First Midwest Bancorp 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year-ended December 31, 2004
For the transition period from to
Commission File Number 0-10967
FIRST MIDWEST BANCORP, INC.
(Exact name of registrant as specified in its charter)
300 Park Blvd., Suite 400, P.O. Box 459
Itasca, Illinois 60143-9768
(Address of principal executive offices) (zip code)
Registrants telephone number, including area code: (630) 875-7450
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.
Indicate by check mark if 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 Form 10-K or any amendment to this Form 10-K. ¨.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨.
The aggregate market value of the registrants outstanding voting common stock held by non-affiliates on June 30, 2004, determined using a per share closing price on that date of $35.21, as quoted on The Nasdaq Stock Market, was $1,521,111,189.
At March 3, 2005 there were 45,744,533 shares of common stock, $.01 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrants Proxy Statement for the 2005 Annual Stockholders Meeting - Part III
TABLE OF CONTENTS
ITEM 1. BUSINESS
First Midwest Bancorp, Inc.
First Midwest Bancorp, Inc. (the Company) is a bank holding company incorporated in Delaware in 1982 for the purpose of becoming a holding company registered under the Bank Holding Company Act of 1956, as amended (the Act). The Company is one of Illinois largest publicly traded banking companies with assets of $6.9 billion at year-end 2004 and is headquartered in the Chicago suburb of Itasca, Illinois.
The Company operates two wholly owned subsidiaries: First Midwest Bank (the Bank), employing 1,630 full-time equivalent employees at December 31, 2004, and First Midwest Insurance Company, which is largely inactive.
The Company has responsibility for the overall conduct, direction, and performance of its subsidiaries. The Company provides various services, establishes Company-wide policies and procedures, and provides other resources as needed, including capital.
At December 31, 2004, the Bank had $6.8 billion in total assets, $5.0 billion in total deposits, and operated 67 banking offices primarily in suburban metropolitan Chicago.
The Bank is engaged in commercial and retail banking and offers a broad range of lending, depository, and related financial services, including accepting deposits; commercial and industrial, consumer, and real estate lending; collections; trust and investment management services; cash management services; safe deposit box operations; and other banking services tailored for consumer, commercial and industrial, and public or governmental customers. The Bank also provides an electronic banking center on the Internet at www.firstmidwest.com, which enables Bank customers to perform banking transactions and provides information about Bank products and services to the general public.
The Bank is comprised of two divisions, a sales division and a support division. The sales division is structured along commercial and retail product lines, and the support division provides corporate, administrative, and support services.
The Bank has one wholly-owned subsidiary, First Midwest Investment Corporation, which manages investment securities and provides corporate management services to its wholly-owned subsidiary, First Midwest Investment Trust, which manages real estate loans.
First Midwest Insurance Company operates as a reinsurer of credit life, accident, and health insurance sold through the Bank, primarily in conjunction with its consumer lending operations, and is largely inactive.
Illinois and the metropolitan Chicago area are highly competitive markets for banking and related financial services. Competition is based on a number of factors, including: interest rates charged on loans and paid on deposits; the ability to attract new deposits; the scope and type of banking and financial services offered; the hours during which business can be conducted; the location of bank branches and ATMs; the availability and range of banking services on the Internet; and a variety of additional services such as investment management, fiduciary, and brokerage services. Within the geographic area it serves, the Bank competes with other banking institutions and savings and loan associations, personal loan and finance companies, and credit unions. In addition, the Bank competes for deposits with money market mutual funds and investment brokers on the basis of interest rates offered and available products. Recently, the competition for banking customers intensified as a number of local and out-of-state banking institutions announced plans for large-scale branch office expansion in the suburban Chicago markets and certain local banks were acquired by larger local and national financial institutions.
In providing investment advisory services, the Bank also competes with retail and discount stockbrokers, investment advisors, mutual funds, insurance companies, and, to a lesser extent, financial institutions for investment management clients. Factors influencing this type of competition generally involve the variety of products and services that can be offered to clients and the performance of funds under management. With the proliferation of investment management service companies, such as mutual funds and discount brokerage services, competition for investment management services comes from financial service providers both within and outside of the geographic areas in which the Bank maintains offices.
Offering a broad array of products and services at competitive prices is an important element in competing for customers. The Company differentiates itself, however, by systematically assessing a customers specific financial needs, selling products and services identified in such assessment, and providing high quality services and products. The Company believes this approach, as well as its knowledge and commitment to the communities in which the Bank is located, is the most important aspect in retaining and expanding its customer base.
Supervision and Regulation
The Company and its subsidiaries are subject to regulation and supervision by various governmental regulatory authorities including the Federal Reserve Board, the Federal Deposit Insurance Corporation (the FDIC), the Illinois Commissioner of Banks and Real Estate Companies (the Commissioner of Illinois), and the Arizona Department of Insurance. Financial institutions and their holding companies are extensively regulated under Federal and state law. The effect of such statutes, regulations, and policies can be significant and cannot be predicted with a high degree of certainty.
Federal and state laws and regulations generally applicable to financial institutions, such as the Company and its subsidiaries, regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations, and dividends. This supervision and regulation is intended primarily for the protection of the FDICs bank (the BIF) and savings association (the SAIF) insurance funds and the depositors, rather than the stockholders, of a financial institution.
The following references to material statutes and regulations affecting the Company and its subsidiaries are brief summaries thereof and are qualified in their entirety by reference to such statutes and regulations. Any change in applicable law or regulations may have a material effect on the business or operations of the Company and its subsidiaries. The operations of the Company and the Bank may also be affected by changes in the policies of various regulatory authorities. The Company cannot accurately predict the nature or the extent of the effects that any such changes would have on its business and earnings.
Bank Holding Company Act of 1956, as amended (the Act)
Generally, the Act governs the acquisition and control of banks and non-banking companies by bank holding companies. A bank holding company is subject to regulation under the Act and is required to register with the Federal Reserve under the Act. A bank holding company is required by the Act to file an annual report of its operations and such additional information as the Federal Reserve may require and is subject, along with its subsidiaries, to examination by the Federal Reserve. The Federal Reserve has jurisdiction to regulate the terms of certain debt issues of bank holding companies, including the authority to impose reserve requirements.
The acquisition of 5% or more of the voting shares of any bank or bank holding company requires the prior approval of the Federal Reserve and is subject to applicable Federal law, including the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Riegle Neal), for interstate transactions, and possible state law limitations as well. The Federal Reserve evaluates acquisition applications based upon, among other things, antitrust, safety and soundness, and community service considerations.
The Act also prohibits, with certain exceptions, a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any non banking company unless the non-banking activities are found by the Federal Reserve to be so closely related to banking . . . as to be a proper incident thereto. Under current regulations of the Federal Reserve, a bank holding company and its nonbank subsidiaries are permitted, among other activities, to engage in such banking-related business ventures as consumer finance, equipment leasing, data processing, mortgage banking, financial and investment advice, and securities brokerage services. The Act does not place territorial restrictions on the activities of a bank holding company or its nonbank subsidiaries.
Federal law prohibits acquisition of control of a bank or bank holding company without prior notice to certain Federal bank regulators. Control is defined in certain cases as the acquisition of as little as 10% of the outstanding shares. Furthermore, under certain circumstances, a bank holding company may not be able to purchase its own stock, where the gross consideration will equal 10% or more of the companys net worth, without obtaining approval of the Federal Reserve. Under the Federal Reserve Act, banks and their subsidiaries (including bank holding companies) are subject to certain requirements and restrictions when dealing with each other (subsidiary transactions). The Company is also subject to the provisions of the Illinois Bank Holding Company Act.
Bank holding companies are permitted in any state to acquire banks and bank holding companies and be acquired subject to the requirements of Riegle Neal, and in some cases, applicable state law.
Under Riegle Neal, adequately capitalized and managed bank holding companies may be permitted by the Federal Reserve to acquire control of a bank in any state. States, however, may prohibit acquisitions of banks that have not been in existence for at least five years. The Federal Reserve is prohibited from approving an application for acquisition if the applicant controls more than 10% of the total amount of deposits of insured depository institutions nationwide. In addition, interstate acquisitions may also be subject to statewide concentration limits.
The Federal Reserve would be prohibited from approving an application if, prior to consummation, the proposed acquirer controls any insured depository institution or branch in the home state of the target bank, and the applicant, following consummation of an acquisition, would control 30% or more of the total amount of deposits of insured depository institutions in that state. This legislation also provides that the provisions on concentration limits do not affect the authority of any state to limit or waive the percentage of the total amount of deposits in the state which would be held or controlled by any bank or bank holding company to the extent the application of this limitation does not discriminate against out-of-state institutions.
Interstate branching under Riegle Neal permits banks to merge across state lines, thereby creating a bank headquartered in one state with branches in other states. Approval of interstate bank mergers is subject to certain conditions, including: adequate capitalization, adequate management, Community Reinvestment Act compliance, deposit concentration limits (as set forth above), compliance with Federal and state antitrust laws, and compliance with applicable state consumer protection laws. An interstate merger transaction may involve the acquisition of a branch without the acquisition of the bank only if the law of the state in which the branch is located permits out-of-state banks to acquire a branch of a bank in that state without acquiring the bank. Following the consummation of an interstate transaction, the resulting bank may establish additional branches at any location where any bank involved in the transaction could have established a branch under applicable Federal or state law, if such bank had not been a party to the merger transaction.
Riegle Neal became effective on June 1, 1997 and allowed each state, prior to the effective date, the opportunity to opt out, thereby prohibiting interstate branching within that state. Of the two states in which the Bank is located (Illinois and Iowa), neither has adopted legislation to opt out of the interstate merger provisions. Furthermore, pursuant to Riegle Neal, a bank is able to add new branches in a state in which it does not already have banking operations if such state enacts a law permitting such de novo branching, or, if the state allows acquisition of branches, subject to applicable state requirements.
The effects on the Company of the changes in interstate banking and branching laws cannot be accurately predicted, but it is likely that there will be increased competition from national and regional banking firms headquartered outside of Illinois which establish banks in Illinois.
Illinois Banking Law
The Illinois Banking Act (IBA) governs the activities of the Company, an Illinois state banking corporation. The IBA defines the powers and permissible activities of an Illinois state chartered bank, prescribes corporate governance standards, imposes approval requirements on mergers of state banks, prescribes lending limits, and provides for the examination of state banks by the Commissioner of Illinois. The Banking on Illinois Act (BIA) became effective in mid-1999 and amended the IBA to provide a potential wide range of new activities for Illinois state chartered banks, including the Bank. The provisions of the BIA are to be construed liberally in order to create a favorable business climate for banks in Illinois. The main features of the BIA are to expand bank powers through a new wild card provision authorizing Illinois chartered banks to offer virtually any product or service that any bank or thrift may offer anywhere in the country, subject to certain safety and soundness considerations and prior notification to the Commissioner of Illinois and the FDIC. Previously, in addition to enumerated powers stated in the IBA, state banks could engage in any activity authorized or permitted to be conducted by a national bank. Management of the Bank remains aware of the favorable environment created by the BIA and will consider the opportunities that may become available to the Bank as a result of such legislation.
The Bank is subject to a variety of Federal and state laws and regulations governing its operations. For example, deposit activities are subject, among other things, to the Federal Truth in Savings Act and the Illinois Consumer Deposit Account Act. Federal and state laws also govern electronic banking transactions. Trust activities of the Bank are subject to the Illinois Corporate Fiduciaries Act. Loans made by the Bank are subject to applicable provisions of the Illinois Interest Act, the Federal Truth in Lending Act, and the Illinois Financial Services Development Act.
The Bank is subject to a variety of other laws and regulations concerning equal credit opportunity, fair lending, customer privacy, fair credit reporting, and community reinvestment. The Bank currently holds an outstanding rating for community reinvestment activity, the highest available.
The Commissioner of Illinois has adopted predatory lending regulations. These regulations apply to high cost mortgages which are defined as mortgages which exceed a specified interest rate or are assessed points in excess of a specified minimum. Once any of these thresholds is reached, the regulations impose certain restrictions on the lender, including: obligating the lender to verify the borrowers ability to repay the loan based on the borrowers income and debt obligations; prohibiting deceptive refinancing known as loan flipping where a lender refinances existing loans; charging additional points and fees, without any financial benefit to the consumer; prohibiting the financing of a single premium credit insurance policy; prohibiting the financing of points and fees in excess of 6% of the total loan amount; limiting the size and interval of balloon payments; and limiting prepayment penalties that could be charged to consumers. These regulations also require the lender to make certain disclosures to borrowers who are seeking high cost mortgages. The regulations apply to all state licensed financial institutions making residential loans in Illinois. The regulations also require lenders to file with the Commissioner of Illinois semi-annual reports on mortgage loans, including information relating to defaults and foreclosures.
The Illinois legislature has also considered the adoption of legislation aimed at curbing what some legislators and consumer-oriented advocacy groups consider to be predatory lending practices by some mortgage brokers and other lenders active in the State of Illinois. Predatory lending consists of fraudulent and deceptive sales practices that occur when borrowers are pressured into taking out loans they do not need or cannot afford. Since neither the Company nor the Bank engages in such practices, it is unlikely that any legislation adopted in Illinois to combat this perceived problem would have an impact on the Company or the Bank, other than the creation of additional reporting requirements.
As an Illinois banking corporation controlled by a bank holding company, the Bank is subject to the rules regarding change of control in the Act and the Federal Deposit Insurance Act and the regulations promulgated thereunder and is also subject to the rules regarding change in control of Illinois banks contained in the IBA.
The Bank is subject to Sections 22(h), 23A and 23B of the Federal Reserve Act, which restrict or impose requirements on financial transactions between federally insured depository institutions and subsidiary companies. The statute limits credit transactions between a bank and its executive officers and its subsidiaries, prescribes terms and conditions for bank subsidiary transactions deemed to be consistent with safe and sound banking practices, requires arms-length transactions between subsidiaries, and restricts the types of collateral security permitted in connection with a banks extension of credit to a subsidiary.
Gramm-Leach-Bliley Act of 1999
The enactment of the Gramm-Leach-Bliley Act of 1999 (GLB Act) swept away large parts of a regulatory framework that had its origins in the Depression Era of the 1930s. Effective March 11, 2000, new opportunities became available for banks, other depository institutions, insurance companies, and securities firms to enter into combinations that permit a single financial services organization to offer customers a more comprehensive array of financial products and services. To further this goal, the GLB Act amends section 4 of the Act providing a new regulatory framework applicable to a financial holding company (FHC), which has as its primary regulator the Federal Reserve. Functional regulation of the FHCs subsidiaries will be conducted by their primary functional regulators. Pursuant to the GLB Act, bank holding companies, subsidiary depository institutions thereof, and foreign banks electing to qualify as a FHC must be well managed, well capitalized, and rated at least satisfactory under the Community Reinvestment Act in order to engage in new financial activities.
An FHC may engage in securities and insurance activities and other activities that are deemed financial in nature or incidental to a financial activity under the GLB Act. While aware of the flexibility of the FHC statute, the Company has, for the time being, decided not to become a FHC, but will continue to follow the reception given FHCs in the marketplace. The activities of bank holding companies that are not FHCs will continue to be regulated by and limited to activities permissible under the Act.
The GLB Act also prohibits a financial institution from disclosing non-public personal information about a consumer to nonaffiliated third parties, unless the institution satisfies various disclosure requirements and the consumer has not elected to opt out of the disclosure. Under the GLB Act, a financial institution must provide its customers with a notice of its privacy policies and practices. The Federal Reserve, the FDIC, and other financial regulatory agencies have issued regulations implementing notice requirements and restrictions on a financial institutions ability to disclose non-public personal information about consumers to nonaffiliated third parties.
The Company is also subject to certain state laws that limit the use and distribution of non-public personal information, both to subsidiaries and unaffiliated entities.
The GLB Act is expected, in time, to alter the competitive landscape of the product markets presently served by the Company. Companies that are presently engaged primarily in insurance activities or securities activities are now permitted to acquire banks and bank holding companies, such as the Company. The Company may, in the future, face increased competition from a broader range of larger, more diversified financial companies.
USA Patriot Act
On October 26, 2001, the President signed into law comprehensive anti-terrorism legislation known as the USA Patriot Act. Title III of the USA Patriot Act requires financial institutions, including the Company and the Bank, to help prevent, detect, and prosecute international money laundering and the financing of terrorism. The Department of the Treasury has adopted additional requirements to further implement Title III.
Under these regulations, a mechanism has been established for law enforcement officials to communicate names of suspected terrorists and money launderers to financial institutions to enable financial institutions to promptly locate accounts and transactions involving those suspects. Financial institutions receiving names of suspects must search their account and transaction records for potential matches and report positive results to the U.S. Department of the Treasury Financial Crimes Enforcement Network (FinCEN). Each financial institution must designate a point of contact to receive information requests. These regulations outline how financial institutions can share information concerning suspected terrorist and money laundering activity with other financial institutions under the protection of a statutory safe harbor if each financial institution notifies FinCEN of its intent to share information.
The Department of the Treasury has also adopted regulations intended to prevent money laundering and terrorist financing through correspondent accounts maintained by U.S. financial institutions on behalf of foreign banks. Financial institutions are required to take reasonable steps to ensure that they are not providing banking services directly or indirectly to foreign shell banks.
In addition, banks must have procedures in place to identify and verify the identity of the persons with whom they deal. The Company and the Bank have augmented their systems and procedures to accomplish compliance with these requirements. The Company and the Bank believe that the cost of compliance with Title III of the USA Patriot Act is not likely to be material to them.
In July 2004, the Company and the Bank entered into an agreement with the Federal Reserve and the Illinois Office of Banks and Real Estate to enhance its compliance with all applicable Federal and state laws, rules, and regulations relating to anti-money laundering policies and procedures. To fully address all cited deficiencies, the Bank authored a written compliance plan and completed a compliance review of certain customer transactions since the date of the last prior satisfactory regulatory review. The Bank has conducted a comprehensive review of policy, procedure, systems, and manpower addressing these important areas and expects that it will be deemed in compliance with this agreement. The Company believes that this agreement will have no negative effect on its financial condition, liquidity, capital resources, or operations.
The Federal Reserve and the other Federal functional bank regulators have established risk-based capital guidelines to provide a framework for assessing the adequacy of the capital of national and state banks and their bank holding companies (collectively, banking institutions). These guidelines apply to all banking institutions, regardless of size, and are used in the examination and supervisory process as well as in the analysis of applications to be acted upon by the regulatory authorities. These guidelines require banking institutions to maintain capital based on the credit risk of their operations, both on and off-balance sheet.
The minimum capital ratios established by the guidelines are based on both Tier 1 and Total capital to total risk-based assets. In addition to the risk-based capital requirements, the Federal Reserve and the FDIC require banking institutions to maintain a minimum leveraged-capital ratio to supplement the risk-based capital guidelines.
The Companys primary source of liquidity is dividend payments from the Bank. In addition to capital guidelines, the Bank is limited in the amount of dividends it can pay to the Company under the IBA. Under this law, the Bank is permitted to declare and pay dividends in amounts up to the amount of its accumulated net profits, provided that it retains in its surplus at least one-tenth of its net profits since the date of the declaration of its most recent dividend until those additions to surplus, in the aggregate, equal the paid-in capital of the Bank. The Bank may not, while it continues its banking business, pay dividends in excess of its net profits then on hand (after deductions for losses and bad debts). As of December 31, 2004, the Bank could distribute dividends of approximately $19.7 million without approval from the Commissioner of Illinois. In addition, the Bank is limited in the amount of dividends it can pay under the Federal Reserve Act and Regulation H. For example, dividends cannot be paid that would constitute a withdrawal of capital, dividends cannot be declared or paid if they exceed a banks undivided profits, and a bank may not declare or pay a dividend greater than current year net income plus retained net income of the prior two years without Federal Reserve approval.
Since the Company is a legal entity, separate and distinct from the Bank, its dividends to stockholders are not subject to the bank dividend guidelines discussed above. The Commissioner of Illinois is authorized to determine, under certain circumstances relating to the financial condition of a bank or bank holding company, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The Federal Reserve has taken the position that dividends that would create pressure or undermine the safety and soundness of the subsidiary bank are inappropriate.
FDIC Insurance Premiums
The Banks deposits are predominantly insured through the BIF, with certain deposits held by the Bank insured through the SAIF, both of which are administered by the FDIC. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the BIF or SAIF.
The FDICs deposit insurance premiums are assessed through a risk-based system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums on deposits based upon their level of capital and supervisory evaluation. For 2005, the Bank will pay premium assessments on both its BIF and SAIF insured deposits in order to service the interest on the Financing Corporation (FICO) bond obligations which were used to finance the cost of thrift bailouts in the 1980s. The FICO assessment rates for the first semi-annual period of 2005 were set at $.0144 per $100 of insured deposits each for BIF and SAIF assessable deposits. These rates may be adjusted quarterly to reflect changes in assessment basis for the BIF and SAIF.
Where You Can Find More Information About First Midwest
The Company makes available, free of charge, on its website, http://www.firstmidwest.com, its annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, as soon as reasonably practicable after those reports are electronically filed with or furnished to the Securities and Exchange Commission (SEC).
ITEM 2. PROPERTIES
The executive offices of the Company, the Bank and certain subsidiary operational facilities are located in a five-story office building in Itasca, Illinois. The Company and the Bank currently occupy approximately 36,179 square feet on the fourth floor of that building, which is leased through an unaffiliated third party.
As of December 31, 2004, the Bank operated through 67 bank branches and operational facilities. Of these, 12 are leased and the remaining 55 are owned and not subject to any material liens. The banking offices are located in various communities primarily throughout Northern Illinois, principally the Chicago metropolitan suburban area. At certain Bank locations, excess space is leased to third parties. The Bank also owns 91 automated teller machines (ATMs), some of which are housed at a banking location and some of which are independently located. In addition, the Company owns other real property that, when considered in the aggregate, is not material to the Companys financial position.
The Company believes its facilities in the aggregate are suitable and adequate to operate its banking business. Additional information with respect to premises and equipment is presented in Note 7 of Notes to Consolidated Financial Statements commencing on page 59 of this Form 10-K.
ITEM 3. LEGAL PROCEEDINGS
There are certain legal proceedings pending against the Company and its subsidiaries in the ordinary course of business at December 31, 2004. The Company believes that any liabilities arising from these proceedings would not have a material adverse effect on the consolidated financial condition of the Company.
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no items submitted to a vote of security holders during the fourth quarter of 2004.
ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS
The Companys common stock is traded on The Nasdaq Stock Market under the symbol FMBI. As of December 31, 2004, there were 2,678 stockholders of record. The following table sets forth the closing common stock price, dividends per share, and book value per share during each quarter of 2004 and 2003.
A discussion regarding the regulatory restrictions applicable to the Banks ability to pay dividends to the Company is included in the Dividends section under Item 1 located on page 8 of this Form 10-K. A discussion of the Companys history and philosophy regarding the payment of dividends is included in the Management of Capital section of Managements Discussion and Analysis of Financial Condition and Results of Operations commencing on page 35 of this Form 10-K.
Equity Compensation Plans
The following table sets forth information, as of December 31, 2004, relating to equity compensation plans of the Company pursuant to which options, restricted stock, restricted stock units, or other rights to acquire shares may be granted from time to time.
The Nonqualified Retirement Plan is a defined contribution deferred compensation plan under which participants are credited with deferred compensation equal to contributions and benefits that would have accrued to the participant under the Companys tax-qualified plans, but for limitations under the Internal Revenue Code, and to amounts of salary and annual bonus that the participant has elected to defer. Participant accounts are deemed to be invested in separate investment accounts under the plan, which mirror the investment accounts available under the Companys tax-qualified savings and profit sharing plan, including an investment account deemed invested in shares of Company common stock. The accounts are adjusted to reflect the investment return related to such deemed investments. Except for the 4,373 shares set forth in the table above, all amounts credited under the Plan are paid in cash.
Issuer Purchases of Equity Securities
The following table summarizes shares repurchased by the Company during the quarter ended December 31, 2004.
ITEM 6. SELECTED FINANCIAL DATA
Consolidated financial information reflecting a summary of the operating results and financial condition of the Company for each of the five years ended December 31, 2004 is presented in the following table. This summary should be read in conjunction with the consolidated financial statements and accompanying notes included elsewhere in this Form 10-K. A more detailed discussion and analysis of the factors affecting the Companys financial condition and operating results is presented in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, commencing on page 12 of this Form 10-K.
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion and analysis is intended to address the significant factors affecting the Companys Consolidated Statements of Income for the years 2002 through 2004 and Consolidated Statements of Condition as of December 31, 2003 and 2004. The discussion is designed to provide stockholders with a comprehensive review of the operating results and financial condition and should be read in conjunction with the consolidated financial statements, accompanying notes thereto, and other financial information presented in this Form 10-K.
A condensed review of operations for the fourth quarter of 2004 is included herein, commencing on page 37 of this Form 10-K. The review provides an analysis of the quarterly earnings performance for the fourth quarter of 2004 as compared to the same period in 2003.
Unless otherwise stated, all earnings per share data included in this section and through the remainder of this discussion are presented on a diluted basis.
Statement under the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995: The Company and its representatives may, from time to time, make written or oral statements that are forward-looking and provide information other than historical information, including statements contained in the Form 10-K, the Companys other filings with the Securities and Exchange Commission (SEC) or in communications to its stockholders. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement. These factors include, among other things, the factors listed below.
In some cases, the Company has identified forward-looking statements by such words or phrases as will likely result, is confident that, expects, should, could, seeks, may, will continue to, believes, anticipates, predicts, forecasts, estimates, projects, potential, intends, or similar expressions identifying forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including the negative of those words and phrases. These forward-looking statements are based on managements current views and assumptions regarding future events, future business conditions, and the outlook for the Company based on currently available information. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.
In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the Company is hereby identifying important factors that could affect the Companys financial performance and could cause the Companys actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any forward-looking statements.
Among the factors that could have an impact on the Companys ability to achieve operating results, growth plan goals, and the beliefs expressed or implied in forward-looking statements are:
The foregoing list of important factors may not be all-inclusive, and the Company specifically declines to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.
With respect to forward-looking statements set forth in the notes to consolidated financial statements, including those relating to contingent liabilities and legal proceedings, some of the factors that could affect the ultimate disposition of those contingencies are changes in applicable laws, the development of facts in individual cases, settlement opportunities, and the actions of plaintiffs, judges, and juries.
CRITICAL ACCOUNTING POLICIES
The Companys consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, those policies that management believes are the most important to the Companys financial position and results of operations, requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the financial statements.
The Company has numerous accounting policies, of which the most significant are presented in Note 1 of Notes to Consolidated Financial Statements commencing on page 47 of this Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that its accounting policies with respect to the reserve for loan losses and income taxes are the accounting areas requiring subjective or complex judgments that are most important to the Companys financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below.
Reserve for Loan Losses
Arriving at an appropriate level of reserve for loan losses involves a high degree of judgment. The Companys reserve for loan losses provides for probable losses based upon evaluations of known, and inherent risks in the loan portfolio. Management uses historical information to assess the adequacy of the reserve for loan losses as well as its assessment of the prevailing business environment, as it is affected by changing economic conditions and various external factors, which may impact the portfolio in ways currently unforeseen. The reserve is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off. For a full discussion of the Companys methodology of
assessing the adequacy of the reserve for loan losses, see Note 1 of Notes to Consolidated Financial Statements commencing on page 47 of this Form 10-K.
The Company accounts for income tax expense by applying an estimated effective tax rate to its pre-tax income. The effective tax rate is based on managements judgments and estimates regarding permanent differences in the treatment of specific items of income and expense for financial statement and income tax purposes. In addition, the Company recognizes deferred tax assets and liabilities, recorded in the Consolidated Statements of Condition, based on managements judgments and estimates regarding temporary differences in the recognition of income and expenses for financial statement and income tax purposes.
The Company must also assess the likelihood that any deferred tax assets will be realized through the reduction or refund of taxes in future periods and establish a valuation allowance for those assets for which recovery is unlikely. In making this assessment, management must make judgments and estimates regarding the ability to realize the asset through carry back to taxable income in prior years, the future reversal of existing taxable temporary differences, future taxable income, and the possible application of future tax planning strategies. Although the Company has determined a valuation allowance is not required for any deferred tax assets, there is no guarantee that these assets are recognizable. For additional discussion of income taxes, see Notes 1 and 15 of Notes to Consolidated Financial Statements commencing on pages 47 and 65, respectively, of this Form 10-K.
The Company, through its banking network, provides the full range of both business and retail banking and trust and investment management services through 67 banking offices, primarily in suburban metropolitan Chicago. The Company believes that its continued profitable growth is the result of its consistent focus on relationship management and fulfilling customer needs, a strong culture of credit and operational control, and the quality and depth of the market it serves. The primary source of the Companys revenue is net interest income from loans and deposits and fees from financial services provided to customers. Business volumes tend to be influenced by overall economic factors including market interest rates, business spending, and consumer confidence, as well as competitive conditions within the marketplace.
The Company had another year of record performance in 2004. The Companys net income for 2004 increased 7.6% on a per diluted share basis to a record $99.1 million, or $2.12 per diluted share, from net income of $92.8 million, or $1.97 per diluted share, in 2003.
In 2004, the Companys return on average assets was 1.45% as compared to 1.50% in 2003 and its return on average equity was 18.7% as compared to 18.3% in 2003. In comparison to 2003, the Companys net income benefited from $612.8 million higher earning-asset levels, which generated higher tax-equivalent net interest income of $18.9 million, $5.2 million higher net realized security gains, $3.4 million lower losses resulting from extinguishment of debt, and improved fee revenue. Partially offsetting these benefits were $2.1 million in higher provisions for loan losses, $13.9 million in higher noninterest expense, lower income generated from the disposition of assets, and a higher effective tax rate. The Companys overall profitability continues to benefit from strong earnings, solid credit quality, cost control, and efficient use of capital.
The Companys total loans of $4.1 billion at December 31, 2004 increased 1.9% from December 31, 2003. During the fourth quarter 2004, the Company converted $74.2 million of its 1-4 family residential mortgages into an investment security. Also in fourth quarter 2004, the Company exited its marginally profitable indirect consumer lending business, resulting in a $60.7 million decline in outstanding loans from year-end 2003 to 2004. Excluding both 1-4 family residential loans and indirect consumer loans, the Companys total loans increased 6.0% as commercial, agricultural, commercial real estate, and home equity consumer loan categories all grew. Commercial loan growth trends remain favorable, and commercial loans outstanding as of December 31, 2004 increased by 8.9% compared to December 31, 2003. Consumer home equity loans increased 10.9% from December 31, 2003, reflecting continued sales success.
Total deposits as of December 31, 2004 totaled $4.9 billion, up 1.9% from December 31, 2003. Demand and time deposit balances outstanding as of December 31, 2004 increased 7.4% and 3.5%, respectively, in comparison to 2003, largely due to targeted sales efforts and consumer preferences.
The Companys credit quality improved during 2004. Nonperforming assets totaled $22.9 million as of December 31, 2004, down 20.6% from $28.9 million as of December 31, 2003. As of December 31, 2004, the ratio of nonperforming assets plus 90 days past due loans to total loans plus foreclosed real estate was 0.62%, improving 21.5% from 0.79% as of December 31, 2003.
During 2004, the Company completed the successful integration of CoVest Bancshares, Inc., a bank holding company in northwestern suburban Cook County that the Company acquired on December 31, 2003 (the CoVest Acquisition). As a result, the Companys average assets increased in 2004 by $645.6 million over 2003, while requiring only a minimal increase in back-office support.
The Company feels that it is well positioned for continued performance improvement because it operates in strong markets with favorable business fundamentals. As a result of improving economic conditions, the Company expects continued expansion in the markets it serves, which should generate a greater demand for the Companys products and services. The competition for bank products and services continues to intensify in the Chicago metropolitan area as banks headquartered both within and outside of Chicago have announced aggressive expansion plans. The Company continues to believe it can compete successfully because of the high quality of its products and services, its unique relationship-based approach to banking, and its knowledge of and connections to its communities.
Overall 2005 performance is expected to benefit from increased net interest income due to higher interest-earning asset levels, deposit acquisition, and fee growth. Interest-earning asset improvement should result from improved loan demand due to favorable trends in corporate and home equity lending. These benefits are likely to be offset by the expectation of a higher loan loss provision due to anticipated loan growth, increased noninterest expense, and an increased effective tax rate.
The Companys optimism for 2005 is tempered by its expectation for higher interest rates and the inherent uncertainties that arise as the economy transitions from a period of 40-year lows in interest rates. Overall, the Company expects net interest margin performance to benefit more from rising than falling or stable interest rates and expects assets to reprice more quickly than liabilities. Although net interest margin in 2005 may benefit from rising rates, it is likely to stabilize or contract if short-term interest rates increase at the same or a faster pace than intermediate and long-term rates. The Companys 2005 earnings could be negatively impacted, however, if interest rates remain stable or unexpectedly decrease. Further, if the relationship between short and long-term rates narrows, the expected benefit from rising short-term interest rates could be offset to some degree.
Net Interest Income
Net interest income represents the difference between interest income and fees earned on interest-earning assets and interest expense incurred on interest-bearing liabilities. Changes in net interest income generally occur due to fluctuations in the volume of earning assets and paying liabilities and the rates earned and paid, on these assets and liabilities. Net interest margin represents net interest income as a percentage of total interest-earning assets. For purposes of this discussion, both net interest income and margin have been adjusted to a fully tax equivalent basis to more appropriately compare the returns on certain tax-exempt loans and securities to those on taxable earning assets. The accounting policies underlying the recognition of interest income on loans, securities, and other earning assets are presented in Notes 1, 6, and 12 of Notes to Consolidated Financial Statements commencing on pages 47, 57, and 62, respectively, of this Form 10-K.
Effect of Tax Equivalent Adjustment
(Dollar amounts in thousands)
Tax equivalent net interest income in 2004 increased 8.3% in comparison to 2003 primarily due to growth in interest-earning assets acquired in the CoVest Acquisition, which was partially offset by lower net interest margins. Tax equivalent net interest income in 2003 decreased in comparison to 2002 primarily due to a decline in net interest margin, which was partially offset by the benefits of higher earning asset levels. Margin contraction in 2004 resulted primarily from the repricing of earning assets in the low interest rate environment and the acceleration of cash flows due to refinance related prepayments on mortgage-backed securities.
Table 2 summarizes the Companys average interest-earning assets and funding sources over the last three years, as well as interest income and interest expense related to each category of assets and funding sources and the yield earned and rates paid on each. The table also shows the trend in net interest margin on a quarterly basis for 2004 and 2003, including the tax equivalent yields on earning assets and rates paid on interest-bearing liabilities. Table 3 analyzes the changes in interest income, interest expense, and net interest income that result from changes in the volumes of earning assets and funding sources, as well as fluctuations in interest rates.
Net Interest Income and Margin Analysis
(Dollar amounts in thousands)
Quarterly Net Interest Margin Trend
Changes in Net Interest Income Applicable to Volumes and Interest Rates (1)
(Dollar amounts in thousands)
Tax equivalent interest income was $332.8 million in 2004 as compared to $308.7 million in 2003 and $343.7 million in 2002. The Companys improved interest income in 2004 primarily resulted from higher average loans outstanding due to the CoVest Acquisition and improved sales activity. The decrease in the Companys tax equivalent interest income in 2003 from 2002 resulted primarily from lower yields on interest-earning assets as loans repriced more quickly than interest-bearing liabilities in 2003s low interest rate environment.
Average interest-earning assets for 2004 increased $612.8 million, or 10.8%, to $6.3 billion as compared to $5.7 billion in 2003, largely as a result of assets acquired in the CoVest Acquisition. The growth in volume increased 2004s interest income by $33.8 million. This increase was partially offset by a reduction in rates received that reduced interest income by $9.8 million. In 2003, average interest-earning assets increased by $253.6 million, or 4.7%, as compared to 2002, primarily due to growth in the Companys loan and security portfolios.
Interest expense increased by $5.2 million to $86.5 million in 2004 as compared to $81.3 million in 2003, following a $29.6 million decrease from $110.9 million in 2002. Average interest-bearing liabilities for 2004 increased by $557.0 million, or 11.6%, to $5.4 billion, due in large part to the CoVest Acquisition, including the $125 million issuance of trust preferred
securities to fund the acquisition. In 2003, average interest-bearing liabilities increased by $201.8 million, or 4.4%, due to an increase in borrowed funds. Interest-bearing liabilities repricing in the lower interest rate environment caused the rate paid on average interest-bearing deposits to fall by 8 basis points to 1.61% in 2004 and 71 basis points to 1.69% in 2003. As discussed in the subsequent section entitled Funding and Liquidity Management commencing on page 32 of this Form 10-K, the repositioning of deposit balances was influenced by pricing and promotional strategies as well as customer liquidity preferences given the prevailing interest rate and economic climate.
The Companys tax equivalent net interest margin was 3.91% in 2004 as compared to 3.99% in 2003 and 4.28% in 2002. Net interest margin in 2004 decreased as interest-earning assets repriced more quickly than interest-bearing liabilities during the continued low interest rate environment. The average yield earned on interest-earning assets decreased by 14 basis points in 2004, while the average rate paid on interest-bearing liabilities decreased by only 8 basis points. Net interest margin for the fourth quarter of 2004 was 3.94%, an improvement from third quarter 2004s 3.90% and second quarter 2004s 3.81%. This linked-quarter margin improvement reflects the benefit of rising short-term interest rates, which increased 125 basis points since June 30, 2004. In addition, linked-quarter performance benefited from higher security yields as mortgage-related prepayment speeds slowed. Net interest margin declined during the first half of 2004 as a greater volume of interest-earning assets began to reprice during that period of continued low interest rates. In part, the speed of this decline was accelerated as a result of the impact of refinance related prepayments on mortgage-backed securities and certain measures taken by management to better insulate net interest income and margin from the potential of future rising interest rates. The section entitled Qualitative and Quantitative Disclosures About Market Risk, commencing on page 38, describes the measures taken during the year and discusses the techniques used to manage the volatility and other factors that affect net interest margin and net interest income.
Noninterest income increased $5.2 million to $79.4 million in 2004 from $74.2 million in 2003, largely the result of higher realized security gains and lower debt extinguishment losses. These increases were offset by the absence in 2004 of gains realized from the Companys 2003 divesture of its two branches in Streator, Illinois. Excluding these transactions, the Companys noninterest income improved slightly to $73.8 million in 2004 from $72.6 million in 2003.
As compared to 2003, increases in service charges on deposit accounts, card-based fees, and trust and investment management fees were offset by a decline in other service charges, commissions, and fees, and other income. In 2004, service charges on deposit accounts increased $913,000, primarily benefiting from higher fees received on items drawn on customer accounts with insufficient funds. Card-based revenues improved $916,000 in 2004, reflecting the continuing acceptance of debit card payment as an alternative to cash or check. Compared to 2003, trust and investment management fees improved $1.1 million, or 10%, in 2004, as an 8.1% year over year increase in assets under management combined with strong sales growth and improving equity markets to generate greater fee revenue. The $1.0 million decline in other service charges, commissions, and fees reflects the impact of lower mortgage-related commissions, as refinancing activity slowed in 2004.
Excluding security gains, losses on the early extinguishment of debt, and gains realized from branch divestitures, noninterest income increased by 9.1% in 2003 from 2002. All major categories of noninterest income increased in 2003, except for corporate owned life insurance income. Service charges on deposit accounts increased by $2.6 million in 2003 as compared to 2002, primarily due to higher revenue resulting from an increase in items drawn on customer accounts with insufficient funds. In 2003, other service charges, commissions, and fees increased by $1.8 million in comparison to 2002, primarily due to higher mortgage loan origination commissions resulting from a comparatively higher volume of originations in 2003s favorable interest rate environment. In addition, the increase in 2003 also reflects higher commissions received from the sale of annuity, insurance, and investment products, reflecting the benefit of improved equity markets and targeted sales forces.
For a discussion on net security gains, refer to the section titled Investment Portfolio Management commencing on page 22 of this Form 10-K. For a discussion on losses on early extinguishment of debt, refer to the section titled Funding and Liquidity Management commencing on page 32 of this Form 10-K. In 2003, the Company recognized a $4.6 million gain on the divestiture of two branches in rural, Streator, Illinois. The transactions together increased noninterest income in 2004 and 2003 by $5.6 million and $1.6 million, respectively.
Noninterest Income Analysis
(Dollar amounts in thousands)
N/M Not meaningful.
Total noninterest expense for 2004 rose $13.9 million to $163.3 million, an increase of 9.3% from 2003. This increase reflects additional expenses associated with operating the CoVest franchise, including increases of $2.9 million in direct salaries, $1.1 million in net occupancy expense, and $2.1 million in core deposit intangible amortization. The increase in salaries and wages also reflects general merit increases as well as $981,000 higher expenses for incentive-related compensation programs, which are based on Company performance. Retirement and other employee benefits increased as the number of full-time equivalent employees grew due to the CoVest acquisition. In addition, pension costs rose by $1.3 million, driven by a decrease in the actuarial assumption for the expected return on plan assets, and employee health care costs increased $1.7 million due to higher claims. Professional service fees rose as a result of higher fees for professional and audit-related services, primarily related to compliance with new SEC requirements regarding internal controls. Advertising and promotion costs also increased in 2004 from 2003 due to an increase in newspaper and print advertising, and merchant card expense increased due to higher volumes. These increases in expenses were partially offset by a decrease in technology and related costs in 2004, principally due to more favorable contract terms negotiated with the Companys external data service provider.
Noninterest expense totaled $149.5 million in 2003 as compared to $148.1 million in 2002 as increases in compensation expense and advertising and promotions were offset by declines in technology and related costs, amortization expense, and other expenses. The year over year increase in salaries and wages in 2003 from 2002 resulted from a combination of annual merit increases and higher commissions paid for increased mortgage origination volumes. In 2003, the decline in technology and related costs as compared to 2002 reflected the cost savings achieved from bringing in-house the backroom operation of the items processing function.
Noninterest Expense Analysis
(Dollar amounts in thousands)
N/M Not meaningful.
The Companys provision for income taxes includes both Federal and state income tax expense. An analysis of the provision for income taxes and the effective income tax rates for the periods 2002 through 2004 are detailed in Table 6.
Income Tax Expense Analysis
(Dollar amounts in thousands)
The Companys accounting policies underlying the recognition of income taxes in the Consolidated Statements of Condition and Income are included in Notes 1 and 15 of Notes to Consolidated Financial Statements commencing on pages 47 and 66, respectively, of this Form 10-K. In accordance with such policies, the Company records income tax expense (benefits) in accordance with SFAS No. 109, Accounting for Income Taxes. Pursuant to SFAS No. 109, the Company recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Net deferred tax assets totaling $2.6 million at December 31, 2004 are recorded in other assets in the accompanying Consolidated Statements of Condition.
Under SFAS No. 109, a valuation allowance must be established for any deferred tax asset for which recovery or settlement is unlikely. In assessing whether a valuation allowance is required, the Company considers the ability to realize the asset through carry back to taxable income in prior years, the future reversal of existing taxable temporary differences, future taxable income, and the possible application of future tax planning strategies. Based on this assessment, the Company has determined that a valuation allowance is not required for any of the deferred tax assets it has recorded.
The 2004 effective income tax rate reflected in the table is comprised of a Federal effective tax rate of 25.1% in 2004, 24.9% in 2003, and 25.9% in 2002 and a state effective tax rate of (0.2%) in 2004, 0.1% in 2003, and 0.4% in 2002.
The Federal effective tax rate, and change in that rate, is primarily attributable to the amounts of tax-exempt income derived from investment securities and COLI. The state effective tax rate, and changes in that rate, is dependent on Illinois and Iowa income tax rules relating to consolidated/combined reporting, sourcing of income and expense, and the amount of tax-exempt income derived from loans, investment securities, and COLI.
For further details regarding the Companys effective tax rate, refer to Note 15 in Notes to Consolidated Financial Statements commencing on page 65 of this Form 10-K.
INVESTMENT PORTFOLIO MANAGEMENT
The investment portfolio is managed to maximize the return on invested funds within acceptable risk guidelines, to meet pledging and liquidity requirements, and to adjust balance sheet interest rate sensitivity to insulate net interest income against the impact of changes in interest rates. The following provides a valuation summary of the Companys investment portfolio as of December 31.
Investment Portfolio Valuation Summary
(Dollar amounts in thousands)
Securities that the Company believes could be sold prior to maturity in order to manage interest rate, prepayment, or liquidity risk are classified as securities available for sale and are carried at fair market value. Unrealized gains and losses on this portfolio segment are reported on an after-tax basis as a separate component of stockholders equity in accumulated other comprehensive income. Securities that the Company has the ability and intent to hold until maturity are classified as securities held to maturity and are accounted for using historical cost, adjusted for amortization of premium and accretion of discount.
At December 31, 2004, the available for sale securities portfolio totaled $2.18 billion as compared with $2.23 billion at December 31, 2003. The $50.2 million decrease in the portfolio from year-end 2003 is primarily as a result of a $38.0 million decrease in the unrealized gain on available for sale securities.
The size and composition of the securities portfolio is influenced by a number of factors, including expected loan growth, anticipated growth in collateralized public funds on account, and managements decisions regarding the level of 1-4 family-related asset exposure held on the balance sheet. This exposure represents both direct loans to customers and mortgage-backed securities. In 2004, the Company held total 1-4 family residential loan exposure of $1.4 billion on its balance sheet, $1.3 billion of which was concentrated in the Companys security portfolio. Approximately 59% of the portfolio as of December 31, 2004 was comprised of mortgage-backed securities as compared to 52% and 58%, respectively, at year-end 2003 and 2002. The concentration of this exposure in the securities portfolio offers the benefits of minimal credit risk, improved liquidity, better monitoring of prepayment characteristics, and greater balance sheet flexibility for the cost of accepting lower yields. As of December 31, 2004, the combination of the Companys security portfolio and 1-4 family residential loan portfolio represented 34.0% of total assets, down from 35.7% at the end of 2003 and 37.3% at the end of 2002.
The unrealized gain on the securities available for sale portfolio (representing the difference between the aggregate cost and market value of the portfolio) totaled $16.1 million at December 31, 2004 as compared to $54.1 million at December 31, 2003. This balance sheet component will fluctuate as current market interest rates and conditions change, thereby affecting the aggregate market value of the portfolio. The unrealized gain decreased due to a slightly higher level of interest rates at the end of 2004 as compared with 2003. The decline in net unrealized portfolio appreciation and the decrease in duration from December 31, 2003 to December 31, 2004 reflect the combined impact of the increase in interest rates and changes in
portfolio composition. The level of unrealized gains affords the Company the flexibility to either extend portfolio duration and receive higher yields or shorten duration and realize security gains as market opportunities present themselves in 2005.
Net gains realized from the Companys securities portfolio totaled $8.2 million in 2004. During 2004, the Company responded to changing market conditions and its continued expectation for higher interest rates, by selling $141.7 million in higher-yielding, longer-term municipal securities, which resulted in the recognition of security gains totaling $9.5 million. Security proceeds were reinvested in collateralized mortgage obligations with a comparatively lower duration. Realized gains during 2004 were partially offset by a $5.4 million other-than-temporary impairment recognized on a single, Federal National Mortgage Association preferred stock issuance during third quarter 2004.
Net gains on sales of securities increased in 2003 to $3.0 million from $0.5 million in 2002. The gains in 2003 occurred primarily as part of certain balance sheet restructuring initiatives, designed to better position the Company for the possibility of rising rates.
The repricing distribution and average yields, on a tax equivalent basis, of the securities portfolio at December 31, 2004 are presented in Table 8.
Repricing Distribution and Portfolio Yields
(Dollar amounts in thousands)
LOAN PORTFOLIO AND CREDIT QUALITY
Loans are the Companys principal source of revenue. The Companys revenue from lending activities is primarily represented by interest income, but it also includes loan origination and commitment fees (net of related costs). The accounting policies underlying the recording of loans in the Consolidated Statements of Condition and the recognition and/or deferral of interest income and fees (net of costs) arising from lending activities are included in Notes 1 and 5 of Notes to Consolidated Financial Statements commencing on pages 47 and 56, respectively, of this Form 10-K.
Portfolio Management and Composition
The Company looks to balance its portfolio among the categories of commercial and industrial loans (including agricultural loans), real estate loans (both commercial and construction loans), and consumer loans (including real estate 1-4 family loans), according to internal policy and as dictated by market and economic conditions. By policy, the Company limits its exposure to real estate and commercial and construction lending to 50% of total loans, commercial and industrial lending to 38% of total loans and consumer lending to 35% of total loans.
The Company concentrates its lending activities in the geographic areas it serves. Consistent with the Companys emphasis on relationship banking, most of these credits represent core, multi-relationship customers of the Company. The customers usually maintain deposit relationships and use other Company banking services, such as cash management.
The Company also reduces its credit risk by limiting its exposure to any one borrower. Although the Companys legal lending limit approximates $146.3 million, the largest loan balance to one borrower at year-end 2004 was $22.3 million, and only 27 borrowers had aggregate loan balances outstanding in excess of $10 million. In terms of commitments to extend credit, the Companys largest exposure to a single borrower is $30.0 million and to a group of related companies comprising a single relationship is $37.8 million. The Company had only 20 credits in the portfolio where total commitments to extend credit to a single borrower relationship exceeded $20 million.
(Dollar amounts in thousands)
The Companys total loans at December 31, 2004 increased 1.9% from December 31, 2003, as increases in corporate lending offset decreases in consumer loans and 1-4 family real estate lending. Corporate loan balances as of December 31, 2004 increased by 6.0% from year-end 2003, primarily due to continued increases in commercial, agricultural, and commercial real estate lending. The increase in commercial and commercial real estate loans reflects the impact of continuing sales efforts and customers drawing upon existing lines of credit, while real estate construction loans declined by 5.8% as certain loans matured.
Total loans at December 31, 2003 were 19.2% higher than at December 31, 2002, primarily due to loans acquired as part of the CoVest Acquisition. Excluding the $530.8 million in loans the Company acquired from CoVest, total loans increased approximately 3.6% over 2002 as all loan categories experienced growth except for 1-4 family real estate and indirect consumer lending.
As of December 31, 2004, corporate loans (defined as commercial and industrial, agricultural, commercial real estate and real estate construction loans) represented 76.8% of total loans outstanding as compared to 73.7% in 2003 and 69.1% in 2002. In 2004, the percentage of corporate loans grew as a result of strong sales activity, managements decision to exit its marginally profitable indirect lending business, and the shift of the Companys exposure to 1-4 family mortgages to its security portfolio. The Company seeks to maintain a diversified portfolio of corporate loans to minimize its exposure to any particular industry or any segment of the economy.
Real estate commercial and construction lending has always been an area of specialty for the Company. Because of the strength of the suburban Chicago real estate market over the past several years, real estate commercial and construction lending grew to approximately 47% of the Companys total loans as of December 31, 2004. The combination of seasoned, long-time borrowers, experienced senior lending officers, managements focus on market fundamentals, and a stringent underwriting process gives the Company a competitive market advantage. These factors and a balanced exposure to any particular industry segment have reduced the Companys exposure to loss.
Real estate commercial loans consist of income-producing commercial property loans, multi-unit residential mortgages, and commercial real estate mortgages. Approximately 20% of the Companys real estate commercial loans represent multi-family loans made to real estate companies and to individual investors to finance or refinance apartment buildings. These apartment buildings are primarily concentrated in the metropolitan Chicago area and typically range in size from five units up to twenty-four units, although larger projects may range up to 100 units or more. The Company believes that this type of lending helps diversify its already strong commercial and multifamily development real estate platform and represents an opportunity for growth.
Real estate construction loans are primarily single-family and multi-family residential and non-residential projects located in the Companys primary markets. Real estate construction loans are a profitable line of lending for the Company due to the higher level of interest rates and fees earned on such loans as compared to other loan categories and the favorable loss experience on these loans.
Table 10 on page 27 of this Form 10-K specifies the Companys corporate loan portfolio, including commercial and industrial loans, by industry segment and illustrates the diversity of its loan portfolio. Table 11 on page 27 of this Form 10-K summarizes the loan portfolios maturities and interest rate sensitivity.
As of December 31, 2004, consumer loans (including real estate 1-4 family loans) represented 23.2% of total loans outstanding as compared to 26.3% in 2003 and 30.9% in 2002. The decrease reflects lower indirect consumer loan and real estate 1-4 family loans. Indirect consumer lending has declined as the Company slowed new volumes by tightening underwriting standards in 2002 and decided to exit this marginally profitable business in 2004. The home equity category represents the single largest and fastest growing portion of the consumer portfolio, consisting mainly of revolving lines of credit secured by junior liens on owner occupied real estate. As a general rule, loan to value ratios for these credits range from 70% to 90%.
Consumer loan balances as of December 31, 2004 decreased 3.0% from December 31, 2003 reflecting two asset redeployment decisions elected by management. First, the Company converted $74.2 million of certain 1-4 family residential mortgages into an investment security during the fourth quarter of 2004. Second, the Company exited its marginally profitable indirect consumer lending business, resulting in a year-over-year $60.7 million reduction of loan outstandings from December 31, 2003. This decline was partially offset in 2004 by increased home equity line sales activity, resulting from pricing and promotional activities.
Real estate 1-4 family loans further declined in 2004 as customers continued to refinance loans in the low interest rate environment. The Company retains originated variable rate and certain other qualifying mortgages, while selling all other originations through a third party provider. As previously discussed in the section titled Investment Portfolio Management commencing on page 22 of this Form 10-K, the Companys portfolio exposure to 1-4 family real estate is balanced with that embedded in its securities portfolio, as these assets tend to be longer in duration and have similar risk characteristics.
Distribution of Corporate Loans By Industry
Table 10 summarizes the Companys ten largest industry segments for the corporate loan portfolio as of December 31, 2004, 2003, and 2002. The effectiveness of such analysis, however, is limited to the extent that classification by segment requires that allocation of a customers aggregate loans outstanding be based upon the nature of the borrowers ongoing business activity as opposed to the purpose of the collateral underlying an individual loan. To the extent that a borrowers underlying
business activity changes, classification differences will arise. As a result, the Company periodically reassesses and adjusts industry classifications.
Corporate Loan Portfolio by Industry Segment(1)
(Dollar amounts in thousands)
The Company believes its loan portfolio is diversified across industries and market segments. The increase in loans made to Lessors of multi-family residential real estate from 2002 to 2003 was primarily due to the CoVest Acquisition.
Maturity and Interest Rate Sensitivity of Corporate Loans
Table 11 summarizes the maturity distribution of the Companys corporate loan portfolio as of December 31, 2004 as well as the interest rate sensitivity of loans in these categories that have maturities in excess of one year.
Maturities and Sensitivities of Corporate Loans to Changes in Interest Rates
(Dollar amounts in thousands)
Credit Quality Management and Reserve for Loan Losses
In addition to the portfolio diversification previously discussed, the Company has established a thorough system of internal controls to mitigate credit risk, including standard lending and credit policies, underwriting criteria and collateral safeguards. The Company monitors and implements its formal credit policies and procedures and continues to evaluate the quality, trends, collectibility, and collateral protection within the loan portfolio. The Companys policy and procedures are regularly reviewed and modified in order to manage risk as conditions change and new credit products are offered.
The Companys credit administration policies include a comprehensive loan rating system. The internal loan review staff annually reviews at least 70% of all corporate loans and commitments and all new loans and commitments in excess of $1 million. Account officers are vested with the responsibility of monitoring their customer relationships and act as the first line of defense in determining changes in the loan ratings on credits for which they are responsible. The Company believes that any significant change in the overall quality of the loan portfolio will be reflected by these loan ratings within this monitoring system.
The Companys senior managers actively review those loans that require some form of remediation. Those loans are reviewed at regular quarterly meetings between the credit administration staff and the account officers, and action plans are developed to either remedy any emerging problem loans or develop a specific plan for removing such loans from the portfolio. Such periodic reviews are then escalated for review by senior executive officers, including the Chief Executive Officer. During times of economic duress, the Company has increased the frequency of these meetings.
The Company maintains a reserve for loan losses to absorb probable losses inherent in the loan portfolio. The reserve for loan losses consists of three components: (i) specific reserves established for expected losses resulting from analysis developed through specific credit allocations on individual loans for which the recorded investment in the loan exceeds the measured value of the loan; (ii) reserves based on historical loan loss experience for each loan category; and (iii) reserves based on general, current economic conditions as well as specific economic factors believed to be relevant to the markets in which the Company operates. Management evaluates the sufficiency of the reserve for loan losses based upon the combined total of the specific, historical loss and general components.
The accounting policies underlying the establishment and maintenance of the reserve for loan losses through provisions charged to operating expense are discussed in Notes 1 and 6 of Notes to Consolidated Financial Statements commencing on pages 47 and 57, respectively, of this Form 10-K.
Table 12 shows the allocation of the reserve for loan losses by loan category, as well as charge-off and recovery information for the last 5 years. During 2003, the Company expanded its reserve assessment to fully allocate its general reserve component to specific pools or groups of loans, thereby better linking its assessment of the underlying risks attributed to each loan category. To facilitate comparison, 2002s allocation by category has been restated to reflect this change in methodology. Data presented for periods prior to 2002 was not restated due to the absence of sufficient, comparable data.
Reserve for Loan Losses and
Summary of Loan Loss Experience
(Dollar amounts in thousands)
As of December 31, 2004, the Companys reserve for loan losses totaled $56.7 million as compared to $56.4 million as of December 31, 2003 and $47.9 million as of December 31, 2002. The ratio of reserve for loan losses to total loans at year-end 2004 was 1.37%, down from 1.39% at year-end 2003 and 1.41% at the end of 2002. The 2004 reserve for loan losses increased by $314,000 or 0.6%, from 2003. The 2003 increase in overall reserve was due to the purchase of $7.2 million of loan loss reserves and