First Business Financial Services 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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
Registrants 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 registrants 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 registrants 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.
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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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 Corporations 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. FBBs 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 Corporations 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 Banks 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 Milwaukees 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 companys 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.
The Corporation maintains a web site at www.fbfinancial.com. This Form 10-K and all of the Corporations 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.
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.
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.
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 banks 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.
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 legislations 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 companys CEO and CFO are each required to certify that the companys 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 Corporations internal controls; (ii) have made certain disclosures to the Corporations auditors and the audit committee of the Corporations board of directors (the Board) about the Corporations internal controls; and (iii) have included information in the Corporations quarterly and annual reports about their evaluation and whether there have been significant changes in the Corporations 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.
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 FDICs 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 Corporations 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 Banks 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 Banks 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 Corporations profitability depends upon the Banks continued ability to successfully maintain and increase market share.
Government Regulation and Monetary Policy. The Corporations 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 Corporations 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 Corporations cost of doing business and affect its ability to attract deposits and make loans.
Key Personnel. The Corporations 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 Corporations 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 Corporations 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 Corporations operations. A number of the Corporations 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 Corporations 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 Corporations 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 Corporations performance of its fiduciary responsibilities. Whether client claims and legal action related to the Corporations 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 Corporations business, which, in turn, could have a material adverse effect on the Corporations financial condition and results of operations.
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 Corporations consolidated financial position, consolidated results of operations or cash flows. Since the Corporations 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 Corporations business.
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
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.
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 NASDAQs 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. Managements Discussion and Analysis of Financial Condition and Results of Operations
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.
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 managements 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, FBFSs 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. FBFSs 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.
Tax Audit. Like the majority of financial institutions located in Wisconsin, FBB transferred investment securities and loans to out-of-state investment subsidiaries. FBBs 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 FBBs 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.
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 managements 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 managements 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 Corporations 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 managements 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 managements 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 FBFSs 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 Corporations 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 BBGs 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 Milwaukees 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 Corporations 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 securitys performance, the credit worthiness of the issuer and the Corporations 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 Corporations 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 equipments 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 Corporations 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 Corporations 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 Corporations 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 Corporations 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 FBBs 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 Corporations 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.
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 Corporations 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 FBBs 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 Corporations 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 Corporations 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 Corporations average balances, average rates, the spread between combined average rates earned on the Corporations interest-earning assets and interest-bearing liabilities and the net interest margin for the years ended December 31, 2006, 2005 and 2004.
The Corporations 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).
December 31, 2006
General. The total assets of FBFS increased $119.1 million, or 17.8%, to $788.3 million at December 31, 2006 from $669.2 million at December 31, 2005. This growth is generally in securities and loans and leases receivable. The asset growth was funded by net increases in deposits of $72.8 million, a $37.5 million increase in FHLB and other borrowings and a $16.0 million increase in subordinated debt partially offset by the $10.3 million decline in junior subordinated debentures.
Securities. Securities available-for-sale increased $8.0 million to $100.0 million at December 31, 2006 from $92.0 million at December 31, 2005 as a net result of purchases of $30.8 million less maturities of $22.5 million and the sale of a security totaling $749,000 during the year. Mortgage-related securities consisted largely of agency-backed mortgage securities in the form of REMICS.
Loans and Leases Receivable. Total net loans and leases increased $107.2 million to $639.9 million at December 31, 2006 from $532.7 million at December 31, 2005. The net increase in the loan and lease portfolio was the result of originations of $276.4 million and purchases of $3.8 million offset by principal repayments of $170.5 million, sales of $1.1 million and an increase in the allowance for loan and lease losses of $1.5 million. Loan originations increased $74.8 million to $276.4 for the year ending December 31, 2006 from $201.6 million from the same time period of 2005 due to increased sales efforts which in part was accomplished by adding additional members to the sales team. Deferred loan fees declined from $241,000 to $187,000 from December 31, 2005 to December 31, 2006. The decrease in deferred loan fees was primarily attributable to a decrease in loans originated in the Corporations asset-based lending subsidiary from the prior year accompanied by increased payoff activity in the prior year as compared to the current year. The increased payoff activity in the prior period resulted in accelerated deferred loan fee amortization for those loans that were paid off.
Non-performing Assets. Non-performing assets consists of non-accrual loans and leases of $1.1 million as of December 31, 2006, or 0.14% of total assets, as compared to $1.5 million, or 0.23% of total assets, as of December 31, 2005. This represents a decrease of $435,000 in non-performing assets largely due to the receipt of payment in full for non-accrual leases of $90,000 and a non-accrual commercial loan of $59,000. Approximately $200,000 of the remaining decrease was the result of the improvement in the borrowers ability to perform as required by the loan agreement due to the addition of a financially capable co-borrower.
Lending and Leasing Activities
General. At December 31, 2006, net loans and leases totaled $639.9 million, representing approximately 81.2% of $788.3 million in total assets at that date. Approximately $422.9 million or 65.2% of the Banks gross loans and leases, at December 31, 2006 were secured by first or second-liens on real estate. An additional $8.9 million of home equity and second mortgage loans which are classified as consumer loans are also secured by real estate.
While the Banks endeavor to originate commercial, industrial, commercial real estate and consumer loans, the majority of the Banks loans are commercial real estate loans secured by properties located primarily in Dane and Waukesha counties and surrounding communities in Wisconsin. In order to increase the yield, minimize interest rate sensitivity, and diversify the risk of their portfolios, the Banks also originate construction, multi-family, commercial, industrial and consumer loans.
Non-real estate loans originated by the Banks consist of a variety of commercial and asset-based loans and leases as well as a small amount of consumer loans. At December 31, 2006, the Banks gross loans and leases included $199.9 million of commercial loans and leases, or 30.8% of the total, and $16.7 million of consumer loans, or 2.6% of the total.
Loan Portfolio Composition. The following table presents information concerning the composition of the Banks consolidated loans and leases held for investment at the dates indicated.
The following table shows the scheduled contractual maturities of the Banks consolidated gross loans and leases held for investment, as well as the dollar amount of such loans and leases which are scheduled to mature after one year which have fixed or adjustable interest rates, as of December 31, 2006.
Commercial Real Estate. The Banks originate commercial real estate loans which have fixed or adjustable rates and terms of generally up to five years and amortizations of twenty years on existing commercial real estate and twenty-five years on new construction. Loans secured by commercial real estate consist of commercial owner-occupied properties as well as investment properties. At December 31, 2006, the Banks had $274.3 million of loans secured by commercial real estate. This represented 42.3%
of the Banks gross loans and leases. Approximately $118.2 million of the commercial real estate loans are owner-occupied properties which represents 28.0% of all loans secured by real estate.
Commercial Loans. At December 31, 2006, commercial loans amounted to $125.3 million or 19.3% of gross loans and leases. The Banks commercial loan portfolio is comprised of loans for a variety of purposes and generally is secured by inventory, accounts receivable, equipment, machinery and other corporate assets. Commercial loans generally have terms of five years or less and interest rates that float in accordance with a designated published index or fixed rates with typical amortization of four to seven years. Most accounts receivable advances do not exceed 65% of receivables less than 90 days past due from invoices; however this may be increased to 75% if the Banks receive a borrowers certificate and accounts receivable aging on a quarterly or more frequent basis. Advances on raw material and finished goods inventory generally do not exceed 50% and advances on machinery and equipment typically do not exceed 65% of net book value. Advances on new equipment and new vehicles generally do not exceed 80% of cost. Substantially all of such loans are secured and backed by personal guarantees of the owners of the borrowing business.
Construction and Multi-family Loans. The Banks originate loans to construct commercial properties. At December 31, 2006, construction loans amounted to $78.3 million, or 12.1% of the Banks gross loans and leases. The Banks construction loans generally have terms of six to twenty-four months with fixed or adjustable interest rates with fees that are due at the time of origination. Loan proceeds are disbursed in increments as construction progresses and as inspections by title companies warrant.
The Banks also originate multi-family loans that amounted to $34.6 million at December 31, 2006, or 5.3% of gross loans and leases. These loans are primarily secured by apartment buildings and are mainly located in Dane County.
Asset-Based Loans and Leases. Asset-based loans are originated through FBCC, the asset based lending subsidiary, and are typically secured by accounts receivable, inventories, equipment and/or real estate. The asset-based loans secured by accounts receivable and inventories amounted to $51.4 million as of December 31, 2006. This represented 7.9% of gross loans and leases. Because asset-based borrowers are usually highly leveraged, such loans have higher interest rates and fees accompanied by close monitoring of assets. The accounts receivable advance rate is determined by a number of factors including concentrations of business with clients, amount of dilution and the credit quality of the client base. The controls include dominion over all cash receipts of the borrowers either through a lockbox collection service or cash collateral account. The accounts receivable borrowing bases are updated daily. Eligibility of accounts receivable and inventories is based on restrictive requirements designed to exclude low-quality or disputed receivables and low-quality, slow moving or obsolete inventories. FBCC monitors adherence to these requirements by updating the borrowing base daily and conducting periodic on-site audits of all borrowers including assessing the quality of the collateral, and determining the financial operating trends of those borrowers. Asset-based loans secured by real estate amounted to $12.4 million as of December 31, 2006.
Leases are originated through FBL (the Leasing Company) and amounted to $23.2 million as of December 31, 2006 and represented 3.6% of gross loans and leases. Such leases are generally secured by equipment and machinery located principally in Wisconsin. Leases are typically originated with a fixed rate and a term of seven years or less. It is customary in the leasing industry to provide 100% financing, however, the Leasing Company will, from time-to-time, require a down payment or lease deposit to provide a credit enhancement. All equipment leases must have an additional insured endorsement and a loss payable clause in the interest of the Leasing Company and must carry sufficient physical damage and liability insurance.
The Leasing Company 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 20% 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. The excess of the minimum lease payments and residual values over the cost of the equipment is recorded as unearned lease income. Unearned lease income is recognized over the term of the lease on a basis which results in an approximate level rate of return on the unrecovered lease investment. Lease payments are recorded when due under the lease contract. Residual
value is the estimated fair market value of the equipment on lease at lease termination. In estimating the equipments fair value, the Leasing Company relies on historical experience by equipment type and manufacturer, published sources of used equipment pricing, internal evaluations and, where available, valuations by independent appraisers, adjusted for known trends. The Leasing Companys estimates are reviewed continuously to ensure reasonableness; however, the amounts the Leasing Company will ultimately realize could differ from the estimated amounts. The majority of the equipment is leased to businesses in the manufacturing, (24.5%), printing, (18.5%), and commercial vehicle leasing, (14.2%) industries as of December 31, 2006.
Consumer and 1-4 Family Loans. The Banks originate a small amount of consumer loans. Such loans amounted to $25.6 million at December 31, 2006 and consist of home equity and second mortgages and credit card and other personal loans for professional and executive clients of the Banks. Generally, the maximum loan to value on home equity loans is 80% with proof of property value required and annual personal financial statements after the initial loan application. The maximum loan to value on new automobiles and trucks is 80%. These loans represented 4.0% of the Banks gross loans and leases at December 31, 2006.
The Banks originate 1 4 family loans which totaled $35.7 million at December 31, 2006 or 5.5% of gross loans and leases. These loans are primarily secured by single family homes and held for investment by clients.
Net Fee Income from Lending Activities. Loan and lease origination and commitment fees and certain direct loan and lease origination costs are deferred and the net amounts are amortized as an adjustment to the related loan and lease yields. The Banks also receive other fees and charges relating to existing loans, which include prepayment penalties, loan monitoring fees, late charges and fees collected in connection with loan modifications.
Loan and Lease Delinquencies. Loans and leases are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. Previously accrued but unpaid interest is deducted from interest income at that time. As a matter of policy, the Banks do not accrue interest on loans or leases past due beyond 90 days.
The following table sets forth information relating to delinquent loans and leases at the dates indicated.
The increase in loans and leases 30 to 59 days past due was attributable to several unrelated loans and leases that, as a result of receiving the required payments in January 2007, were brought current.
Non-performing Assets and Impaired Loans and Leases. Non-performing assets consists of non-accrual loans and leases of $1.1 million as of December 31, 2006, or 0.14% of total assets, as compared to $1.5 million, or 0.23% of total assets, as of December 31, 2005. This represents a decrease of $435,000 in non-performing assets. The decrease is largely due to the receipt of payment in full for non-accrual leases of $90,000 and a non-accrual commercial loan of $59,000. Approximately $200,000 of the remaining decrease was the result of the improvement in the borrowers ability to perform as required by the loan agreement due to the addition of a financially capable co-borrower.
A loan or lease is considered impaired if, based upon current information and events, it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan or lease agreement. Certain homogeneous loans, including residential mortgage and consumer loans, are collectively evaluated for impairment, and therefore, do not have individual credit risk ratings and are excluded from impaired loans. Impaired loans include all nonaccrual loans as well as certain accruing loans judged to have higher risk of noncompliance with the present contractual repayment schedule for both interest and principal. Once a loan has been determined to be impaired, it is measured to establish the amount of the impairment. While impaired loans exhibit weaknesses that inhibit repayment in compliance with the original note terms, the measurement of impairment may not always result in an allowance for loan loss for every impaired loan. The amount in the allowance for loan losses for impaired loans is based on the present value of expected future cash flows discounted at the loans effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, net of cost to sell.
Information about impaired loans at or for the years ended December 31, 2006, 2005 and 2004 is as follows:
The net amount of foregone interest for the years ended December 31, 2006, 2005 and 2004 was $(7,000), $112,000 and $92,000, respectively.
Allowance for Loan and Lease Losses. Management regularly reviews and revises its methodology to provide greater precision in its assessment of risks in the loan and lease portfolio and related evaluation of adequate allowance for loan and lease losses by incorporating historical charge-off migration analysis and an analysis of the current level and trend of factors felt indicative of loan and lease
quality. The historical charge-off migration analysis utilizes the most recent five years of net charge-offs and traces the migration of the risk rating from origination through charge-off. The historical percentage of the amounts charged-off for each risk rating, for each subsidiary is averaged for the five year period giving greater weight in the calculation to the recent years. These percentages are then applied to the current loan and lease portfolio for this portion of the Allowance for Loan and Lease Losses. The other factors consider the risks inherent in the mix of the portfolio reflective of the weighting toward commercial and commercial real estate lending. The loan and lease portfolio is examined for any material concentrations and additional reserves have been established in an amount that, based on the experience of senior management, is adequate to cover concentration risk. These reserves are increased on a pro rata basis as the loan and lease portfolio grows.
As a result of this review process combined with an increase in a specific reserve of $476,000 for a loan to a roofing contractor, the provision for 2006 is $1.5 million, an increase of $1.1 million from $400,000 in 2005 and resulted in an increase in the allowance for loan and lease losses as a percent of total loans from 1.25% to 1.28%. As of December 31, 2005, the allowance for loan and lease losses has increased $398,000 due to increased loan volume offset by a decrease in non-accrual loans and leases. The evaluation process focuses on several factors including, but not limited to, managements ongoing review and risk rating of the portfolio, with particular attention paid to loans and leases identified by management as impaired and to potential impaired loans and leases based upon historical trends and ratios, the fair value of the underlying collateral, historical losses, changes in the size of the portfolio, trends in the level of delinquencies, concentrations of loans and leases to specific borrowers or industries and other factors which could affect potential credit losses.
To determine the level and composition of the allowance for loan and lease losses the portfolio is broken out by categories and risk ratings. Impaired loans and leases and potential impaired loans and leases are evaluated for a specific reserve based upon the estimated value of the underlying collateral for collateral-dependent loans, or alternatively, the present value of expected cash flows. Historical trends of the identified factors are applied to each category of loans that have not been specifically evaluated for the purpose of establishing the general reserve.
The Corporation reviews its methodology and periodically adjusts its allocation percentages based upon historical results. Within the specific categories certain loans or leases have been identified for specific reserve allocations as well as the whole category of that loan type or lease being reviewed for a general reserve based on the foregoing analysis of trends and overall balance growth within that category.
Foreclosed properties are recorded at the lower of cost or fair value. If, at the time of foreclosure, the fair value less cost to sell is lower than the carrying value of the loan, the difference, if any, is charged to the allowance for loan losses prior to transfer to foreclosed property. The fair value is primarily based on appraisals, discounted cash flow analysis (the majority of which is based on current occupancy and lease rates) and verifiable offers to purchase. After foreclosure, valuation allowances or future write-downs to fair value less costs to sell are charged directly to expense.
A summary of the activity in the allowance for loan and lease losses follows:
Loan charge-offs were $0 and $10,000 for the year ended December 31, 2006 and for the year ended December 31, 2005, respectively. Recoveries for the year ended December 31, 2006 were $4,000 and were $8,000 for the year ended December 31, 2005.
The table below shows the Corporations allocation of the allowance for loan and lease losses by loan and lease loss reserve category at the dates indicated.
Although management believes the allowance for loan and lease losses is adequate based on the current level of loan delinquencies, non-performing assets, trends in charge-offs, economic conditions and other factors as of December 31, 2006, there can be no assurance that future adjustments to the allowance will not be necessary. Management adheres to high underwriting standards in order to maintain strong asset quality and continues to pursue practical and legal methods of collection, repossession and disposal of any such troubled assets. As of December 31, 2006, there were no significant industry concentrations in the loan portfolio.
The Banks Boards of Directors (Boards) review and approve the investment policy on an annual basis. Management, as authorized by the Boards, implements this policy. The Boards review investment activity on a monthly basis.
Investment objectives are formed to meet liquidity requirements and generate a favorable return on investments without compromising other business objectives and levels of interest rate risk and credit risk. Consideration is also given to investment portfolio concentrations. Federal and state chartered banks are allowed to invest in various types of assets, including U.S. Treasury obligations, securities of various federal agencies, state and municipal obligations, mortgage-related securities, certain time deposits of insured financial institutions, repurchase agreements, loans of federal funds, and, subject to certain limits, corporate debt and equity securities, commercial paper and mutual funds. The Corporations investment policy provides that it will not engage in any practice that the Federal Financial Institutions Examination Council considers an unsuitable investment practice.
The Banks investment policies allow participation in hedging strategies or the use of financial futures, options or forward commitments or interest rate swaps with prior Board approval. The Banks utilize derivative instruments in the course of their asset/liability management. These derivative instruments are primarily interest rate swap agreements which are used 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.
Securities are classified as available-for-sale, held-to-maturity and trading. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders equity. There were no securities designated as held-to-maturity or trading as of December 31, 2006.
The Corporations investment securities include U.S. government obligations and securities of various federal agencies as well as a small amount of money market investments and corporate stock.
The Corporation also purchases mortgage-related securities, in particular, agency-backed mortgage securities to supplement loan production and to provide collateral for borrowings. Management believes that certain mortgage-derivative securities represent attractive alternative investments due to the wide variety of maturity and repayment options available and due to the limited credit risk associated with such investments. Mortgage-derivative securities include real estate mortgage investment conduits (REMICS) which are securities derived by reallocating cash flows from mortgage pass-through securities or from pools of mortgage loans held by a trust. The Corporation invests in mortgage-related securities which are insured or guaranteed by FHLMC, FNMA, or GNMA. Of the total available-for-sale mortgage securities at December 31, 2006, $41.9 million, $17.7 million, and $38.8 million were insured or guaranteed by FHLMC, FNMA, and GNMA, respectively. The Corporation has no held-to-maturity mortgage securities at December 31, 2006.
Mortgage-related securities are subject to inherent risks based upon the future performance of the underlying collateral, mortgage loans, for these securities. Among the risks are prepayment risk, extension risk, and interest rate risk. Should general interest rates decline, the mortgage-related securities portfolio would be subject to prepayments caused by borrowers seeking lower financing rates. A decline in interest rates could also cause a decline in interest income on adjustable-rate mortgage-related securities. Conversely, an increase in general interest rates could cause the mortgage-related securities portfolio to be subject to a longer term to maturity caused by borrowers being less likely to prepay their loans. Such a rate increase could also cause the fair value of the mortgage-related securities portfolio to decline.
The Corporation has mortgage-backed securities available-for-sale at December 31, 2006 with a fair value of $1.5 million.
At December 31, 2006, $35.4 million of the Corporations mortgage-related securities were pledged to secure various obligations of the Corporation.
The table below sets forth information regarding the amortized cost and fair values of the Corporations investments and mortgage-related securities at the dates indicated.
The following table sets forth the maturity and weighted average yield characteristics of the Corporations debt securities at December 31, 2006, classified by term maturity. The balances are reflective of fair value.
Derivative Activities. 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. For further discussion on the Corporations interest rate risk management activities and use of derivatives, see managements previous discussion of critical accounting policies in this Item 7 and Note 1 to the Consolidated Financial Statements.
Deposits. As of December 31, 2006, deposits increased $72.8 million to $640.3 million from $567.5 million at December 31, 2005. The increase during the year ended December 31, 2006 was largely attributable to an increase in money market accounts of $33.5 million accompanied by an increase of $28.9 million in certificates of deposit and an increase of $10.4 million in transaction accounts, respectively. The weighted average cost of deposits increased to 4.58% for the year ended 2006 from 3.44% for the same period of 2005.
Deposits are a major source of the Banks funds for lending and other investment activities. A variety of accounts are designed to attract both short and long-term deposits. These accounts include time deposits, money market and demand deposits. The Banks deposits are obtained primarily from Dane and Waukesha Counties. At December 31, 2006, $325.9 million of the Corporations time deposits were comprised of brokered certificates of deposit with $20.5 million maturing in three months or less, $36.7 million maturing in over three to six months, $40.7 million in over six to twelve months and $228.0 million maturing in over twelve months. The Banks enter into agreements with certain brokers who provide funds for a specified fee. The Banks liquidity policy limits the amount of brokered deposits to 75% of total deposits.
Deposit terms offered by the Banks vary according to minimum balance required, the time period the funds must remain on deposit, U.S. Treasury securities offerings and the interest rates charged on
other sources of funds, among other factors. In determining the characteristics of deposit accounts, consideration is given to profitability of the Banks, matching terms of the deposits with loan and lease products, the attractiveness to clients and the rates offered by the Banks competitors.
The following table sets forth the amount and maturities of the Banks certificates of deposit at December 31, 2006.
At December 31, 2006, time deposits included $36.0 million of certificates of deposit in denominations greater than or equal to $100,000. Of these certificates, $14.4 million are scheduled to mature in three months or less, $14.2 million in greater than three through six months, $4.1 million in greater than six through twelve months and $3.3 million in greater than twelve months.
Borrowings. The Corporation had borrowings of $93.0 million as of December 31, 2006, largely consisting of FHLB advances of $36.6 million which had a weighted average rate of 4.83% and Fed funds purchased and securities sold under agreement to repurchase of $33.8 million which had a weighted average rate of 5.12%. The Corporation also has a $7.0 million line of credit with $1.6 million outstanding and a weighted average rate of 6.82% and a $21.0 million subordinated note payable which carried a weighted average rate of 7.58%. The $15.0 million increase in subordinated debt was primarily used to repay the junior subordinated debentures. Borrowings increased $42.9 million during the year ended December 31, 2006. The increase in Fed funds purchased was $14.3 million and the increase in FHLB advances was $24.0 million. At December 31, 2005, FHLB advances were $12.5 million with a weighted average rate of 3.67%. Fed funds purchased and securities sold under agreement to repurchase totaled $19.5 million and had a weighted average rate of 3.45%. The Corporations outstanding line of credit balance of $2.8 million had a weighted average rate of 5.39%, the subordinated note payable of $5.0 million carried a weighted average rate of 5.75% and junior subordinated debentures of $10.3 million had a weighted average rate of 9.18%.
The Banks obtain advances from the FHLB. Such advances are made pursuant to several different credit programs, each of which has its own interest rate and maturity. The FHLB may prescribe acceptable uses for these advances as well as limitations on the size of the advances and repayment provisions. The Banks pledge a portion of their 1-4 family loans, commercial loans, and mortgage-related securities as collateral.
The Banks may also enter into repurchase agreements with selected clients. Repurchase agreements are accounted for as borrowings by the Banks and are secured by mortgage-related securities.
The Corporation has a short-term line of credit to fund short-term cash flow needs. The interest rate is based on the London Interbank Offer Rate (LIBOR) plus a spread of 1.70% with an embedded floor of 3.75% and is payable monthly. The final maturity of the credit line is April 30, 2007. The Corporation also has a subordinated note payable with an interest rate based on LIBOR plus 2.35% subject to a floor of 4.25% which matures on December 31, 2013. See Note 11 to the Corporations Consolidated Financial Statements for more information on borrowings.
The following table sets forth the outstanding balances, weighted average balances and weighted average interest rates for the Corporations borrowings (short-term and long-term) as indicated.
The following table sets forth maximum amounts outstanding at month-end for specific types of borrowings for the periods indicated.
Stockholders Equity. As of December 31, 2006, stockholders equity was $45.8 million or 5.8% of total assets. Stockholders equity increased $3.9 million during the year ended December 31, 2006 primarily as a result of comprehensive income of $4.2 million, which includes net income of $3.7 million plus a decrease in accumulated other comprehensive loss of $464,000. Stock options exercised totaled $136,000. Share based compensation related to restricted stock totaled $182,000. These increases were partially offset by treasury stock purchases of $21,000 and cash dividends of $595,000. As of December 31, 2005, stockholders equity totaled $41.8 million or 6.3% of total assets.
First Madison Investment Corporation. FMIC is an operating subsidiary of FBB that was incorporated in the State of Nevada in 1993. FMIC was organized for the purpose of managing a portion of the Banks investment portfolio. FMIC invests in marketable securities and also invests in commercial real estate, multi-family, commercial and some 1-4 family loans in the form of loan participations with FBB retaining servicing and charging a servicing fee of .25%. As an operating subsidiary, FMICs results of operations are consolidated with FBBs for financial and regulatory purposes. FBBs investment in FMIC amounted to $177.9 million at December 31, 2006. FMIC had net income of $6.0 million for the year ended December 31, 2006. This compares to a total investment of $171.5 million at December 31, 2005 and net income of $5.1 million for the year ended December 31, 2005.
First Business Capital Corp. FBCC is a wholly-owned subsidiary of FBB formed in 1995 and headquartered in Madison, Wisconsin. FBCC is a commercial lending company designed to meet the needs of growing, highly leveraged manufacturers and wholesale distribution businesses and specializes in providing secured lines of credit as well as term loans on equipment and real estate assets. FBBs investment in FBCC at December 31, 2006 was $9.7 million and net income for the year ended December 31, 2005 was $1.3 million. This compares to a total investment of $8.4 million and net income of $1.5 million, respectively, at and for the year ended December 31, 2005.
FMCC Nevada Corp. (FMCCNC) is a wholly-owned subsidiary of FBCC incorporated in the state of Nevada in 2000. FMCCNC invests in asset based loans in the form of loan participations with FBCC retaining servicing. FBCCs total investment in FMCCNC at December 31, 2006 was $20.3 million. FMCCNC had net income of $1.4 million for the year ended December 31 2006. This compares to a total investment of $18.9 million and net income of $1.0 million, respectively, at and for the year ended December 31, 2005.
First Business Leasing, LLC. FBL, headquartered in Madison, Wisconsin, was formed in 1998 for the purpose of purchasing leases from m2 Lease Funds, LLC (m2) and to originate leases. Until its sale on January 4, 2005, FBB had a 50% equity interest in m2, which is a commercial finance joint venture specializing in the lease of general equipment to small and medium-sized companies nationwide. Typically FBL originates leases and extends credit in the form of loans to finance general equipment for small and medium-sized companies. FBBs total investment in FBL at December 31, 2006 was $3.4 million and net income was $203,000 for the year ended December 31, 2006. This compares to a total investment of $3.2 million and net income of $155,000, respectively, at and for the year ended December 31, 2005.
During the years ended December 31, 2006, 2005 and 2004, the Banks did not make dividend payments to the Corporation. The Banks are subject to certain regulatory limitations regarding their ability to pay dividends to the Corporation. Management believes that the Corporation will not be adversely affected by these dividend limitations and that any future projected dividends from the Banks will be sufficient to meet the Corporations liquidity needs. The Corporations principal liquidity requirements at December 31, 2006 are the repayment of a short-term borrowing of $1.6 million and interest payments due on subordinated debentures. The Corporation expects to meet its liquidity needs through existing cash flow sources, its bank line of credit and/ or dividends received from the Banks. The Corporation and its subsidiaries continue to have a strong capital base and the Corporations regulatory capital ratios continue to be significantly above the defined minimum regulatory ratios. See Note 12 in Notes to Consolidated Financial Statements for the Corporations comparative capital ratios and the capital ratios of its Banks.
FBFS manages its liquidity to ensure that funds are available to each of its Banks to satisfy the cash flow requirements of depositors and borrowers and to ensure the Corporations own cash requirements are met. The Banks maintain liquidity by obtaining funds from several sources.
The Banks primary sources of funds are principal and interest repayments on loans receivable and mortgage-related securities, FHLB advances, deposits and other borrowings such as federal funds and Federal Home Loan Bank advances. The scheduled repayments of loans and the repayments of mortgage-related securities are a predictable source of funds. Deposit flows and loan repayments, however, are greatly influenced by general interest rates, economic conditions and competition.
Brokered deposits are used by the Banks, which allows them to gather funds across a larger geographic base at price levels considered attractive. Access to such deposits allows the flexibility to not pursue single service deposit relationships in markets that have experienced some unprofitable pricing levels. Brokered deposits account for $325.9 million of deposits as of December 31, 2006. Brokered deposits are utilized to support asset growth and are generally a lower cost source of funds when compared to the interest rates that would need to be offered in the local markets to generate a sufficient level of funds. In addition, the administrative costs associated with brokered deposits are considerably less than the administrative costs that would be incurred to administer a similar level of local deposits. Although local market deposits are expected to increase as new client relationships are established and as existing clients increase the balances in their deposit accounts, the usage of brokered deposits will likely remain. In order to provide for ongoing liquidity and funding, all of the brokered deposits are certificates of deposit that do not allow for withdrawal, at the option of the depositor, before the stated maturity. In the event that there is a disruption in the availability of brokered deposits at maturity, the Banks have managed the maturity structure so that at least 90 days of maturities would be funded through other means, including but not limited to advances from the Federal Home Loan Bank, replacement with higher cost local market deposits or cash flow from borrower repayments and security maturities.
The Banks are required by federal regulators to maintain levels of liquid investments in qualified U.S. Government and agency securities and other investments which are sufficient to ensure the safety and
soundness of operations. The regulatory requirements for liquidity are discussed in Item 1 under Supervision and Regulation.
During the year ended December 31, 2006, operating activities resulted in a net cash inflow of $4.5 million. Operating cash flows for the year ended December 31, 2006 included earnings of $3.7 million. Net cash provided from financing activities of $113.8 million, which included an increase in deposits of $72.8 million, was offset by net cash outflows of $115.6 million in loan origination and investment activities. During the year ended December 31, 2005, operating activities resulted in a net cash inflow of $2.6 million. Operating cash flows for the fiscal year included earnings of $4.8 million. Net cash provided from financing activities of $102.3 million, which included an increase in deposits of $92.8 million, was partially offset by net cash outflows of $97.0 million in loan origination and investment activities.
As of December 31, 2006 the Corporation had outstanding commitments to originate $211.6 million of loans and commitments to extend funds to or on behalf of clients pursuant to standby letters of credit of $12.2 million. Commitments to extend funds typically have a term of less than one year; however the Banks have $81.2 million of commitments which extend beyond one year. See Note 16 to the Consolidated Financial Statements. No losses are expected as a result of these funding commitments. The Banks also utilize interest rate swaps for the purposes of interest rate risk management. Such instruments are discussed in Note 18 to the Consolidated Financial Statements. Additionally the Corporation has committed to provide an additional $2.5 million to Aldine Capital Fund, LP, a mezzanine fund and $20,000 of additional funding to Cap Vest, LP. Management believes adequate capital and liquidity are available from various sources to fund projected commitments.
The following table summarizes the Corporations contractual cash obligations and other commitments at December 31, 2006.
Recently Issued Accounting Pronouncements
See Note 1- Summary of Significant Accounting Policies and Nature of Operations, Recent Accounting Changes in the accompanying financial statements included elsewhere in this report for details of recently issued accounting pronouncements and their expected impact on the Corporations financial statements.
Interest rate risk, or market risk, arises from exposure of the Corporations financial position to changes in interest rates. It is the Corporations strategy to reduce the impact of interest rate risk on net interest margin by maintaining a favorable match between the maturities and repricing dates of interest-earning assets and interest-bearing liabilities. This strategy is monitored by the respective Banks Asset/
Liability Management Committees, in accordance with policies approved by the respective Banks Boards. These committees meet regularly to review the sensitivity of the Corporations assets and liabilities to changes in interest rates, liquidity needs and sources, and pricing and funding strategies.
The Corporation uses two techniques to measure interest rate risk. The first is simulation of earnings. The balance sheet is modeled as an ongoing entity whereby future growth, pricing, and funding assumptions are implemented. These assumptions are modeled under different rate scenarios that include a simultaneous, instant and sustained change in interest rates.
The following table illustrates the potential impact of changing rates on the Corporations net interest margin for the next twelve months, as of December 31, 2006.
The second measurement technique used is static gap analysis. Gap analysis involves measurement of the difference in asset and liability repricing on a cumulative basis within a specified time frame. A positive gap indicates that more interest-earning assets than interest-bearing liabilities reprice/mature in a time frame and a negative gap indicates the opposite. As shown in the cumulative gap position in the table presented below, at December 31, 2006, interest-bearing liabilities repriced faster than interest-earning assets in the short term. In addition to the gap position, other determinants of net interest income are the shape of the yield curve, general rate levels, reinvestment spreads, balance sheet growth and mix, and interest rate spreads.
The Corporation manages the structure of interest earning assets and interest bearing liabilities by adjusting their mix, yield, maturity and/or repricing characteristics based on market conditions. Broker certificates of deposit are a significant source of funds. We use a variety of maturities to augment our management of interest rate exposure.
The following table illustrates the Corporations static gap position.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF FIRST BUSINESS FINANCIAL SERVICES
First Business Financial Services, Inc.
Consolidated Balance Sheets
First Business Financial Services, Inc.
Consolidated Statements of Income