Monarch Community Bancorp 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For the quarterly period ended June 30, 2010
For the transition period from to
Commission file number: 000-49814
MONARCH COMMUNITY BANCORP, INC.
(Exact name of registrant as specified in its charter)
375 North Willowbrook Road, Coldwater, MI 49036
(Address of principal executive offices)
(Registrants telephone number)
Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for 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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell Company (as defined in Rule 12b-2 of the Exchange Act). Yes: o No: þ
State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practical date: At July 30, 2010, there were 2,044,606 shares of the issuers Common Stock outstanding.
Monarch Community Bancorp, Inc.
PART IFINANCIAL INFORMATION
Item 1. CONDENSED FINANCIAL STATEMENTS
Condensed Consolidated Balance Sheets
See accompanying notes to condensed consolidated financial statements.
Condensed Consolidated Statements of Income (Unaudited)
See accompanying notes to condensed consolidated financial statements.
Condensed Consolidated Statements of Cash Flows (Unaudited)
See accompanying notes to condensed consolidated financial statements.
MONARCH COMMUNITY BANCORP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Monarch Community Bancorp, Inc. (the Corporation) was incorporated in 2002 under Maryland law to hold all of the common stock of Monarch Community Bank (the Bank), formerly known as Branch County Federal Savings and Loan Association. The Bank converted to a stock savings institution effective August 29, 2002. In connection with the conversion, the Corporation sold 2,314,375 shares of its common stock in a subscription offering.
Monarch Community Bank provides a broad range of banking services to its primary market area of Branch, Calhoun and Hillsdale counties in Michigan. The Bank operates six full service offices. The Bank owns 100% of First Insurance Agency. First Insurance Agency is a licensed insurance agency established to allow for the receipt of fees on insurance services provided to the Banks customers. The Bank also owns a 24.98% interest in a limited partnership formed to construct and operate multi-family housing units.
BASIS OF PRESENTATION
The condensed consolidated financial statements of the Corporation include the accounts of Monarch Community Bank and First Insurance Agency. All significant intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements for interim periods are unaudited; however, in the opinion of the Corporations management, all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the Corporations financial position and results of operations have been included.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates and assumptions.
The accompanying financial statements have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and footnotes required by generally accepted accounting principles in annual consolidated financial statements. These condensed consolidated financial statements should be read in conjunction with the Corporations Form 10-K for the year ended December 31, 2009 filed with the Securities and Exchange Commission.
The results of operations for the three and six month period ended June 30, 2010 are not necessarily indicative of the results to be expected for the full year period.
ALLOWANCE FOR LOAN LOSSES
The appropriateness of the allowance for loan losses is reviewed by management based upon our evaluation of then-existing economic and business conditions affecting our key lending areas and other conditions, such as credit quality trends (including trends in delinquencies, nonperforming loans and foreclosed assets expected to result from existing conditions), collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments and recent loss experience in particular segments of the portfolio that existed as of the balance sheet date and the impact that these conditions were believed to have had on the collectability of the loan. Senior management reviews these conditions at least quarterly.
To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, managements estimate of the effect of this condition may be reflected as a specific allowance applicable to this credit or portfolio segment.
The allowance for loan losses is based on estimates of losses inherent in the loan portfolio. Actual losses can vary significantly from the estimated amounts. Our methodology as described permits adjustments to any loss factor used in the computation of the formula allowance in the event that, in managements judgment, significant factors which affect the collectability of the portfolio as of the evaluation date are not reflected in the loss factors. By assessing the estimated losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon any more recent information that has become available.
Certain 2010 amounts have been reclassified to conform to the 2009 presentation.
The amortized cost and fair value of securities at period-end were as follows (dollars in thousands):
Proceeds from sales of securities available for sale were $1.6 million and $0 for the six months ended June 30, 2010 and 2009, respectively. Gross gains of $37,000 and $0 were realized on these sales during 2010 and 2009, respectively.
The amortized cost and fair value of securities available for sale at June 30, 2010 by contractual maturity follow (dollars in thousands). The actual maturity may differ from the contractual maturity because issuers may have a right to call or prepay obligations.
There were no securities with unrealized losses at June 30, 2010.
Our portfolio of available for sale securities reviewed quarterly for other-than-temporary-impairment (OTTI) in value. In performing this review many factors are considered including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospect of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether management intends to sell the security, or it is more likely than not that management will be required to sell the security at a loss before anticipated recovery.
Management determined that there were no securities with OTTI at June 30, 2010.
EARNINGS PER SHARE
A reconciliation of the numerators and denominators used in the computation of the basic earnings per share and diluted earnings per share is presented below (000s omitted except per share data):
RECENT ACCOUNTING PRONOUNCEMENTS
In July 2010, FASB issued a statement which expands disclosures about credit quality of financing receivables and allowance for credit losses. The standard will require the Company to expand disclosures about the credit quality of our loans and the related reserves against them. The extra disclosures will include details on our past due loans, credit quality indicators, and modifications of loans. The Company will adopt the standard beginning with our December 31, 2010 financial statements.
FAIR VALUE MEASUREMENTS
In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access.
Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.
Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability.
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporations assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.
The following table presents information about the Corporations assets and liabilities measured at fair value on a recurring basis at June 30, 2010, and December 31, 2009, and the valuation techniques used by the Corporation to determine those fair values. Investment securities with fair value determined by level 1 input include U.S. Treasury securities. Investment securities with fair value determined by level 2 inputs include mortgage backed securities, obligations of states and political subdivisions and U.S Government Agency obligations.
The Corporation also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include loans and foreclosed assets. These assets are not measured at fair value on an ongoing basis, but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following table presents the Corporations assets at fair value on a nonrecurring basis as of June 30, 2010 and December 31, 2009 (000s omitted):
Fair Value of Financial Instruments
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Corporations various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Financial Accounting Standards Board (FASB), Accounting Standards Codification (ASC), FASB ASC 820-10-50, Fair Value Measurements and Disclosures, excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Corporation.
The fair value of all financial instruments not discussed below (Cash and cash equivalents, Federal funds sold, Federal Home Loan Bank stock, Accrued interest receivable, Federal funds purchased and Interest payable) are estimated to be equal to their carrying amounts as of June 30, 2010 and December 31, 2009. The following methods and assumptions were used by the Corporation in estimating fair value disclosures for financial instruments:
Securities Fair values for securities are described above.
Loans Held for Sale Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.
Loans Receivable For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for other loans are estimated using discounted cash flows analyses using current market rates applied to the estimated life. Fair values for non-performing loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.
Deposit Liabilities The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable-rate, fixed term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Federal Home Loan Bank Advances The fair values of the Corporations Federal Home Loan Bank advances are estimated using discounted cash flow analyses based on the Corporations current incremental borrowing rates for similar types of borrowing arrangements.
The estimated fair values, and related carrying or notional amounts, of the Corporations financial instruments are as follows (000s omitted):
ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements of the Corporation and the accompanying notes.
In addition to historical information, the following discussion contains forward-looking statements that involve risks and uncertainties. All statements regarding the expected financial position, business and strategies are forward-looking statements and the Corporation intends for them to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. The words anticipates, believes, estimates, seeks, expects, plans, intends, and similar expressions, as they relate to the Corporation or management, are intended to identify forward-looking statements. The Corporation believes that the expectations reflected in these forward-looking statements are reasonable based on our current beliefs and assumptions; however, these expectations may prove to be incorrect.
Factors which could have a material adverse effect on our operations include, but are not limited to, changes in interest rates, changes in the relative difference between short and long-term interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, including levels of non-performing assets, demand for loan products, deposit flows, competition, demand for financial services in our market area, our operating costs and accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and you should not rely too much on these statements.
CRITICAL ACCOUNTING POLICIES
The nature of the financial services industry is such that, other than described below, the use of estimates and management judgment is not likely to present a material risk to the financial statements. In cases where estimates or management judgment are required, internal controls and processes are established to provide assurance that such estimates and management judgments are materially correct to the best of managements knowledge.
Allowance for Loan Losses. Accounting for loan classifications, accrual status, and determination of the allowance for loan losses is based on regulatory guidance. This guidance includes, but is not limited to, generally accepted accounting principles, the uniform retail credit classification and account management policy issued by the Federal Financial Institutions Examination Council, the joint policy statement on the allowance for loan losses methodologies issued by the Federal Financial Institutions Examination Council and guidance issued by the Securities and Exchange Commission. Accordingly, the allowance for loan losses includes a reserve calculation based on an evaluation of loans determined to be impaired, risk ratings, historical losses, loans past due, collateral values and cost of disposal and other subjective factors.
Foreclosed Assets. Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of the foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less estimated selling expenses, which consist primarily of commissions that will be paid to an independent real estate agent upon sale of the property. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.
Income Taxes Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the various temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. A valuation allowance, if needed, reduces deferred tax assets to the amount expect to be realized.
Following Monarch Community Banks most recent Safety and Soundness examination, the Board of Directors of Monarch Community Bank stipulated to the terms of a formal enforcement action (Consent Order) with Federal Deposit Insurance Corporation (FDIC) and the Office of Financial and Insurance Regulation for the State of Michigan (OFIR). The Consent Order, which was effective May 6, 2010, contains specific actions needed to address certain findings from their examination and to address our current financial condition.
We have made substantive progress in implementation of provisions identified within the Consent Order. Our progress includes:
Total assets decreased $19.6 million, or 7.4%, to $263.6 million at June 30, 2010 compared to $283.2 million at December 31, 2009. The decrease in assets is largely due to a decrease in loans of $16.6 million or 7.5%, which is attributable to the refinancing of one to four residential mortgages into the secondary market and the write downs of commercial real estate loans.
Securities increased to $16.5 million at June 30, 2010 compared to $16.1 million at December 31, 2009. The increase was attributable to the replacement of securities to reposition maturities and improve overall credit quality of the portfolio. The yield on investment securities has decreased to 2.9% during the three months ended June 30, 2010 from 3.36% for the same period a year ago. Management has continued to maintain a diversified securities portfolio, which includes obligations of U.S. government-sponsored agencies, securities issued by states and political subdivisions and mortgage-backed securities. Management regularly evaluates asset/liability management needs and attempts to maintain a portfolio structure that provides sufficient liquidity and cash flow.
The Banks net loan portfolio decreased by $16.5 million, or 7.5%, from $220.9 million at December 31, 2009 to $204.3 million at June 30, 2010. The following table presents information concerning the composition of our loan portfolio in dollar amounts and in percentages as of the dates indicated:
One-to-four family loans decreased $6.4 million from year end 2009 as a result of the Banks continued strategy to sell a large portion of new one to four family loan originations. Historically low rates on residential mortgages provided us the opportunity to refinance loans and our gains on the sale of mortgages increased substantially in 2009. Management does not expect to see similar gains in 2010. Commercial real estate loans and construction loans decreased $3.7 million or 5.1%. The Bank expects future loan origination to come primarily from in-market lending.
Changes in the allowance for loan losses were as follows for the three and six months ended June 30, 2010 and 2009.
Summary of Allowance for Loan Losses
The allowance for loan losses was $9.8 million at June 30, 2010 representing 4.79% of total loans, compared to $5.8 million at December 31, 2009, or 2.62% of total loans and $5.5 million at June 30, 2009 or 2.35% of total loans. The increase of $4.0 million during the six months ended June 30, 2010 was necessitated by the increases in net charge offs and nonperforming assets which are directly related to the continued overall weakness in the Michigan economy. Net charge offs totaled $4.9 million compared to $1.3 million for the same period a year ago. Net charge offs year to date consisted of 26% construction loans, 44% one to four family residential mortgages, 26% commercial real estate, and the remaining 4% included consumer, commercial and industrial and home equity lines of credit. The allowance for loan losses to non-performing loans ratio was 41.4% at June 30, 2010 compared to 37.14% at December 31, 2009 and 69.6% at June 30, 2009. See Provision for Loan Losses below for further explanation regarding charge-offs and non-performing loans. The current level of the allowance for loan losses is the result of managements assessment of the risks within the portfolio based on the information revealed in credit monitoring processes.
The allowance balance is established after considering past loan loss experience, current economic conditions, composition of the loan portfolio, delinquencies, and other relevant factors. We continue to be diligent in reviewing our loan portfolios for problem loans and believe that early detection of troubled credits is critical. We maintain the allowance for loan losses at a level considered adequate to cover losses within the loan portfolio.
Total deposits decreased $11.9 million, or 5.6%, from $213.4 million at December 31, 2009 to $201.5 million at June 30, 2010. The decline in deposits included decreases of $9.7 million in money market deposits, $4.9 million in brokered certificates of deposits and $3.5 million in local certificates of deposit. The Bank continues to be committed to increasing its core deposit balances during 2010 and saw increases in demand deposits of $1.4 million and in interest bearing checking and savings accounts of $4.8 million.
We have used brokered certificates of deposit to diversity our sources of funds and improve pricing at certain terms compared to the local market and advances available from Federal Home Loan Bank of Indianapolis. Due to the fact that Banks regulatory capital ratios are less than the levels necessary to be considered well capitalized, it may not obtain new brokered funds as a funding source and is subject to rate restrictions that limit the amount that can be paid on all types of retail deposits. The maximum rates the Bank can pay on all types of retail deposits are limited to the national average rate, plus 75 basis points. We have compared the Banks current rates with the national rate caps and reduced any rates over the rate cap to fall within those caps. There has been no material impact to our deposit balances resulting from the rate caps.
Federal Home Loan Bank Advances
Total Federal Home Loan Bank (FHLB) advances remained unchanged during the six months ended June 30, 2010 compared December 31, 2009. Management is attempting to reduce its reliance on borrowed funds through the growth of low cost core deposits. Should this strategy not succeed, management anticipates the need for future borrowings to fund loan growth. See Net Interest Income below, and also see Liquidity later in this report regarding available borrowings.
Total equity was $15.1 million at June 30, 2010 compared to $23.2 million at December 31, 2009. This represents 5.7% and 8.2% of total assets at June 30, 2010 and December 31, 2009, respectively. Decreases in equity for the six months ended June 30, 2010 included a net loss of $8.1 million and $170,000 in accrued dividend payments on the Preferred Stock. The annual 5% dividend on the Preferred Stock together with the amortization of the discount will reduce net income (or increase the net loss) applicable to common stock by approximately $350,000 annually. Effective February 2010, the Corporation deferred regularly scheduled dividend payments on the $6.7 million in principal outstanding on its Series A fixed rate, cumulative perpetual preferred stock (aggregate liquidation preference of $6.8 million) which was issued to the U.S. Treasury in February 2009.
RESULTS OF OPERATIONS
Net Interest Income
Net interest income before any provision for loan losses decreased $269,000 for the quarter ended June 30, 2010 compared to the same period in 2009. Net interest income before any provision for loan losses decreased $335,000 for the six months ended June 30, 2010 compared to the same period in 2009.
The net interest margin for the second quarter of 2010 decreased 24 basis points to 2.83% compared to 3.07% for the same period in 2009. The decline in the margin is largely due to the decline in earning assets. The Bank has seen runoff in the mortgage portfolio as loan originations have moved into the secondary market, (see further discussion below). The increased level of nonperforming loans and the associated nonaccrual interest adjustment have also significantly impacted the margin. The yield on loans has decreased to 5.67% for the quarter compared to 6.44% for the same period in 2009.
The net interest margin decreased 10 basis points to 2.96% for the six months ending June 30, 2010 compared to 3.06% for the same period in 2009. The decline in margin year over year is mainly due to the reasons mentioned previously. Cost of funds continues to decrease to 2.2% as the Corporation remains focused on deposit pricing strategies and growing core deposits to reduce its reliance on whole sale funding.
The Banks ability to maintain its net interest margin is heavily dependent on future loan demand and its ability to attract core deposits to offset the effect of higher cost certificates of deposits and borrowings. The Bank continues to be challenged in its efforts to increase lower costing core deposits. Management continues to put its efforts towards meeting this challenge.
The following table presents, for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. No tax equivalent adjustments were made.
Provision for Loan Losses
The provision for loan losses was $7.0 million in the second quarter of 2010 compared to $3.4 million for the second quarter of 2009. The significant increase in the provision was primarily driven by the continued deteriorating economic conditions in Michigan and weaknesses in the local real estate markets which resulted in downgrades to the credit ratings of certain loans in the portfolio and a significant increase in the balances of nonperforming loans. The Company continues to monitor real estate dependent loans and focus on asset quality. Non-performing assets totaled $27.3 million at the end of the second quarter of 2010, an increase of $8.9 million from December 31, 2009. Net charge offs for the quarter ended June 30, 2010 were $3.5 million compared to $1.1 million for the same period in 2009. Year to date 2010 net charge offs totaled $4.9 million compared to $1.3 million for the same period a year ago. Net charge offs year to date consisted of 46% one to four family residential mortgages, 26% construction, 26% commercial real estate, and the remaining 3% included consumer, commercial and industrial and home equity lines of credit.
Nonperforming assets including the amount of real estate in judgment and foreclosed and repossessed properties, increased from $18.4 million at the end of 2009 to $27.3 million as of June 30, 2010. This increase was largely due to an increase nonperforming loans, specifically in commercial real estate loans. Management classified two large commercial loan relationships in the amount of $7.3 million as non-performing during the second quarter.
The following table presents non-performing assets and certain asset quality ratios at June 30, 2010 and December 31, 2009.
Non-interest income for the quarter ended June 30, 2010 decreased $614,000, or 42.0%, from $1.5 million to $854,000 compared to the same period a year ago. This decrease is attributable to a decrease in gain on sale of loans offset by an increase in other income.
Net gain on of sale loans decreased $599,000 for the quarter ended June 30, 2010 from $748,000 to $149,000 compared to the same period a year ago. The decrease is largely due to the decline in one to four family residential mortgage refinancing activity. Management expects current trends to continue through the remainder of the year and be more consistent with the gains recognized in 2008.
Non-interest income for the six months ended June 30, 2010 decreased $916,000, or 32.2%, from $2.8 million to $1.9 million for the same period in 2009. Net gain on sale loans decreased $1.1 million for the six months ended June 30, 2009 from $1.5 million to $349,000 compared to the same period a year ago. Fees and Service charges increased $44,000 for the six months ended June 30, 2010 compared to the same period a year ago. The increase in fees and service charges is primarily due to an increase in deposit related fees of $24,000 which consists of an increase in ATM income of $28,000 and in early withdrawal penalties of $18,000. Overdraft fees decreased $18,000 as a result of customers managing their finances more closely in order to reduce overdraft fees because of the current challenging economic conditions. All other deposit fees decreased $4,000. An increase in loan related fees of $20,000 which consisted of an increase in Brokered loan income of $16,000 also significantly impacted fees and service charges.
A gain of $37,000 on the sale of investments was recognized in the six months of 2010 as management replaced securities to reposition maturities and improve overall credit quality of the portfolio. Other income increased $91,000 primarily due to a $34,000 increase in gain on sale of other repossessed property.
Noninterest expense decreased $96,000, or 3.7%, for the three months ended June 30, 2010 compared to the same period ending a year ago. Salaries and employee benefits decreased $30,000. The decline in personnel expense was primarily attributable to a decline in general staffing, the discontinuance of our 401k match and the increased employee match for health insurance coverage. Amortization of mortgage servicing rights decreased $55,000 as a result of the slow down in residential mortgage refinancing activity mentioned previously. Foreclosed property expense decreased $18,000. Other operating expenses decreased $115,000. Professional services increased $122,000 primarily due to increases in legal fees associated with non-performing loans.
Noninterest expense decreased $111,000, or 2.2%, for the six months ended June 30, 2010 compared to the same period ending a year ago. Salaries and employee benefits decreased $73,000, in 2010. Cost control remains a focus of the Corporation and early in the third quarter the Corporation completed a reduction-in-staff initiative and a branch consolidation that will significantly reduce the Banks salaries and employee benefits expenses. Approximately 20 full-time equivalent positions were eliminated as a result of the reduction-in-staff initiative, with pre-tax savings estimated to be approximately $800,000 on an annual basis. Management will continue to reduce staffing levels, where possible, through attrition, throughout 2010.
Amortization of mortgage servicing rights decreased $166,000 for reasons mentioned previously. Occupancy and equipment decreased $46,000. Other operating expenses decreased $125,000. Professional services increased $144,000 primarily due to increases in legal fees associated with non-performing loans and legal fees associated with the Consent Order. Foreclosed property expense increased $155,000, due to increases in loan collection costs, and losses and impairment charges associated with the disposition of other real estate.
Federal Income Tax Expense
An income tax benefit was not recognized for the first six month of 2010. A $2.0 million tax benefit for the six months of 2010, primarily associated with the $8.1 million net operating loss before income taxes, was offset by a corresponding increase in the valuation allowance on deferred tax assets. A significant component of income tax expense is made up of general tax credits generated each year. Due to the current year loss, these tax credits may not be fully utilized.
The Banks liquidity, represented by cash, overnight funds and investments, is a product of our operating, investing, and financing activities. The Banks primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans, and funds provided from operations. While scheduled payments from the amortization of loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank also generates cash through borrowings. The Bank utilizes Federal Home Loan Bank advances to leverage its capital base and provide funds for its lending and investment activities, and to enhance its interest rate risk management.
At June 30, 2010, the Bank was considered adequately capitalized under regulatory guidelines which subjects the Bank to restrictions under the FDIC. These restrictions prohibit the Bank from accepting, renewing, or rolling over brokered deposits except with a waiver from the FDIC. This act also subjects the Bank to restrictions on the interest rates that can be paid on deposits.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments such as overnight deposits. On a longer-term basis, the Bank maintains a strategy of investing in various investments and lending products. The Bank uses its sources of funds primarily to meet its ongoing commitments, to pay maturing certificates of deposit and savings withdrawals and to fund loan commitments. Certificates of deposit scheduled to mature in one year or less at June 30, 2010 totaled $46.3 million. Management believes that a significant portion of these certificates of deposit will remain with the Bank provided the Bank pays a rate of interest that is competitive both in the local and national markets.
If necessary, additional funding sources include additional deposits, Federal Home Loan Bank advances and securities available for sale. Deposits can be obtained in the local market area. At June 30, 2010 and based on current collateral levels, the Bank could borrow an additional $15.1 million from the Federal Home Loan Bank at prevailing interest rates. This borrowing capacity can be increased in the future if the Bank pledges additional collateral to the Federal Home Loan Bank. The Corporation anticipates that it will continue to have sufficient funds, through deposits, and borrowings, to meet its current commitments.
The Banks total cash and cash equivalents decreased by $4.1 million during the six months ended June 30, 2010 compared to a $6.6 million increase for the same period in 2009. The primary sources of cash for the six months ended June 30, 2010 were $10.9 million in proceeds from the sale of mortgage loans, $3.9 million in sales and maturities of available-for-sale investment securities and $5.4 of principal loan collections in excess of loan originations compared to $6.8 million increase in cash generated by the issuance of preferred stock, $10.2 million increase in deposits, $66.3 million in proceeds from the sale of mortgage loans, $6.1 million in maturities of available-for-sale investment securities. The primary uses of cash for the six months ended June 30, 2010 were $10.9 million of mortgage loans originated for sale, decrease in deposits of $11.9 million and $4.2 million in purchases of available-for-sale investment securities compared to $65.3 million of mortgage loans originated for sale, $3.5 million in repayments of FHLB advances, $1.0 million in repayment of Fed funds purchased and $17.8 million in purchases of available-for-sale investment securities.
Effective February 2010, the Corporation deferred regularly scheduled dividend payments on the $6.7 million in principal outstanding on its Series A fixed rate, cumulative perpetual preferred stock (aggregate liquidation preference of $6.8 million) which was issued to the U.S. Treasury in February 2009. By taking this action, the Corporation expects to save approximately $339,250 in annual cash payments.
CONTRACTUAL OBLIGATIONS AND OFF BALANCE SHEET ARRANGEMENTS
The Corporation has certain obligations and commitments to make future payments under contracts. At June 30, 2010, the aggregate contractual obligations and commitments are:
Commitments to grant loans are governed by the Banks credit underwriting standards, as established by the Banks Loan Policy. The Banks policy is to grant Home Equity Lines of Credits (HELOCs) for periods of up to 15 years.
The Bank is subject to various regulatory capital requirement administered by federal and state banking agencies. The Banks regulatory capital ratios as of June 30, 2010 were as follows: Tier 1 leverage ratio 4.9%, Tier 1 risk-based capital ratio 6.80%; and total risk-based capital, 8.04%. As of June 30, 2010, the Bank is considered adequately capitalized.
In May 2010, the Bank agreed with the FDIC to increase the Banks Tier 1 risk-based capital ratio to at least 9%, and its total risk-based capital ratio to at least 11.0%. At June 30, 2010, these capital ratio requirements had not been met. The Board of Directors and management remain committed to reaching the capital requirements and continue to evaluate different capital raising alternatives.
Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that if undertaken could have a material adverse effect. Under the FDICs prompt corrective action framework, banks with less than a 4% Tier 1 leverage ratio are considered undercapitalized, banks with less than a 3% Tier 1 leverage ratio are considered significantly undercapitalized, and banks with a tangible equity to total assets ratio of less than 2% are considered critically undercapitalized. Each of these categories subjects such bank to increasing levels of regulatory scrutiny which may include increased supervision; restrictions on operations, expansion of activities and growth; potential civil penalties; and in the case of critically undercapitalized banks, the appointment of a conservator.
Following Monarch Community Banks most recent Safety and Soundness examination, the Board of Directors of Monarch Community Bank stipulated to the terms of a formal enforcement action (Consent Order) with Federal Deposit Insurance Corporation (FDIC) and the Office of Financial and Insurance Regulation for the State of Michigan (OFIR). The Consent Order, which was effective May 6, 2010, contains specific actions needed to address certain findings from their examination and to address our current financial condition. The Consent Order, among other things, requires the following:
The Bank believes that it is in compliance with all of the terms of the Consent Order with the exception of the requirement that the Bank increase the Banks level of Tier 1 capital as a percentage of total assets to at least nine percent and its total capital as a percentage of risk-weighted assets at a minimum of eleven percent. The Board of Directors and management remain committed to reaching the capital requirements and continue to evaluate different capital raising alternatives.
The Corporations primary market risk exposure is interest rate risk (IRR). Interest rate risk refers to the risk that changes in market interest rates might adversely affect the Corporations net interest income or the economic value of its portfolio of assets, liabilities, and off-balance sheet contracts. Interest rate risk is primarily the result of an imbalance between the price sensitivity of the Corporations assets and its liabilities (including off-balance sheet contracts). Such imbalances can be caused by differences in the maturity, repricing and coupon characteristics of assets and liabilities, and options, such as loan prepayment options, interest rate caps and floors, and deposit withdrawal options. These imbalances, in combination with movement in interest rates, will alter the pattern of the Corporations cash inflows and outflows, affecting the earnings and economic value of the Corporation.
The Corporations primary tool for assessing IRR is a model that uses scenario analysis to evaluate the IRR exposure of the Bank by estimating the sensitivity of the Banks portfolios of assets, liabilities, and off-balance sheet contracts to changes in market interest rates. To measure the sensitivity of the Banks Net Portfolio Value (NPV) to changes in interest rates, the (NPV) model estimates what would happen to the economic value of each type of asset, liability, and off-balance sheet contract under six different interest rate scenarios. The model estimates the NPV that would result following instantaneous, parallel shifts in the Treasury yield curve of -300, -200, -100, +100, +200, +300 basis points. Management then compares the resulting NPV and the magnitude of change in NPA to regulatory and industry guidelines to determine if the Corporations IRR is acceptable.
An evaluation of the Corporations disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 (the Exchange Act)) as of June 30, 2010 was carried out under the supervision and with the participation of the Corporations Chief Executive Officer, Chief Financial Officer and several other members of the Corporations senior management. The Corporations Chief Executive Officer and Chief Financial Officer concluded that the Corporations disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Corporation in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Corporations management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within time periods specified in the SECs rules and forms. There have been no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the quarter ended June 30, 2010, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
The Corporation intends to continually review and evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Corporations business. While the Corporation believes the present design of its disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Corporation to modify its disclosure controls and procedures.
PART II-OTHER INFORMATION
The Corporation and the Bank are from time-to-time involved in legal proceedings arising out of, and incidental to, their business. Management, based on its review with counsel of all actions and proceedings affecting the Corporation and the Bank, has concluded that the aggregate loss, if any, resulting from the disposition of these proceedings should not be material to the Corporations financial condition or results of operations.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2009, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Corporation. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
See the index to exhibits.
In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
INDEX TO EXHIBITS