First Midwest Bancorp 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year-ended December 31, 2005
For the transition period from to
Commission File Number 0-10967
FIRST MIDWEST BANCORP, INC.
(Exact name of registrant as specified in its charter)
One Pierce Place, Suite 1500
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:
Title of each class:
Common Stock, $.01 Par Value
Preferred Share Purchase Rights
Indicate by check mark whether the issuer is a well-known seasoned issuer as defined in Rule 405 of the Securities Act of 1933. Yes x No ¨.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x.
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. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x.
The aggregate market value of the registrants outstanding voting common stock held by non-affiliates on June 30, 2005, determined using a per share closing price on that date of $35.08, as quoted on The Nasdaq Stock Market, was $1,478,199,847.
At February 27, 2006 there were 45,442,134 shares of common stock, $.01 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrants Proxy Statement for the 2006 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 $7.2 billion at year-end 2005 and is headquartered in the Chicago suburb of Itasca, Illinois.
The Company operates two wholly owned subsidiaries: First Midwest Bank (the Bank), employing 1,622 full-time equivalent employees at December 31, 2005, 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, 2005, the Bank had $7.2 billion in total assets, $5.2 billion in total deposits, and 68 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 Banks operations are divided into sales and support functions. The sales function is structured along commercial and retail product lines, and the support function provides corporate, administrative, and support services.
The Bank operates two wholly owned subsidiaries: FMB Investment Corporation and First Midwest Investments, Inc., which currently is inactive.
FMB Investment Corporation is a Delaware corporation established in 1998. FMB Investment Corporation manages investment securities, principally state and municipal obligations, and provides corporate management services to its wholly owned subsidiary FMB Investment Trust, a Maryland business trust also established in 1998. FMB Investment Trust manages real estate loans originated by the Bank. FMB Investment Trust has elected to be taxed as a Real Estate Investment Trust for federal income tax purposes.
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.
On December 12, 2005, the Company announced the execution of a definitive agreement to acquire Bank Calumet, Inc. (Bank Calumet) and its wholly owned subsidiary bank for $307 million in cash. Bank Calumet is a bank holding company headquartered in Hammond, Indiana with $1.2 billion in assets and 30 branches located predominantly in Lake County, Indiana and the contiguous Illinois counties of Cook and Will. In February 2006, the transaction was approved by the Board of Governors of the Federal Reserve Board (the Federal Reserve) and by Bank Calumets shareholders. The Company expects to complete this acquisition early in the second quarter of 2006, subject to customary closing conditions, including the approval of the Department of Financial Institutions of the State of Indiana.
The Company believes that Bank Calumet represents an excellent opportunity to expand its franchise in the southeast Chicago metropolitan area. The Company looks forward to building upon the long-standing relationships that Bank Calumet has developed in its 73 years of banking service to these dynamic markets and expects that Bank Calumets conservative policies, diversified lending base, and community banking approach will fit well with the Companys established business model.
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, ease of use, and range of banking services on the Internet; the availability of related services; and a variety of additional services such as investment management, fiduciary, and brokerage services. Within the geographic areas it serves, the Bank competes with other banks 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. The competition for banking customers remains intense as a number of local and out-of-state banking institutions have engaged in large-scale branch office expansion in the suburban Chicago markets, whether through acquisition or establishment of de novo branches.
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. 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, in the way it systematically assesses a customers specific financial needs, sells products and services identified in such assessment, and provides its high quality services and products. The Company believes its approach and its knowledge and commitment to the communities in which the Bank is located are the most important aspects 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 Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation (the FDIC), the Illinois Department of Financial and Professional Regulation (the IDFRP), 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 nonbanking 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, competitive factors, supervisory factors, adequacy of financial and managerial resources, and banking 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 nonbanking company unless the nonbanking 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 are subject to certain requirements and restrictions when dealing with each other (affiliate transactions including transactions with their bank holding company). The Company is also subject to the provisions of the Illinois Bank Holding Company Act.
Bank holding companies are permitted to acquire banks and bank holding companies in any state and to 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. Illinois law allows de novo banking with other states that allow Illinois banks to branch de novo in those states.
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. Likewise, the Company may establish branches in reciprocity states (such as Indiana) on a de novo basis.
Illinois Banking Law
The Illinois Banking Act (IBA) governs the activities of the Bank, 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 IDFPR. 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 IDFPR 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 law, including the Electronic Funds Transfer Act, 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.
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 and the Illinois Bank Holding Company Act.
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 affiliated companies. The statute limits credit transactions between a bank and its executive officers and its subsidiaries, prescribes terms and conditions for bank affiliate transactions deemed to be consistent with safe and sound banking practices, requires arms-length transactions between affiliates, and restricts the types of collateral security permitted in connection with a banks extension of credit to affiliates.
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 an 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, such as merchant banking activities. While aware of the flexibility of the FHC statute, the Company has, for the time being, decided not to become an 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 unaffiliated 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 unaffiliated 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, affiliates, 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.
Bank Secrecy Act and USA Patriot Act
In 1970, Congress enacted the Currency and Foreign Transactions Reporting Act, commonly known as the Bank Secrecy Act (the BSA). The BSA requires financial institutions to maintain records of certain customers and currency transactions and to report certain domestic and foreign currency transactions, which have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings. Under this law, financial institutions are required to develop a BSA compliance program.
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 those involved in 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 IDFPR (the Written Agreement) 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 the deficiencies cited in the Written Agreement, 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. As a result, the Bank conducted a comprehensive review of policy, procedure, systems, and manpower addressing these important areas. The Bank successfully resolved the deficiencies cited, and received a letter dated September 30, 2005 from the Federal Reserve Bank of Chicago and the IDFPR, which formally communicated the termination of the Written Agreement. The Written Agreement did not have a significant effect on the Banks 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, thrifts, and their 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 Company and the Bank are well capitalized by these standards, the highest applicable ratings.
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, 2005, the Bank could distribute dividends of approximately $32.0 million without approval from the IDFPR. 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 IDFPR is authorized to determine, under certain circumstances relating to the financial condition of a bank or bank holding company, that the payment of dividends by the Company 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 2006, 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 2006 were set at $.0132 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 1A. RISK FACTORS
The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision with respect to any of the Companys securities, you should carefully consider the risks and uncertainties as described below together with all of the information included herein. The risks and uncertainties described below are not the only risks and uncertainties the Company faces. Additional risks and uncertainties not presently known or that are currently deemed immaterial also may have a material adverse effect on the Companys results of operations and financial condition. If any of the following risks actually occur, the Companys results of operations and financial condition could suffer, possibly materially. In that event, the trading price of the Companys common stock or other securities could decline. The risks discussed below also include forward-looking statements, and actual results may differ substantially from those discussed or implied in these forward-looking statements.
Risks Related To The Companys Business
Competition in the banking industry is intense.
Competition in the banking and financial services industry is intense. In its primary market areas, the Bank competes with other commercial banks, savings and loan associations, credit unions, finance companies, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Many of these competitors have substantially greater resources and lending limits than the Bank and may offer certain services that the Bank does not provide. The Companys profitability depends upon the Banks continued ability to compete effectively in its market areas. A number of local and out-of-state banking institutions have engaged in large-scale branch office expansion in the suburban Chicago markets, through acquisition or establishment of de novo branches.
The Company operates in a heavily regulated environment.
The banking industry is heavily regulated. The banking business of the Company and the Bank are subject, in certain respects, to regulation by the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency, the IDFPR, and the SEC. The Companys success depends not only on competitive factors but also on state and federal regulations affecting banks and bank holding companies. The regulations are primarily intended to protect depositors, not stockholders or other security holders. The ultimate effect of recent and proposed changes to the regulation of the financial institution industry cannot be predicted. Regulations now affecting the Company may be modified at any time, and there is no assurance that such modifications, if any, will not adversely affect the Companys business.
Changes in the policies of monetary authorities could adversely affect the Companys profitability.
The Companys results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve. The instruments of monetary policy employed by the Federal Reserve include open market operations in United States government securities, changes in the discount rate or the federal funds rate on bank borrowings, and changes in reserve requirements against bank deposits. Changes in these policies could adversely affect the Companys profitability. For example, changes impacting the Companys cost of funds could reduce net interest income. No certainty can be given as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of the Bank due to changing conditions in the national economy and in the money markets.
The Companys business is concentrated in the Chicago metropolitan area, and a downturn in the economy of this area may adversely affect the Companys business.
The Companys success depends to a large degree on the general economic conditions of the geographic markets served by the Bank in the State of Illinois and, to a lesser extent, contiguous states. The local economic conditions in these areas have a significant impact on the generation of the Banks commercial, real estate commercial, and real estate construction loans; the ability of borrowers to repay these loans; and the value of the collateral securing these loans. Adverse changes in the economic conditions of the Chicago metropolitan area in general could also negatively impact the financial results of the Companys operations and have a negative effect on its profitability. For example, these factors could lead to reduced interest income and an increase in the provision for loan losses.
A significant portion of the loans in the Companys portfolio is secured by real estate. Most of these loans are secured by properties located in the Chicago metropolitan area. Negative conditions in the real estate markets where collateral for a mortgage loan is located could adversely affect the borrowers ability to repay the loan and the value of the collateral securing the loan. Real estate values are affected by various factors, including changes in general or regional economic conditions, supply and demand for properties and governmental rules or policies.
Changes in the reserve for loan losses could affect profitability.
Managing the Companys reserve for loan losses is based upon, among other things, (1) historical experience, (2) an evaluation of local and national economic conditions, (3) regular reviews of delinquencies and loan portfolio quality, (4) current trends regarding the volume and severity of past due and problem loans, (5) the existence and effect of concentrations of credit and (6) results of regulatory examinations. Based upon such factors, management makes various assumptions and judgments about the ultimate collectibility of the respective loan portfolios. Although the Company
believes that the reserve for loan losses is adequate, there can be no assurance that such reserve will prove sufficient to cover future losses. Future adjustments may be necessary if economic conditions change or adverse developments arise with respect to nonperforming or performing loans or if regulatory supervision changes. Material additions to the reserve for loan losses would result in a material decrease in the Companys net income, and possibly its capital, and could result in the inability to pay dividends, among other adverse consequences.
The Company is a bank holding company, and its sources of funds are limited.
The Company is a bank holding company and its operations are primarily conducted by the Bank, which is subject to significant federal and state regulation. Cash available to pay dividends to stockholders of the Company is derived primarily, if not entirely, from dividends paid by the Bank. As a result, the Companys ability to receive dividends or loans from its subsidiaries is restricted. At December 31, 2005, $32.0 million of the retained earnings of the Bank were available to pay dividends to the Company without regulatory approval. Dividend payments by the Bank to the Company in the future will require generation of future earnings by the Bank and could require regulatory approval if the proposed dividend is in excess of prescribed guidelines. Further, the Companys right to participate in the assets of the Bank upon its liquidation, reorganization or otherwise will be subject to the claims of the Banks creditors, including depositors, which will take priority except to the extent the Company may be a creditor with a recognized claim. As of December 31, 2005, the Companys subsidiaries had deposits and other liabilities of approximately $6.6 billion.
The Company is subject to environmental liability risk associated with lending activities.
A significant portion of the Companys loan portfolio is secured by real property. During the ordinary course of business, the Company may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Company to incur substantial expenses and may materially reduce the affected propertys value or limit the Companys ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Companys exposure to environmental liability.
Changes in interest rates could have an adverse effect on the Companys income.
The Companys financial performance depends to a significant extent upon its 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. The Companys net interest income is adversely affected if interest paid on deposits and borrowings increases faster than the interest earned on loans and investments. Changes in interest rates could also adversely affect the income of certain components of the Companys noninterest income. For example, if mortgage interest rates increase, the demand for residential mortgage loans would likely decrease, which would have an adverse effect on the gain on the sale of mortgages.
Changes in the mix of the Companys funding sources could have an adverse effect on the Companys income. Over half of the Companys funding sources are in lower-rate transactional deposit accounts. Market rate increases or competitive pricing could heighten the risk of moving to higher-rate funding sources, which would cause an adverse impact on the Companys net income.
Future acquisitions may disrupt the Companys business, dilute stockholder value, and adversely affect operating results.
The Company has grown by strategically acquiring banks or branches of other banks. The Company intends to continue to pursue acquisitions to supplement internal growth opportunities. Acquiring other banks or branches involves risks commonly associated with acquisitions, including:
Competition for acquisition candidates is intense.
Competition for acquisitions is intense. Numerous potential acquirors compete with the Company for most acquisition candidates, particularly on the basis of price to be paid. The Company may not be able to successfully identify and acquire suitable targets, which could slow the Companys growth rate.
The Companys continued pace of growth may require it to raise additional capital in the future, but that capital may not be available when it is needed.
The Company is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. To the extent the Company continues to expand its asset base, primarily through loan growth, it will be required to support such growth by increasing its capital. In addition, the Company may be required to raise capital to support its acquisition strategy. Accordingly, the Company may need to raise capital in the future to support continued growth.
The Companys ability to raise capital will depend on conditions in the capital markets, which are outside of its control, and on the Companys financial performance. Accordingly, the Company cannot assure you of its ability to raise capital when needed or on favorable terms. If the Company cannot raise additional capital when needed, it will be subject to increased regulatory supervision and the imposition of restrictions on its growth and business. These could negatively impact the Companys ability to further expand its operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could harm its operating results.
Any reduction in the Companys credit ratings could increase its financing costs.
The Company cannot give any assurance that its current credit ratings will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances in the future so warrant. Any downgrade could increase the cost of borrowings or make it more difficult to obtain capital.
Our junior subordinated debentures have been assigned a rating by Standard & Poors Ratings Group, a division of The McGraw-Hill Companies, Inc. (S&P), of BBB- (stable outlook), by Moodys Investors Service, Inc. (Moodys) of Baa2 (stable outlook), and by Fitch, Inc. (Fitch) of BBB (negative outlook). Fitch changed its outlook on our rating to negative on December 12, 2005.
The Company may experience greater than expected difficulties in integrating Bank Calumet into its operations.
The acquisition of Bank Calumet will involve the integration of two financial institutions that have previously operated independently of one another. The Company expects to realize cost savings together with other financial and operating benefits from the acquisition of Bank Calumet, but there can be no assurance as to when, or the extent to which, if at all, the Company will be able to realize these benefits. The Company may experience greater than expected difficulties in integrating Bank Calumets business, which could have an adverse effect on the Companys ability to realize the expected benefits of the acquisition.
There are many things that could go wrong and adversely affect the business and profitability of the combined financial institution. The Company cannot predict the full range of post-acquisition problems that may occur. Some possible difficulties include:
The Company intends to finance a portion of the acquisition of Bank Calumet with a combination of the net proceeds of a common stock offering and the net proceeds from the issuance of subordinated debentures. The Company intends to finance the remainder of the purchase price with senior debt, which may take the form of senior debentures, a bank term loan, or a draw under the Companys revolving credit facility. The Companys final determination as to the mix of subordinated notes and senior debt will depend upon market conditions at the time of the offering of the debt securities among other considerations.
The Company cannot give any assurance that it will be able to consummate the Bank Calumet acquisition during the time frame currently contemplated or at all. In the event that the closing of the acquisition is delayed or does not occur, and if the common stock and debt securities have been issued, the Company will incur significant interest expense and stockholders will suffer dilution without the benefit of having acquired Bank Calumet.
The Companys business is continually subject to technological change, and it may have fewer resources than its competition to continue to invest in technological improvements.
The banking and financial services industry continually undergoes rapid technological changes, with frequent introductions of new technology-driven products and services. In addition to better serving customers and thereby preserving its customer base, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Companys future success will depend, in part, upon its ability to address the needs of its customers by using technology to provide products and services that enhance customer convenience, as well as create additional efficiencies in the Companys operations. Many of the Companys competitors have greater resources to invest in technological improvements, and the Company may not effectively implement new technology-driven products and services or do so as quickly, which could reduce its ability to effectively compete.
The Companys information systems may experience an interruption or breach in security.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in the Companys customer relationship management, general ledger, deposit, loan, or other systems. While the Company has policies and procedures designed to prevent or limit the effect of a failure, interruption, or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Companys information systems could damage the Companys reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability, any of which could have an adverse effect on the Companys financial condition and results of operations.
The Company and its subsidiaries are subject to examinations and challenges by tax authorities.
In the normal course of business, the Company and its subsidiaries are routinely subject to examinations and challenges from federal and state tax authorities regarding the amount of taxes due in connection with investments made and the businesses in which we have engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. These tax positions may relate to tax compliance, sales and use, franchise, gross receipts, payroll, property, or income tax issues, including tax base, apportionment, and tax credit planning. The challenges made by tax authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in the Companys favor, they could have an adverse effect on the Companys financial condition and results of operations.
Consumers and businesses may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks at one or both ends of the transaction. For example, consumers can now pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries, known as disintermediation, could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits.
Risks Related to the Securities Markets
Substantial sales of the Companys common stock could cause its stock price to fall.
If stockholders sell substantial amounts of the Companys common stock in the public market, the market price of the Companys common stock could fall. Such sales also might make it more difficult for the Company to sell equity or equity-related securities in the future at a time and price that it deems appropriate.
The Companys Restated Certificate of Incorporation, Amended and Restated By-Laws, and Amended and Restated Rights Agreement as well as certain banking laws may have an anti-takeover effect.
Provisions of the Companys Restated Certificate of Incorporation and Amended and Restated By-laws, federal banking laws, including regulatory approval requirements, and the Companys Amended and Restated Rights Plan could make it more difficult for a third party to acquire the Company, even if doing so would be perceived to be beneficial by the Companys stockholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Companys common stock.
The Company may issue additional securities, which could dilute the ownership percentage of holders of the Companys common stock.
The Company may issue additional securities to raise additional capital or finance acquisitions or upon the exercise or conversion of outstanding options, and if it does, the ownership percentage of holders of the Companys common stock could be diluted.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None. The Company did not receive written comments from the Commission during the 180 days preceding the end of the fiscal year to which this annual report relates.
ITEM 2. PROPERTIES
The executive offices of the Company, the Bank, and certain subsidiary operational facilities are located in a 16-story office building in Itasca, Illinois. The Company and the Bank currently occupy approximately 60,933 square feet of that building, which is leased through an unaffiliated third party.
As of December 31, 2005, the Bank operated through 68 bank branches and one operational facility. Of these, 12 are leased and the remaining 57 are owned and not subject to any material liens. The banking offices are largely located in various communities throughout northern Illinois, primarily the Chicago metropolitan suburban area. At certain Bank locations, excess space is leased to third parties. The Bank also owns 92 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 individually or 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 6 of Notes to Consolidated Financial Statements in Item 8 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, 2005. 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. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no items submitted to a vote of security holders during the fourth quarter of 2005.
ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY,
RELATED STOCKHOLDER MATTERS, AND
ISSUER PURCHASES OF EQUITY SECURITIES
The Companys common stock is traded on The Nasdaq Stock Market under the symbol FMBI. As of December 31, 2005, there were 2,605 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 2005 and 2004.
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 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 in Item 7 of this Form 10-K.
Equity Compensation Plans
The following table sets forth information, as of December 31, 2005, 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, with similar investment alternatives as those 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 4,498 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, 2005.
Issuer Purchases of Equity Securities
For further details regarding the Companys stock repurchase programs, refer to the section titled Management of Capital in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, of this Form 10-K.
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, 2005 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, 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 2003 through 2005 and Consolidated Statements of Condition as of December 31, 2004 and 2005. 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 2005 is included herein in the section titled Fourth Quarter 2005 vs. 2004. The review provides an analysis of the quarterly earnings performance for the fourth quarter of 2005 as compared to the same period in 2004.
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.
ACQUISITION AND DIVESTITURE ACTIVITY
On December 12, 2005, the Company announced the execution of a definitive agreement to acquire Bank Calumet, Inc. (Bank Calumet) and its wholly owned subsidiary bank for $307 million in cash. Bank Calumet is a bank holding company headquartered in Hammond, Indiana with $1.2 billion in assets and 30 branches located predominantly in Lake County, Indiana and the contiguous Illinois counties of Cook and Will. In February 2006, the transaction was approved by the Federal Reserve and by Bank Calumets shareholders. The Company expects to complete this acquisition early in the second quarter of 2006, subject to customary closing conditions, including the approval of the Department of Financial Institutions of the State of Indiana.
The Company believes that Bank Calumet represents an excellent opportunity to expand its franchise in the southeast Chicago metropolitan area. The Company looks forward to building upon the long-standing relationships that Bank Calumet has developed in its 73 years of banking service to these dynamic markets and expects that Bank Calumets conservative policies, diversified lending base, and community banking approach will fit well with the Companys established business model.
On December 31, 2003, the Company completed the acquisition of CoVest Bancshares, Inc. (the CoVest Acquisition), a $645.6 million single bank holding company, in a cash transaction valued at $27.45 per CoVest share, or approximately $102.2 million in the aggregate. CoVest provided retail and commercial banking services to customers through three full service locations in the northwest suburbs of Chicago, Illinois. The transaction, which was accounted for under the purchase method of accounting, included the recognition of $12.9 million of identifiable intangible assets to be amortized over a weighted-average life of 7.1 years and the excess of purchase price over the fair value of identifiable net assets (goodwill) of $49.7 million. The goodwill and intangibles resulting from this transaction were not deductible for income tax purposes.
On November 17, 2003, the Company completed the sale of two retail branch offices in Streator, Illinois, which included $69.1 million of deposits and other liabilities, $11.3 million of loans, and $500,000 of premises and equipment. The Company received a deposit premium of 7%, or $4.9 million. The pre-tax gain from the sale was $4.6 million, net of associated costs, and was reflected in other non-interest income.
On June 13, 2003, the Company acquired from The Northern Trust Company a single retail branch office located in Chicago, Illinois, which had $102.9 million of deposits and $13.9 million of loans. This acquisition was accounted for under the purchase method of accounting and resulted in the recognition of $18.4 million and $0.9 million in goodwill and core deposit intangibles, respectively. Both the goodwill and core deposit intangibles resulting from the transaction were deductible for income tax purposes.
CRITICAL ACCOUNTING POLICIES
The Companys consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles 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 in Item 8 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 in Item 8 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 carryback 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 14 of Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.
FORWARD LOOKING STATEMENTS
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 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.
2005 Compared with 2004
The Company, through its banking network, provides a full range of both business and retail banking and trust and investment management services through 68 banking offices, primarily in suburban metropolitan Chicago. The primary source of the Companys revenue is net interest income, which represents the difference between interest and fees earned on interest-earning assets and interest expense incurred on interest-bearing liabilities, 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 Companys net income for 2005 increased 4.2% on a per diluted share basis to $101.4 million, or $2.21 per diluted share, from net income of $99.1 million, or $2.12 per diluted share, in 2004.
In 2005, the Companys return on average assets was 1.44% as compared to 1.45% in 2004 and its return on average equity was 18.8% as compared to 18.7% in 2004. The Companys performance reflects continuing solid levels of profitability and credit quality as well as the benefits of growth in corporate lending and fee-based business lines.
In comparison to 2004, the Companys net income benefited from growth in interest-earning asset levels of $210.1 million, which generated higher tax equivalent net interest income of $5.6 million, lower provisions for loan losses of $4.0 million, and increased fee-based revenue of $5.4 million. Partially offsetting these benefits were $3.3 million in security losses, $2.4 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, reflecting improving net interest income and noninterest income, solid credit quality, cost control, and efficient use of capital.
The Companys total loans as of December 31, 2005 increased 4.1% to $4.3 billion, an increase of $170.9 million as compared to December 31, 2004, as growth in corporate and real estate 1-4 family lending offset declines in consumer lending. Corporate lending, representing commercial and industrial, real estate commercial, real estate construction, and agricultural lending categories, increased 8.2% from December 31, 2004.
Total average deposits for 2005 were $5.1 billion, an increase of 3.8% as compared to 2004, largely as the result of a 15.9% increase in average time deposits. Average time deposits for 2005 in comparison to 2004 reflect the combined impact of targeted sales promotion and higher levels of brokered deposits. The increase in time deposit balances was partially offset by decreases in savings, NOW, and money market balances as consumer preferences changed in response to the higher level of interest rates and time deposit promotion.
Nonperforming assets as of December 31, 2005 totaled $14.9 million, down 35.2% from $22.9 million as of December 31, 2004. As of December 31, 2005, nonperforming assets, including foreclosed real estate, represented 0.35% of loans plus foreclosed real estate as compared to 0.55% as of December 31, 2004 and near the Companys historical low of 0.34% as of June 30, 2005. Loans past due 90 days and still accruing totaled $9.0 million as of December 31, 2005, down from $10.4 million as of September 30, 2005 and up from $2.7 million as of December 31, 2004. The 2005 increase in loans past due 90 days primarily resulted from the transfer of a $3.6 million loan in the process of collection to accruing status and a single $1.2 million past due loan, which is fully secured by cash.
Net charge-offs for 2005 totaled $9.3 million, or 0.22% of average loans. In comparison to full year 2004, net charge-offs declined by $3.4 million, or 26.6%. As of December 31, 2005, the reserve for loan losses stood at 1.31% of total loans as compared to 1.37% as of December 31, 2004.
Net losses realized from the Companys securities portfolio totaled $3.3 million in 2005. During the first quarter of 2005, the Company responded to changing market conditions and its continued expectation for higher interest rates by selling $23.0 million in municipal securities and $26.7 million in collateralized mortgage obligations, resulting in a gain of $2.6 million. Security proceeds were reinvested in shorter-term mortgage-backed securities. In December 2005, the Company announced its intent to sell approximately $212.0 million of under-performing mortgage-backed securities, representing 9.0% of the Companys total securities portfolio. As a result of this action, the Company realized approximately $6.2 million of pre-tax security losses in fourth quarter 2005. As of December 31, 2005, 55.4% of the projected sales of securities had been completed, and the proceeds were reinvested in longer-term municipal securities. The remaining $94.5 million of targeted sales were completed in January 2006 with the proceeds used to temporarily reduce short-term borrowings. $377,000 in security gains was recognized in January 2006 relating to these sales. The proceeds may subsequently be used to acquire higher interest-yielding assets as market conditions warrant.
2004 Compared with 2003
The Companys net income for 2004 increased 7.6% on a per diluted share basis to $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 interest-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, and lower income generated from the disposition of assets.
The Companys total loans of $4.1 billion at December 31, 2004 increased 1.9% from December 31, 2003. 2004 growth was influenced by two separate asset deployment decisions. During the fourth quarter 2004, the Company converted $74.2 million of its 1-4 family residential mortgages into an investment security. During 2004, indirect consumer loans declined $60.7 million, reflecting the Companys decision in 2004 to cease the origination of new volumes from this marginally profitable business line. Excluding both 1-4 family residential loans and indirect consumer loans, the Companys total loans would have increased 6.0% as commercial, agricultural, real estate commercial, and home equity consumer loan categories all grew. 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 sales success and targeted promotion.
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 synergies created by the Companys 2005 activities put the Company in a strong position to continue its forward momentum in 2006. The Companys efforts in fourth quarter 2005 to modestly restructure the securities portfolio, tightly manage credit risk, and rationalize staffing costs, combined with favorable trends in deposit, corporate loans, and fee-based business lines, should benefit 2006 performance. In 2006, the Company will work to balance these benefits with the challenges of a flat interest rate yield curve that offers little prospect of reversing in the near term and a competitive response in the marketplace that remains vigorous.
2006 performance will be impacted by the expensing of stock options and the anticipated acquisition of Bank Calumet early in the second quarter of 2006. The Company is especially encouraged by the values inherent in the Bank Calumet franchise represented by a strong depository base coupled with a marketplace that has strong loan expansion potential. The Company expects 2006 earnings to be in the range of $2.42 to $2.50 per diluted share, including the estimated impact of the acquisition of Bank Calumet.
The Company feels that it is well positioned for continued performance improvement because it operates in strong markets with favorable business fundamentals. 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 the communities it serves.
Overall 2006 performance is expected to benefit from increased net interest income due to higher interest-earning asset levels funded by deposit acquisition and increased fee-based revenue. Interest-earning asset improvement should result from improved loan demand due to favorable trends in corporate lending and targeted pricing and promotion of home equity lending. These benefits are likely to be offset by expected increases in noninterest expense.
Net interest margin is anticipated to remain under short-term pressure given the prolonged, flattened interest rate yield curve and the Companys expectation of increasing interest rates. In this environment, net interest margin pressure would result from a narrowing spread between repricing asset yields and deposit and borrowing costs. The Companys actual net interest margin performance will depend upon a number of factors, such as the growth in interest-earning assets, the Companys mix of assets and liabilities, the pace and timing of changes in interest rates, and the shape of the yield curve.
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. The level of interest rates and the volume and mix of interest-earning assets and interest-bearing liabilities impact net interest income. Net interest margin represents net interest income as a percentage of total interest-earning assets. The accounting policies underlying the recognition of interest income on loans, securities, and other interest-earning assets are presented in Notes 1, 5, and 11 of Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.
For purposes of this discussion, both net interest income and net interest 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 interest-earning assets. The effect of such adjustment is presented in the following table:
Effect of Tax Equivalent Adjustment
(Dollar amounts in thousands)
Tax equivalent net interest income in 2005 increased 2.3% in comparison to 2004 primarily due to growth in interest-earning assets. The benefits of this growth were partially offset by a lower net interest margin, which fell 4 basis points from 3.91% in 2004 to 3.87% in 2005. The decrease in net interest margin reflects the combined impact of the flat interest rate curve on interest-earning asset yields and increasing liability costs as the deposit mix shifted in response to higher interest rates and competitive pricing.
Tax equivalent net interest income in 2004 increased 8.3% from 2003 primarily as a result of growth in interest-earning assets acquired as part of the CoVest Acquisition. This increase was partially offset by lower net interest margins. Margin contraction of 8 basis points 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 2005 and 2004, 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.
Tax equivalent interest income was $382.8 million in 2005 as compared to $332.8 million in 2004 and $308.7 million in 2003. Of the $50.0 million increase in tax equivalent interest income in 2005 as compared to 2004, $40.4 million was attributable to comparatively higher interest rate levels, and $9.6 million was attributable to higher average interest-earning assets. Average interest-earning assets for 2005 increased by $210.1 million to $6.5 billion as compared to $6.3 billion in 2004. The 2005 increase included a $160.9 million increase in average securities balances and a $71.7 million increase in average loan balances.
Interest expense increased by $44.4 million to $130.9 million in 2005 as compared to $86.5 million in 2004, following a $5.2 million increase from $81.3 million in 2003. The 2005 increase was comprised of a $39.2 million increase attributable to increases in interest rates, and $5.2 million increase attributable to increased balances of average interest-bearing liabilities.
The Companys improved interest income in 2004 from 2003 primarily resulted from higher average loans outstanding due to the CoVest Acquisition and improved sales activity. 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. 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.
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)
The Companys tax equivalent net interest margin was 3.87% in 2005 as compared to 3.91% in 2004 and 3.99% in 2003. The 2005 decrease reflected the impact of the flattening interest rate yield curve on longer-term asset yields as well as the shift of customer balances from lower-costing transaction accounts to higher-costing time deposits, as consumer preferences adjusted to the increasing level of shorter-term interest rates and competitive pricing over this period. This impact was partially offset by a $2.7 million contribution to net interest income and to net interest margin resulting from the return to accruing status of a $3.6 million nonperforming real estate construction loan during the second half of 2005. This loan returned to accruing status as the Company expects ongoing remediation efforts to result in recoveries in excess of recorded principal by the end of first quarter 2006, with the amount of such excess recoveries recorded as interest income. The loan was included in loans past due 90 days and still accruing interest as of December 31, 2005.
Net interest margin for fourth quarter 2005 was 3.79%, down from 3.88% for third quarter 2005 and 3.93% for second quarter 2005. The decreases from second quarter 2005 to third quarter 2005 and from third quarter 2005 to fourth quarter
2005 reflect the combined impact of the flat interest rate curve on interest-earning asset yields and increasing liability costs as the deposit mix shifted in response to higher interest rates and competitive pricing. Net interest margin for second quarter 2005 increased 6 basis points from 3.87% for first quarter 2005. This increase reflected the positive impact of comparatively higher shorter-term interest rates on loan yields and the lagging effects on repricing deposit costs, both of which were offset, in part, by the impact of a flattening yield curve on longer-term asset yields.
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 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 from June 30, 2004 to December 31, 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.
Item 7A, Quantitative and Qualitative Disclosures About Market Risk, of this Form 10-K describes the measures taken and discusses the techniques used to manage the volatility and other factors that affect net interest margin and net interest income.
The Companys noninterest income totaled $74.6 million in 2005, as compared to $79.4 million in 2004. Noninterest income in 2005 included net security losses of $3.3 million, and 2004 noninterest income included both security gains of $8.2 million and losses from the early extinguishment of debt of $2.7 million. As shown in Table 4 below, excluding these transactions, total noninterest income for full year 2005 would have improved 5.6% from 2004.
Other service charges, commissions, and fees increased $2.4 million, or 16.0%, to $17.6 million in 2005 as compared to $15.1 million in 2004. These increases primarily resulted from a $1.3 million increase in merchant fees reflecting the benefits of a change in fee structure. Card-based revenues improved by 10.3%, or $955,000, to $10.2 million in 2005 as compared to $9.3 million in 2004 as more consumers used point-of-sale transactions. Service charges on deposit accounts increased by 4.7%, or $1.4 million, in 2005 from 2004. This improvement in service charges primarily resulted from a $2.8 million increase in fees received on items drawn on customer accounts with insufficient funds and was partially offset by a $1.2 million decrease in service charges on business accounts. Trust and investment management fees increased $705,000, or 5.9%, from 2004 as greater fee revenue was generated primarily as a result of a 6.5% increase in assets under management that generated more fees.
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 divestiture of its two branches in Streator, Illinois. Excluding these transactions, the Companys noninterest income would have improved in 2004 to $73.8 million 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 10.0%, in 2004, as an 8.1% year over year increase in assets under management and strong sales growth and improving equity markets generated 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.
Nonoperating revenues include net security (losses) gains, net losses on the early extinguishment of debt, and net gains on branch divestitures. For a discussion on net security (losses) gains, refer to the section titled Investment Portfolio Management. For a discussion on losses on early extinguishment of debt, refer to the section titled Funding and Liquidity Management. In 2003, the Company recognized a $4.6 million gain on the divestiture of two branches in rural, Streator, Illinois. Nonoperating revenues decreased noninterest income by $3.3 million in 2005 and increased noninterest income by $5.6 million in 2004 and $1.6 million in 2003.
Noninterest Income Analysis
(Dollar amounts in thousands)
Noninterest expense totaled $165.7 million for 2005, an increase of 1.4% as compared to $163.3 million for 2004. Increases in compensation expense, professional services, and merchant card expense were partially offset by a decline in technology and related costs.
Salaries and wages increased to $70.8 million in 2005, an increase of $1.9 million, or 2.8%, from $68.9 million in 2004, reflecting the impact of general merit increases and an $870,000 increase in incentive compensation, partially offset by a $655,000 decrease in certain deferred compensation obligations. Retirement and other employee benefits increased $1.1 million, or 4.6%, to $24.3 million for 2005 as compared to $23.3 million for 2004, resulting from a $487,000 increase in pension and profit sharing expense, a $415,000 increase in employee insurance, and a $110,000 increase in payroll taxes. Merchant card expense for 2005 increased 19.9% from 2004 to $4.8 million as a result of the increase in merchant card fee income referred to above. Professional service fees increased $947,000, or 11.8%, in 2005 as compared to 2004 as a result of higher fees for professional and audit-related services, primarily related to compliance with expanded regulatory and internal control requirements. These increases in expenses were partially offset by a $1.0 million, or 15.0%, reduction in technology and related costs in 2005 as compared to 2004, principally due to more favorable contract terms negotiated with the Companys external data service provider in third quarter 2004. In addition, other expenses declined $2.0 million in 2005. Included in other expenses were repossession expense, which declined $409,000, and other real estate expense, which declined $341,000 in 2005 as compared to 2004. 2004 noninterest expense included $650,000 in integration costs related to the CoVest Acquisition.
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 in 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 Analysis
(Dollar amounts in thousands)
The efficiency ratio expresses noninterest expense as a percentage of tax equivalent net interest income plus total fees and other income. The Companys efficiency ratio improved to 49.4% for 2005 from 50.1% for 2004 and 48.3% for 2003. The decrease in the efficiency ratio from 2004 to 2005 was primarily a result of higher revenues. The increase in the efficiency ratio from 2003 to 2004 was due to the 9.3% increase in noninterest expense.
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 2003 through 2005 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 14 of Notes to Consolidated Financial Statements in Item 8 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 $15.4 million at December 31, 2005 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 carryback 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 2005 effective income tax rate reflected in the table is comprised of a federal effective tax rate of 25.7% in 2005, 25.1% in 2004, and 24.9% in 2003 and a state effective tax rate of (0.3%) in 2005, (0.2%) in 2004, and 0.1% in 2003.
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 upon 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 14 in Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.
INVESTMENT PORTFOLIO MANAGEMENT
The Company manages its investment portfolio 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.
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, 2005, the available for sale securities portfolio totaled $2.29 billion as compared with $2.18 billion at December 31, 2004. The $107.2 million increase in the portfolio from year-end 2004 is primarily the result of security purchases, partially offset by a $29.3 million decrease in the unrealized gain (loss) on available for sale securities. In comparison to 2004, the mix of securities held in the portfolio reflects more longer-term municipal securities and less shorter-term U.S. Agency securities. In the uncertain and evolving interest rate environment, the Company believes these municipal securities should help stabilize its net interest margin and limit future price volatility resulting from changing interest rates, as compared to alternative investment options. The effective duration of the available for sale portfolio increased from 2.54% as of December 31, 2004 to 3.18% as of December 31, 2005, primarily reflecting the impact of an increase in longer-term interest rates on mortgage-backed securities, as well as the increase in longer-term state and municipal securities.
The Company adjusts the size and composition of its securities portfolio according to a number of factors, including expected loan growth, anticipated growth in collateralized public funds on account, and 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 2005, the Company held total 1-4 family residential loan exposure of $1.3 billion on its balance sheet, $1.2 billion of which was concentrated in the Companys securities portfolio. Approximately 52% of the Companys securities portfolio as of December 31, 2005 was comprised of mortgage-backed securities as compared to 59% at year-end 2004 and 52% at year-end 2003. Concentrating this exposure in the securities portfolio reduces the Companys credit risk, improves liquidity, enables it to better monitor prepayments, and provides greater balance sheet flexibility in exchange for the cost of accepting lower yields. As of December 31, 2005, the combination of the Companys securities portfolio and 1-4 family residential loan portfolio represented 34.5% of total assets, up from 34.0% at the end of 2004 and down from 35.7% at the end of 2003.
The unrealized loss on the securities available for sale portfolio (representing the difference between the aggregate cost and market value of the portfolio) totaled $13.2 million at December 31, 2005 as compared to an unrealized gain of $16.1 million at December 31, 2004. This balance sheet component will fluctuate as current market interest rates and conditions change,
thereby affecting the aggregate market value of the portfolio. The higher level of interest rates existent at the end of 2005 as compared with 2004 caused the portfolio to shift to an unrealized loss position. 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.
Net losses realized from the Companys securities portfolio totaled $3.3 million in 2005. During the first quarter of 2005, the Company responded to changing market conditions and its continued expectation for higher interest rates by selling $23.0 million in municipal securities with an average tax equivalent yield of 7.0% and an average maturity of 12.5 years, resulting in the recognition of securities gains of $1.3 million. With the expectation of increasing interest rates, security proceeds were reinvested in shorter-term mortgage-backed securities. In addition, the Company sold $26.7 million in collateralized mortgage obligations, resulting in a gain of $1.3 million. Proceeds from the securities sold were reinvested in comparable shorter average life securities.
In late fourth quarter 2005, in response to existing and expected market conditions, the Company decided to sell approximately $212.0 million of under-performing mortgage-backed securities, representing 9.0% of the Companys total securities portfolio. As a result of this action, the Company realized approximately $6.2 million of pre-tax security losses in fourth quarter 2005. As of December 31, 2005, 55.4% of the projected sales of securities had been completed, and the proceeds were reinvested in longer-term municipal securities. The remaining proceeds generated from sales in early 2006 are expected to reduce short-term borrowings and to acquire higher interest-yielding assets as market conditions warrant.
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 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 then reinvested in collateralized mortgage obligations with a comparatively lower duration. Realized gains from sales of securities during 2004 were partially offset by a $5.4 million other-than-temporary impairment the Company was required to recognize during third quarter 2004 on a single, Federal National Mortgage Association preferred stock issuance.
Repricing Distribution and Portfolio Yields
(Dollar amounts in thousands)
LOAN PORTFOLIO AND CREDIT QUALITY
The Companys principal source of revenue arises from lending activities, primarily represented by interest income and, to a lesser extent, from 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 4 of Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.
Portfolio Management and Composition
The Companys portfolio is comprised of both corporate and consumer loans, with corporate loans representing approximately 80% of total loans outstanding. The corporate loan component represents commercial and industrial, agricultural, real estate commercial, and real estate construction lending categories. The Company seeks to balance its corporate loan portfolio among loan categories as well as by industry segment, subject to internal policy limits and as influenced by market and economic conditions. The Company seeks to maintain a diversified portfolio of both corporate and consumer loans to minimize its exposure to any particular industry or any segment of the economy.
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 utilize other Company banking services, such as cash management or trust services.
The Company seeks to reduce its credit risk by limiting its exposure to any one borrower. Although the Companys legal lending limit approximates $152.9 million, the largest loan balance to a single borrower at year-end 2005 was $19.9 million, and only 25 borrowers had aggregate loan balances outstanding in excess of $10 million. In terms of overall commitments to extend credit, the Companys largest exposure to a single borrower as of December 31, 2005 was $29.2 million and to a group of related companies comprising a single relationship was $37.0 million. The Company had only 25 credits in the portfolio where total commitments to extend credit to a single borrower relationship exceeded $20 million as of December 31, 2005.
(Dollar amounts in thousands)
The Companys total loans as of December 31, 2005 increased 4.1% to $4.3 billion, an increase of $170.9 million as compared to $4.1 billion as of December 31, 2004 as increases in corporate lending and real estate 1-4 family loans offset declines in direct and indirect installment loans. Corporate loan balances as of December 31, 2005 increased 8.2% as compared to December 31, 2004, primarily due to growth in commercial and real estate commercial lending resulting from continuing sales efforts producing growth in both loans to existing customers and new customer relationships.
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. 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 real estate commercial lending. The increase in commercial and real estate commercial 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.
As of December 31, 2005, corporate loans represented 79.8% of total loans outstanding as compared to 76.8% at December 31, 2004 and 73.7% at December 31, 2003. In 2005, the percentage of corporate loans to total loans grew as a result of strong real estate commercial lending activity, as well as declining indirect and direct consumer loan balances. Real estate commercial and construction lending has always been an area of focus 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 a combined 49.7% of the Companys total loans as of December 31, 2005. The combination of seasoned, long-time borrowers, experienced senior lending officers, managements focus on market fundamentals, and a rigorous underwriting process are believed to give the Company a competitive market advantage. The Company believes these factors and a balanced exposure to any particular industry segment reduce the Companys exposure to loss.
Real estate commercial loans consist of residential development loans, multi-unit residential mortgages, and real estate commercial mortgages. Lessors of commercial real estate comprise approximately 27% of the Companys real estate commercial loans. These loans represent various types of commercial properties, including industrial buildings, office buildings, retail shopping centers, and other business-related activities. Another 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 real estate development 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 Companys favorable loss experience on these loans.
Table 10 specifies the Companys corporate loan portfolio, including commercial and industrial loans, by industry segment and illustrates the diversity of its loan portfolio. Table 11 summarizes the loan portfolios maturities and interest rate sensitivity.
As of December 31, 2005, consumer loans represented 20.2% of total loans outstanding as compared to 23.2% at December 31, 2004 and 26.3% at December 31, 2003. The decline in consumer loans as a percentage of total loans is largely influenced by lower indirect consumer loans, reflecting the Companys decision in 2004 to cease the origination of new volumes from this marginally profitable business line. The home equity category represents the single largest 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 collateral value ratios for these credits range from 70% to 90%, with 90% of home equity loans having a loan to collateral value ratio of 90% or less.
Consumer loan balances as of December 31, 2005 decreased 9.4% from December 31, 2004 following a decrease of 9.8% during 2004, primarily reflecting a decrease in indirect installment loans offset by an increase in real estate 1-4 family lending. Indirect consumer lending declined by 46.1%, as payments received on existing loans were not replaced with new volumes. Real estate 1-4 family loans increased by $50.8 million, or 54.9%, from year-end 2004 as the Company elected to retain in its loan portfolio certain mortgage loans originated through established community reinvestment programs or loans that have met certain other lending criteria. As previously discussed in the section titled Investment Portfolio Management, the Company also has exposure to 1-4 family real estate embedded in its securities portfolio, as these assets tend to be longer in duration and have similar risk characteristics.
The decline in consumer loan balances in 2004 resulted from 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 loans outstanding from December 31, 2003. This decline was partially offset in 2004 by increased home equity line sales activity, resulting from pricing and promotional activities.
Distribution of Corporate Loans By Industry
Table 10 summarizes the Companys ten most significant industry segments for the corporate loan portfolio as of December 31, 2005, 2004, and 2003. These categories are based upon the nature of the borrowers ongoing business activity as opposed to the collateral underlying an individual loan. To the extent that a borrowers underlying business activity changes, classification differences between periods will arise. As a result, the Company periodically reassesses and adjusts industry classifications. The Company believes its loan portfolio is diversified across industries and market segments.
Corporate Loan Portfolio by Industry Segment (1)
(Dollar amounts in thousands)
Maturity and Interest Rate Sensitivity of Corporate Loans
Table 11 summarizes the maturity distribution of the Companys corporate loan portfolio as of December 31, 2005 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 portfolio diversification, the Company has established a 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 regularly evaluates 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 performance standard of the Companys internal loan review staff is to annually review at least 70% of the balance of all corporate loans and all new loans in excess of $1 million. Account officers are responsible for monitoring their customer relationships and determining changes in the loan ratings on credits they monitor. The Company believes that any significant change in the overall quality of the loan portfolio will be reflected in the cumulative effect of changes to these loan ratings.
In addition, the Companys senior managers actively review those loans that require some form of remediation. These loans are reviewed quarterly, and action plans are developed to either remedy any emerging problem loans or to remove any such loans from the portfolio. Certain loans may also be reviewed by senior executive officers, including the Chief Executive Officer and the Chief Credit Officer. During times of economic downturns, the Company has increased the frequency of these reviews.
The Company also 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. Management believes that the reserve for loan losses of $56.4 million is adequate to absorb credit losses inherent in the loan portfolio at December 31, 2005.
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 5 of Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.
Reserve for Loan Losses and
Summary of Loan Loss Experience
(Dollar amounts in thousands)
As of December 31, 2005, the Companys reserve for loan losses totaled $56.4 million as compared to $56.7 million as of December 31, 2004 and $56.4 million as of December 31, 2003. The ratio of reserve for loan losses to total loans at year-end 2005 was 1.31%, down from 1.37% at year-end 2004 and 1.39% at the end of 2003. The 2005 reserve for loan losses decreased by $325,000, or 0.6%, from 2004 following an increase of $314,000, or 0.6%, in 2004.
The provision for loan losses decreased in 2005 to $8.9 million compared to $12.9 million in 2004 and $10.8 million in 2003. Total loans charged-off, net of recoveries, were $9.3 million, or 0.22% of average loans, in 2005 and $12.6 million, or 0.30% of average loans, in 2004.
Gross charge-offs decreased in 2005 to $11.0 million from $15.1 million in 2004 and $12.1 million in 2003, with decreases in all major loan categories except for home equity loans. The decrease in gross charge-offs from 2004 to 2005 resulted from the charge-off in 2004 of certain loans acquired as part of the CoVest Acquisition. These CoVest loans charged-off also drove the increase in gross charge-offs from 2003 to 2004. The lower level of charge-offs in 2003 primarily benefited from a tightening of the underwriting standards for the indirect lending portfolio initiated in 2002 as the economy weakened. In addition, the level of corporate charge-offs in 2002 and 2001 were elevated as the Company recognized the weakening economy and adopted an aggressive problem loan identification and charge-off strategy.
In 2005, the Company decreased the reserves allocated to the commercial and industrial, agricultural, and real estate commercial categories as a result of improved delinquency and charge-off trends. Reserve allocations to the consumer loan portfolio also decreased in 2005 as compared to 2004 due to the decline in the total consumer loan portfolio. The increase in the reserve for loan losses allocated to the real estate construction category in 2005 reflects the comparatively greater influence placed on the concentration of large loans in this category.
The Company increased the reserve for loan losses allocated to the commercial and industrial and real estate commercial categories in 2004 from 2003 due to loan growth, as well as elevated losses attributed to loans acquired from and originated by CoVest. Reserve allocations to the consumer loan portfolio decreased in 2004 compared to 2003 as a result of improved delinquency and charge-off trends as the portfolio mix shifted from higher-risk, indirect lending to lower-risk home equity lending.
In 2003, allocation of the Companys reserve to the commercial and industrial, real estate commercial, and real estate construction categories increased as compared to 2002, due in large part to comparatively higher exposures to single borrowers and portfolio growth amid concerns relative to the continuing level of economic weakness. The growth in the commercial reserve allocation was also caused by an increase in specific reserves relating to the higher level of impaired loans. These category increases were partly offset by improved delinquency and charge-off trends in all corporate lending areas. Reserve allocations to the consumer loan portfolio decreased in relation to 2002 due to improved delinquency and charge-off trends.
Nonperforming assets include loans for which the accrual of interest has been discontinued, loans for which the terms have been renegotiated to provide for a reduction or deferral of interest and principal due to a weakening of the borrowers financial condition, and real estate that has been acquired primarily through foreclosure and is awaiting disposition. For a detailed discussion on the Companys policy on accrual of interest on loans see Note 1 of Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.
Loans past due 90 days and still accruing interest are not included in nonperforming assets and continue to accrue interest because they are adequately secured by collateral, in the process of collection, and reasonably expected to result in repayment or restoration to current status.
The following table summarizes nonperforming assets and past due loans for the past five years as well as certain information relating to interest income on nonaccrual loans outstanding during 2005.
Nonperforming Assets and Past Due Loans
(Dollar amounts in thousands)