, an insured depository institution may be liable for any loss the FDIC has incurred or expects to incur in connection with the failure of a former affiliate institution and, if the FDIC determines that remaining affiliates have a liability to the FDIC, then they would be required to pay that liability to the FDIC. Payment of a cross-guaranty liability to the FDIC could have a material adverse impact on the results of operations, capital adequacy and financial position of Capitol and its banking subsidiaries. To date, none of Capitol's subsidiary banks have received any notice of assessment of cross-guaranty liability. Capitol's banks have, however, received notice from the FDIC that the FDIC may assess a cross-guaranty liability relating to a failed community bank in Florida which ceased operations in November 2009. The FDIC alleges that the Florida bank was an affiliated institution of Capitol, although Capitol owned no securities of that bank or otherwise controlled the failed institution. At the time the Florida bank ceased operations, the FDIC estimated the aggregate loss to the FDIC Bank Insurance Fund to be $23.6 million. Previously, the FDIC had until November 2011, two years from the date of such notice, to determine whether to assess that potential cross-guaranty liability, if any. In November 2011, the FDIC and Capitol's banks entered into a mutual tolling agreement, which both extends the ability of the FDIC to impose the cross-guaranty liability, and extends the statute of limitations for the banks to take action against the FDIC for two additional years, ending in November 2013.
In addition to the previously mentioned potential cross-guaranty liability, some of Capitol's banking subsidiaries were advised in December 2009 that, to mitigate the effects of any possible assessment arising from potential cross-guaranty liability, they should develop a plan to arrange a sale, merger or recapitalization such that Capitol no longer controls the bank. This guidance was preceded by Capitol's previously announced plans to selectively divest some of its bank subsidiaries in conjunction with reallocating capital resources to its remaining banks. Capitol's pending divestitures are subject to regulatory approval which may take an extended period of time to obtain.
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was signed into law and is significantly impacting the regulation of financial institutions and the financial services industry. The Dodd-Frank Act includes provisions affecting large and small financial institutions alike, including several provisions that will profoundly affect how community banks, thrifts, and smaller bank holding companies
will be regulated in the future. Among other things, these provisions abolished the Office of Thrift Supervision and transferred its functions to the other federal banking agencies, relaxed rules regarding interstate branching, allowed financial institutions to pay interest on business checking accounts, changed the scope of FDIC insurance coverage and imposed new capital requirements on bank holding companies including the removal of trust-preferred securities as a permitted component of a holding company's Tier 1 capital, following a three-year phase-in period beginning January 1, 2013. The Dodd-Frank Act also establishes the Bureau of Consumer Financial Protection as an independent entity within the Federal Reserve, which was given the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks. Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards affecting, among other things, originator compensation, minimum repayment standards and prepayments. Management is continuing to evaluate the provisions of the Dodd-Frank Act and assess its probable impact on the Corporation's business, financial condition and results of operations. However, the ultimate effect of the Dodd-Frank Act on the financial services industry in general, and on the Corporation in particular, currently remains uncertain.
One particularly important aspect of the Dodd-Frank Act (as amended) is that certain trust-preferred securities issued by bank holding companies with total assets less than $10 billion, such as Capitol, are permitted to be included as an element of qualifying capital for regulatory capital-adequacy purposes. Accordingly, Capitol's trust-preferred securities may be included in regulatory capital measurements in the future, subject to certain limitations, although none of those securities are currently included, as discussed earlier.
In December 2010, the Basel Committee on Banking Supervision, an international forum for cooperation on banking supervisory matters, announced the "Basel III" capital rules, which set new capital requirements for banking organizations. On June 7, 2012, the Federal Reserve Board requested comment on three proposed rules that, taken together, would establish an integrated regulatory capital framework implementing the Basel III regulatory capital reforms in the United States. Comments were accepted through October 22, 2012, but to date final rules have not been issued. As proposed, the U.S. implementation of Basel III would lead to significantly higher capital requirements and more restrictive leverage and liquidity ratios than those currently in place. Once adopted, these new capital requirements would be phased in over time. Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust-preferred securities as Tier 1 capital would be phased out over a ten-year period. The ultimate impact of the U.S. implementation of the new capital and liquidity standards to Capitol and its affiliate banks will depend upon the final rules. If Capitol's planned recapitalization, restructure and bulk disposition of nonperforming loans proceed as planned, management expects that the consolidated entity and individual affiliate banks will immediately have significantly lower credit risk and sufficient Tier 1 equity to exceed minimum regulatory standards including new deductions, limitations and capital conservation buffers proposed to be phased in between 2013 and 2019. At this point, however, Capitol is unable to determine the ultimate effect that any final regulations, if enacted, would have upon its earnings or financial position.
An Internal Revenue Service ("IRS") examination which commenced in 2011 has concluded. On October 11, 2012, the IRS issued a written letter to Capitol stating that the congressional Joint Committee on Taxation took no exception with the findings of the IRS pursuant to an examination report which denied the deductibility of certain expenses on the Corporation's 2009 income tax return.
In December 2011, Capitol recorded a liability approximating $6.5 million as a result of the preliminary findings of this examination, which pertained primarily to expense deductions claimed in 2009 relating to problem loans and other real estate owned. The final liability was adjusted down to $6.4 million in 2012 at the conclusion of the audit. Pursuant to the examination, these expenses will be deductible by Capitol over a period of three years, beginning with the 2010 income tax return. Potential interest charges related to the final assessed liability have been estimated at $422,000 which Capitol recorded in other noninterest expense in 2012. Since Capitol had already recorded a liability upon the preliminary findings, the conclusions of this IRS examination did not have a material impact on Capitol's consolidated financial statements as of December 31, 2012. On March 1, 2013, the Office of the Chief Counsel – Internal Revenue Service concluded that, in large part, the banking industry's treatment of deducting other real estate owned expenses for tax purposes was appropriate. This ruling could result in a $1.5 million reduction to Capitol's $6.4 million tax liability for expense deductions taken in 2009 related to other real estate owned activities.
Capitol received a final notice of taxes due from the State of Michigan related to the Michigan Business Tax. The notice, dated September 25, 2012, pertained to the year ended December 31, 2009 and indicated an amount due of $771,000, including penalties and interest. Included in this notice, and in response to the Corporation's filing for reorganization, the State alleged that Capitol had not properly computed and filed its 2009 Michigan Business Tax return. Capitol received an earlier notice from the State of Michigan, dated September 21, 2012, claiming additional tax was due for the year ended December 31, 2010 in the amount of $202,000, including penalties and interest. In response to these notices, Capitol filed a Petition with the Michigan Tax Tribunal on October 30, 2012, formally appealing the 2009 findings and stating that all required returns were properly filed and all associated Michigan Business Tax due was paid. In addition, Capitol also requested an informal hearing with the State in regard to the 2009 and 2010 returns, which has been granted, but not yet scheduled.
Further, the State of Michigan filed an objection to the confirmation of Capitol's Joint Plan of Reorganization with the Court on September 5, 2012, in which it alleged the Corporation has outstanding, unfiled Michigan Business Tax returns for 2009, 2010 and 2011, and owes $1.0 million in unpaid taxes, interest and penalties; Capitol believes this alleged amount due is inclusive of the amounts reflected in the two notices subsequently received by Capitol. Capitol responded to the State's objection by filing a reply with the Court on October 8, 2012, in which the Corporation submitted that all required returns for 2009, 2010 and 2011 were properly filed and all tax due was paid.
In July 2011, Capitol adopted a Tax Benefits Preservation Plan (the "Plan") designed to preserve substantial tax assets. Capitol's tax attributes include net operating losses that could be utilized in certain circumstances to offset future taxable income and to reduce federal income tax liability. Capitol's ability to use these tax attributes would be substantially limited if there were an "ownership change" as defined under Section 382 of the Internal Revenue Code and related IRS pronouncements. In accordance with the provisions of the Plan, Capitol's board of directors declared a dividend of one preferred share purchase right for each outstanding share of its common stock distributable to shareholders of record as of August 1, 2011, as well as to holders of common stock issued subsequent to that date, which would only be activated if triggered under the Plan.
The Plan is designed to reduce the likelihood that Capitol will experience an ownership change by discouraging any person from becoming a 5-percent shareholder. There is no guarantee, however, that the Plan will prevent Capitol from experiencing an ownership change.
The issuance of the preferred share purchase rights will not affect Capitol's reported per-share results and is not taxable to Capitol or its shareholders.
As of December 31, 2012, there are several significant adverse aspects of Capitol's consolidated financial position and results of operations which include, but are not limited to, the following:
The foregoing considerations raise some level of doubt (potentially substantial doubt) as to the Corporation's ability to continue as a going concern.
Capitol has commenced several initiatives and other actions to mitigate these going concern considerations and to improve the Corporation's financial condition, equity, regulatory capital and regulatory compliance. In early 2011, a partial exchange of trust-preferred securities was completed and the Corporation's stockholders approved an amendment to the articles of incorporation to increase its authorized common stock and authorize its board of directors to proceed with a rights offering and reverse stock split, in addition to a potential share-exchange regarding second-tier bank-development subsidiaries.
Improvement in Capitol's and its banking subsidiaries' capitalization, financial position, asset quality and results of operations requires multi-faceted efforts, which are currently being pursued aggressively in the following areas, among others:
Capitol's ability to continue as a going concern is contingent on the successful achievement of the items listed above. Capitol's board of directors and management are fully engaged and committed to successful completion of those items, with a clear sense of urgency, subject to the availability of capital and continued cooperation by regulatory agencies.
The most significant trends which can impact the financial condition and results of operations of financial institutions are changes in market rates of interest and changes in general economic conditions.
Quantitative and Qualitative Disclosure About Market Risk
Changes in interest rates, either up or down, have an impact on net interest income (plus or minus), depending upon the direction and timing of such changes. At any point in time, there is an imbalance between interest rate-sensitive assets and interest rate-sensitive liabilities. This means that when interest rates change, the timing and magnitude of the effect of such interest rate changes can alter the relationship between asset yi