Midwest Banc Holdings 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number 001-13735
Midwest Banc Holdings, Inc.
(Exact name of Registrant as specified in its charter)
501 West North Avenue, Melrose Park, Illinois 60160
(Address of principal executive offices including ZIP Code)
(Registrants telephone number including Area Code)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value, Nasdaq National Market
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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 þ No o
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. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer þ Non-accelerated filer o
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
The aggregate market value of the voting and nonvoting common equity held by nonaffiliates of the registrant on June 30, 2005, based on the last sales price quoted on the Nasdaq National Market System on that date, the last business day of the registrants most recently completed second fiscal quarter, was approximately $353.4 million.
As of March 15, 2006, the number of shares outstanding of the registrants common stock, par value $0.01 per share, was 21,924,071.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Companys Proxy Statement for the 2006 Annual Meeting of Stockholders are incorporated by reference into Part III.
MIDWEST BANC HOLDINGS, INC.
Midwest Banc Holdings, Inc. (the Company), a Delaware corporation founded in 1983, is a community-based bank holding company under the Bank Holding Company Act of 1956, as amended, for its bank subsidiary and is headquartered in Melrose Park, Illinois. Through its wholly owned subsidiaries, the Company provides a wide range of services, including traditional banking services, personal and corporate trust services, residential mortgage services, insurance brokerage and retail securities brokerage services. The Companys principal operating subsidiary is Midwest Bank and Trust Company (the Bank), an Illinois state bank that operates 17 banking centers in the Chicago metropolitan area. The Company operates in one business segment, community banking, providing a full range of services to individual and corporate customers. Midwest Financial and Investment Services, Inc., a subsidiary of the Company, provides securities brokerage services to customers of the Bank. Midwest Bank Insurance Services, L.L.C., a subsidiary of the Bank, acts as an insurance agency for individuals and corporations.
The Company focuses on establishing and maintaining long-term relationships with customers and is committed to serving the financial services needs of the communities it serves. In particular, the Company has emphasized in the past and intends to continue to emphasize its relationships with individual customers and small-to-medium-sized businesses. The Company actively evaluates the credit needs of its markets, including low-and moderate-income areas, and offers products that are responsive to the needs of its customer base. The markets served by the Company provide a mix of real estate, commercial and consumer lending opportunities, as well as a stable core deposit base.
From the fourth quarter of 2004 through 2005, the Company implemented several initiatives to focus on growth in the Chicago market. Repositioning initiatives, which were essentially complete as of the end of the third quarter of 2005, included:
Sale of Midwest Bank of Western Illinois. In September 2005, the Company sold Midwest Bank of Western Illinois, a six-branch bank subsidiary with $282.5 million in assets, to an investor group including members of the subsidiarys management team and board of directors. The Company recognized a $6.9 million gain, net of tax, in the third quarter as a result of the transaction.
Exit from Regulatory Process. In September 2005, the Company successfully completed a number of initiatives included in a written agreement among the Company, the Bank, the Federal Reserve Bank of Chicago and the Illinois Department of Financial and Professional Regulation, which led to the termination of the written agreement at that time. The Company had entered a written agreement with the regulators in March 2004, after a regulatory review led to a call for improved oversight of asset quality, internal controls, and certain risk management processes.
Issuance of 3,450,000 shares of common stock. In August 2005, the Company raised $67.9 million, net of issuance costs, through an offering of 3,450,000 shares of common stock, including the over-allotment exercise by underwriters, at $21 per share. The infusion of capital strengthened the Companys balance sheet, following a number of charges related to its repositioning.
Company repositioning. From September 2004 through June 2005, the Company completed a number of repositioning steps, including asset write downs and other steps to reduce earnings volatility and risk of the Companys investment securities portfolio, reduce asset and liability risk, and increase asset quality. These initiatives included redemption of high-rate trust preferred securities and the issuance of lower-rate trust preferred securities, as replacement therefor, exiting hedge accounting, unwinding of interest rate swaps, sale of debt securities, prepayment of Federal Home Loan Bank advances, and other actions. In connection with these actions, the Company recognized pre-tax costs from continuing operations of $30.8 million in 2005 and $11.3 million in 2004.
Expansion of management depth. From September 2004 through 2005, the Company expanded the senior management group, both at the holding company level and at the Bank, to increase asset quality oversight, loan growth, branch management depth, and other functions. James J. Giancola became Director, President, and Chief Executive Officer of the Company and Bank in September 2004. Other staffing changes included appointment of 3 executive vice presidents, 3 senior vice presidents and 16 vice presidents.
Board of Directors Alignment. In May 2005, two new directors were elected at the annual stockholders meeting. In June 2005, the Company aligned the membership of the holding company board with that of the Bankss Board of Directors, resulting in the addition of two new directors. By creating identical boards for the two entities, the Company intends to increase the consistency and depth of oversight for both organizations. The Companys By-laws were amended to reduce the number of qualifying shares to 3,000 and eliminate the staggered board and have each director nominated and stand for election on an annual basis.
As described in greater detail later in this document, the Companys performance in 2005 and 2004 includes a number of one-time items, special charges, and discontinued operations that can make comparisons of 2005 and 2004 results difficult. To provide increased clarity to investors and other interested parties, additional tables and discussions of ongoing or core operations are included herein.
The Companys strategic plan emphasizes expanded penetration of the community banking market in the Chicago metropolitan area, along with strong management of asset quality and risk. Repositioning initiatives implemented in recent quarters have increased the level of stockholders equity, added to the depth of management at the Bank and Company, reduced the risk in the securities portfolio and improved operational controls. Among the strategies developed to achieve growth targets are:
Expand and diversify loan portfolio. The Company has increased its staff of commercial loan officers and assigned more aggressive goals for loan origination. Beyond loan growth itself, the Company has added emphasis to commercial and industrial loans and retail lending to provide balance to the strong penetration of real estate lending in the Banks markets. As a result, loans outstanding increased 23.1% to $1.4 billion at December 31, 2005 from $1.1 billion at December 31, 2004.
Expand deposit base. To fund loan growth, the Company is focused on deposit generation, including demand deposits, interest-bearing demand deposits, money market, and savings accounts. The Company has changed and expanded staffing and management at its banking centers and initiated a number of customer outreach initiatives to expand deposits in a highly competitive market environment. The Company is in the process of creating a performance-driven sales environment and increasing customer activity in its branches.
Expand footprint in Chicago market. The Company plans to expand in the Chicago market through acquisitions and selective branch opportunities, in addition to internal growth. Management believes the Chicago market to be somewhat saturated with branches at present creating less opportunities to open new branches. Therefore, acquiring existing branches at a reasonable cost is generally believed to be a preferable means of expansion. As part of this strategy, the Company plans to open a branch in Franklin Park, Illinois in the second quarter of 2006 and has entered into an agreement and plan of merger with Royal American Corporation, as discussed further in the History section.
Expand noninterest income. The Company is focusing on opportunities to build the contribution of fees as a percentage of revenue, emphasizing corporate cash management, insurance and investment services, trust services, and secondary-market mortgage lending.
Management believes its growth strategies to be fundamentally sound and based on reasonable opportunities available in the Chicago market. The Company has established internal benchmarks for each growth initiative and has taken a number of steps to align compensation with achievement of these benchmarks.
Certain information with respect to the Bank and the Companys nonbank subsidiaries as of December 31, 2005, is set forth below:
Midwest Bank and Trust Company was established in 1959 in Elmwood Park, Illinois to provide community and commercial banking services to individuals and businesses in the neighboring western suburbs of Chicago. The Company pursued growth opportunities through acquisitions and the establishment of new branches; the more recent are described below.
As discussed in the Strategy section, the Company plans to enlarge its presence in the Chicago market and will be selective in the manner in which it accomplishes this expansion. Management believes that there will be limited branch opportunities, however it is looking to acquire targets that would meet its objectives including diversifying the loan and deposit mix and reducing the Companys risk profile.
The Companys nonbank subsidiaries were established to support the retail and commercial banking activities of the Bank.
Midwest Bank Insurance Services, L.L.C. is an independent insurance agency established in 1998. This subsidiary concentrates in commercial and individual insurance products.
In March 2002, the Company acquired the assets of Service 1st Financial Corp. through its newly formed subsidiary, Midwest Financial and Investment Services, Inc. This subsidiary provides securities brokerage services to both bank and nonbank customers.
In August 2002, the Bank established MBTC Investment Company. This subsidiary was capitalized through the transfer of investment securities from the Bank and was formed to diversify management of that portion of the Companys securities portfolio.
In May 2000, the Company formed MBHI Capital Trust I (Trust I). Trust I was a statutory business trust formed under the laws of the State of Delaware and is wholly owned by the Company. In June 2000, Trust I issued 10.0% preferred securities with an aggregate liquidation amount of $20.0 million ($25 per preferred security) to third-party investors in an underwritten public offering. The Company redeemed these securities on June 7, 2005. This trust was then liquidated.
The Company has formed four statutory trusts between October 2002 and June 2005 to issue $54.0 million in floating rate trust preferred securities through four statutory trusts. The floating rate offerings were pooled private placements exempt from registration under the Securities Act pursuant to Section 4(2) thereunder. The Company has provided a full, irrevocable, and unconditional subordinated guarantee of the obligations of the four trusts under the preferred securities. The Company is obligated to fund dividends on these securities before it can pay dividends on its shares of common stock. See Note 13 to the Notes to the Consolidated Financial Statements. These four trusts and its trust preferred securities are detailed below as follows:
The largest segments of the Companys customer base live and work in relatively mature markets in Cook, DuPage, Lake, and McHenry Counties. The Company considers its primary market areas to be those areas immediately surrounding its offices for retail customers and generally within a 10-20 mile radius for commercial relationships. The Bank operates 17 full-service locations in the Chicago metropolitan area. The communities in which the Banks offices are located have a broad spectrum of demographic characteristics.
These communities include a number of densely populated areas as well as suburban areas, and some extremely high-income areas as well as many middle-income and some low-to-moderate income areas.
The Company competes in the financial services industry through the Bank, Midwest Bank Insurance Services, L.L.C., and Midwest Financial and Investment Services, Inc. The financial services business is highly competitive. The Company encounters strong direct competition for deposits, loans, and other financial services. The Companys principal competitors include other commercial banks, savings banks, savings and loan associations, mutual funds, money market funds, finance companies, credit unions, mortgage companies, insurance companies and agencies, private issuers of debt obligations and suppliers of other investment alternatives, such as securities firms.
In addition, in recent years, several major multibank holding companies have entered or expanded in the Chicago metropolitan market. Generally, these financial institutions are significantly larger than the Company and have access to greater capital and other resources. In addition, many of the Companys nonbank competitors are not subject to the same degree of regulation as that imposed on bank holding companies, federally insured banks, and Illinois chartered banks. As a result, such nonbank competitors have advantages over the Company in providing certain services.
The Company addresses these competitive challenges by creating market differentiation and by maintaining an independent community bank presence with local decision-making within its markets. The Bank competes for deposits principally by offering depositors a variety of deposit programs, convenient office locations and hours, and other services. The Bank competes for loan originations primarily through the interest rates and loan fees charged, the efficiency and quality of services provided to borrowers, the variety of loan products, and a trained staff of professional bankers.
The Company competes for qualified personnel by offering competitive levels of compensation, management and employee cash incentive programs, and by augmenting compensation with stock options and restricted stock grants pursuant to its stock and incentive plan. Attracting and retaining high quality employees is important in enabling the Company to compete effectively for market share.
The Chicago market is highly competitive making it more difficult to retain and attract customer relationships. The Company recognizes this and has new initiatives to address the competition. Part of the Companys marketing strategy is to create a performance-driven sales environment, increase activity in its branches, build and launch a renewed promotional image, and build and market a strong private banking program.
Products and Services
Management believes the Bank offers competitive deposit products and programs which address the needs of customers in each of the local markets served. These products include:
Checking and Interest-bearing Checking Accounts. The Company has developed a range of different checking account products designed and priced to meet specific target segments (e.g., Free Checking and Business Advantage Checking) of the local markets served by each branch. The Company offers several types of premium rate interest-bearing checking accounts with interest rates indexed to the prime rate or the 91-day U.S. Treasury bill rate.
Savings and Money Market Accounts. The Company offers multiple types of money market accounts and savings accounts.
Time Deposits. The Company offers a wide range of innovative time deposits (including traditional and Roth Individual Retirement Accounts), usually offered at premium rates with special features to protect the customers interest earnings in changing interest rate environments.
The Companys loan portfolio consists of commercial loans, construction loans, commercial real estate loans, consumer real estate loans, and consumer loans. Management emphasizes credit quality and seeks to avoid undue concentrations of loans to a single industry or based on a single class of collateral. The Company generally requires personal guarantees of the principal except on cash secured, state or political subdivision, or not-for-profit organization loans. The Company has focused its efforts on building its lending business in the following areas:
Commercial Loans. Commercial and industrial loans are made to small- to medium-sized businesses that are sole proprietorships, partnerships, and corporations. Generally, these loans are secured with collateral including accounts receivable, inventory and equipment; the personal guarantees of the principals may also be required. Frequently, these loans are further secured with real estate collateral.
Construction Loans. Construction loans include loans for land development and for commercial and residential development. The majority of these loans are in-market to known and established borrowers and have pre-sale requirements.
Commercial Real Estate Loans. Commercial real estate loans include loans for development and construction and are generally secured by the real estate involved. Other real estate loans are secured by farmland, multifamily residential properties, and other nonfarm or nonresidential properties. These loans are generally short-term balloon loans and adjustable rate mortgages with initial fixed terms of one to five years.
Consumer Real Estate Loans. Consumer real estate loans are made to finance residential units that will house from one to four families. While the Company originates both fixed and adjustable rate consumer real estate loans, most medium-term fixed-rate loans originated pursuant to Fannie Mae and Freddie Mac guidelines are sold in the secondary market. In the normal course of business, the Company retains one- to five-year adjustable rate loans.
Consumer Loans. Consumer loans (other than consumer real estate loans) are collateralized loans to individuals for various personal purposes such as automobile financing.
Home equity lines of credit, included within the Companys consumer loan portfolio, are secured by the borrowers home and can be drawn at the discretion of the borrower. These lines of credit are generally at variable interest rates. Home equity lines, combined with the outstanding loan balance of prior mortgage loans, generally do not exceed 80% of the appraised value of the underlying real estate collateral.
Lending officers are assigned various levels of loan approval authority based upon their respective levels of experience and expertise. Loan approval is also subject to the Companys formal loan policy, as established by the Banks Board of Directors. The Banks loan policies establish lending authority and limits on an individual and committee basis. The loan approval process is designed to facilitate timely decisions while enhancing adherence to policy parameters and risk management targets.
The Bank maintains a network of 20 ATM sites generally located within the Banks local market. All except one ATM is owned by the Bank. Eighteen of the ATM sites are located at various banking centers and two are maintained off-site. The Bank is now a member of the STARsf Surcharge-Free Network. As a member, this allows customers to access their accounts at several hundred ATMs nationwide.
The Bank offers land trusts, personal trusts, custody accounts, retirement plan services, and corporate trust services. As of December 31, 2005, the Bank maintained trust relationships representing an aggregate market value of $13.5 million in assets with an aggregate book value of $12.0 million. In addition, it administered 1,674 land trust accounts as of December 31, 2005.
Midwest Bank Insurance Services, L.L.C. is an independent insurance agency which concentrates in commercial and individual insurance products including fixed rate annuities.
The Companys subsidiary, Midwest Financial and Investment Services, Inc. offers brokerage activities through the Banks investment centers. Licensed brokers serve all branches and provide investment-related services, including securities trading, financial planning, mutual funds sales, fixed and variable rate annuities, and tax-exempt and conventional unit trusts. This activity is furthering one of the Companys strategic goals of increasing revenues from nontraditional sources and to enhance the Companys profitability.
As of December 31, 2005, the Company and its subsidiaries had 402 full-time equivalent employees compared to 382 full-time equivalent employees a year ago. Management considers its relationship with its employees to be good.
The Companys internet address is www.midwestbanc.com. The Company is an SEC registrant and posts its SEC filings, including Forms 10-K, 10-Q, and 8-K, on its website on the day they are filed. The Company will also provide free copies of its filings upon written request to: Chief Financial Officer, 501 West North Ave., Melrose Park, IL 60160.
The public may read and copy any materials filed with the SEC at the SECs Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company is an electronic filer. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at the SECs site: http://www.sec.gov.
SUPERVISION AND REGULATION
Bank holding companies and banks are extensively regulated under federal and state law. References under this heading to applicable statutes or regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to those statutes and regulations. Any change in applicable laws or regulations may have a material adverse effect on the business of commercial banks and bank holding companies, including the Company and the Bank. However, management is not aware of any current recommendations by any regulatory authority which, if implemented, would have or would be reasonably likely to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Finally, please remember that the supervision, regulation and examination of banks and bank holding companies by bank regulatory agencies are intended primarily for the protection of depositors rather than stockholders of banks and bank holding companies.
Bank Holding Company Regulation
The Company is registered as a bank holding company with the Board of Governors of the Federal Reserve System (the Federal Reserve) and, accordingly, is subject to supervision and regulation by the Federal Reserve under the Bank Holding Company Act (the Bank Holding Company Act and the regulations issued thereunder are collectively referred to as the BHC Act). The Company is required to file with the Federal Reserve periodic reports and such additional information as the Federal Reserve may require pursuant to the BHC Act. The Federal Reserve examines the Company and the Bank, and may examine MBHI Capital Trust II, MBHI Capital Trust III, MBHI Capital Trust IV, MBHI Capital Trust V, Midwest Financial and Investment Services, Inc., MBTC Investment Company, and Midwest Bank Insurance Services, L.L.C.
The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined, by regulation or order, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto, such as performing functions or activities that may be performed by a trust company, or acting as an investment or financial advisor. The Federal Reserve, however, expects bank holding companies to maintain strong capital positions while experiencing growth. In addition, the Federal Reserve, as a matter of policy, may require a bank holding company to be well-capitalized at the time of filing an acquisition application and upon consummation of the acquisition.
Under the BHC Act, the Company and the Banks are prohibited from engaging in certain tie-in arrangements in connection with an extension of credit, lease, sale of property or furnishing of services. This means that, except with respect to traditional banking products, the Company may not condition a customers purchase of one of its services on the purchase of another service.
The passage of the Gramm-Leach-Bliley Act allows bank holding companies to become financial holding companies. Financial holding companies do not face the same prohibitions on entering into certain business transactions that bank holding companies currently face.
Under the Illinois Banking Act, any person who acquires 25% or more of the Companys stock may be required to obtain the prior approval of the Illinois Department of Financial and Professional Regulation (IDFPR). Under the Change in Bank Control Act, a person may be required to obtain the prior approval of the Federal Reserve before acquiring the power to directly or indirectly control the management, operations or policies of the Company or before acquiring 10% or more of any class of its outstanding voting stock.
It is the policy of the Federal Reserve that the Company is expected to act as a source of financial strength to the Banks and to commit resources to support the Banks. The Federal Reserve takes the position that in implementing this policy, it may require the Company to provide such support when the Company otherwise would not consider itself able to do so.
The Federal Reserve has adopted risk-based capital requirements for assessing bank holding company capital adequacy. These standards define regulatory capital and establish minimum capital ratios in relation to assets, both on an aggregate basis and as adjusted for credit risks and off-balance-sheet exposures. The Federal Reserves risk-based guidelines apply on a consolidated basis for bank holding companies with consolidated assets of $150 million or more and on a bank-only basis for bank holding companies with consolidated assets of less than $150 million, subject to certain terms and conditions. Under the Federal Reserves risk-based guidelines, capital is classified into two categories. For bank holding companies, Tier 1, or core, capital consists of common stockholders equity, qualifying noncumulative perpetual preferred stock (including related surplus), qualifying cumulative perpetual preferred stock (including related surplus) (subject to certain limitations) and minority interests in the common equity accounts of consolidated subsidiaries, and is reduced by goodwill, and specified intangible assets (Tier 1 Capital). Tier 2, or supplementary capital consists of the allowance for loan and lease losses, perpetual preferred stock and related surplus, hybrid capital instruments, unrealized holding gains on equity securities, perpetual debt and mandatory convertible debt securities, and term subordinated debt and intermediate-term preferred stock, including related surplus.
Under the Federal Reserves capital guidelines, bank holding companies are required to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 Capital. The Federal Reserve also requires a minimum leverage ratio of Tier 1 Capital to total assets of 3% for strong bank holding companies (those rated a composite 1 under the Federal Reserves rating system). For all other bank holding companies, the minimum ratio of Tier 1 capital to total assets is 4%.
In addition, the Federal Reserve continues to consider the Tier 1 leverage ratio in evaluating proposals for expansion or new activities.
In its capital adequacy guidelines, the Federal Reserve emphasizes that the foregoing standards are supervisory minimums and that banking organizations generally are expected to operate well above the minimum ratios. These guidelines also provide that banking organizations experiencing growth, whether internally or by making acquisitions, are expected to maintain strong capital positions substantially above the minimum levels.
As of December 31, 2005, the Company had regulatory capital in excess of the Federal Reserves minimum requirements. The Company had a total capital to risk-weighted assets ratio of 18.1%, a Tier 1 capital to risk-weighted assets ratio of 17.0%, and a leverage ratio of 12.2% as of December 31, 2005. See Capital Resources.
As a bank holding company, the Company is primarily dependent upon dividend distributions from its operating subsidiaries for its income. Federal and state statutes and regulations impose restrictions on the payment of dividends by the Company and the Bank.
Federal Reserve policy provides that a bank holding company should not pay dividends unless (i) the bank holding companys net income over the prior year is sufficient to fully fund the dividends and (ii) the prospective rate of earnings retention appears consistent with the capital needs, asset quality and overall financial condition of the bank holding company and its subsidiaries.
Delaware law also places certain limitations on the ability of the Company to pay dividends. For example, the Company may not pay dividends to its stockholders if, after giving effect to the dividend, the Company would not be able to pay its debts as they become due. Because a major source of the Companys revenues is dividends the Company receives and expects to receive from the Bank, the Companys ability to pay dividends is likely to be dependent on the amount of dividends paid by the Bank. No assurance can be given that the Bank will, continue to, pay such dividends to the Company on their stock.
Under Illinois law, the Bank is subject to supervision and examination by IDFPR. The Bank is a member of the Federal Reserve System and as such is also subject to examination by the Federal Reserve. The Federal Reserve also supervises compliance with the provisions of federal law and regulations, which place restrictions on loans by member banks to their directors, executive officers and other controlling persons. The Bank is also a member of the FHLB of Chicago and may be subject to examination by the FHLB of Chicago. Any affiliates of the Bank and the Company are also subject to examination by the Federal Reserve.
The deposits of the Bank are insured by the Bank Insurance Fund (BIF) under the provisions of the Federal Deposit Insurance Act (the FDIA), and the Bank is, therefore, also subject to supervision and examination by the FDIC. The FDIA requires that the appropriate federal regulatory authority approve any merger and/or consolidation by or with an insured bank, as well as the establishment or relocation of any bank or branch office. The FDIA also gives the Federal Reserve and other federal bank regulatory agencies power to issue cease and desist orders against banks, holding companies or persons regarded as institution affiliated parties. A cease and desist order can either prohibit such entities from engaging in certain unsafe and unsound bank activity or can require them to take certain affirmative action.
Furthermore, banks are affected by the credit policies of the Federal Reserve, which regulates the national supply of bank credit. Such regulation influences overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans and paid on deposits. The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.
As discussed above, under Illinois law, the Bank is subject to supervision and examination by IDFPR, and, as a member of the Federal Reserve System, by the Federal Reverse. Each of these regulatory agencies conducts routine, periodic examinations of the Bank and the Company.
Financial Institution Regulation
Transactions with Affiliates. Transactions between a bank and its holding company or other affiliates are subject to various restrictions imposed by state and federal regulatory agencies. Such transactions include loans and other extensions of credit, purchases of securities and other assets and payments of fees or other distributions. In general, these restrictions limit the amount of transactions between a bank and an affiliate of such bank, as well as the aggregate amount of transactions between a bank and all of its affiliates, impose collateral requirements in some cases and require transactions with affiliates to be on terms comparable to those for transactions with unaffiliated entities.
Dividend Limitations. As a state member bank, the Bank may not, without the approval of the Federal Reserve, declare a dividend if the total of all dividends declared in a calendar year exceeds the total of its net income for that year, combined with its retained net income of the preceding two years, less any required transfers to the surplus account. Under Illinois law, the Bank may not pay dividends in an amount greater than its net profits then on hand, after deducting losses and bad debts. For the purpose of determining the amount of dividends that an Illinois bank may pay, bad debts are defined as debts upon which interest is past due and unpaid for a period of six months or more, unless such debts are well-secured and in the process of collection.
In addition to the foregoing, the ability of the Company and the Bank to pay dividends may be affected by the various minimum capital requirements and the capital and noncapital standards established under the Federal Deposit Insurance Corporation Improvements Act of 1991 (FDICIA), as described below. The right of the Company, its stockholders and its creditors to participate in any distribution of the assets or earnings of its subsidiaries is further subject to the prior claims of creditors of the respective subsidiaries.
Capital Requirements. State member banks are required by the Federal Reserve to maintain certain minimum capital levels. The Federal Reserves capital guidelines for state member banks require state member banks to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 Capital. In addition, the Federal Reserve requires a minimum leverage ratio of Tier 1 Capital to total assets of 3% for strong banking institutions (those rated a composite 1 under the Federal Reserves rating system) and a minimum leverage ratio of Tier 1 Capital to total assets of 4% for all other banks.
At December 31, 2005, the Bank has a Tier 1 capital to risk-weighted assets ratio and a total capital to risk-weighted assets ratio which meets the above requirements. The Bank has a Tier 1 capital to risk-weighted assets ratio of 11.7% and a total capital to risk-weighted assets ratio of 12.8%. See Capital Resources.
Standards for Safety and Soundness. The FDIA, as amended by FDICIA and the Riegle Community Development and Regulatory Improvement Act of 1994, requires the Federal Reserve, together with the other federal bank regulatory agencies, to prescribe standards of safety and soundness, by regulations or guidelines, relating generally to operations and management, asset growth, asset quality, earnings, stock valuation and compensation. The Federal Reserve and the other federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards pursuant to FDICIA. The guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, the Federal Reserve adopted regulations that authorize, but do not require, the Federal Reserve to order an institution that has been given notice by the Federal Reserve that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the Federal Reserve must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized association is subject under the prompt corrective action provisions of FDICIA. If an institution fails to comply with such an order, the Federal Reserve may
seek to enforce such order in judicial proceedings and to impose civil money penalties. The Federal Reserve and the other federal bank regulatory agencies also adopted guidelines for asset quality and earnings standards.
A range of other provisions in FDICIA include requirements applicable to closure of branches; additional disclosures to depositors with respect to terms and interest rates applicable to deposit accounts; uniform regulations for extensions of credit secured by real estate; restrictions on activities of and investments by state-chartered banks; modification of accounting standards to conform to generally accepted accounting principles including the reporting of off-balance-sheet items and supplemental disclosure of estimated fair market value of assets and liabilities in financial statements filed with the banking regulators; increased penalties in making or failing to file assessment reports with the FDIC; greater restrictions on extensions of credit to directors, officers and principal stockholders; and increased reporting requirements on agricultural loans and loans to small businesses.
In addition, the Federal Reserve, FDIC and other federal banking agencies adopted a final rule, which modified the risk-based capital standards to provide for consideration of interest rate risk when assessing the capital adequacy of a bank. Under this rule, the Federal Reserve and the FDIC must explicitly include a banks exposure to declines in the economic value of its capital due to changes in interest rates as a factor in evaluating a banks capital adequacy. The Federal Reserve, the FDIC and other federal banking agencies also have adopted a joint agency policy statement providing guidance to banks for managing interest rate risk. The policy statement emphasizes the importance of adequate oversight by management and a sound risk management process. The assessment of interest rate risk management made by the banks examiners will be incorporated into the banks overall risk management rating and used to determine the effectiveness of management.
Prompt Corrective Action. FDICIA requires the federal banking regulators, including the Federal Reserve and the FDIC, to take prompt corrective action with respect to depository institutions that fall below minimum capital standards and prohibits any depository institution from making any capital distribution that would cause it to be undercapitalized. Institutions that are not adequately capitalized may be subject to a variety of supervisory actions including, but not limited to, restrictions on growth, investment activities, capital distributions and affiliate transactions and will be required to submit a capital restoration plan which, to be accepted by the regulators, must be guaranteed in part by any company having control of the institution (such as the Company). In other respects, FDICIA provides for enhanced supervisory authority, including greater authority for the appointment of a conservator or receiver for undercapitalized institutions. The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions. However, federal banking agencies have indicated that, in regulating bank holding companies, the agencies may take appropriate action at the holding company level based on their assessment of the effectiveness of supervisory actions imposed upon subsidiary insured depository institutions pursuant to the prompt corrective action provisions of FDICIA.
Insurance of Deposit Accounts. Under FDICIA, as a FDIC-insured institution, the Bank is required to pay deposit insurance premiums based on the risk it poses to the insurance fund. The FDIC has authority to raise or lower assessment rates on insured deposits in order to achieve statutorily required reserve ratios in the insurance funds and to impose special additional assessments. Each depository institution is assigned to one of three capital groups: well capitalized, adequately capitalized or undercapitalized. An institution is considered well capitalized if it has a total risk-based capital ratio of 10% or greater, has a Tier 1 risk-based capital ratio of 6% or greater, has a leverage ratio of 5% or greater and is not subject to any order or written directive to meet and maintain a specific capital level. An adequately capitalized institution is defined as one that has a total risk-based capital ratio of 8% or greater, has a Tier 1 risk-based capital ratio of 4% or greater, has a leverage ratio of 4% or greater and does not meet the definition of a well capitalized bank. An institution is considered undercapitalized if it does not meet the definition of well-capitalized or adequately capitalized. Within each capital group, institutions are assigned to one of three supervisory subgroups: A (institutions with few minor weaknesses), B (institutions which demonstrate weaknesses which, if not corrected, could result in significant deterioration of the institution and increased risk of loss to BIF), and C (institutions that pose a substantial probability of loss to BIF unless effective corrective action is taken). Accordingly, there are nine combinations of capital groups and supervisory subgroups to which varying
assessment rates would be applicable. An institutions assessment rate depends on the capital category and supervisory category to which it is assigned.
During 2005, the Bank was assessed deposit insurance in the aggregate amount of $202,000. Deposit insurance may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Such terminations can only occur, if contested, following judicial review through the federal courts. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Federal Reserve System. The Bank is subject to Federal Reserve regulations requiring depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve regulations generally require 3% reserves on the first $48.3 million of transaction accounts and 10% on the remainder. The first $7.8 million of otherwise reservable balances (subject to adjustments by the Federal Reserve) are exempted from the reserve requirements. The Bank is in compliance with the foregoing requirements.
Community Reinvestment. Under the Community Reinvestment Act (CRA), a financial institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institutions discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. However, institutions are rated on their performance in meeting the needs of their communities. Performance is judged in three areas: (a) a lending test, to evaluate the institutions record of making loans in its assessment areas; (b) an investment test, to evaluate the institutions record of investing in community development projects, affordable housing and programs benefiting low or moderate income individuals and business; and (c) a service test to evaluate the institutions delivery of services through its branches, ATMs and other offices. The CRA requires each federal banking agency, in connection with its examination of a financial institution, to assess and assign one of four ratings to the institutions record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by the institution, including applications for charters, branches and other deposit facilities, relocations, mergers, consolidations, acquisitions of assets or assumptions of liabilities and savings and loan holding company acquisitions. The CRA also requires that all institutions make public disclosure of their CRA ratings. The Bank received a satisfactory rating on its most recent CRA performance evaluation.
Consumer Compliance. The Bank has been examined for consumer compliance on a regular basis.
Brokered Deposits. Well-capitalized institutions are not subject to limitations on brokered deposits, while an adequately capitalized institution is able to accept, renew or rollover brokered deposits only with a waiver from the FDIC and subject to certain restrictions on the yield paid on such deposits. Undercapitalized institutions are not permitted to accept brokered deposits.
Enforcement Actions. Federal and state statutes and regulations provide financial institution regulatory agencies with great flexibility to undertake enforcement action against an institution that fails to comply with regulatory requirements, particularly capital requirements. Possible enforcement actions range from the imposition of a capital plan and capital directive to civil money penalties, cease and desist orders, receivership, conservatorship or the termination of deposit insurance.
Interstate Banking and Branching Legislation. Under the Interstate Banking and Efficiency Act of 1994 (the Interstate Banking Act), bank holding companies are allowed to acquire banks across state lines subject to various requirements of the Federal Reserve. In addition, under the Interstate Banking Act, banks are permitted, under some circumstances, to merge with one another across state lines and thereby create a main bank with branches in separate states. After establishing branches in a state through an interstate merger transaction, a bank may establish and acquire additional branches at any location in the state where any bank
involved in the interstate merger could have established or acquired branches under applicable federal and state law.
The State of Illinois has adopted legislation opting in to interstate bank mergers, and allows out of state banks to enter the Illinois market through de novo branching or through branch-only acquisitions if Illinois state banks are afforded reciprocal treatment in the other state. It is anticipated that this interstate merger and branching ability will increase competition and further consolidate the financial institutions industry.
Insurance Powers. Under state law, a state bank is authorized to act as agent for any fire, life or other insurance company authorized to do business in the State of Illinois. Similarly, the Illinois Insurance Code was amended to allow a state bank to form a subsidiary for the purpose of becoming a firm registered to sell insurance. Such sales of insurance by a state bank may only take place through individuals who have been issued and maintain an insurance producers license pursuant to the Illinois Insurance Code.
State banks are prohibited from assuming or guaranteeing any premium on an insurance policy issued through the bank. Moreover, state law expressly prohibits tying the provision of any insurance product to the making of any loan or extension of credit and requires state banks to make disclosures of this fact in some instances. Other consumer oriented safeguards are also required.
Midwest Bank Insurance Services, L.L.C. is an independent insurance agency established by Midwest Bank and Trust Company in 1998. Midwest Bank Insurance Services, L.L.C. is registered with, and subject to examination by, the Illinois Department of Insurance, and the Company believes that it is operating in compliance with applicable laws of the State of Illinois.
Securities Brokerage. Midwest Financial and Investment Services, Inc., a subsidiary of the Company, makes available investment services through Raymond James, a broker dealer and investment advisory firm registered with the SEC and a member of the National Association of Securities Dealers.
Monetary Policy and Economic Conditions
The earnings of banks and bank holding companies are affected by general economic conditions and by the fiscal and monetary policies of federal regulatory agencies, including the Federal Reserve. Through open market transactions, variations in the discount rate and the establishment of reserve requirements, the Federal Reserve exerts considerable influence over the cost and availability of funds obtainable for lending or investing.
The above monetary and fiscal policies and resulting changes in interest rates have affected the operating results of all commercial banks in the past and are expected to do so in the future. Banks and their respective holding company cannot fully predict the nature or the extent of any effects which fiscal or monetary policies may have on their business and earnings.
On April 16, 2004, the Company was informed by a letter from the Securities and Exchange Commission that the Commission was conducting an inquiry in connection with the Companys restatement of its September 30, 2002 financial statements. The Company is cooperating fully with the Commission on this matter.
On September 21, 2005, the Company and the Bank received a letter from the Federal Reserve Bank of Chicago and Illinois Department of Financial and Professional Regulation stating that the written agreement entered into by the parties has been terminated.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995
This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended: 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, 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. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in, or implied by, these statements. 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 Company wishes to caution that the foregoing list of important factors may not be all-inclusive and 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.
EXECUTIVE OFFICERS OF THE REGISTRANT
Listed below are the executive officers of the Company as of March 1, 2006.
James J. Giancola (57) was named Director, President, and Chief Executive Officer of the Company and Midwest Bank and Trust Company (the Bank) in September 2004. In November 2004, Mr. Giancola was named Chairman, Director, President, Chief Executive Officer of MBTC Investment Company. In February 2005, he was named Director of Midwest Financial and Investment Services, Inc. Prior to joining the
Company, he was semi-retired and a private investor. Mr. Giancola has over 30 years experience in the banking industry. He served as president of Fifth Third Bank, Indiana from 1999 to 2000. He also served as president and CEO of CNB Bancshares, Inc., a seven billion dollar bank holding company in Evansville, Indiana from 1997 to 1999. Mr. Giancola also served as president of Gainer Bank located in Northwest Indiana.
Daniel R. Kadolph, CPA (43) was named Senior Vice President and Chief Financial Officer in 2000 of the Company. Mr. Kadolph was also named director of Midwest Financial and Investment Services, Inc. in March 2002 and a director, secretary, and treasurer of MBTC Investment Company in 2002. He has served as Comptroller of the Company since 1994 and Treasurer since 1997. Mr. Kadolph has served in various management capacities at the Company and its subsidiaries since 1988.
David M. Viar (56) was named Executive Vice President and Chief Investment Officer of the Company and the Bank in December 2004. In February 2005, Mr. Viar was named Director and Executive Vice President of MBTC Investment Company. Mr. Viar has over 25 years of experience in fixed income securities, funds management, derivatives, and asset/liability management for financial institutions. He has served as manager of funding and investments for Integra Bank Corporation, Evansville, Indiana from 2000 to 2004. He also served in similar capacities at CNB Bancshares, Inc., Evansville, Indiana and Dominion Bankshares, Inc., Roanoke, Virginia.
Mary C. Ceas, SPHR (48) was named Senior Vice President Human Resources of the Company in 2000. Previously, Ms. Ceas was Vice President Human Resources since 1997 and served as Director Training and Development from 1995 to 1997.
Sheldon Bernstein (59) was named Executive Vice President of the Bank in January 2005. He previously served as Senior Vice President of the Company from 2001 to 2005. Mr. Bernstein has served as President of the Bank, Cook County Region from 2000 to 2004. From 2000 through 2002, he served as Chief Operating Officer of the Bank. Previously, Mr. Bernstein served as Executive Vice President-Lending of the Bank since 2000 and 1993, respectively. He was also served as director of Midwest Financial and Investment Services, Inc. from 2002 to 2005. Mr. Bernstein was a director of First Midwest Data Corp from 2001 to 2002.
Thomas A. Caravello (57) was named Executive Vice President and Chief Credit Officer of the Bank in January 2005. He has served as Senior Vice President Credit Administration from 2003 to 2005. Previously he served as Vice President Credit Administration from 1998 to 2003.
Bruno P. Costa (45) was named Executive Vice President and Chief Operations and Technology Officer of the Bank in January 2005. He served as President of the Information Services Division of the Bank from 2002 to 2005. Mr. Costa served as President and Chief Executive Officer of First Midwest Data Corp. from 1995 to 2002. He held various management positions at the Bank since 1983.
Thomas H. Hackett (58) was named Executive Vice President of the Bank in November 2003. He previously was division manager at Banc One, Chicago, Illinois from 2002 to 2003. Prior, he was first vice president of American National Bank of Chicago from 1997 to 2002. He has also served in similar capacities at First Chicago/ NBD, Park Ridge, IL, NBD of Woodridge and Heritage Bank of Woodridge, Illinois.
Mary M. Henthorn (48) was named Executive Vice President of the Bank in January 2005. She previously served as Senior Vice President of the Company from 2001 to 2005. She also served as President of the Bank, DuPage County Region from 2002 to 2004. She served as director of Midwest Financial and Investment Services, Inc. from 2002 to 2005. Ms. Henthorn served as President and Chief Executive Officer of Midwest Bank of Hinsdale from 2000 to 2002. Previously, she served as Executive Vice President and a director of Midwest Bank of Hinsdale from 1996 to 2002. She held various management positions at Midwest Bank of Hinsdale and the Bank since 1992.
Dennis M. Motyka (55) was named Executive Vice President of the Bank and director of Midwest Financial and Investment Services, Inc. in October 2005. He previously was senior vice president and director of banking centers for Cole Taylor Bank in Rosemont from 2002 to 2005. Previously, he was senior vice president and Illinois regional manager for LaSalle Bank in Chicago from 1996 to 2002. He also held positions
with Comerica Bank and Affiliated Bank, both in Franklin Park, as well as with Western National Bank in Cicero.
William H. Stoll (50) was named Executive Vice President of the Bank in January 2005. In February 2005, he was named Director of Midwest Financial and Investment Services, Inc. He previously was senior vice president and chief lending officer of Mercantile Bank, Hammond, Indiana from 2002 to 2005. Prior, he was national bank examiner of the Comptroller of the Currency, Chicago, IL from 2000 to 2002 and senior vice president manager commercial lending of Fifth Third Bank, Merrillville, Indiana from 1999 to 2000. He has also served in similar capacities at Merchantile National Bank, Hammond, Indiana and NBD Gainer Bank, Merrillville, Indiana.
The Companys business, financial condition or results of operations could be materially adversely affected by any of these risks.
Changes in economic conditions, in particular an economic slowdown in Chicago, Illinois, could hurt the Companys business materially.
The Companys business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond its control. Deterioration in economic conditions, in particular an economic slowdown in Chicago, Illinois, could result in the following consequences, any of which could hurt the Companys business materially:
A large percentage of the Companys loans are collateralized by real estate, and an adverse change in the real estate market may result in losses and adversely affect its profitability.
Approximately 84.9% of the Companys loan portfolio as of December 31, 2005 was comprised of loans collateralized by real estate; a substantial portion of this real estate collateral is located in the Chicago market. An adverse change in the economy affecting real estate values generally or in the Chicago market specifically could significantly impair the value of the Companys collateral and its ability to sell the collateral upon foreclosure. In the event of a default with respect to any of these loans, amounts received upon sale of the collateral may be insufficient to recover outstanding principal and interest on the loan. As a result, the Companys profitability could be negatively impacted by an adverse change in the real estate market.
The Companys business is subject to interest rate risk and fluctuations in interest rates may adversely affect its earnings.
The majority of the Companys assets and liabilities are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, the Companys earnings and profitability depend significantly on its net interest income, which is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company expects that it will periodically experience gaps in the interest rate sensitivities of its assets and liabilities, meaning that either its interest-bearing liabilities will be more sensitive to changes in market interest rates than its interest-earning assets, or vice versa. However, the actual effect of
changing interest rates on the Companys earnings may vary due to the speed and magnitude of the changes, the degree to which short-term and long-term rates are similarly affected, and other factors. The Companys asset-liability management strategy may not be able to control its risk from changes in market interest rates, and it may not be able to prevent changes in interest rates from having a material adverse effect on its results of operations and financial condition.
In addition, the Company is unable to predict or control fluctuations of market interest rates, which are affected by many factors, including the following:
Changes in interest rates may also adversely affect the growth rate of the Companys loans and deposits, the quality of its loan portfolio, loan and deposit pricing, the volume of loan originations in its mortgage banking business and the value that it can recognize on the sale of mortgage loans in the secondary market.
The Companys allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect its results of operations.
As a lender, the Company is exposed to the risk that its loan customers may not repay their loans according to their terms and that the collateral securing the payment of these loans may be insufficient to assure repayment. The Company may experience significant loan losses which could have a material adverse effect on its operating results. Management makes various assumptions and judgments about the collectibility of the Companys loan portfolio, which are based in part on:
The Company maintains an allowance for loan losses in an attempt to cover probable incurred loan losses inherent in its loan portfolio. Additional loan losses will likely occur in the future and may occur at a rate greater than the Company has experienced to date. In determining the size of the allowance, the Company relies on an analysis of its loan portfolio, its experience, and its evaluation of general economic conditions. If the Companys assumptions and analysis prove to be incorrect, its current allowance may not be sufficient. In addition, adjustments may be necessary to allow for unexpected volatility or deterioration in the local or national economy or other factors such as changes in interest rates that may be beyond its control. Material additions to the allowance would materially decrease the Companys net income. In addition, federal regulators periodically review the Companys allowance for loan losses and may require it to increase its provision for loan losses or recognize further loan charge-offs, based on judgments different than those of the Companys management. Any increase in the Companys loan allowance or loan charge-offs as required by these regulatory agencies could have a material adverse effect on its results of operations.
An interruption in or breach in security of the Companys information systems may result in a loss of customer business.
The Company relies heavily on communications and information systems to conduct its business. Any failure or interruptions or breach in security of these systems could result in failures or disruptions in its customer relationship management, general ledger, deposits, servicing, or loan origination systems. The
occurrence of any failures or interruptions could result in a loss of customer business and have a material adverse effect on the Companys results of operations and financial condition.
The Companys ability to pay dividends and make payment on its debt securities is dependent on the earnings of its subsidiaries and is subject to other restrictions.
Most of the Companys revenues available for payment of dividends and to make payments on its debt securities derive from amounts paid to it by its subsidiary bank. Under applicable banking law, the total dividends declared in any calendar year by a state-chartered bank (the Bank) may not, without the approval of the Federal Reserve, or the FDIC, as the case may be, exceed the aggregate of the banks net profits and retained net profits for the preceding two years. The Bank is also subject to limits on dividends under the Illinois Banking Act.
If, in the opinion of the federal bank regulatory agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution, could include the payment of dividends), the agency may require that the bank cease and desist from the practice. The Federal Reserve has similar authority with respect to bank holding companies. In addition, the federal bank regulatory agencies have issued policy statements which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. Finally, these regulatory authorities have established guidelines with respect to the maintenance of appropriate levels of capital by a bank, bank holding company or savings association under their jurisdiction. Compliance with the standards set forth in these guidelines could limit the amount of dividends that the Company and its affiliates may pay in the future.
Under the terms of junior indentures the Company has issued, it has agreed not to declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of its common stock or preferred stock if, at that time, there is a default under the junior indenture or a related guarantee or it has delayed interest payments on the securities issued under the junior indenture. The Company also has dividend limitations under its revolving line of credit agreement.
The Companys business may be adversely affected by the highly regulated environment in which it operates.
The Company is subject to extensive federal and state legislation, regulation and supervision. The burden of regulatory compliance has increased under current legislation and banking regulations and is likely to continue to have or may have a significant impact on the financial services industry. Recent legislative and regulatory changes, as well as changes in regulatory enforcement policies and capital adequacy guidelines, are increasing the Companys costs of doing business and, as a result, may create an advantage for its competitors who may not be subject to similar legislative and regulatory requirements. In addition, future regulatory changes, including changes to regulatory capital requirements, could have an adverse impact on the Companys future results. In addition, the federal and state bank regulatory authorities who supervise the Company have broad discretionary powers to take enforcement actions against banks for failure to comply with applicable regulations and laws. If the Company fails to comply with applicable laws or regulations, it could become subject to enforcement actions that have a material adverse effect on its future results.
The Company could encounter difficulties or unexpected developments related to any future acquisitions.
The Company plans to pursue potential acquisitions of other community-oriented banks as well as specialty lending and related financial services businesses which could also present challenges relating to the integration of the operations of acquired businesses into its organization. To the extent acquisitions divert a significant amount of management time and attention, the Companys business could be disrupted.
Provisions in the Companys amended and restated certificate of incorporation and its amended and restated by-laws may delay or prevent an acquisition of the Company by a third party.
The Companys amended and restated certificate of incorporation and its amended and restated by-laws contain provisions that may make it more difficult for a third party to gain control or acquire the Company
without the consent of its board of directors. These provisions also could discourage proxy contests and may make it more difficult for dissident stockholders to elect representatives as directors and take other corporate actions.
These provisions of the Companys governing documents may have the effect of delaying, deferring or preventing a transaction or a change in control that some or many of its stockholders might believe to be in their best interest.
The following table sets forth certain information regarding the Companys principal office and bank branches.
Management believes that the facilities are of sound construction, in good operating condition, appropriately insured, and adequately equipped for carrying on the business of the Company.
The Company and its subsidiaries are from time to time parties to various legal actions arising in the normal course of business. Management believes that there is no proceeding pending against the Company or
any of its subsidiaries which, if determined adversely, would have a material adverse effect on the financial condition or results of operations of the Company.
The Companys common stock is traded over-the-counter and quoted on the Nasdaq National Market under the symbol MBHI. As of March 1, 2006, the Company had approximately 4,515 stockholders of record. The table below sets forth the high and low sale prices of the common stock and the cash dividends declared during the periods indicated. The Company has not repurchased common shares in 2004 or 2005.
Holders of common stock are entitled to receive such dividends that may be declared by the Board of Directors from time to time and paid out of funds legally available therefore. Because the Companys consolidated net income consists largely of net income of the Bank, the Companys ability to pay dividends depends upon its receipt of dividends from the Bank. The Banks ability to pay dividends is regulated by banking statutes. See Supervision and Regulation, Financial Institution Regulation Dividend Limitations. The declaration of dividends by the Company is discretionary and depends on the Companys earnings and financial condition, regulatory limitations, tax considerations and other factors including limitations imposed by the terms of the Companys revolving lines of credit and limitations imposed by the terms of the Companys outstanding junior subordinated debt owed to its unconsolidated trusts. See Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity. While the Board of Directors expects to continue to declare dividends quarterly, there can be no assurance that dividends will be paid in the future.
The following table sets forth certain selected consolidated financial data at or for the periods indicated. In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the related results of operations and gain for MBWI are reflected in the Companys statements of income as discontinued operations. This information should be read in conjunction with the Companys Consolidated Financial Statements and notes thereto included herein. See Item 8, Consolidated Financial Statements and Supplementary Data.
The Companys principal business is conducted by the Bank and consists of a full range of community-based financial services, including commercial and retail banking. The profitability of the Companys operations depends primarily on its net interest income, provision for loan losses, noninterest income, and noninterest expenses. Net interest income is the difference between the income the Company receives on its loan and securities portfolios and its cost of funds, which consists of interest paid on deposits and borrowings. The provision for loan losses reflects the cost of credit risk in the Companys loan portfolio. Noninterest income consists of service charges on deposit accounts, securities gains or losses, net trading profits or losses, gains on sales of loans, insurance and brokerage commissions, trust income, increase in cash surrender value of life insurance, and other noninterest income. Noninterest expenses include salaries and employee benefits, occupancy and equipment expenses, professional services, and other noninterest expenses.
Net interest income is dependent on the amounts of and yields on interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities. Net interest income is sensitive to changes in market interest rates and is dependent on the Companys asset/liability management procedures to cope with such changes. The provision for loan losses is based upon managements assessment of the collectibility of the loan portfolio under current economic conditions. Noninterest expenses are influenced by the growth of operations, with additional employees necessary to staff and open new bank branches, and marketing expenses necessary to promote them. Growth in the number of account relationships directly affects such expenses as data processing costs, supplies, postage, and other miscellaneous expenses.
The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto and the Selected Consolidated Financial Data presented herein. In addition to historical information, the following Managements Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Companys actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed in this report.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the Companys financial position or results of operations. Actual results could differ from those estimates. Discussed below are those critical accounting policies that are of particular significance to the Company.
Allowance for Loan Losses: The allowance for loan losses represents managements estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on managements periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Companys methodology for determining the allowance for loan losses represents an estimation pursuant to SFAS No. 5, Accounting for Contingencies, and SFAS No. 114, Accounting by Creditors for Impairment of a Loan. The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The
specific credit allocations are based on regular analyses of commercial, commercial real estate, and agricultural loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The Companys historical loss factors are updated quarterly. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect the Companys earnings or financial position in future periods.
A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loans existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Evaluation of Securities for Impairment: Securities are classified as held-to-maturity when the Company has the ability and management has the positive intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on the disposition of securities available-for-sale are based on the net proceeds and the adjusted carrying amounts of the securities sold, using the specific identification method. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary losses, management considers (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The evaluation also considers the impact that impairment may have on future capital, earnings, and liquidity.
Fair Value of Financial Instruments and Derivatives: Fair values of financial instruments, including derivatives, are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for the particular items. There is no ready market for a significant portion of the Companys financial instruments. Accordingly, fair values are based on various factors relative to expected loss experience, current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment. As a consequence, fair values cannot be determined with precision. Changes in assumptions or in market conditions could significantly affect these estimates.
On May 31, 2005, the Company entered into a Stock Purchase Agreement with Western Illinois Bancshares, Inc. (WIB), pursuant to which WIB acquired Midwest Bank of Western Illinois, Monmouth, Illinois (MBWI), formerly one of the Companys bank subsidiaries.
The sale of MBWI closed on September 30, 2005. The sale price was $32.0 million. MBWI made a dividend distribution to the Company, prior to the sale closing, in an amount equal to $3.9 million. The after-tax gain on the sale of MBWI of $6.9 million is reflected in the income statement in discontinued operations for the year ended December 31, 2005. The Stock Purchase Agreement provides the parties with a method for resolving any disputes arising in connection with the transaction. On November 29, 2005, WIB furnished the Company with a notice to arbitrate the computation of the final purchase price. No further developments have occurred since that time, and the Company currently does not anticipate any significant changes to the final purchase price.
In June 2005, the Company completed its balance sheet repositioning which included the sale of low-yielding, long duration U.S. government-sponsored entity notes, prepayment of long-term high cost FHLB advances, and redemption of 10% trust preferred securities with pre-tax charges of $30.8 million from continuing operations.
On August 16, 2005, the Company issued 3,450,000 shares of its common stock at $21.00 in a secondary public offering. This offering, which included 450,000 shares to cover over-allotments, increased equity by $67.9 million, after issuance costs.
On February 8, 2006, the Company entered into an agreement and plan of merger with Royal American Corporation (Royal American) for a cash and stock merger transaction. The Company expects to issue 2.9 million common shares and pay $64.3 million in cash for an expected total purchase price of $130.2 million. The Companys stock will comprise up to 51% of the purchase price, at an exchange ratio of 3.58429 shares for each Royal American common share, and the remainder will be paid in cash at the rate of $80 per Royal American common share. This transaction is expected to close in mid-2006, pending regulatory approval as well as Royal American stockholder approval.
Consolidated Results of Operations
Set forth below are some highlights of 2005 results compared to 2004. In accordance with SFAS 144, the results of operations and gain on sale of MBWI are reflected in the Companys statements of income as discontinued operations and are not included in the discussion below.
Net Interest Income. Net interest income on a fully tax-equivalent basis increased $11.5 million, or 21.9%, to $64.1 million in 2005 from $52.6 million in 2004, mainly driven by the repositioning of the securities portfolio and the increase in rates and growth in loans. Average yields on earning assets increased to a greater extent than average rates paid on deposits and borrowings. Evidence of this is the increase in the Companys net interest margin (tax equivalent net interest income as a percentage of earning assets) to 3.31% for 2005 compared to 2.82% for 2004.
Trends in average earning assets include:
Trends in average interest-bearing liabilities include:
Provision for Loan Losses. The provision for loan losses decreased by $811,000, or 23.9%, to $2.6 million in 2005 from $3.4 million in 2004 due to reduced provisions relating to a lower level of nonaccruing loans, which decreased from $9.3 million at December 31, 2004 to $7.9 million at December 31, 2005 (see Nonaccruing Loans). As of December 31, 2005, the allowance for loan losses totaled $17.8 million, or 1.31% of total loans, and was equal to 224.7% of nonaccruing loans.
Noninterest Income. The Companys total noninterest income decreased $6.2 million to a loss of $6.2 million in 2005 from a loss of $88,000 in 2004. The decrease in noninterest income in 2005 compared to 2004 was primarily due to the increase in net losses on securities transactions of $13.7 million, as a result of the balance sheet repositioning. Other changes in noninterest income are noted below:
As part of the Companys strategic plan, the Company is focusing on opportunities to increase noninterest income especially in the areas of corporate cash management, insurance and investment services, trust services, and secondary-market mortgage lending.
Noninterest Expenses. The Companys total noninterest expenses increased by $14.0 million, or 30.2%, to $60.5 million in 2005 from $46.5 million in 2004, mainly due to the charges taken in connection with the balance sheet repositioning. Noninterest expenses as a percentage of average assets were 2.63% for the year
ended 2005 compared to 2.01% for the year ended 2004. Net overhead expenses were 2.14% as a percentage of average assets in 2005 compared to 1.58% in 2004. The increase in total noninterest expenses in 2005 was primarily due to the following factors:
These increases contributed to a slight deterioration in the efficiency ratio to 75.44% for the year ended December 31, 2005 compared to 72.79% in 2004. The core efficiency ratio (which excludes the balance sheet repositioning and employee severance charges as well as the life insurance benefit) was 58.00% for 2005 and 63.67% for 2004 which is attributed to an increase in revenues more than offsetting the increase in overhead expenses.
Federal and State Income Tax. The Companys consolidated income tax rate varies from statutory rates principally due to interest income from tax-exempt securities and loans. The Company recorded income tax benefit of $6.3 million in 2005 compared to $2.9 million in 2004. Set forth below is a reconciliation of the effective tax rate from continuing operations as of December 31, 2005 and December 31, 2004.
Supplemental Information. Core net income is net income excluding the balance sheet repositioning charges, severance charges, write down of other real estate owned, and the gain on the sale of MBWI. Management believes that core income from continuing operations is a more useful measure of operating performance since it excludes items that are not recurring in nature. In addition, management believes core income is more reflective of current trends. The following table reconciles reported net income to core net income from continuing operations for the years ended December 31, 2005 and 2004:
Set forth below are some highlights of 2004 results compared to 2003. In accordance with SFAS 144, the related results of operations for MBWI are reflected in the Companys statements of income as discontinued operations and are not included in the discussion below.
Net Interest Income. Net interest income on a fully tax-equivalent basis decreased $5.8 million, or 9.9%, to $52.6 million in 2004 from $58.4 million in 2003, despite an increase in total earning assets of $31.5 million
in 2004 (which was offset by a $59.7 million increase in interest-bearing liabilities). The decline in net interest income was primarily the result of lower yields on earning assets (which was partially offset by a decrease in the rates paid on liabilities), which resulted in a decrease in the net interest margin to 2.82% from 3.19% in 2003.
Interest income on loans (on a fully tax-equivalent basis) decreased $5.0 million to $59.7 million in 2004 from $64.7 million in 2003 due to a decrease in average rates paid on loans from 6.48% to 6.06% and an decrease of $11.5 million in average loans. The Company held $117.0 million in cash equivalents in 2004 (compared with $23.1 million in 2003) which earned 1.14% on average. Interest income on securities (on a fully tax-equivalent basis) decreased $3.4 million to $32.3 million in 2004 from $35.6 million in 2003 as a result of a decrease of yields on securities from 4.49% in 2003 to 4.33% in 2004 plus a $50.0 million decrease in average securities.
The Company took several actions in the fourth quarter to change the mix and profile of its securities portfolio. Set forth are some of those steps.
The Company expects these newly purchased securities to provide added cash flow to fund future loan growth. The Companys focus on future securities purchases is to maintain an adequate level of liquidity and to shorten the duration of its securities portfolio.
Interest expense on interest-bearing liabilities decreased $1.5 million to $41.8 million in 2004 from $43.3 million in 2003, or 3.4%, despite an increase of $59.7 million in average balances, due primarily to the decrease in interest expense on borrowings. The Company prepaid $92.0 million in FHLB advances in its efforts to reposition the balance sheet. Interest expense on total borrowings decreased due to a purchase accounting adjustment related to the BFFC acquisition of $2.1 million associated with part of the prepayment of FHLB advances which reduced the interest expense on the FHLB advances in 2004.
Provision for Loan Losses. The provision for loan losses decreased $6.1 million, or 64.0%, to $3.4 million in 2004 from $9.5 million in 2003 primarily due to reduced provisions relating to a decline in nonaccruing loans, which decreased from $14.9 million at December 31, 2003 to $9.3 million at December 31, 2004 (see Nonaccruing Loans). As of December 31, 2004, the allowance for loan losses totaled $16.2 million, or 1.48% of total loans, and was equal to 174.5% of nonaccruing loans.
Noninterest Income. The Companys total noninterest income decreased $19.9 million, or 100.4%, to a loss of $88,000 in 2004 from income of $19.8 million in 2003. The decrease in noninterest income in 2004 compared to 2003 was primarily due to the following factors:
These decreases were partially offset by the increase in service charges on deposits and the cash surrender value of life insurance, which increased by $61,000 and $642,000, respectively, in 2004.
Noninterest Expenses. The Companys total noninterest expenses increased $8.4 million, or 22.0%, to $46.5 million in 2004 from $38.1 million in 2003. Noninterest expenses as a percentage of average assets were 2.01% for the year ended 2004 compared to 1.71% for the year ended 2003. Net overhead expenses were 1.58% as a percentage of average assets in 2004 compared to 1.01% in 2003. The increase in total other expenses in 2004 was primarily due to the following factors:
These increases contributed to an increase in the efficiency ratio to 72.79% for the year ended December 31, 2004 compared to 49.56% in 2003.
Federal and State Income Tax. The Companys consolidated income tax rate varies from statutory rates principally due to interest income from tax-exempt securities and loans. The Company recorded income tax benefit of $2.9 million in 2004 compared to $7.8 million in expense in 2003, a decrease of 136.9%. Interest income on U.S. government-sponsored entity notes is exempt from state income tax. In addition, net income before tax was significantly lower than in the prior year.
Interest-Earning Assets and Interest-Bearing Liabilities
The following table sets forth the average balances, net interest income and expense and average yields and rates for the Companys interest-earning assets and interest-bearing liabilities for the indicated periods on a tax-equivalent basis assuming a 35.0% tax rate for 2005, 2004, and 2003.
Changes in Interest Income and Expense
The changes in net interest income from period to period are reflective of changes in the interest rate environment, changes in the composition of assets and liabilities as to type and maturity (and the inherent interest rate differences related thereto), and volume changes. Later sections of this discussion and analysis address the changes in maturity composition of loans and investments and in the asset and liability repricing gaps associated with interest rate risk, all of which contribute to changes in net interest margin.
The following table sets forth an analysis of volume and rate changes in interest income and interest expense of the Companys average interest-earning assets and average interest-bearing liabilities for the indicated periods on a tax-equivalent basis assuming a 35.0% tax rate in 2005, 2004, and 2003. The table distinguishes between the changes related to average outstanding balances (changes in volume holding the interest rate constant) and the changes related to average interest rates (changes in average rate holding the outstanding balance constant). The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
The following table sets forth the composition of the Companys loan portfolio as of the indicated dates.
Total loans increased $253.9 million, or 23.1%, to $1.4 billion at December 31, 2005 from December 31, 2004; however, the mix did not changed materially. Set forth below are other highlights of the loan portfolio.
Many consumer residential mortgage loans the Company originates are sold in the secondary market. At any point in time, loans will be at various stages of the mortgage banking process. Included as part of consumer real estate loans are loans held for sale. The carrying value of these loans approximated their market value at that time.
The Company attempts to balance the types of loans in its portfolio with the objective of reducing risk. Some of the risks the Company attempts to reduce include:
The following table sets forth the remaining maturities, based upon contractual dates, for selected loan categories as of December 31, 2005.
The Companys financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on its loan portfolio. The accrual of interest on loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Under SFAS No. 114 and No. 118, the Company currently defines loans that are individually evaluated for impairment to include commercial, commercial real estate and agricultural loans over $300,000 that are in nonaccrual status or were restructured. All other smaller balance loans with similar attributes (such as auto) are evaluated for impairment in total.
The classification of a loan as impaired or nonaccrual does not necessarily indicate that the principal is uncollectible, in whole or in part. The Company makes a determination as to the collectibility on a case-by-case basis based upon the specific facts of each situation. The Company considers both the adequacy of the collateral and the other resources of the borrower in determining the steps to be taken to collect impaired or nonaccrual loans. Alternatives that are typically considered to collect impaired or nonaccrual loans are foreclosure, collection under guarantees, loan restructuring, or judicial collection actions.
Loans that are considered to be impaired are reduced to the present value of expected future cash flows or to the fair value of the related collateral by allocating a portion of the allowance to such loans. If these allocations require an increase to be made to the allowance for loan losses, such increase is reported as a provision for loan losses charged to expense.
The following table sets forth information on the Companys nonaccruing loans and nonperforming assets as of the indicated dates.
During 2005, 2004, and 2003, the Company recognized interest income on impaired loans of $2.4 million, $2.8 million and $1.9 million, respectively.
Nonaccruing loans decreased $1.4 million or 15.0% to $7.9 million at December 31, 2005 from $9.3 million at December 31, 2004. A number of problem loans were successfully collected during the year.
Other real estate increased to $11.2 million in 2005 from $8.1 million in 2004. This increase was due to the acquisition of an office building and advertisement billboard from one loan customer which represents $3.8 million of the total other real estate. See Note 7 to the Notes to Consolidated Financial Statements.
Total nonperforming assets increased by $1.7 million from $17.4 million in 2004 to $19.1 million in 2005.
The Company recognizes that credit losses will be experienced and the risk of loss will vary with, among other things, general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and in the case of a collateralized loan, the quality of the collateral for such loan. The allowance for loan losses represents the Companys estimate of the amount deemed necessary to provide for probable incurred losses in the portfolio. In making this determination, the Company analyzes the ultimate collectibility of the loans in its portfolio by incorporating feedback provided by internal loan staff and information provided during examinations performed by regulatory agencies. The Company makes an ongoing evaluation as to the adequacy of the allowance for loan losses.
On a quarterly basis, management of the Bank meets to review the adequacy of the allowance for loan losses. Each loan officer grades his or her individual commercial credits and the Companys independent loan review personnel reviews the officers grades. In the event that the loan is downgraded during this review, the loan is included in the allowance analysis at the lower grade. The grading system is in compliance with the regulatory classifications, and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are known differences (e.g. collateral value is nominal).
The allowance for loan losses represents managements estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on managements periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Companys methodology for determining the allowance for loan losses represents an estimation done pursuant to SFAS No. 5, Accounting for Contingencies, and SFAS No. 114, Accounting by Creditors for Impairment of a Loan. The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of commercial, commercial real estate and agricultural loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The Companys historical loss factors are updated quarterly. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which potentially result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect the Companys earnings or financial position in future periods.
The following table sets forth loans charged off and recovered by type of loan and an analysis of the allowance for loan losses for the indicated periods.
The provision for loan losses decreased $811,000, or 23.9%, to $2.6 million for the year ended December 31, 2005 from $3.4 million for the year ended December 31, 2004. The allowance for loan losses was $17.8 million at December 31, 2005 and $16.2 million at December 31, 2004. Total recoveries on loans previously charged off were $1.5 million for the year ended December 31, 2005 and $506,000 for the year ended December 31, 2004. These recoveries were due primarily to payments from customers bankruptcy
proceedings or payment plans on charged-off loans. Two commercial loan recoveries in 2005 were from charged-off loans in prior years; $850,000 and $229,000 were received from loans charged off in 2003 and 2002, respectively.
Net charge-offs decreased $596,000 to $1.0 million, or 0.09% of average loans in 2005 compared to $1.6 million, or 0.17%, of average loans in 2004. Allowance for loan losses to nonaccruing loans ratio was 2.25x and 1.74x at December 31, 2005 and December 31, 2004, respectively.
The following table sets forth the Companys allocation of the allowance for loan losses by types of loans as of the indicated dates.
As of December 31, 2005, approximately 43.5% of the allowance was allocated to commercial loans, while 50.1% was allocated in the prior year. During March 2003, $13.3 million of classified nonperforming loans were sold to an insider group. See footnote (1) to the table on page 40. During 2002 and 2003, the Company experienced asset quality deterioration in commercial and commercial real estate loans. Asset quality has improved and is evidenced by the following:
The Company has a reserve for losses on unfunded commitments of $258,000 at December 31, 2005.
The Company utilizes an internal asset classification system as a means of reporting problem and potential problem assets. At each scheduled Bank Board of Directors meeting, a watch list is presented, showing significant loan relationships listed as Special Mention, Substandard, and Doubtful. Set forth below is a discussion of each of these classifications.
Special Mention: A special mention extension of credit is defined as having potential weaknesses that deserve managements close attention. If left uncorrected, these potential weaknesses may, at some future
date, result in the deterioration of the repayment prospects for the credit or the institutions credit position. Special mention credits are not considered as part of the classified extensions of credit category and do not expose an institution to sufficient risk to warrant classification. They are currently protected but are potentially weak. They constitute an undue and unwarranted credit risk.
Loans in this category have some identifiable problem, most notably slowness in payments, but, in managements opinion, offer no immediate risk of loss. An extension of credit that is not delinquent also may be identified as special mention. These loans are classified due to Bank managements actions or the servicing of the loan. The lending officer may be unable to properly supervise the credit because of an inadequate loan or credit agreement. There may be questions regarding the condition of and/or control over collateral. Economic or market conditions may unfavorably affect the obligor in the future. A declining trend in the obligors operations or an imbalanced position in the balance sheet may exist, although it is not to the point that repayment is jeopardized. Another example of a special mention credit is one that has other deviations from prudent lending practices.
If the Bank may have to consider relying on a secondary or alternative source of repayment, then collection may not yet be in jeopardy, but the loan may be considered special mention. Other trends that indicate that the loan may deteriorate further include such red flags as continuous overdrafts, negative trends on a financial statement, such as a deficit net worth, a delay in the receipt of financial statements, accounts receivable ageings, etc. These loans on a regular basis can be 30 days or more past due. Judgments, tax liens, delinquent real estate taxes, cancellation of insurance policies and exceptions to Bank policies are other red flags.
Substandard: A substandard extension of credit is one inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Extensions of credit so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. In other words, there is more than normal risk of loss. Loss potential, while existing in the aggregate amount of substandard credits, does not have to exist in individual extensions of credit classified substandard.
The likelihood that a substandard loan will be paid from the primary source of repayment may also be uncertain. Financial deterioration is underway and very close attention is warranted to insure that the loan is collected without a loss. The Bank may be relying on a secondary source of repayment, such as liquidating collateral, or collecting on guarantees. The borrower cannot keep up with either the interest or principal payments. If the Bank is forced into a subordinated or unsecured position due to flaws in documentation, the loan may also be substandard. If the loan must be restructured, or interest rate concessions made, it should be classified as such. If the bank is contemplating foreclosure or legal action, the credit is likely substandard.
Doubtful: An extension of credit classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high; however, because of certain important and reasonably specific pending factors that may work to the advantage of and strengthen the credit, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceedings, capital injection, perfecting liens on additional collateral, or refinancing plans.
If the primary source of repayment is gone, and there is doubt as to the quality of the secondary source, then the loan will be considered doubtful. If a court suit is pending, and is the only means of collection, a loan is generally doubtful. As stated above, the loss amount in this category is often undeterminable, and the loan is classified doubtful until said loss can be determined.
The Companys determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Banks primary regulators in the course of its regulatory examinations, which can order the establishment of additional general or specific loss allowances. There can be no assurance that regulators, in reviewing the Companys loan portfolio, will not request the Company to materially increase its allowance for loan losses. Although management believes that adequate specific and general loan loss
allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific and general loan loss allowances may become necessary. The Companys allowance for loan losses at December 31, 2005 is considered by management to be adequate.
The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Bank has an asset/liability committee which develops current investment policies based upon its operating needs and market circumstances. The investment policy of the Bank is reviewed by senior financial management of the Company in terms of its objectives, investment guidelines and consistency with overall Company performance and risk management goals. The Banks investment policy is formally reviewed and approved annually by its Board of Directors. The asset/liability committee of the Bank is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to the Banks Board of Directors and the Board of Directors of the Company on a regular basis.
The total fair value of the securities portfolio was $746.3 million as of December 31, 2005, or 98.2% of amortized cost. The fair value of the securities portfolio was $526.1 million and $718.9 million as of December 31, 2004 and 2003, respectively.
The following tables set forth the composition of the Companys securities portfolio by major category as of the indicated dates. The securities portfolio as of December 31, 2005, 2004, and 2003 has been categorized as either available-for-sale or held-to-maturity in accordance with SFAS No. 115.
As of December 31, 2005, the Company held no securities of a single issuer with a book value exceeding 10% of stockholders equity other than those of the U.S. Treasury or other U.S. government or government-sponsored entities.
The Companys securities available-for-sale portfolio increased $250.9 million, or 57.4%, in 2005 compared to 2004 as a result of investing excess cash and cash equivalents held at December 31, 2004. Set forth below is a summary of the change in the available-for-sale securities as a result of asset liability strategy adjustments:
Securities held-to-maturity decreased $29.5 million, or 33.2%, from $89.0 million at December 31, 2004 to $59.5 million at December 31, 2005, mainly due to the paydowns on mortgage-backed securities.
There were no trading securities held at December 31, 2005 or December 31, 2004. The Company holds trading securities and derivatives on a short-term basis based on market and liquidity conditions. Compared to 2004, trading activities have been curtailed with reductions in the volume of securities traded and number of transactions.
The Companys strategies are being implemented by a new chief investment officer as of the beginning of 2005. As a result, management believes the risk in the securities portfolio has decreased significantly compared to 2004. The Company intends to implement strategies to reduce its securities as a percentage of earning assets and provide funding for higher yielding loans. The Company expects the newly purchased securities mentioned above to provide added cash flow to fund future loan growth; its focus on future investment purchases will be to maintain an adequate level of liquidity and a shorter duration of its securities portfolio.
The Company has a number of available-for-sale securities that have unrealized losses at December 31, 2005; see Note 4 to the Notes to Consolidated Financials Statements for further information.
During 2004, the Company recognized a $6.2 million loss on securities deemed as other-than-temporarily impaired. Although this investment had a variable, tax-advantaged dividend rate that resets every two years at the two-year treasury rate less 16 basis points and carried an investment grade rating, the market value of this investment was impacted by the current and expected level of interest rates. While the Company expected this investment to recover its original cost as interest rates increased and had both the intent and ability to hold the investment until such recovery occurred, this investment was deemed to be other-than-temporarily impaired given the duration of the unrealized loss position and uncertainty as to the timing of a full recovery. It is the practice of the Company not to retain securities that are classified other-than-temporarily impaired. These securities were liquidated in February 2005 at an $825,000 gain in excess of the year-end carrying value.
In 2004, the Company entered into 2,900 U.S. Treasury 10-year note futures contracts with a notional value of $290.0 million and a delivery date of March 2005. The Company sold these contracts in order to hedge certain U.S. government-sponsored entities notes held in its available-for-sale portfolio. The Companys objective was to offset changes in the fair market value of the U.S. government-sponsored entities notes with changes in the fair market value of the futures contracts, thereby reducing interest rate risk. The Company documented these futures contracts as fair value hedges with the changes in market value of the futures contracts as well as the changes in the market value of the hedged items charged or credited to earnings on a quarterly basis in net gains (losses) on securities transactions. The hedging relationship is assessed to ensure that there is a high correlation between the hedge instruments and hedged items. For the year ending December 31, 2004, the change in the market values resulted in a net loss of $5.2 million which was recorded in net gains (losses) on securities transactions compared to the $508,000 loss recorded for the year ended December 31, 2003. Gains or losses for fair value hedges occur when changes in the market value of the hedged items are not identical to changes in the market value of hedge instruments during the reporting period. The Company de-designated this hedge as of December 31, 2004 and the futures contracts then became stand-alone derivatives. These futures contracts were terminated in January 2005 at a gain of $336,000. See Note 20 to the Notes to Consolidated Financials Statements for further information.
In 2004, the Company entered into spread lock swap agreements with a notional value of $247.0 million, with a determination date of March 31, 2005, and spread lock strike of 0.41%. The Company entered into these contracts in order to minimize earnings volatility associated with spread widening of the hedged U.S. Agency notes through the first quarter of 2005. These are stand-alone derivatives that are carried at their estimated fair value with the corresponding gain or loss recorded in net trading profits or losses. The Company terminated these agreements in January 2005 at a loss of $425,000.
The Company has bought and sold various put and call options, with terms approximating 90 days, on U.S. Treasury and government-sponsored entities obligations, mortgage-backed securities, and futures
contracts during 2005 and 2004. These are stand-alone derivatives that are carried at their estimated fair value with the corresponding gain or loss recorded in net trading profits or losses. See Note 20 to the Notes to Consolidated Financial Statements for further discussion. Option income was $502,000 and $4.9 million for the years ended December 31, 2005 and 2004, respectively. The Companys option strategy has changed by reducing risk which resulted in a lower level of option fee income in 2005. During 2005, the covered call options were written to provide incremental revenue enhancement when market conditions provided such opportunities.
The following tables set forth the contractual or estimated maturities of the components of the Companys securities portfolio as of December 31, 2005 and the weighted average yields on a non-tax-equivalent basis. The table assumes estimated fair values for available-for-sale securities and amortized cost for held-to-maturity securities:
Set forth below is a summary of the change in the Companys deposits:
The Companys marketing efforts focus on core deposit account growth in its retail markets. The Company competes for core deposits in the over-banked Chicago Metropolitan Statistical Area. Competitive pricing has made it difficult to maintain and grow these types of deposits. In the second quarter of 2005, the Company reduced pricing on its interest-bearing demand, money market, and savings deposits to be in line with its peers. The level of pressure for core deposits is not expected to ease in the near term. To overcome this challenge, the Company has changed and expanded staffing and management at its banking centers and initiated a number of customer outreach initiatives to expand deposits. In addition, the Company is in the process of creating a performance-driven sales environment and increasing activity in its branches. Aggressive marketing of free checking and interest-bearing demand accounts continues. Deposit growth is expected in the future as new customers are added due to the addition of new commercial and industrial loans and a commitment to relationship banking.
The following table sets forth the average amount of and the average rate paid on deposits by category for the indicated periods.
The average rates paid on deposits have increased during 2005 and continue to increase in 2006. The average rates paid on savings and money market accounts and time deposits were 1.69% and 3.56%, respectively, for the fourth quarter of 2005 compared to the 1.64% and 3.19%, respectively, for the year end December 31, 2005. The Companys cost of funds has risen, and the rates shown above do not reflect current rates for time deposits.
The following table summarizes the maturity distribution of certificates of deposit in amounts of $100,000 or more as of the dates indicated. These deposits have been made by individuals, businesses, and public and other not-for-profit entities, most of which are located within the Companys market area.
The following table summarizes the Companys borrowings for the periods indicated.
The increase in short-term borrowings at December 31, 2005 reflects the funding needs the Company experienced during the year as a result of loan growth when deposit growth was flat. This increase in Federal funds purchased and securities sold under agreements to repurchase was a result of the Companys difficulty in raising low cost deposits. The tables below also reflect the increasing rates on short-term borrowings which continue to increase in 2006.
The Companys borrowings include overnight funds purchased, securities sold under agreements to repurchase, FHLB advances, junior subordinated debt, and commercial bank lines of credit. The following tables set forth categories and the balances of the Companys short-term or revolving lines of credit borrowings (notes payable) for the periods indicated.
The Bank is a member of the FHLB. Membership requirements include common stock ownership in the FHLB. The Bank has callable FHLB advances due at various times during 2010. These advances are used as a supplemental source of funds. The Bank is currently in compliance with the FHLBs membership requirements.
During June 2005, the Company prepaid $121.5 million in FHLB advances and replaced them with $150.0 million in new advances. The weighted average rate for these FHLB advances was 3.48% at December 31, 2005, with maturities on such advances of 5 years. Of these $150.0 million in advances, $50.0 million have a one-time call provision after one year and $100.0 million have a one-time call provision after two years.
In the fourth quarter of 2004, the Company prepaid $115.0 million in FHLB advances. A purchase accounting adjustment, related to the acquisition of BFFC, of $2.1 million reduced the interest expense on the FHLB advances in 2004.
The Company had various interest rate swap transactions as of December 31, 2004, which resulted in the Company synthetically converting $121.5 million of its FHLB advance fixed rate debt to floating rate debt. The swap transactions required payment of interest by the Company at the one-month LIBOR rate plus a spread and, in turn, the Company received an interest payment based on a fixed rate. These swap transactions resulted in a $319,000 decrease in interest expense for the year ended December 31, 2005. The Company unwound the interest rate swaps associated with those advances when they were prepaid in June 2005.
The following table sets forth categories and the balances of the Companys of FHLB advances as of the indicated dates or for the indicated periods.
The following table sets forth categories and balances of the Companys short-term or revolving lines of credit borrowings from correspondent banks as of the indicated dates or for the indicated periods.
The Company entered into a credit agreement with a correspondent bank on April 8, 2004, which provides the Company with a revolving line of credit with a maximum availability of $25.0 million. The maturity date for the revolving line of credit is April 30, 2006.
Amounts outstanding under the Companys revolving line of credit represent borrowings incurred to provide capital contributions to the Bank to support its growth. The Company makes interest payments, at its option, at the 90 day London Inter-Bank Offered Rate (LIBOR) plus 150 basis points or the prime rate. There was no principal balance outstanding under the line as of December 31, 2005.
The revolving line of credit includes the following covenants at December 31, 2005: (1) the Bank must not have nonperforming assets in excess of 25% of Tier 1 capital plus the loan loss allowance and (2) the Company and the Bank must be considered well capitalized. The Company has complied with both of these debt covenants at December 31, 2005.
The Company had $55.7 million in junior subordinated debt owed to unconsolidated trusts that were formed to issue trust preferred securities. The following table details the four unconsolidated trusts and their common and trust preferred securities:
The Company monitors compliance with bank and bank-holding company regulatory capital requirements, focusing primarily on risk-based capital guidelines. Under the risk-based capital method of capital measurement, the ratio computed is dependent upon the amount and composition of assets recorded on the balance sheet and the amount and composition of off-balance-sheet items, in addition to the level of capital. Included in the risk-based capital method are two measures of capital adequacy, Tier 1, or core capital, and total capital, which consists of Tier 1 plus Tier 2 capital. See Business Supervision and Regulation Bank Holding Company Regulation for definitions of Tier 1 and Tier 2 capital.
The following tables set forth the Companys capital ratios as of the indicated dates.
In August 2005, the Company issued 3,450,000 new common shares through a public offering raising a net amount of new capital of $67.9 million. The Company includes $54.0 million for 2005, $51.3 million for 2004, and $54.0 million for 2003, of trust preferred securities in Tier I capital.
The Company manages its liquidity position with the objective of maintaining sufficient funds to respond to the needs of depositors and borrowers and to take advantage of earnings enhancement opportunities. At December 31, 2005, the Company had cash and cash equivalents of $70.6 million. In addition to the normal inflow of funds from core-deposit growth, together with repayments and maturities of loans and securities, the Company utilizes other short-term, intermediate-term and long-term funding sources such as securities sold under agreements to repurchase, overnight funds purchased from correspondent banks and the acceptance of short-term deposits from public entities.
The FHLB provides an additional source of liquidity which has been used by the Bank extensively since 1999. Assuming that collateral is available to secure loans, the Bank can borrow up to 35% of its assets from the FHLB which provided the Bank with a total additional $653.9 million in unused capacity at December 31, 2005. The Company believes it has sufficient liquidity to meet its current and future liquidity needs.
The Bank also has various funding arrangements with commercial and investment banks providing up to $2.2 billion of available funding sources in the form of Federal funds lines, repurchase agreements, and brokered and public funds certificate of deposit programs. Unused capacity under these lines was $1.8 billion at December 31, 2005. The Bank maintains these funding arrangements to achieve favorable costs of funds, manage interest rate risk, and enhance liquidity in the event of deposit withdrawals. The repurchase agreements and public funds certificate of deposit are subject to the availability of collateral.
The Company monitors and manages its liquidity position on several levels, which vary depending upon the time period. As the time period is expanded, other data is factored in, including estimated loan funding requirements, estimated loan payoffs, securities portfolio maturities or calls, and anticipated depository buildups or runoffs.
The Company classifies the majority of its securities as available-for-sale, thereby maintaining significant liquidity. The Companys liquidity position is further enhanced by the structuring of a majority of its loan portfolio interest payments as monthly and also by the representation of residential mortgage loans in the Companys loan portfolio.
The Companys cash flows are composed of three classifications: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. See Statement of Cash Flows in the Consolidated Financial Statements.
Contractual Obligations, Commitments, and Off-Balance Sheet Arrangements
The following table details the amounts and expected maturities of significant commitments as of December 31, 2005. Further discussion of these commitments is included in Note 18 to the Notes to Consolidated Financial Statements.
Asset/ Liability Management
The business of the Company and the composition of its balance sheet consists of investments in interest-earning assets (primarily loans, mortgage-backed securities, and other securities) that are primarily funded by interest-bearing liabilities (deposits and borrowings). All of the financial instruments of the Company as of December 31, 2005 were held for other than trading purposes. Such financial instruments have varying levels of sensitivity to changes in market rates of interest. The Companys net interest income is dependent on the amounts of and yields on its interest-earning assets as compared to the amounts of and rates on its interest-bearing liabilities. Net interest income is therefore sensitive to changes in market rates of interest.
The Companys asset/liability management strategy is to maximize net interest income while limiting exposure to risks associated to changes in interest rates. This strategy is implemented by the Companys ongoing analysis and management of its interest rate risk. A principal function of asset/liability management is to coordinate the levels of interest-sensitive assets and liabilities to minimize net interest income fluctuations in times of fluctuating market interest rates.
Interest rate risk results when the maturity or repricing intervals and interest rate indices of the interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments are different, thus creating a risk that will result in disproportionate changes in the value of and the net earnings generated from
the Companys interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments. The Companys exposure to interest rate risk is managed primarily through the Companys strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. Because the Companys primary source of interest-bearing liabilities is customer deposits, the Companys ability to manage the types and terms of such deposits may be somewhat limited by customer maturity preferences in the market areas in which the Company operates. Over the past few years, several hundred new bank branches have opened in the Companys marketplace. Deposit pricing is competitive with frequent promotional rates paid by competitors. Ongoing competition for core and time deposits are driving up yields paid. Borrowings, which include FHLB advances, short-term borrowings, and long-term borrowings, are generally structured with specific terms which, in managements judgment, when aggregated with the terms for outstanding deposits and matched with interest-earning assets, reduce the Companys exposure to interest rate risk. The rates, terms, and interest rate indices of the Companys interest-earning assets result primarily from the Companys strategy of investing in securities and loans (a substantial portion of which have adjustable rate terms). This permits the Company to limit its exposure to interest rate risk, together with credit risk, while at the same time achieving a positive interest rate spread from the difference between the income earned on interest-earning assets and the cost of interest-bearing liabilities.
Management uses a duration model for the Banks internal asset/liability management. The model uses cash flows and repricing information from loans and certificate of deposits, plus repricing assumptions on products without specific repricing dates (e.g., savings and interest-bearing demand deposits), to calculate the durations of the Banks assets and liabilities. Securities are stress tested, and the theoretical changes in cash flow are key elements of the Companys model. The model also projects the effect on the Companys earnings and theoretical value for a change in interest rates. The model computes the duration of the Banks rate sensitive assets and liabilities, a theoretical market value of the Banks rate sensitive assets and liabilities and the effects of rate changes on the Banks earnings and market value. The Banks exposure to interest rates is reviewed on a monthly basis by senior management and the Companys Board of Directors.
Effects of Inflation
Inflation can have a significant effect on the operating results of all industries. However, management believes that inflationary factors are not as critical to the banking industry as they are to other industries, due to the high concentration of relatively short-duration monetary assets in the banking industry. Inflation does, however, have some impact on the Companys growth, earnings, and total assets and on its need to closely monitor its equity capital levels. Management does not expect inflation to be a significant factor in 2006.
Interest rates are significantly affected by inflation, but it is difficult to assess the impact, since neither the timing nor the magnitude of the changes in the various inflation indices coincide with changes in interest rates. Inflation does impact the economic value of longer term, interest-earning assets and interest-bearing liabilities, but the Company attempts to limit its long-term assets and liabilities, as indicated in the tables set forth under Financial Condition and Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
The Company performs a net interest income analysis as part of its asset/liability management practices. Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% and 2.0% increases and 1.0% and 2.0% decreases in market interest rates. The tables below present the Companys projected changes in net interest income for the various rate shock levels at December 31, 2005 and 2004, respectively.
As shown above, at December 31, 2005, the effect of an immediate 200 basis point increase in interest rates would increase the Companys net interest income by 0.26%, or approximately $167,000. Overall net interest income sensitivity remains within the Companys and recommended regulatory guidelines.
As shown above, at December 31, 2004, the effect of an immediate 200 basis point increase in interest rates would increase the Companys net interest income by 0.43%, or approximately $251,000. Overall net interest income sensitivity remains within the Companys and recommended regulatory guidelines. This decreased sensitivity was due to the changes in interest rates that affected various earning assets and interest-bearing liabilities. Due to the low level of interest rates at December 31, 2004, the Company was not able to model an additional 200 basis point decrease in rates.
The change in net interest income over the one year horizon from December 31, 2005 compared to December 31, 2004 can be attributed to the balance sheet repositioning (the sale of lower-yielding securities and the pre-payment of higher rate FHLB advances), increases in loans (which are primarily variable rate), and changes in core deposit pricing disciplines during the first nine months of 2005. The Company has reduced rates paid on core deposits. These changes more accurately reflect the Companys current pricing strategy for core deposits and its planned actions in an environment of sharply changing rates. Interest bearing assets and liabilities are shocked +/-100 and + 200 basis points instantaneously, except interest bearing core deposits, where they are modeled to increase 25 basis points in a +100 basis points shock and +50 basis points in a +200 basis point shock. Under a declining rate shock, they have a 25 basis point floor. Core deposits are priced off various internal indices set by management. Management will adjust the indices accordingly, depending on rate movement and market conditions. An analysis of core deposit pricing for the past four years indicates that, for a cumulative 100 basis points increase in rates, the cumulative core deposit rate increases did not exceed 25 basis points, except for the master money market rate which was then priced off the 91-day U.S. Treasury bill rate. The master money market was de-coupled from the 91-day U.S. Treasury bill rate and is now priced off an internal index. The Company offers special promotions to attract deposits as needed.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments, and deposit decay rates, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates.
Gap analysis is used to determine the repricing characteristics of the Companys assets and liabilities. The following table sets forth the interest rate sensitivity of the Companys assets and liabilities as of December 31, 2005, and provides the repricing dates of the Companys interest-earning assets and interest-
bearing liabilities as of that date, as well as the Companys interest rate sensitivity gap percentages for the periods presented.
This chart shows that the Company is mismatched at zero to three and four to 12 months; that is, there were more liabilities repricing or maturing under these periods. The Gap position does not necessarily indicate the Companys interest rate sensitivity or the impact to net interest income because interest-earning assets and interest-bearing liabilities are repricing off of different indices.
Mortgage-backed securities, including adjustable rate mortgage pools, are included in the above table based on their estimated weighted average lives obtained from outside analytical sources. Loans are included in the above table based on contractual maturity or contractual repricing dates.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates. These computations should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. The Gap analysis is based upon assumptions as to when assets and liabilities will reprice in a changing interest rate environment. Because such assumptions can be no more than estimates, certain assets and liabilities indicated as maturing or otherwise repricing within a stated period may, in fact, mature or reprice at different times and at different volumes than those estimated. Also, the renewal or repricing of certain assets and liabilities can be discretionary and subject to competitive and other pressures. Therefore, the gap table included above does not and cannot necessarily indicate the actual future impact of
general interest rate movements on the Companys net interest income. See Managements Discussion and Analysis of Financial Condition and Results of Operations Asset/ Liability Management.
See Contents of Consolidated Financial Statements on page F-1.
On May 2, 2003, the Audit Committee appointed McGladrey & Pullen, LLP (McGladrey) to serve as the Companys independent accountant for the fiscal year ending December 31, 2003. This change in accountants was previously reported in our Current Report on Form 8-K filed with the SEC on April 29, 2003 and as amended by Form 8-K/ A filed May 19, 2003.
During the fiscal years ended December 31, 2002 and 2001, and through May 1, 2003, the Company did not consult McGladrey with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Companys consolidated financial statements, or regarding any other matters or reportable events described under Item 304(a)(2) of Regulation S-K.
On March 11, 2005, McGladrey & Pullen, LLP informed the Company that it had resigned as the Companys independent accountant. The reports of McGladrey on the Companys financial statements for the years ended December 31, 2004 and 2003 did not contain an adverse opinion or disclaimer of opinion, nor were such reports qualified or modified as to uncertainty, audit scope or accounting principles.
During the fiscal years ended December 31, 2004 and 2003, and through March 11, 2005, except as noted below, there were no disagreements with McGladrey on matters of accounting principles or practices, financial statement disclosure, or audit scope or procedure, which disagreement, if not resolved to the satisfaction of McGladrey, would have caused it to make reference to the subject matter of the disagreement in its reports on the financial statements for such fiscal years. There were no reportable events as that term is described in Item 304(a)(1)(v) of Regulation S-K for the fiscal years ended December 31, 2004 and 2003 and through the date of this report.
The Company received an unqualified audit opinion for the years ended December 31, 2004 and 2003 on its financial statements. McGladrey expressed an unqualified opinion on managements assessment of the effectiveness of the Companys internal control over financial reporting and an adverse opinion on the effectiveness of the Companys internal control over financial reporting as of December 31, 2004.
McGladrey advised the Companys audit committee that during the conduct of the 2004 audit, McGladrey encountered a disagreement with management over whether the impairment of FNMA Series F perpetual preferred shares held by the Company as available-for-sale securities at December 31, 2004 was other than temporary.
At December 31, 2004, shares of the floating rate FNMA Series F perpetual preferred equity securities were trading at amounts less than their amortized cost for a period of sixteen consecutive months. Management believed that the decline in the value of the securities was due in large part to the reset of the dividend rate in the spring of 2004, which was a low point in the interest rate cycle, followed by a subsequent increase in interest rates. Management noted that the next dividend reset date is scheduled for March 2006. The Company expected this investment to recover its original cost as interest rates increased and had both the intent and ability to hold the investment until such recovery occurred.
At the urging of its independent accountant, the Company adopted a more conservative position and classified the security as other-than-temporarily impaired. The Company recognized a non-cash pre-tax charge of $10.1 million, in its fourth quarter statement of income, for the other-than-temporary impairment of its floating rate FNMA Series F perpetual preferred equity securities; $3.9 million of that charge was related to securities held by MBWI (see Note 3 to the Notes to the Consolidated Financial Statements). This loss
previously had been reflected in comprehensive income. This action resulted in the reclassification, after tax, of $5.6 million, or $0.31 per diluted share, from comprehensive income to the statement of income for the fourth quarter and reduced net income to $2.4 million, or $0.13 per diluted share, for the year ended December 31, 2004. The reclassification had a minimal impact on stockholders equity at December 31, 2004.
It is the practice of the Company not to retain securities that are classified other-than-temporarily impaired. As a consequence, these securities were liquidated in February 2005 at a $1.3 million gain in excess of the year-end carrying value; $510,000 of that gain was related to securities held by MBWI (see Note 3 to the Notes to the Consolidated Financial Statements).
The Audit Committee discussed with McGladrey the disagreement McGladrey had with management as to whether shares of the Companys available-for-sale floating rate perpetual preferred equity securities were other-than-temporarily impaired, as defined in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and Securities and Exchange Commission Staff Accounting Bulletin No. 59, Accounting for Noncurrent Marketable Equity Securities.
The Company authorized McGladrey to respond fully to the inquiries of the Companys successor accountant concerning the subject matter of the disagreement described herein.
On April 19, 2005, the Audit Committee appointed PricewaterhouseCoopers LLP to serve as the Companys independent registered public accounting firm for the fiscal year ending December 31, 2005. During the fiscal years ended December 31, 2003 and 2004, and through April 19, 2005, the Company did not consult PricewaterhouseCoopers LLP with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Companys consolidated financial statements, or regarding any other matters or reportable events described under Item 304(a)(2) of Regulation S-K. This change in accountants was previously reported in our Current Report on Form 8-K filed with the SEC on April 19, 2005.
As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of the Companys Chief Executive Officer and Chief Financial Officer of the effectiveness of the Companys disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Companys disclosure controls and procedures as of December 31, 2005 are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commissions rules and forms and such information is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). The Companys internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. There are inherent limitations to the effectiveness of any control system. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control Integrated Frame-
work. Based on managements assessment, it determined that, as of December 31, 2005, the Companys internal control over financial reporting is effective based on those criteria.
Managements assessment of the effectiveness of the Companys internal control over financial reporting as of December 31, 2005, has been audited by PricewaterhouseCoopers LLP, the independent registered public accounting firm who also audited the Companys consolidated financial statements, as stated in their report included under Item 8.
Item 9B. Other Information
Information regarding directors of the Company is included in the Companys Proxy Statement for its 2006 Annual Meeting of Stockholders (the Proxy Statement) under the heading Election of Directors and the information included therein is incorporated herein by reference. Information regarding the executive officers of the Company is included in Item 1. Business of this report.
Information regarding compensation of executive officers and directors is included in the Companys Proxy Statement under the headings Directors Compensation and Executive Compensation, and the information included therein is incorporated herein by reference.
Information regarding equity compensation plan is included in the Companys Proxy Statement under the heading Equity Compensation Plan Information, and the information included therein is incorporated herein by reference.
Information regarding security ownership of certain beneficial owners and management is included in the Companys Proxy Statement under the headings Voting Securities and Security Ownership of Certain Beneficial Owners, and the information included therein is incorporated herein by reference.
Information regarding certain relationships and related transactions is included in the Companys Proxy Statement under the heading Transactions with Certain Related Persons, and the information included therein is incorporated herein by reference.
Information regarding principal accountant fees and services is included in the Companys Proxy Statement under the heading Independent Public Accountants, and the information included therein is incorporated herein by reference.
(a)(1) Index to Financial Statements
The consolidated financial statements of the Company and its subsidiaries as required by Item 8 of Form 10-K are filed as a part of this document. See Contents of Consolidated Financial Statements on page F-1.
(a)(2) Financial Statement Schedules
All financial statement schedules as required by Item 8 and Item 15 of Form 10-K have been omitted because the information requested is either not applicable or has been included in the consolidated financial statements or notes thereto.
The following exhibits are either filed as part of this report or are incorporated herein by reference: