First Business Financial Services (FBIZ)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

ANNUAL REPORT PURSUANT TO

SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

Commission file number 0-51028

 

FIRST BUSINESS FINANCIAL SERVICES, INC.

 

 

(608) 238-8008

Registrant’s telephone number, including area code

 

Securities registered pursuant to Section 12(b) of the Act:

 

Common Stock, $0.01 par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  o Yes  þ No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  o Yes  þ No

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  þ Yes  o No

 

Indicate by check mark if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this From 10-K or any amendment to this Form 10-K.  o 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

o Large accelerated filer     o Accelerated filer     þ Non-accelerated filer

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  o Yes  þ No

 

The aggregate market value of the common equity held by non-affiliates computed by reference to the closing price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter was approximately $59.4 million.

 

As of March 12, 2007, 2,498,171 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III – Portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on May 7, 2007 are incorporated by reference into Part III hereof.

 

 

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Table of Contents

 

 

General

 

First Business Financial Services, Inc. (“FBFS” or “the Corporation”) is a registered bank holding company incorporated under the laws of the State of Wisconsin and is engaged in the commercial banking business through its wholly-owned banking subsidiaries First Business Bank and First Business Bank – Milwaukee (referred to as “the Banks”). All of the operations of FBFS are conducted through the Banks and certain subsidiaries of First Business Bank. The Corporation operates as a business bank focusing on delivering products and services to small and medium size businesses. The Corporation does not utilize its locations to attract retail customers. FBFS seeks to provide lending, leasing and deposit products as well as trust and investment services to local businesses, business owners, executives, professionals and high net worth individuals. The Corporation generally targets businesses with sales between $2 million and $50 million. For a more detailed discussion of loans, leases and the underwriting criteria of the Banks, see “Lending and Leasing Activities” in this section. To supplement its business banking deposit base, the Corporation utilizes wholesale funding alternatives to fund a portion of the Corporation’s assets.

 

First Business Bank (“FBB”) is a state bank that was chartered in 1909 under the name Kingston State Bank. In 1990, FBB relocated its home office to Madison, Wisconsin, opened a banking facility in University Research Park, and began focusing on providing high-quality banking services to small and medium-sized businesses located in Madison and the surrounding area. First Business Bank offers a full line of commercial banking products and services in the greater Madison, Wisconsin area, tailored to meet the specific needs of businesses, business owners, executives, professionals and high net worth individuals. FBB’s product lines include cash management services, commercial lending, commercial real estate lending and equipment leasing. FBB also offers trust and investment services through First Business Trust & Investments (“FBTI”), a division of FBB. In addition, FBB offers business owners, executives, professionals and high net worth individuals consumer services including a variety of deposit accounts, personal lines of credit and personal loans. In addition to the Madison locations FBB opened a loan production office in Oshkosh, Wisconsin in September, 2006 to serve the Oshkosh and the surrounding area.

 

FBB has two wholly owned subsidiaries that are complementary to the Corporation’s business banking services. First Business Capital Corp. (“FBCC”) is a wholly-owned subsidiary of FBB operating as an asset-based commercial lending company specializing in providing secured lines of credit as well as term loans on equipment and real estate assets primarily to manufacturers and wholesale distribution companies located throughout the United States. First Business Leasing, LLC (“FBL”) is a commercial equipment finance company specializing in financing of general equipment to small and middle market companies throughout the United States.

 

First Madison Investment Corp. (“FMIC”) and FMCC Nevada Corp. (“FMCCNC”) are operating subsidiaries located in and formed under the laws of the state of Nevada. FMIC was organized for the purpose of managing a portion of the Bank’s investment portfolio. FMIC invests in marketable securities and loans purchased from FBB. FMCCNC, a wholly-owned subsidiary of FBCC, invests in loans purchased from FBCC.

 

First Business Bank – Milwaukee (“FBB – Milwaukee”) is a state bank that was chartered in 2000 in Wisconsin. FBB – Milwaukee also offers a wide range of commercial banking products and services tailored to meet the specific needs of businesses, business owners, executives, professionals and high net worth individuals in the greater Milwaukee, Wisconsin area through a single location in Brookfield, Wisconsin. Like FBB, FBB – Milwaukee’s product lines include cash management services, commercial lending and commercial real estate lending for similar sized businesses as FBB. FBB – Milwaukee also offers trust and investment services through a trust service office agreement with FBB. FBB – Milwaukee also offers business owners, executives, professionals and high net worth individuals consumer services which include a variety of deposit accounts, personal lines of credit, and personal loans.

 

In June 2000, FBFS purchased a 51% interest in The Business Banc Group Ltd. (“BBG”), a corporation formed to act as a bank holding company owning all the stock of a Wisconsin chartered bank to be newly organized and headquartered in Brookfield, a suburb of Milwaukee, Wisconsin. In June 2004

all shares of BBG stock were successfully exchanged for FBFS stock pursuant to a conversion option. Subsequent to this transaction, BBG was dissolved. This transaction resulted in FBB – Milwaukee becoming a wholly-owned subsidiary of the Corporation.

 

In December 2001, FBFS formed FBFS Statutory Trust I (“Trust”), a statutory trust organized under the laws of the State of Connecticut and a wholly-owned financing subsidiary of FBFS. In December 2001, the Trust issued $10.0 million in aggregate liquidation amount of floating rate trust preferred securities in a private placement offering. These securities mature 30 years after issuance and are callable at face value after five years. The Trust used the proceeds from the offering to purchase $10.3 million of 3 month LIBOR plus 3.60% Junior Subordinated Debentures (the “Debentures”) of the Corporation. In December 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51, Revised” (“FIN 46 R”) to provide guidance on how to identify a variable interest entity and determine when an entity needs to be included in a company’s consolidated financial statements. As a result of the adoption of FIN 46R in 2004, the Trust was no longer consolidated by FBFS. On December 18, 2006 the Corporation exercised its right to redeem the Debentures purchased by the Trust. The Trust subsequently redeemed the preferred securities and the Trust was closed. See Note 11 to the consolidated financial statements.

 

Available Information

 

The Corporation maintains a web site at www.fbfinancial.com. This Form 10-K and all of the Corporation’s filings under the Exchange Act are available through that web site, free of charge, including copies of annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, on the date that the Corporation files those materials with, or furnishes them to, the Securities and Exchange Commission.

 

Employees

 

At December 31, 2006, FBFS had 130 employees which include 112 full-time equivalent employees. No employee is covered by a collective bargaining agreement, and we believe our relationship with our employees to be excellent.

 

Supervision and Regulation

 

Below is a brief description of certain laws and regulations that relate to the Corporation and the Banks. This narrative does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.

 

General

 

The Banks are chartered in the State of Wisconsin and are subject to regulation and supervision by the Division of Wisconsin Banking Review Board (the “Division”), and more specifically the Wisconsin Department of Financial Institutions (“WDFI”), and are subject to periodic examinations. Review of fiduciary operations is included in the periodic examinations. The Banks’ deposits are insured by the Deposit Insurance Fund (“DIF”). The DIF is administered by the Federal Deposit Insurance Corporation (“FDIC”), and therefore the Banks are also subject to regulation by the FDIC. Periodic examinations of both Banks are also conducted by the FDIC. The Banks must file periodic reports with the FDIC concerning their activities and financial condition and must obtain regulatory approval prior to entering into certain transactions such as mergers with or acquisitions of other depository institutions and opening or acquiring branch offices. This regulatory structure gives the regulatory authorities extensive direction in connection with their supervisory and enforcement activities and examination policies, including policies regarding the classification of assets and the establishment of adequate loan and lease loss reserves.

 

Wisconsin banking laws restrict the payment of cash dividends by state banks by providing that (i) dividends may be paid only out of a bank’s undivided profits, and (ii) prior consent of the Division is required for the payment of a dividend which exceeds current year income if dividends declared have exceeded net profits in either of the two immediately preceding years. The various bank regulatory agencies have authority to prohibit a bank regulated by them from engaging in an unsafe or unsound

practice; the payment of a dividend by a bank could, depending upon the circumstances, be considered as such. In the event that (i) the FDIC or the Division should increase minimum required levels of capital; (ii) the total assets of the Banks increase significantly; (iii) the income of the Banks decrease significantly; or (iv) any combination of the foregoing occurs, then the Boards of Directors of the Banks may decide or be required by the FDIC or the Division to retain a greater portion of the Banks’ earnings, thereby reducing dividends.

 

The Banks are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to their parent holding company, FBFS. Also included in this act are restrictions on investments in stock or other securities of FBFS and on taking of such stock or securities as collateral for loans to any borrower. Under this act and regulations of the Federal Reserve Board, FBFS and its Banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or any property or service.

 

The Corporation

 

FBFS is a financial holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and is subject to regulation, supervision, and examination by the Board of Governors of the Federal Reserve System (the “FRB”). The Corporation is required to file an annual report with the FRB and such other reports as the FRB may require. Prior approval must be obtained before the Corporation may merge with or consolidate into another bank holding company, acquire substantially all the assets of any bank or bank holding company, or acquire ownership or control of any voting shares of any bank or bank holding company if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank or bank holding company.

 

In reviewing applications for such transactions, the FRB considers managerial, financial, capital and other factors, including financial performance of the bank or banks to be acquired under the Community Reinvestment Act of 1977, as amended (the “CRA”). Also, under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended, state laws governing interstate banking acquisitions subject bank holding companies to some limitations in acquiring banks outside of their home state without regard to local law.

 

The Gramm-Leach Bliley Act of 1999 (the “GLB”) eliminates many of the restrictions placed on the activities of bank holding companies. Bank holding companies such as FBFS can expand into a wide variety of financial services, including securities activities, insurance, and merchant banking without the prior approval of the FRB.

 

Sarbanes-Oxley Act of 2002.  The Sarbanes-Oxley Act was established to provide a comprehensive framework for the modernization and reform of the oversight of public company auditing, to improve the quality and transparency of financial reporting by such companies, and to strengthen the independence of auditors. The Act stemmed from the systemic and structural weaknesses identified in the capital markets in the United States and perceptions that such structural weakness contributed to recent corporate scandals. The legislation’s significant reforms are listed below.

 

 

 

Effective August 29, 2002, as prescribed by Sections 302(a) and 906 (effective July 29, 2002) of Sarbanes-Oxley, a public company’s CEO and CFO are each required to certify that the company’s quarterly and annual reports do not contain any untrue statements of a material fact and that the financial statements, and other financial information included in each such report, fairly present in all material respects the financial condition, results of operations and cash flows of the company for the periods presented in that report.

 

Section 404 of Sarbanes-Oxley, which does not become effective for the Corporation until the filing of its annual report for the year ended December 31, 2007, requires that management certify that they (i) are responsible for establishing, maintaining, and regularly evaluating the effectiveness of the Corporation’s internal controls; (ii) have made certain disclosures to the Corporation’s auditors and the audit committee of the Corporation’s board of directors (the “Board”) about the Corporation’s internal controls; and (iii) have included information in the Corporation’s quarterly and annual reports about their evaluation and whether there have been significant changes in the Corporation’s internal controls or in other factors that could significantly affect internal controls subsequent to such evaluation. The Corporation intends to be prepared for timely compliance with these requirements.

 

The Banks

 

As state-chartered DIF-insured banks, the Banks are subject to extensive regulation by the WDFI and the FDIC. Lending activities and other investments must comply with federal statutory and regulatory requirements. This federal regulation establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the DIF, the FDIC, and depositors.

 

Insurance of Deposits.  The Banks’ deposits are insured under the DIF of the FDIC. The Basic insurance coverage is up to $100,000. Depositors may qualify for additional coverage if the deposit accounts are in different ownership categories. In addition, federal law provides up to $250,000 in coverage for self-directed retirement accounts. The FDIC assigns institutions to a particular capital group based on the levels of the Banks’ capital – “well-capitalized,” “adequately capitalized,” or “undercapitalized.” These three groups are then divided into three subgroups reflecting varying levels of supervisory concern, ranging from those institutions considered to be healthy to those that represent substantial supervisory concern. The result is nine assessment risk classifications, with well-capitalized, financially sound institutions paying lower rates than those paid by undercapitalized institutions that pose a risk to the insurance fund.

The Banks’ assessment rate depends on the capital category to which they are assigned. Assessment rates for deposit insurance currently range from 0 to 27 basis points. The Banks are well capitalized. The supervisory subgroup to which the Banks are assigned by the FDIC is confidential and may not be disclosed. The Banks’ rate of deposit insurance assessments will depend upon the category or subcategory to which the Banks are assigned. Any increase in insurance assessments could have an adverse affect on the earnings of the Banks.

 

Regulatory Capital Requirements.  The FRB monitors the capital adequacy of the Banks, since on a consolidated basis, they have assets in excess of $500.0 million. A combination of risk-based and leverage ratios are determined by the FRB. Failure to meet these capital guidelines could result in supervisory or enforcement actions by the FRB. Under the risk-based capital guidelines, different categories of assets, including certain off-balance sheet items, such as loan commitments in excess of one year and letters of credit, are assigned different risk weights, with perceived credit risk of the asset in mind. These risk weighted assets are calculated by assigning risk-weights to corresponding asset balances to determine the risk-weight of the entire asset base. Total capital, under this definition, is defined as the sum of “Tier 1” and “Tier 2” capital elements, with Tier 2 capital being limited to 100% of Tier 1 capital. Tier 1 capital, with some restrictions, includes common stockholders’ equity, any perpetual preferred stock, qualifying trust preferred securities, and minority interests in any unconsolidated subsidiaries. Tier 2 capital, with certain restrictions, includes any perpetual preferred stock not included in Tier 1 capital, subordinated debt, any trust preferred securities not qualifying as Tier 1 capital, specific maturing capital instruments and the allowance for loan and lease losses (limited to 1.25% of risk-weighted assets). The regulatory guidelines require a minimum total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 capital. The FRB also has a leverage ratio requirement which is defined as Tier 1 capital divided by average total consolidated assets. The minimum leverage ratio required is 3%.

The Corporation and the Banks’ actual capital amounts and ratios are presented in the table below and reflect the Banks’ well-capitalized positions.

 

 

Prompt Corrective Action.  The Banks are also subject to capital adequacy requirements under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), whereby the Banks could be required to guarantee a capital restoration plan, should they become “undercapitalized” as defined by FDICIA. The maximum liability under such a guarantee would be the lesser of 5% of the Banks’ total assets at the time they became undercapitalized or the amount necessary to bring the Banks into compliance with the capital restoration plan. The Corporation is also subject to the “source of strength doctrine” per the FRB, which requires that holding companies serve as a source of “financial and managerial” strength to their subsidiary banks.

 

If banks fail to submit an acceptable restoration plan, they are treated under the definition of “significantly undercapitalized” and would thus be subject to a wider range of regulatory requirements and restrictions. Such restrictions would include activities involving asset growth, acquisitions, branch establishment, establishment of new lines of business and also prohibitions on capital distributions, dividends and payment of management fees to control persons, if such payments and distributions would cause undercapitalization.

 

The following table sets forth the FDIC’s definition of the five capital categories, in the absence of a specific capital directive.

 

 

 

 

Limitations on Dividends and Other Capital Distributions.  Federal and state regulations impose various restrictions or requirements on state-chartered banks with respect to their ability to pay dividends or make various other distributions of capital. Generally, such laws restrict dividends to undivided profits or profits earned during preceding periods. Also, FDIC insured institutions may not pay dividends while undercapitalized or if such a payment would cause undercapitalization. The FDIC also has authority to prohibit the payment of dividends if such a payment constitutes an unsafe or unsound practice in light of the financial condition of a particular bank. At December 31, 2006, subsidiary unencumbered retained earnings of approximately $30.5 million could be transferred to the Corporation in the form of cash dividends without prior regulatory approval, subject to the capital needs of each subsidiary.

 

Liquidity.  The Banks are required by federal regulation to maintain sufficient liquidity to ensure safe and sound operations. Management believes that its Banks have an acceptable liquidity percentage to match the balance of net withdrawable deposits and short-term borrowings in light of present economic conditions and deposit flows.

 

Federal Reserve System.  The Banks are required to maintain non-interest bearing reserves at specified levels against their transaction accounts and non-personal time deposits. As of December 31, 2006, the Banks were in compliance with these requirements. Because required reserves must be maintained in the form of cash or non-interest bearing deposits at the FRB, the effect of this requirement is to reduce the Banks’ interest-earning assets.

 

Federal Home Loan Bank System.  The Banks are members of the FHLB of Chicago. The FHLB serves as a central credit facility for its members. The FHLB is funded primarily from proceeds from the sale of obligations of the FHLB system. It makes loans to member banks in the form of FHLB advances. All advances from the FHLB are required to be fully collateralized as determined by the FHLB.

 

As a member, each Bank is required to own shares of capital stock in the FHLB in an amount equal to the greatest of $500, 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year, or 20% of its outstanding advances. The FHLB also imposes various limitations on advances relating to the amount and type of collateral, the amount of advances and other items. At December 31, 2006, the Banks owned a total of $2.0 million in FHLB stock and were in compliance with their respective requirements. The Banks received combined dividends from the FHLB totaling $82,000 for fiscal 2006 as compared to $138,000 for fiscal 2005.

 

In 2006 the FHLB announced the decision to allow redemptions of excess or “voluntary” stock by its members at selected dates as determined by the FHLB. The FHLB believes this action will help ensure an adequate capital base as it continues serving housing finance needs of its members. Voluntary stock is stock held by members beyond the amount required as a condition of membership or to support advance borrowings. As of December 31, 2006 the Banks held $165,000 of voluntary stock.

 

Restrictions on Transactions with Affiliates.  The Banks’ loans to their own and the Corporation’s executive officers, directors and owners of greater than 10% of any of their respective stock (so-called “insiders”) and any entities affiliated with such insiders are subject to the conditions and limitations under Section 23A of the Federal Reserve Act and the Federal Reserve Bank’s Regulation O. Under these regulations, the amount of loans to any insider is limited to the same limit imposed in the

loans-to-one borrower limits of the respective Banks. All loans to insiders must not exceed the Banks’ unimpaired capital and unimpaired surplus. Loans to executive officers, other than loans for the education of the officers’ children and certain loans secured by the officers’ residence, may not exceed the greater of $25,000 or 2.5% of the Banks’ unimpaired capital and unimpaired surplus, and may never exceed $100,000. Regulation O also requires that loans to insiders must be approved in advance by a majority of the Board of Directors, at the bank level. Such loans, in general, must be made on substantially the same terms as, and with credit underwriting procedures no less stringent than those prevailing at the time for, comparable transactions with other persons.

 

The Banks can make exceptions to the foregoing procedures if they offer extensions of credit that are widely available to employees of the Banks and that do not give any preference to insiders over other employees of the Banks.

 

Community Reinvestment Act.  The Community Reinvestment Act (“CRA”) requires each Bank to have a continuing and affirmative obligation in a safe and sound manner to help meet the credit needs of its entire community, including low and moderate income neighborhoods. Federal regulators regularly assess the Banks’ record of meeting the credit needs of their respective communities. Applications for additional acquisitions would be affected by the evaluation of the Banks’ effectiveness in meeting its CRA requirements.

 

Riegle Community Development and Regulatory Improvement Act of 1994.  Federal regulators have adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate risk, asset growth, asset quality, earnings and compensation, fees, and benefits. These guidelines require, in general, that appropriate systems and practices are in place to identify and manage the risks and exposures specified by the guidelines. Such prohibitions include excessive compensation when amounts paid appear to be unreasonable or disproportionate to the services performed by executive officers, employees, directors or principal shareholders.

 

USA PATRIOT Act of 2001.  The USA PATRIOT Act requires banks to establish anti-money laundering programs; to establish due diligence policies, procedures, and controls with respect to private banking accounts and correspondent banking accounts involving foreign individuals and specific foreign banks; and to avoid establishing, maintaining, administering or managing correspondent accounts in the United States for or on behalf of foreign banks that maintain no presence in any country. Additionally, the USA PATRIOT Act encourages cooperation among financial institutions, regulatory authorities, and law enforcement with respect to individuals or organizations that could reasonably be suspected of engaging in terrorist activities. Federal regulators have begun proposing and implementing regulations in efforts to interpret the USA PATRIOT Act. The Banks must comply with Section 326 of the Act which provides for minimum procedures in the verification of identification of new customers.

 

Commercial Real Estate Guidance.  On December 12, 2006, the FDIC and the Federal Reserve Board issued joint guidance entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” (the “CRE Guidance”). The CRE Guidance provides supervisory criteria, including the following numerical indicators, to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny: (1) commercial real estate loans exceed 300% of capital and increased 50% or more in the preceding three years, or (2) construction and land development loans exceed 100% of capital. The CRE Guidance does not limit banks’ levels of commercial real estate lending activities but rather guides institutions in developing risk management practices and levels of capital that are commensurate with the level and nature of their commercial real estate concentrations. Based on our current loan portfolio the CRE Guidance applies to the Banks. We believe that we have taken appropriate precautions to address the risks associated with our concentrations in commercial real estate lending. We do not expect the Guidance to adversely affect our operations or our ability to execute our growth strategy.

 

Changing Regulatory Structure.  Regulation of the activities of national and state banks and their holding companies imposes a heavy burden on the banking industry. The FRB, FDIC, and WDFI all have extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. These agencies can assess civil monetary penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such

actions. Moreover, the authority of these agencies has expanded in recent years, and the agencies have not yet fully tested the limits of their powers.

 

The laws and regulations affecting banks and financial or bank holding companies have changed significantly in recent years, and there is reason to expect changes will continue in the future, although it is difficult to predict the outcome of these changes. From time to time, various bills are introduced in the United States Congress with respect to the regulation of financial institutions. Certain of those proposals, if adopted, could significantly change the regulation of banks and the financial services industry.

 

Monetary Policy.  The monetary policy of the FRB has a significant effect on the operating results of financial or bank holding companies and their subsidiaries. Among the means available to the FRB to affect the money supply are open market transactions in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid on deposits.

 

Executive Officers of the Registrant

 

The following contains certain information about the executive officers of FBFS. There are no family relationships between any directors or executive officers of FBFS.

 

Corey A. Chambas, age 44, has served as Chief Executive Officer of the Corporation since December, 2006, as President of the Corporation since February, 2005, and as a Director since July, 2002. He served as Chief Operating Officer of the Corporation from February, 2005 to September, 2006, and as Executive Vice President of the Corporation from July, 2002 to February, 2005. He served as Chief Executive Officer of First Business Bank from July, 1999 to September, 2006 and as President of First Business Bank from July, 1999 to February, 2005. He currently serves as a Director of First Business Bank-Milwaukee, First Business Leasing, LLC, First Business Capital Corp, First Madison Investment Corp. and FMCC Nevada Corp.

 

James F. Ropella, age 47, has served as Senior Vice President and Chief Financial Officer of the Corporation since September, 2000. Mr. Ropella also serves as the Chief Financial Officer of the subsidiaries of the Corporation. He currently serves as a Director of First Madison Investment Corp. and FMCC Nevada Corp.

 

Joan A. Burke, age 55, has served as President of First Business Bank’s Trust Division since September, 2001. Prior to that, from November, 1996 to May, 2001, Ms. Burke was the President, Chief Executive Officer and Chairperson of the Board of Johnson Trust Company and certain of its affiliates.

 

Mark J. Meloy, age 45, was elected President and a Director of First Business Bank in September, 2006. He served as Executive Vice President of First Business Bank from September, 2004 to September, 2006. He served as President and Chief Executive Officer of First Business Bank-Milwaukee from January, 2003 to October, 2004, and as a Director from November, 2002 to October, 2004. From November, 2002 to December 2002, he served as Executive Vice President and Chief Operating Officer of First Business Bank-Milwaukee. From April 2000, to November, 2002 he served as Senior Vice President and Senior Lending Officer at First Business Bank. He currently serves as a Director of First Business Leasing, LLC and First Business Capital Corp.

 

Michael J. Losenegger, age 49, was elected Chief Operating Officer of the Corporation in September, 2006. He was also elected Chief Executive Officer of First Business Bank in September, 2006. He was elected President and a Director of First Business Bank in February, 2005. He served as Chief Operating Officer of First Business Bank from September, 2004 to February, 2005. He served as Senior Vice President-Business Development from February, 2003 to September, 2004. Prior to that, from March, 1989 to January, 2003, Mr. Losenegger served as Assistant Vice President and Vice President and Senior Vice President of Lending at M&I Bank in Madison, Wisconsin. He currently serves as a Director of First Business Leasing, LLC and First Business Capital Corp.

 

Charles H. Batson, age 53, joined the Corporation and was elected President and Chief Executive Officer of First Business Capital Corp. in January, 2006. Prior to joining the Corporation, from February

1986 to December, 2005, Mr. Batson served as Vice President and Business Development Manager for Wells Fargo Business Credit, Inc. He currently serves as a Director of First Business Capital Corp.

 

The following risks and uncertainties should be carefully read and considered because they could materially and adversely affect our business, financial condition, results of operations and prospects.

 

Competition.  The Banks encounter strong competition in attracting commercial loan, equipment finance and deposit clients as well as trust and investment clients . Such competition includes banks, savings institutions, mortgage banking companies, credit unions, finance companies, equipment finance companies, mutual funds, insurance companies, brokerage firms and investment banking firms. The Banks’ market areas include branches of several commercial banks that are substantially larger in terms of loans and deposits. Furthermore, tax exempt credit unions operate in most of the Banks’ market areas and aggressively price their products and services to a large portion of the market. The Banks also compete with regional and national financial institutions, many of which have greater liquidity, higher lending limits, greater access to capital, more established market recognition and more resources and collective experience than the Banks. The Corporation’s profitability depends upon the Banks’ continued ability to successfully maintain and increase market share.

 

Government Regulation and Monetary Policy.  The Corporation’s businesses are subject to extensive state and federal government supervision, regulation, and control. Existing state and federal banking laws subject the Corporation to substantial limitations with respect to loans, purchases of securities, payment of dividends and many other aspects of the Corporation’s businesses. See “Supervision and Regulation.” There can be no assurance that future legislation or government policy will not adversely affect the banking industry or the operations of the Corporation. In addition, economic and monetary policy of the Federal Reserve may increase the Corporation’s cost of doing business and affect its ability to attract deposits and make loans.

 

Key Personnel.  The Corporation’s success has been and will be greatly influenced by its continuing ability to retain the services of its existing senior management and, as it expands, to attract and retain additional qualified senior and middle management. The unexpected loss of services of any of the key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on the Corporation’s business and financial results.

 

Technology.  The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving clients, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Corporation’s future success will depend in part on its ability to address the needs of its clients by using technology to provide products and services that will satisfy client demands for convenience as well as create additional efficiencies in the Corporation’s operations. A number of the Corporation’s competitors have substantially greater resources to invest in technological improvements. There can be no assurance that the Corporation will be able to implement new technology-driven products and services to its clients.

 

Market Area.  One of the primary focal points of the Banks’ business development and marketing strategy is serving the needs of growing, small to medium-sized businesses. The origination of loans secured by real estate and business assets of those businesses is the Banks’ primary business and the principal source of profits. If client demand for such loans decreases, the Banks’ income could be affected because alternative investments, such as securities, typically earn less income than such loans. Client demand for these loans could be reduced by a weaker economy, an increase in unemployment, a decrease in real estate values, or an increase in interest rates. Any factors that would adversely affect commercial real estate values in Dane, Waukesha and Winnebago Counties in Wisconsin and surrounding areas in general could be expected to have a similar effect on the earnings and growth potential of the Corporation.

 

The principal factors that are used to attract core deposit accounts and that distinguish one financial institution from another include rates of return, types of accounts, service fees, convenience of office locations and hours and quality of service to the depositors. The primary factors in competing for commercial loans are interest rates, loan fee charges, loan structure and timeliness and quality of service to the borrower.

Most of the Banks’ loans are to businesses located in or adjacent to Dane and Waukesha Counties in Wisconsin. Any general adverse change in the economic conditions prevailing in these areas could reduce the Banks’ growth rate, impair their ability to collect loans or attract deposits, and generally have an adverse impact on the results of operations and financial condition of the Corporation. If this region experienced adverse economic, political or business conditions, the Banks would likely experience higher rates of loss and delinquency on their loans than if their loans were geographically more diverse.

 

Loan Portfolio Risk.  The Banks originate commercial mortgage, construction, multi-family, 1-4 family, commercial, asset-based, consumer loans, and leases, all of which are primarily within their respective market areas. Such loans expose a lender to greater credit risk than the home mortgages which form a greater part of the business of many commercial banks, because the collateral securing these loans may not be sold as easily as residential real estate. These loans also have greater credit risk than residential real estate for the following reasons:

 

 

Environmental Risk.  The Banks encounter certain environmental risks in their lending activities. Under federal and state law, lenders may become liable for costs of cleaning up hazardous materials found on secured properties. Certain states may also impose liens with higher priorities than first mortgages on properties to recover funds used in such efforts. The Banks attempt to control their exposure to environmental risks with respect to loans secured by larger properties by monitoring available information on hazardous waste disposal sites and occasionally requiring environmental inspections of such properties prior to closing the loan, as warranted. No assurance can be given, however, that the value of properties securing loans in the Banks’ portfolio will not be adversely affected by the presence of hazardous materials or that future changes in federal or state laws will not increase the Banks’ exposure to liability for environmental cleanup.

 

Loan and Lease Loss Allowance Risk.  As lenders, the Banks are exposed to the risk that our loan and lease clients may not repay their loans and leases according to their terms and that the collateral securing the payment of these loans and leases may be insufficient to assure repayment. The Banks may experience significant loan and lease losses which could have a material adverse impact on operating results. There is a risk that various assumptions and judgments about the collectibility of the loan and lease portfolios made by management could be formed from inaccurately assessed conditions leading to and related to such judgments and assumptions. Those assumptions and judgments are based, in part, on assessment of the following conditions:

 

 

The Banks maintain an allowance for loan and lease losses to cover probable losses inherent in the loan and lease portfolios. Additional loan and lease losses will likely occur in the future and may occur at a rate greater than that experienced to date. An analysis of the loan and lease portfolios, historical loss experience and an evaluation of general economic conditions are all utilized in determining the size of the allowance. Additional adjustments may be necessary to allow for unexpected volatility or deterioration in the local or national economy. If material additions must be made to the allowance, this would materially decrease net income. Additionally, regulators periodically review the allowance for loan and lease losses or identify further loan or lease charge-offs to be recognized based on judgments different from those of management. Any increase in the loan or lease allowance or loan or lease charge-offs as required by regulatory agencies could have a material adverse impact on net income.

 

Interest Rate Risk.  The Corporation is subject to interest rate risk. Changes in the interest rate environment may reduce the Corporation’s profits. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing

liabilities. They are also affected by the proportion of interest-earning assets that are funded by interest-bearing liabilities. Loan volume and yield are affected by market interest rates on loans, and rising interest rates are generally associated with a lower volume of loan originations. There is no assurance that the Corporation can minimize its interest rate risk. In addition, a rise in the general level of interest rates may adversely affect the ability of certain borrowers to pay their obligations if the reason for that rise in rates is not a result of a general expansion of the economy. Accordingly, changes in levels of market interest rates could materially and adversely affect the Corporation’s net interest spread, asset quality, loan origination volume and overall profitability.

 

Trust Operations Risk.  The Corporation is subject to trust operations risk related to performance of fiduciary responsibilities. Clients may make claims and take legal action pertaining to the Corporation’s performance of its fiduciary responsibilities. Whether client claims and legal action related to the Corporation’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Corporation, they may result in significant financial liability and/or adversely affect the market perception of the Corporation and its products and services, as well as impact client demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.

 

None

 

At December 31, 2006, the Banks conducted business from their full service offices located in Madison, Wisconsin at 401 Charmany Drive and in Brookfield, Wisconsin located at 18500 W. Corporate Drive. The Banks lease their full-service offices and these leases expire in 2016 and 2010, respectively. FBB conducts trust and investment business from a limited purpose branch located at 3500 University Avenue, Madison, Wisconsin. Office space is also leased in Burnsville, Minnesota, Independence, Ohio and Oshkosh, Wisconsin under short-term lease agreements which have terms of less than one year. See Note 8 to the Consolidated Financial Statements for more information regarding the premises and equipment. See Note 14 to the Consolidated Financial Statements for more information regarding the operating lease agreements.

 

Management believes that no litigation is threatened or pending in which the Corporation faces potential loss or exposure which could materially affect the Corporation’s consolidated financial position, consolidated results of operations or cash flows. Since the Corporation’s subsidiaries act as depositories of funds and trust agents, they could occasionally be named as defendants in lawsuits involving claims to the ownership of funds in particular accounts. This and other litigation is incidental to the Corporation’s business.

 

No matters were submitted to a vote of security holders during the fourth quarter of 2006.

PART II.

 

The common stock of the Corporation is traded on the Nasdaq National Market under the symbol “FBIZ”. At March 1, 2007, there were approximately 539 shareholders of record of FBFS common stock.

 

The following table presents the range of high and low closing sale prices of our common stock for each quarter within the two most recent fiscal years, according to information available, and cash dividends declared for the years ended December 31, 2006 and 2005, respectively.

 

 

The timing and amount of future dividends are at the discretion of the Board of Directors of the Corporation (the “Board”) and will depend upon the consolidated earnings, financial condition, liquidity and capital requirements of the Corporation and its subsidiaries, the amount of cash dividends paid to the Corporation by its subsidiaries, applicable government regulations and policies and other factors considered relevant by the Board. The Board anticipates it will continue to pay quarterly dividends in amounts determined based on the above factors. Dividends are subject to restrictions tied to the Banks’ earnings. See “Supervision and Regulation – The Banks – Limitations on Dividends and Other Capital Distributions” under Item 1 of Part I.

 

The Corporation did not purchase or sell any FBFS common stock during the quarter ended December 31, 2006.

Performance Graph

 

The performance graph below compares the cumulative total shareholder return on First Business Financial Services, Inc. common stock with the cumulative total return on the equity securities of companies included in NASDAQ’s Composite and the SNL NASDAQ Bank Index. The graph assumes an investment of $100 on October 7, 2005, the first day the Company stock was traded on NASDAQ, and reinvestment of dividends on the date of payment without commissions. The performance graph represents past performance and should not be considered to be an indication of future performance.

 

 

 

Five Year Comparison of Selected Consolidated Financial Data

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Statements

 

When used in this report, and in any oral statements made with the approval of an authorized executive officer, the words or phrases “may,” “could,” “should,” “hope,” “might,” “believe,” “expect,” “plan,” “assume,” “intend,” “estimate,” “anticipate,” “project,” “will likely result,” or similar expressions are intended to identify “forward-looking statements.” Such statements are subject to risks and uncertainties, including, without limitation, changes in economic conditions in the market area of First Business Bank (“FBB”) or First Business Bank – Milwaukee (“FBB – Milwaukee”), changes in policies by regulatory agencies, fluctuation in interest rates, demand for loans in the market area of FBB or FBB – Milwaukee, borrowers defaulting in the repayment of loans and competition. These risks could cause actual results to differ materially from what FBFS has anticipated or projected. These risk factors and uncertainties should be carefully considered by potential investors. Investors should not place undue reliance on any such forward-looking statements, which speak only as of the date made. The factors described within this Form 10-K could affect the financial performance of FBFS and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods.

 

Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, FBFS cautions that, while its management believes such assumptions or bases are reasonable and are made in good faith, assumed facts or bases almost always vary from actual results, and the differences between assumed facts or bases and actual results can be material, depending on the circumstances. Where, in any forward-looking statement, an expectation or belief is expressed as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will result in, or be achieved or accomplished.

 

FBFS does not intend to update any forward-looking statements, whether written or oral, to reflect change. Furthermore, FBFS specifically disclaims any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

 

The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of FBFS for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto and the Selected Consolidated Financial Data presented herein.

 

Overview

 

The principal business of FBFS is conducted by FBB and FBB – Milwaukee and consists of a full range of financial services focusing on small and medium-sized businesses. Products include commercial lending, asset-based lending, leasing, trust and investment services and a broad range of deposit products. The profitability of FBFS depends primarily on its net interest income, provision for loan and lease losses, non-interest income, and non-interest expenses. Net interest income is the difference between the income FBFS receives on its loans, leases and investment securities, and its cost of funds, which consists of interest paid on deposits and borrowings. The provision for loan and lease losses reflects the cost of credit risk in the loan and lease portfolio of FBFS. Non-interest income consists of service charges on deposit accounts, securities gains, loan and lease fees, trust fees, brokerage and investment income, and other income. Non-interest expenses include salaries and employee benefits, occupancy, equipment expenses, professional services, marketing expenses, and other non-interest expenses.

 

Net interest income is dependent on the amounts of and yields on interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities. Net interest income is sensitive to changes in market rates of interest and the asset/liability management procedures used by FBFS in responding to such changes. The provision for loan and lease losses is dependent upon the credit quality of loans and leases and management’s assessment of the collectibility of loans and leases under current economic conditions. Non-interest expenses are influenced by the growth of operations, with additional

employees necessary to staff such growth. Growth in the number of relationships directly affects such expenses as data processing costs, supplies, postage, and other miscellaneous expenses.

 

In the following discussion, as required by generally accepted accounting principles, FBFS’s interest income, interest expense, provision for loan and lease losses, net interest income, non-interest income, non-interest expense and income tax expense include 100% of the amounts reported by BBG for the periods and as of the dates stated, although FBFS owned only 51% of the outstanding shares of BBG stock through June 1, 2004. FBFS’s net income is reported net of an adjustment to reflect the 49% outstanding minority interests of BBG. As of June 1, 2004, FBFS owned 100% of the shares of BBG. BBG was subsequently dissolved and as a result FBB – Milwaukee became a direct wholly-owned subsidiary of FBFS. See “Item 8 – Financial Statements and Supplementary Data.”

 

Recent Developments

 

Tax Audit.  Like the majority of financial institutions located in Wisconsin, FBB transferred investment securities and loans to out-of-state investment subsidiaries. FBB’s Nevada investment subsidiaries now hold and manage these assets. The investment subsidiaries have not filed returns with, or paid income or franchise taxes to, the State of Wisconsin. The Wisconsin Department of Revenue (the “Department”) implemented a program to audit Wisconsin financial institutions which formed investment subsidiaries located outside of Wisconsin, and the Department has generally indicated that it intends to assess income or franchise taxes on the income of the out-of-state investment subsidiaries of Wisconsin financial institutions. FBB has received a Notice of Audit from the Department that would cover years 1999 through 2002 and would relate primarily to the issue of income of the Nevada subsidiaries. During 2004, the Department offered a blanket settlement agreement to most banks in Wisconsin having Nevada investment subsidiaries. The Department has not issued an assessment to FBB, but the Department has stated that it intends to do so if the matter is not settled.

 

Prior to the formation of the investment subsidiaries FBB sought and obtained private letter rulings from the Department regarding the non-taxability of income generated by the investment subsidiaries in the State of Wisconsin. FBB believes it complied with Wisconsin law and the private rulings received from the Department. Should an assessment be forthcoming, FBB intends to defend its position vigorously through the normal administrative appeals process in place at the Department and through other judicial channels should they become necessary. Although FBB will vigorously oppose any such assessment there can be no assurance that the Department will not be successful in whole or in part in its efforts to tax the income of FBB’s Nevada investment subsidiary. FBB has accrued, as a component of current state income tax expense, an estimated liability including interest which is the most likely amount within a range of probable settlement amounts. FBFS does not expect the resolution of this matter to materially affect its consolidated results of operations and financial position beyond the amounts accrued. Should the Department be wholly successful in its efforts to tax the income of the Nevada investment subsidiaries then future cash flow would be negatively affected by as much as $3.1 million.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the financial position or results of operations for FBFS. Actual results could differ from those estimates. Please refer to Note 1 to the Consolidated Financial Statements for a discussion of the most significant accounting policies followed by FBFS. Discussed below are certain policies that are critical to FBFS. Management views critical accounting policies to be those which are highly dependent on subjective or complex judgments, estimates, and assumptions, and where changes in those estimates and assumptions could have a significant impact on the financial statements.

 

Allowance for Loan and Lease Losses.  The allowance for loan and lease losses represents management’s recognition of the risks of extending credit and its evaluation of the quality of the loan and lease portfolio and as such, requires the use of judgment as well as other systematic objective and quantitative methods. The risks of extending credit and the accuracy of management’s evaluation of the

quality of the loan and lease portfolio are neither static nor mutually exclusive and could result in a material impact on the Corporation’s financial statements. Management could over-estimate the quality of the loan and lease portfolio resulting in a lower allowance for loan and lease losses than necessary, overstating net income and equity. Conversely, management could under-estimate the quality of the loan and lease portfolio, resulting in a higher allowance for loan and lease losses than necessary, understating net income and equity. The allowance for loan and lease losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs, net of recoveries. Management estimates the allowance balance required and the related provision for loan and lease losses based on quarterly evaluations of the loan and lease portfolio, with particular attention paid to loans and leases that have been specifically identified as needing additional management analysis because of the potential for further problems. During these evaluations, consideration is also given to such factors as the level and composition of impaired and other non-performing loans and leases, historical loss experience, results of examinations by regulatory agencies, independent loan and lease reviews, the market value of collateral, the strength and availabilities of guarantees, concentration of credits and other factors. Allocations of the allowance may be made for specific loans or leases, but the entire allowance is available for any loan or lease that, in management’s judgment, should be charged off. Loan and lease losses are charged against the allowance when management believes that the un-collectibility of a loan or lease balance is confirmed. See Note 7 to the Consolidated Financial Statements for further discussion of the allowance for loan and lease losses.

 

Historical loss rates for the various classifications and pools of loans and leases may be adjusted by management from time to time for significant factors that, in management’s judgment, reflect the effect of current conditions on loss recognition. The loss rates used also consider the imprecision in estimating losses on individual loans and leases or pools of loans and leases.

 

Management also continues to pursue all practical and legal methods of collection, repossession and disposal, and adheres to high underwriting standards in the origination process in order to continue to maintain strong asset quality. Although management believes that the allowance for loan and lease losses is adequate based upon current evaluation of loan and lease delinquencies, non-performing assets, charge-off trends, economic conditions and other factors, there can be no assurance that future adjustments to the allowance will not be necessary. Should the quality of loans or leases deteriorate, then the allowance for loan and lease losses would be expected to increase relative to total loans and leases. When loan or lease quality improves, then the allowance would be expected to decrease relative to total loans and leases.

 

Income Taxes.  FBFS and its wholly owned subsidiaries file a consolidated Federal income tax return and separate state tax returns. Subsidiaries for which FBFS’s interest is less than 80% file a separate Federal tax return from FBFS. Deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The determination of current and deferred income taxes is based on complex analyses of many factors, including the interpretation of Federal and state income tax laws, the difference between the tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts currently due or owed, such as the timing of reversals of temporary differences and current accounting standards. The Federal and state taxing authorities who make assessments based on their determination of tax laws periodically review the Corporation’s interpretation of Federal and state income tax laws. Tax liabilities could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities based on the completion of taxing authority examinations. FBFS accrues through its current income tax provision the amounts it deems probable of assessment related to federal and state income tax expenses. Such accruals would be reduced when such taxes are paid or reduced by way of a credit to the current income tax provision when it is no longer probable that such taxes will be paid. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred taxes is recognized in income in the period that includes the enactment date. FBFS and its subsidiaries have State of Wisconsin net operating loss (“NOL”) carryforwards as of December 31, 2006 of approximately $36.2 million, which expire in years 2012 through 2021. See Note 15 to the Consolidated Financial Statements for further discussion of income taxes.

 

FBFS has made its best estimates on valuation allowances needed for deferred tax assets on certain net operating loss carryforwards and other temporary differences and has made its best estimate of

the probable loss related to a state tax exposure matter. These estimates are subject to changes. Changes in these estimates could adversely affect future consolidated results of operations. Through 2003, BBG, which was consolidated by FBFS for financial reporting, but not tax purposes, had NOL carryforwards that were generated in 2000 through 2002, the first three years of BBG’s existence. Realization of the net deferred tax assets related to such NOLs over time was dependent upon BBG generating sufficient taxable income in future periods. Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes, requires establishment of a valuation allowance reserve for some portion or all of the NOLs if it is more likely than not that sufficient taxable income will not be generated in future periods to utilize the NOLs before they expire. FBFS has determined the benefit of these NOL carryforwards to be probable of realization in full based upon the profitability of FBB – Milwaukee, the significant reduction in non-performing loans, the ability of FBFS to sell earning assets to FBB – Milwaukee, the achievement of a growth in earning assets sufficient to forecast future earnings more than sufficient to utilize the full NOL, and the length of the remaining life of the NOL carryforwards which range from 10 to 12 years.

 

As noted elsewhere herein, in June 2004, BBG shareholders completed the exchange of their 49% minority ownership in BBG to FBFS for shares of FBFS. This event resulted in FBFS owning 100% of BBG shares. BBG was subsequently dissolved and as a result, FBB – Milwaukee became a direct wholly-owned subsidiary of FBFS. Since 2004, FBFS has filed a consolidated Federal tax return with FBB – Milwaukee enabling the usage of FBB – Milwaukee’s NOL carryforwards to offset consolidated taxable income, subject to certain IRS annual limitations. This event increases further the probability that all of the benefits related to these NOL carryforwards will be fully realized. FBFS will continue to evaluate the probability of the usage of the NOL carryforwards and if in the future it is no longer deemed more likely than not that the benefit of the NOL carryforwards will be realized, then a valuation allowance will be established through a charge to income tax expense. At December 31, 2006, $497,000 of the BBG NOL remains unused.

 

Valuation of Securities.  The Corporation’s available-for-sale security portfolio is reported at fair value. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Available-for-sale securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the credit worthiness of the issuer and the Corporation’s intent and ability to hold the security to maturity. A decline in value that is considered to be other-than-temporary is recorded as a loss within non-interest income in the Consolidated Statements of Income. See Note 6 to the Consolidated Financial Statements for further discussion of securities.

 

The Corporation infrequently sells securities available for sale. During 2006 the Corporation sold one security with no sales in 2005 or 2004. The Corporation holds debt securities of the U.S. Government and collateralized mortgage obligations. The fair value of these securities is affected mostly by changes in interest rates. It is the Corporation’s intent and ability to hold securities with unrealized losses until maturity or until recovery of any unrealized losses.

 

Lease Residuals.  The Corporation leases machinery and equipment to clients under leases which qualify as direct financing leases for financial reporting and as operating leases for income tax purposes. Under the direct financing method of accounting, the minimum lease payments to be received under the lease contract, together with the estimated unguaranteed residual value (approximating 3 to 15% of the property cost of the related equipment), are recorded as lease receivables when the lease is signed and the lease property is delivered to the client. Residual value is the estimated fair market value of the equipment on lease at lease termination. In estimating the equipment’s fair value, the Corporation relies on historical experience by equipment type and manufacturer published sources of used equipment prices, internal evaluations and, where available, valuations by independent appraisers, adjusted for known trends. The Corporation’s estimates are reviewed regularly to ensure reasonableness; however, the amounts the Corporation will ultimately realize could differ from the estimated amounts. Where declines in residual amounts are estimated to be other-than-temporary , the residual amount is reduced and a loss is recorded. See Note 7 to the Consolidated Financial Statements for further discussion of leases and lease residuals.

Derivatives.  The Corporation uses derivative instruments, principally interest rate swaps, to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows.

 

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, requires all derivative instruments to be carried at fair value on the balance sheet. The accounting for the gain or loss due to changes in the fair value of the derivative instrument depends on whether the derivative instrument qualifies as a hedge. If the derivative instrument does not qualify as a hedge, the gains or losses are reported in earnings when they occur. However, if the derivative instrument qualifies as a hedge the accounting varies based on the type of risk being hedged.

 

Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under SFAS No. 133. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows or other types of forecasted transactions, are considered cash flow hedges. The Corporation, at the inception of the hedge, formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking each hedge transaction.

 

SFAS No. 133 requires that at the inception of each hedge and at least quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivative instruments have been highly effective in offsetting changes in the fair values or cash flows of the hedged items and whether they are expected to be highly effective in the future. If it is determined that a derivative instrument has not been or will not continue to be highly effective, hedge accounting is discontinued. Thereafter, the derivative instrument would continue to be marked to market with changes in fair value charged or credited to earnings.

 

For fair value hedges, gains or losses on derivative hedging instruments are recorded in earnings. In addition, gains or losses on the hedged item are recognized in earnings in the same period and the same income statement line as the change in fair value of the derivative. Consequently, if gains or losses on the derivative hedging instrument and the related hedged item do not completely offset, the difference (i.e. the ineffective portion of the hedge) is recognized currently in earnings.

 

For cash flow hedges, the reporting of gains or losses on derivative hedging instruments depends on whether the gains or losses are effective at offsetting the cash flows of the hedged item. The effective portion of the gain or loss is accumulated in other comprehensive income and recognized in earnings during the period that the hedged forecasted transaction affects earnings. The ineffective portion of the hedge is recognized currently in earnings.

 

When available, the fair values of derivatives and the hedged assets or liabilities are obtained from third party sources. Such fair values are based upon interest rates using discounted cash flow modeling techniques in the absence of market quotes. Therefore, management must make estimates regarding the amount and timing of cash flows, which are susceptible to significant change in future periods based upon changes in interest rates. The assumptions used by management in the cash flow models are based on yield curves, forward yield curves and implied volatilities observable in the cash and derivatives markets. The pricing models are validated periodically by testing through comparison with other third parties. See Note 18 to the Consolidated Financial Statements for further discussion of derivatives.

 

At December 31, 2006, there are no fair value hedges and there is one cash flow hedge. The interest rate swap designated as a cash flow hedge has a negative fair value of $5,000 and $14,000 at December 31, 2006 and 2005, respectively.

 

Goodwill and Other Intangible Assets.  Goodwill was recorded as a result of the acquisition of BBG on June 1, 2004, the purchase price of which exceeded the fair value of the net assets acquired. Goodwill is reviewed at least annually for impairment. This review requires judgment. If goodwill is determined to be impaired, a reduction in value would be expensed in the period in which it became impaired. See Note 4 to the Consolidated Financial Statements for further discussion of goodwill and other intangibles.

Judgment is also used in the valuation of other intangible assets consisting of a core deposit intangible and a client list from a purchased brokerage/investment business. Core deposit intangibles were recorded for core deposits acquired in the BBG acquisition which was accounted for as a purchase business combination. The core deposit intangible assets were recorded under the presumption that they provide a more favorable source of funding than wholesale borrowings. An intangible asset was recorded for the present value of the difference between the expected interest to be incurred on these deposits and interest expense that would be expected if these deposits were replaced by wholesale borrowings, over the expected lives of the core deposits. The current estimate of the underlying lives of core deposits is fifteen years and ten years for the client list. If it is determined that the deposits or the client list have shorter lives, the assets will be adjusted and an expense will be recorded for the amount that is impaired.

 

Results of Operations
Comparison of the Years Ended December 31, 2006 and 2005

 

General.  Net income decreased $1.1 million to $3.7 million for the year ended December 31, 2006 from $4.8 million in the same period of 2005. The year ended December 31, 2006 included an increase in interest expense of $10.0 million, an increase of $1.1 million in provision for loan and lease losses and an increase of $1.3 million in non-interest expenses. The year ended December 31, 2005 included a gain on the sale of the 50% equity investment in a leasing joint venture, m² of $973,000. These components that caused a decrease in net income were partially offset by increases in interest income of $11.2 million and trust and investment services fee income of $311,000 and a decrease in income tax expense of $774,000. The returns on average assets and average stockholders’ equity for the year ended December 31, 2006 were 0.54% and 8.65%, respectively, as compared to 0.78% and 11.79%, respectively, for the same period in 2005.

 

Net Interest Income.  Net interest income increased $1.2 million, or 6.7%, to $19.0 million for the year ended December 31, 2006 from $17.8 million for the same period in 2005. The improvement in net interest income was due to an increase in average earning assets partially offset by a decrease in net interest margin. Net interest margin decreased to 2.87% for the year ended December 31, 2006 from 3.03% in the same period of 2005. The decrease in the net interest margin was the result of the increase in yields paid on interest-bearing liabilities outpacing the increase in yields earned on interest-bearing assets. This was also reflected in the decrease in the interest rate spread to 2.44% for the year ended December 31, 2006 from 2.62% for the same period in 2005.

 

Interest income on total interest-earning assets increased $11.2 million to $47.7 million for the year ended December 31, 2006 from $36.5 million for the same period in 2005. In particular, interest income on loans and leases increased $10.4 million to $43.5 million as of the year ended December 31, 2006 from $33.1 million for the same period of 2005 due to an increase of $64.4 million, or 13.0%, in average loans and leases outstanding accompanied by an increase in average yields earned on loans and leases to 7.75% from 6.68% principally caused by the change in market rates. The average balance of loans and leases increased to $560.8 million for the year ended December 31, 2006 from $496.4 million for the same period in 2005. The increase was driven largely by growth in mortgage loans which includes commercial real estate, construction, multi-family and 1-4 family loans partially offset by decreases in leases. Growth in total average mortgage loans amounted to $44.8 million, or 13.6%. Average commercial loans grew $22.5 million, or 15.7%, while average leases declined by $2.9 million or 13.6%. The rate of growth in commercial real estate, construction and commercial loans has largely been the result of attracting new clients within the Banks’ principal markets in Wisconsin.

 

Also contributing to the increase in income on interest earning assets was an increase in income on mortgage related securities of $872,000 to $3.9 million for the year ended December 31, 2006 from $3.0 million for the same period in 2005. Net purchases of approximately $8 million were made to maintain adequate balance sheet liquidity. The yields on those securities have increased as a result of rising consumer mortgage rates. Average balances of mortgage related securities increased $10.1 million to $92.4 million for the year ended December 31, 2006 from $82.3 million for the same period in 2005. These increases were accompanied by an increase in average yields on such securities to 4.24% in 2006 from 3.71% in 2005. It is the Corporation’s policy to diversify assets and part of that diversification includes an investment portfolio that is not less than 10.0% of total assets.

Interest expense on interest-bearing liabilities increased $10.0 million to $28.7 million for the year ended December 31, 2006 from $18.7 million for the same period in 2005 primarily due to a $8.4 million increase in interest expense on deposits with the weighted average interest rate increasing to 4.58% from 3.44% for the same period in 2005. The increase in interest expense was largely due to rising rates on deposits accompanied by an increase in average interest-bearing deposits of $64.7 million or 13.4% to $548.0 million for the year ended December 31, 2006 from $483.3 million for the same period in 2005. This increase was largely a result of growth in money market accounts acquired primarily within the local markets and growth in average certificates of deposit primarily acquired through deposit brokers. Average money market deposits increased $39.3 million or 34.3% to $154.0 million for the year ended December 31, 2006 from $114.7 million in 2005. Average certificates of deposit increased $23.4 million or 6.8% to $343.0 million for the year ended December 31, 2006 from $319.5 million in 2005. The average balance of Federal Home Loan Bank (“FHLB”) advances, used as another source of funding, increased 66.8% or $7.7 million to $19.1 million for the year ended December 31, 2006 from $11.4 million for the same period in 2005, with the average cost of such advances increasing to 4.83% in 2006 from 3.67% for 2005. The overall weighted average cost of borrowings increased to 6.82% for the year ended December 31, 2006 from 5.49% for the same period in 2005. The rate increase of the borrowings was primarily the result of an increase in market rates. Additionally, upon exercising its option to redeem the junior subordinated debentures in December, 2006 the Corporation fully amortized to interest expense the remaining debt issuance costs totaling $260,000. This acceleration had the affect of increasing the overall weighted average cost of borrowings by 49 basis points thereby reducing the net interest margin by 4 basis points.

 

The Banks’ funding strategies include ongoing prospecting of new potential clients as well as continuing to focus on developing deeper relationships through the sale of products and services that meet clients’ needs accompanied by incentive programs. Specific non-incentive deposit initiatives include service and retention calling programs, increased advertising and identification of high growth potential individuals and businesses. Additionally, the Banks’ use of wholesale funding in the form of deposits generated through distribution channels other than the Corporation’s own bank locations allows the Banks to gather funds across a wider geographic base at pricing levels considered attractive.

 

Provision for Loan and Lease Losses.  The provision for loan and lease losses increased $1.1 million to $1.5 million for the year ended December 31, 2006 compared to $400,000 for the same period in 2005. The primary reason for the provision for loan and lease losses during 2006 is due to the inherent risk associated with the growth in the loan and lease portfolio. In order to establish the levels of the allowance for loan and lease losses, management regularly reviews its historical charge-off migration analysis and an analysis of the current level and trend of several factors that management believes provides an indication of losses in the loan and lease portfolio. These factors include delinquencies, volume, average size, average risk rating, technical defaults, geographic concentrations, industry concentrations, loans and leases on the management attention list, experience in the credit granting functions and changes in underwriting standards.

 

Non-Interest Income.  Non-interest income, consisting primarily of deposit and loan related fees and fees earned for trust and investment services as well as changes in the cash surrender value of bank-owned life insurance, decreased $565,000, or 13.3%, to $3.7 million for the year ended December 31, 2006 from $4.2 million for the same period in 2005. The primary contributor to this decrease was the gain of $973,000 on the sale from the Corporation’s 50% owned joint venture, m² during 2005. See Note 2 to the Consolidated Financial Statements as of and for the year ended December 31, 2006. In addition to this there was a decrease in service charges on demand deposit accounts of $89,000. This decrease is the result of higher interest rates and higher average demand deposit account balances. These two factors result in additional value, earned by deposit clients, which offsets demand deposit account service charges. Additionally there was a decrease in income related to derivatives of $45,000. Partially offsetting these decreases, was a $311,000 increase in trust and investments services fee income from FBB’s trust and investment services area due to successful efforts to increase assets under management. Money transferred in from new and existing clients as well as market appreciation contributed to the increase in trust assets managed. Additionally, there was an increase of $199,000 in the income from bank-owned life insurance for the year ended December 31, 2006 as compared to the same period during 2005 due to the purchase of additional bank-owned life insurance during 2005.

Non-Interest Expense.  Non-interest expense increased $1.3 million, or 8.2%, to $15.7 million for the year ended December 31, 2006 from $14.4 million in the same period for 2005. A significant portion of this increase was due to an increase of $778,000 in employee salaries and benefits to $9.3 million from $8.5 million in the same period for 2005 reflecting additions to staff and merit increases. Professional and consulting fees decreased $102,000 for the year ended December 31, 2006 as compared to the same period in 2005 due to additional fees associated with the Corporation’s process to register its common stock with the Securities and Exchange Commission in 2005. Marketing increased $139,000 as a result of loan, deposit, and general marketing campaigns. Data processing expense increased $192,000 largely to keep pace with internal growth as well as overall technology in the industry. Other expenses increased $159,000 to $1.7 million for the year ended December 31, 2006 from $1.5 million for the same period in 2005 largely due to the $78,000 loss associated with investments in two tax-preferred limited partnership equity investments.

 

Income Taxes.  FBFS recorded income tax expense of $1.7 million for the year ended December 31, 2006, with an effective rate of 31.0%, as compared to $2.5 million for the same period in 2005, with an effective rate of 34.0%. Contributing to the reduction in the effective tax rate during the year ended December 31, 2006 was an increase in the amount of non-taxable income from bank-owned life insurance of $199,000 in comparison to the same period in 2005.

 

Comparison of the Years Ended December 31, 2005 and 2004

 

General.  Net income increased $498,000 to $4.8 million for the year ended December 31, 2005 from $4.3 million in the same period of 2004. The year ended December 31, 2005 included a gain on the sale of the 50% equity investment in a leasing joint venture, m2, of $973,000. In addition to the gain on sale of m2, interest income increased $8.4 million, trust and investment services fee income increased $313,000 and income tax expense decreased by $800,000. These components that caused an increase in net income were partially offset by increases in interest expense of $7.5 million, an increase of $940,000 in provision for loan and lease losses and an increase in non-interest expense of $1.3 million. The returns on average assets and average stockholders’ equity for the year ended December 31, 2005 were .78% and 11.79%, respectively, as compared to .79% and 13.81%, respectively, for the same period in 2004.

 

Net Interest Income.  Net interest income increased $913,000, or 5.4%, to $17.8 million for the year ended December 31, 2005 from $16.9 million for the same period in 2004. The improvement in net interest income was due to an increase in average earning assets offset by a decrease in net interest margin. Net interest margin decreased to 3.03% for the year ended December 31, 2005 from 3.25% in the same period of 2004. The decrease in the net interest margin was the result of the increase in yields paid on interest-bearing liabilities outpacing the increase in yields earned on interest-bearing assets. This was also reflected in the decrease in the interest rate spread to 2.62% for the year ended December 31, 2005 from 2.93% for the same period in 2004.

 

Interest income on total interest-earning assets increased $8.4 million to $36.5 million for the year ended December 31, 2005 from $28.1 million for the same period in 2004. In particular, interest income on loans and leases increased $7.3 million to $33.1 million as of the year ended December 31, 2005 from $25.9 million for the same period of 2004 due to an increase in average loans and leases outstanding of $42.9 million, or 9.5%, accompanied by an increase in average yields earned on loans and leases to 6.68% from 5.70% caused by the change in market rates. The average balance of loans and leases increased to $496.4 million for the year ended December 31, 2005 from $453.5 million for the same period in 2004. The increase was driven largely by growth in mortgage loans which includes commercial real estate, construction, multi-family and 1-4 family loans partially offset by decreases in the lease and consumer loan categories. Total average mortgage loan growth amounted to $32.9 million, or 11.1%. Average commercial loans grew $13.8 million, or 10.7%, while average leases declined by $3.4 million or 13.4%. The rate of growth in commercial real estate, construction and commercial loans has largely been the result of attracting new clients in the Banks’ two principal markets.

 

Also contributing to the increase in income on interest earning assets was an increase in income on mortgage related securities of $1.1 million to $3.0 million for the year ended December 31, 2005 from $1.9 million for the same period in 2004. Net purchases of approximately $30 million were made as interest rates became more attractive in those securities as a result of rising mortgage rates. Average balances of mortgage related securities increased $25.2 million to $82.3 million for the year ended

December 31, 2005 from $57.1 million for the same period in 2004. These increases were accompanied by an increase in average yields on such securities to 3.71% in 2005 from 3.38% in 2004.

 

Interest expense on interest-bearing liabilities increased $7.5 million to $18.7 million for the year ended December 31, 2005 from $11.3 million for the same period in 2004 primarily due to a $7.0 million increase in interest expense on deposits with the weighted average rate increasing to 3.44% from 2.34% for the same period in 2004. The increase in interest expense was largely due to rising rates on deposits accompanied by an increase in average interest-bearing deposits of $71.3 million or 17.3% to $483.3 million for the year ended December 31, 2005 from $411.9 million for the same period in 2004. This increase was largely a result of growth in money market accounts acquired primarily within the local market and growth in average certificates of deposit primarily acquired through deposit brokers. Average money market deposits increased $39.5 million or 52.6% to $114.7 million for the year ended December 31, 2005 from $75.1 million in 2004. Average certificates of deposit increased $25.9 million or 8.9% to $319.5 million for the year ended December 31, 2005 from $293.6 million in 2004. These increases were partially offset by a decrease in the average balance of Federal Home Loan Bank (“FHLB”) advances, used as another source of funding, of $11.4 million to $11.4 million for the year ended December 31, 2005 from $22.8 million for the same period in 2004, or 50.0%, with the average cost of such advances increasing to 3.67% in 2005 from 1.91% for 2004. The overall weighted average cost of borrowings increased to 5.49% for the year ended December 31, 2005 from 3.99% for the same period in 2004.

 

Provision for Loan and Lease Losses.  The provision for loan and lease losses increased $940,000 to $400,000 for the year ended December 31, 2005 compared to a negative provision of $540,000 for the same period in 2004. The primary reason for the provision for loan and lease losses during 2005 was the inherent risk associated with the growth in the loan and lease portfolio.

 

Non-Interest Income.  Non-interest income, consisting primarily of deposit and loan related fees as well as fees earned for trust and investment services, changes in fair value of derivatives and net cash settlements on interest rate swaps, increased $971,000, or 29.7%, to $4.2 million for the year ended December 31, 2005 from $3.3 million for the same period in 2004. The primary contributor to this increase was the gain of $973,000 on the sale from the Corporation’s 50% owned joint venture, m2. See Note 2 of the Notes to the Consolidated Financial Statements. In addition, trust and investments services fee income from FBB’s trust and investment services area increased $313,000 due to successful efforts to increase assets under management. Money transferred in from new and existing clients as well as market appreciation contributed to the increase in trust assets managed. In addition, there was an increase of $160,000 in the income from bank-owned life insurance for the year ended December 31, 2005 as compared to the same period during 2004 due to the purchase of additional bank-owned life insurance. These increases were partially offset by decreases in service charges on demand deposit accounts of $159,000 and a decrease in income related to derivatives of $265,000. Also contributing to the offset was a decrease in other non-interest income, of which $124,000 represents the Corporation’s 50% share of income attributable to m2 which was reported for the year ended 2004.

 

Non-Interest Expense.  Non-interest expense increased $1.3 million, or 9.5%, to $14.4 million for the year ended December 31, 2005 from $13.1 million in the same period for 2004. A significant portion of this increase was due to an increase of $567,000 in employee salaries and benefits to $8.5 million from $7.9 million in the same period for 2004 reflecting additions to staff and merit increases. Professional and consulting fees increased $380,000 for the year ended December 31, 2005 as compared to the same period in 2004 due to additional fees associated with the Corporation’s process to register its common stock with the Securities and Exchange Commission and increases in fees paid to Directors. Marketing increased $109,000 as a result of loan, deposit, and general marketing campaigns. Data processing expense increased $130,000 largely to keep pace with internal growth as well as overall technology in the industry. Other expenses increased $99,000 to $1.5 million for the year ended December 31, 2005 from $1.4 million for the same period in 2004 largely due to losses in 2005 for the investment in a community housing project of $112,000.

 

Minority Interest.  For the year ended December 31, 2005 the consolidated financial statements included the accounts of FBFS and its wholly-owned subsidiaries. In 2004, the consolidated financial statements also included the 51% share of BBG prior to the acquisition of all of the minority interests in

BBG shares effective June 1, 2004. Minority interest in net income of consolidated subsidiary represents the 49% minority ownership interest in BBG prior to that date, which was $9,000.

 

Income Taxes.  FBFS recorded income tax expense of $2.5 million for the year ended December 31, 2005, with an effective rate of 34.0%, as compared to $3.3 million for the same period in 2004, with an effective rate of 43.3%. The higher than expected effective rate in 2004 is the result of an accrual made in 2004 related to tax exposure associated with the Wisconsin Department of Revenue (the “Department”) audits of Wisconsin financial institutions, like First Business Bank, which formed investment subsidiaries located outside of Wisconsin. See Note 15 to the Consolidated Financial Statements.

 

Also contributing to the reduction in the effective tax rate during the year ended December 31, 2005 was an increase in the amount of non-taxable income from bank-owned life insurance of $160,000 in comparison to the same period in 2004.

Net Interest Income Information

 

Average Interest-Earning Assets, Average Interest Bearing Liabilities, Interest Rate Spread, and Net Interest Margin.  The following tables show the Corporation’s average balances, average rates, the spread between combined average rates earned on the Corporation’s interest-earning assets and interest-bearing liabilities and the net interest margin for the years ended December 31, 2006, 2005 and 2004.

 

 

 

 

Rate/Volume Analysis

 

The Corporation’s net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest-earning assets and interest-bearing liabilities. The dollar volume of loans, leases and investments compared to the dollar volume of deposits and borrowings, combined with the interest rate spread, produces the changes in net interest income between periods. The following tables show the relative contribution of the changes in average volume and average interest rates on changes in net interest income for the years ended December 31, 2006, 2005, and 2004. Information is provided with respect to (i) the effect on interest income attributable to changes in rate (changes in rate multiplied by prior volume), (ii) the effect on interest income attributable to changes in volume (changes in volume multiplied by prior rate) and (iii) the changes in rate/volume (changes in rate multiplied by changes in volume).