Monarch Community Bancorp 10-Q 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For the quarterly period ended September 30, 2011
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: x No: ¨
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 x No ¨
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: ¨ No: x
State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practical date: At November 1, 2011, there were 2,049,485 shares of the issuers Common Stock outstanding.
Monarch Community Bancorp, Inc.
PART IFINANCIAL INFORMATION
Condensed Consolidated Balance Sheets
See accompanying notes to condensed consolidated financial statements.
See accompanying notes to condensed consolidated financial statements.
See accompanying notes to condensed consolidated financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - 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 five 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, 2010 filed with the Securities and Exchange Commission.
The results of operations for the nine month period ended September 30, 2011 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 which cover a twenty four month historical period and are carried at a weighted average with the most recent twelve months weighted 60% and the later weighted 40%, can vary 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. Management estimates probable losses by evaluating quantitative and qualitative factors for each loan portfolio segment, including net charge-off trends, internal risk ratings, changes in internal risk ratings, loss forecasts, collateral values, geographic location, delinquency rates, nonperforming and restructured loans, origination channel, product mix, underwriting practices, industry conditions, and economic trends.
As of September 30, 2011 the residential loan historical loss ratios were increased by .08% to .27% based on the particular segment. Multi-family real estate loan historical loss ratios were increased by .07% to 2.40%. All other commercial real estate loan historical loss ratios were increased .02% to .99%. Construction loan historical loss ratios were increased .04% to .43%, Consumer loan historical loss ratios, .50% to .60% and commercial and industrial loan historical loss ratios were increased by .03% to .28%. As of September 30, 2011 7% of the allowance for loan loss reserve was attributable to adjustments to the loss factors. No adjustments were made to the loss factors in the fourth quarter of 2010 or in the first six months of 2011. Factors regarding changes in experience, ability and depth of lending management and changes in the quality of loan review system and the degree of oversight by the Board of Directors were decreased in the third quarter of 2011. 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 2011 presentation.
NOTE 2 - SECURITIES
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 $8.6 and $4.8 million for the nine months ended September 30, 2011 and 2010, respectively. Gross gains of $469,000 and $76,000 were realized on these sales during 2011 and 2010, respectively.
The amortized cost and fair value of securities available for sale at September 30, 2011 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 September 30, 2011.
Our portfolio of available for sale securities is 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 September 30, 2011.
NOTE 3 - 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):
NOTE 4 - RECENT ACCOUNTING PRONOUNCEMENTS
FASB ASU 2010-06, Improving Disclosures about Fair Value Measurements. The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06 to amend ASC 820, Fair Value Measurement and Disclosures (ASC 820), to require additional disclosures regarding fair value measurements. Specifically, the ASU requires disclosure of the amounts of significant transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for these transfers; the reasons for any transfers in or out of Level 3; and information in the reconciliation of recurring Level 3 measurements about gross purchases, sales, issuances and settlements. Except for the requirement to disclose purchases, sales, issuances and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, all the amendments to ASC 820 made by ASU 2010-06 were effective for the Corporation on January 1, 2010. The requirement to separately disclose purchases, sales, issuances and settlements of recurring Level 3 measurements was effective for the Corporation as of January 1, 2011. All required disclosures are incorporated into Note 5.
FASB ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. In July 2010, the FASB issued ASU 2010-20, which requires new qualitative and quantitative disclosures on the allowance for credit losses, credit quality, impaired loans, modifications and nonaccrual and past due financing receivables. The guidance requires that an entity provide disclosures facilitating financial statement users evaluation of the nature of credit risk inherent in the entitys portfolio of financing receivables (i.e., loans), how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. These required disclosures are to be presented on a disaggregated basis at the portfolio segment and the class of financing receivables level. As it relates to disclosures as of the end of a reporting period, ASU 2010-20 was effective for the Corporation as of December 31, 2010. Disclosures that relate to activity during a reporting period were required for the Corporation in the period beginning January 1, 2011 and are incorporated into Note 6 and Note 7. In January 2011, the FASB temporarily deferred the effective date for disclosures about troubled debt restructurings under ASU 2010-20. See ASU 2011-2 below which requires disclosures about troubled debt restructurings under ASU 2010-20 on a prospective basis beginning in the quarter ended September 30, 2011.
FASB ASU 2011-02, A Creditors Determination of Whether a Restructuring Is a Troubled Debt Restructuring. In April 2011, the FASB issued ASU 2011-02, which provides additional guidance to help creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The amendments in this update are effective for the Corporation beginning in the quarter ended September 30, 2011 and are to be applied retrospectively to January 1, 2011. In addition, the modification disclosures described in ASU 2010-20, which were subsequently deferred by ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings, were effective on a prospective basis beginning in the quarter ended September 30, 2011. The Corporation has included the evaluation of the impact of ASU 2011-02 on its consolidated financial statements in Note 6.
The FASB has issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term fair value. The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. The amendments to the Codification in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The impact of adoption of this ASU is not expected to be material.
FASB ASU 2011-05, Presentation of Comprehensive Income. In September 2011, the FASB issued ASU 2011-05, which provides entities with the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income, along with a total for other comprehensive income, and a total amount for comprehensive income. Regardless of whether an entity chooses to present comprehensive income in a single continuous statement or in two separate but consecutive statements, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. This update should be applied retrospectively effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We anticipate this statement will be adopted with our 2012 annual financial statements.
NOTE 5 - 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 September 30, 2011, and December 31, 2010, 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). Adjustments in 2011 and 2010 to the impaired loans were recorded as additional allocations to the allowance for loan and lease losses. Adjustments in 2011 to foreclosed assets were recorded as additional allocations to the allowance for loan and lease losses. The following table presents the Corporations assets at fair value on a nonrecurring basis as of September 30, 2011 and December 31, 2010 (000s omitted):
The fair value of impaired loans is estimated using either discounted cash flows or collateral value. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Impaired loans where a specific reserve is established based on the fair value of the collateral require classification in the fair value hierarchy. Impaired loans are categorized as level 3 assets because the values are based on available collateral (typically based on outside appraisals obtained at least annually) and discounted based on internal loan to value limits which typically range from 50% to 80% based on the collateral. Management reviews the impaired loans no less than quarterly for potential additional impairment and when there is little prospect of collecting principal or interest, loans or portions thereof may be charged off to the allowance for loan losses. Losses are recognized in the period a debt becomes uncollectible. The recognition of a loss does not mean that the loan has no recovery or salvage value, but rather it is not practical or desirable to defer writing off the loan even though a partial recovery may occur in the future. During the nine months ended September 30, 2011 the Company charged off $455,000 of impaired loans to the allowance for loan losses. The change in fair value of impaired loans is accounted for in the allowance for loan losses (see Note 6).
Foreclosed assets, which include real estate owned and real in estate in judgment and subject to redemption, 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 performed annually 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. The valuations consist of obtaining a broker price opinion or a new appraisal depending on the value of the asset. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets. Assets held as real estate in judgment may be subject to redemption for a period of six to twelve months depending on the collateral, following the foreclosure sale. Assets may be redeemed by the borrower for the foreclosure sale price, accrued interest and foreclosure costs. Any asset redeemed would be treated as a paid off loan. As of September 30, 2011 the Company held $4.5 million in foreclosed assets owned as a result of foreclosure or the acceptance of a deed in lieu and $3.0 million in foreclosed assets as of December 31, 2010. No assets were redeemed in 2010 or in the nine months of 2011.
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 September 30, 2011 and December 31, 2010. The following methods and assumptions were used by the Corporation in estimating fair value disclosures for financial instruments:
Securities - Fair values for securities are based on quoted market prices.
Mortgage 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):
NOTE 6 - LOANS
The following table presents information concerning the composition of our loan portfolio in dollar amounts and in percentages as of the dates indicated:
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. All loan classes on which principal or interest is in default for 90 days or more are put on nonaccrual status, unless there is sufficient documentation to conclude that the loan is well secured and in the process of collection. Loans will also be placed on nonaccrual status if the Bank cannot reasonably expect full and timely repayment. All nonaccrual loans are also deemed to be impaired unless they are residential loans whose status as nonaccrual loans is based solely on having reached 90 days past due, are in the process of collection, but whose status as well secured has not yet been established.
A loan is considered impaired when it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the agreement. All impaired loans are also classified as nonaccrual loans unless they are deemed to be impaired solely due to their status as a troubled debt restructure and, 1) the borrower is not past due or, 2) there is verifiable adequate cash flow to support the restructured debt service or, 3) there is an adequate collateral valuation supporting the restructured loan.
An age analysis of past due loans including nonaccrual loans, segregated by class of loans, as of September 30, 2011 and December 31, 2010 are as follows:
All commercial loans will be assigned a risk rating by the Credit Analyst at inception. The risk rating system is composed of eight levels of quality and utilizes the following definitions. The risk rating system was last updated in June 2010. No changes have been made to the risk ratings in the third quarter of 2011.
Risk Rating Scores by definition:
The following table represents the risk category of loans by class based on the most recent analysis performed as of September 30, 2011 and December 31, 2010 (in thousands):
For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan which was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned grades as of September 30, 2011 and December 31, 2010.
The following table presents loans individually evaluated for impairment by class of loans as of September 30, 2011 and December 31, 2010 (in thousands).
Payments received on loans in nonaccrual status are typically applied to reduce the recorded investment in the asset. While an loan is in nonaccrual status, some or all of the cash interest payments received may be treated as interest income on a cash basis as long as the remaining recorded investment in the asset (i.e., after charge-off of identified losses, if any) is deemed to be fully collectible. As of September 30, 2011 and December 31, 2010 the Company had not recognized any interest income on a cash basis. The following presents by class, the recorded investment in loans and leases on non-accrual status as of September 30, 2011 and December 31, 2010.
Financing Receivables on Nonaccrual Status
Financing Receivables on Nonaccrual Status
Loans in which the Bank elects to grant a concession, providing terms more favorable than those prevalent in the market (e.g., rate, amortization term), and are formally restructured due to the weakening credit status of a borrower are reported as trouble debt restructure ( TDR). All other modifications in which the new terms are at current market conditions and are granted to clients due to competitive pressures and because of the customers favorable past and current performance and credit risk do not constitute a TDR loan and are not monitored.
In order to maximize the collection of loan balances, we evaluate troubled loans on a case-by-case basis to determine if a loan modification would be appropriate. We pursue loan modifications when there is a reasonable chance that an appropriate modification would allow our client to continue servicing the debt. For loans secured by either commercial or residential real estate, if the client demonstrates a loss of income such that the client cannot reasonably support even a modified loan, we may pursue foreclosure, short sales and/or deed-in-lieu arrangements. For all troubled loans, we review a number of factors, including cash flows, loan structures, collateral values, and guarantees. Based on our review of these factors and our assessment of overall risk, we evaluate the benefits of renegotiating the terms of the loans so that they have a higher likelihood of continuing to perform. To date, we have restructured loans in a variety of ways to help our clients service their debt and to mitigate the potential for additional losses. The primary restructuring methods being offered to our clients are reductions in interest rates and extensions in terms. Loans that, after being restructured, remain in compliance with their modified terms and whose modified interest rate yielded a market rate at the time the loan was restructured, are reviewed annually and may be reclassified as non-TDR, provided they conform with the prevailing regulatory criteria. As of September 30, 2011 there have been no loans in which the TDR designation has been removed.
The following table represents the level of TDRs as of September 30, 2011.
All TDR loans are considered impaired. When individually evaluating loans for impairment, we may measure impairment using (1) the present value of expected future cash flows discounted at the loans effective interest rate (i.e., the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan), (2) the loans observable market price, or (3) the fair value of the collateral. If the present value of expected future cash flows discounted at the loans effective interest rate is used as the means of measuring impairment the change in the present value attributable to the passage time is recognized as bad-debt expense. As previously mentioned all impaired loans are also classified as nonaccrual loans unless they are deemed to be impaired solely due to their status as a troubled debt restructure and, 1) the borrower is not past due or, 2) there is verifiable adequate cash flow to support the restructured debt service or, 3) there is an adequate collateral valuation supporting the restructured loan. Nonaccruing TDR loans that demonstrate a history of repayment performance in accordance with their modified terms are reclassified to accruing restructured status, typically after six months of repayment performance and are supported by a current credit evaluation of the borrowers financial condition and expectations for repayment under the revised terms. Included in the troubled debt restructured balances above were $14.2 million of accruing TDRs at September 30, 2011 and $15.8 million at December 31, 2010. Also included in the troubled debt restructured balances above $14.9 million are paying in accordance with modified terms at September 30, 2011 and $15.4 million at December 31, 2010.
NOTE 7 - ALLOWANCE FOR LOAN LOSSES
Changes in the allowance for loan losses were as follows for the nine months ended September 30, 2011.
Summary of Allowance for Loan Losses
The allowance for loan losses was $5.2 million at September 30, 2011 representing 3.3% of total loans, compared to $6.9 million at December 31, 2010 or 3.74% of total loans and $9.7 million at September 30, 2010 or 4.9% of total loans. The allowance for loan losses to non-performing loans ratio was 49.7% at September 30, 2011 compared to 48.7% at December 31, 2010 and 40.5% at September 30, 2010. At September 30, 2011 we believe that our allowance appropriately considers incurred losses in our loan portfolio.
Analysis related to the allowance for credit losses (in thousands) as of September 30, 2011 is as follows:
The Companys charge-off policy which meets regulatory minimums has not required any revisions during the third quarter of 2011. Losses on unsecured consumer loans are recognized at or before 120 days past due. Secured consumer loans, including residential real estate, are typically charged-off between 120 and 180 days past due, depending on the collateral type, in compliance with the FFIEC guidelines. Specific loan reserves are established based on credit and or collateral risks on an individual loan basis. When the probability for full repayment of a loan is unlikely the Bank will initiate a full charge-off or a partial write down of a loan based upon the status of the loan. Impaired loans or portions thereof are charged-off when deemed uncollectible. Loans that have been partially charged-off remain on nonperforming status, regardless of collateral value, until specific borrower performance criteria are met. Total impaired loans as reported above were $24.4 million as of September 30, 2011 and $27.8 million as of December 31, 2010. Partial charge-offs associated with the impaired loans totaled $6.3 million as of September 30, 2011 and $7.1 million as of December 31, 2010.
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 Safety and Soundness examination which was completed in early 2010, 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. Following Monarch Community Banks most recent Safety and Soundness examination, there were no changes to the existing formal enforcement action (Consent Order).
Since stipulating to the terms of the Consent Order, we have complied with all of the required actions, with the exception of fully raising our capital levels to the required levels. Management continues to work toward the achievement of the required capital levels through:
Management continues to focus on the improvement of credit quality at the Bank, and has completed three comprehensive external loan reviews over the last twelve months, with no recommendations for additional loan loss provisions or charge-offs, and no identification of material weaknesses in the credit approval or administration processes. Likewise, the Bank retained the services of Rehman Consulting to conduct the Banks internal audit function, a task which had previously been performed by a Bank employee. Since retaining Rehman, the firm has performed three comprehensive internal audits, in compliance with Sarbanes Oxley standards, and has found no material weaknesses in the Banks policies and procedures.
In addition to the enhanced loan review and audit functions, the Bank has continued to focus on the reduction of problem loans. As a result, the Banks total non-performing assets have declined from $26.4 million at September 30, 2010 to $14.9 million at September 30, 2011. This constitutes a 44% drop in non-performing assets over a 12 month period.
While continuing the focus on the reduction in problem loans, the Bank has also pursued the development of additional sources of fee income. Since January of 2011, the Bank has opened three new residential loan production offices in Portage, Okemos, and St. Joseph, Michigan. Management has identified a number of additional markets in Michigan and Indiana where residential loan production offices will be opened over the next six to twelve months. Each of these offices also has the potential to add commercial lenders and investment advisors as the market conditions may merit.
Improved growth and profitability will be derived from the following ongoing initiatives:
1. The reduction in non-performing assets and classified loans. As demonstrated in the aforementioned data, non-performing assets have declined significantly over the past 12 months. Our intent is to continue our disciplined, aggressive approach to further reducing non-performing and classified loans.
2. Organic growth, focusing on commercial lending, residential mortgage lending in existing markets and the expansion of our wealth management revenue. We recently established a new relationship with Investment Professionals, Inc., (IPI) replacing our previous relationship with Prudential. IPI will provide compliance, sales, research and clearing support for investment advisors that will be employed by the Bank and will provide investment services under the name of Monarch Investment Services. This will provide for enhanced branding of the Monarch name and increased fee income potential from investment services.
3. De novo LPOs, opened in markets across the state and across state lines that have strong demographic features. The offices are opened with at least two residential mortgage originators. This can be followed by the addition of a commercial lender and, where appropriate, a Monarch Investment Services Advisor.
4. A continued exploration of acquisition opportunities, where markets and synergies combine for the potential of enhanced shareholder value.
Summary. Total assets decreased by $32.9 million, or 12.8%, to $223.9 million at September 30, 2011 compared to $256.9 million at December 31, 2010. Loans, excluding loans held for sale, totaled $154.9 million at September 30, 2011, down 15.2% from $182.8 million at December 31, 2010.
Securities decreased to $6.4 million at September 30, 2011 compared to $11.5 million at December 31, 2010. The decrease was attributable to the Bank selling a portion of the portfolio to improve overall quality of the portfolio. The yield on investment securities has increased to 3.51% during the nine months ended September 30, 2011 from 3.06% 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 $27.9 million, or 15.2%, from $182.8 million at December 31, 2010 to $154.9 million at September 30, 2011. 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 $11.2 million from year end 2010 as a result of the Banks continued strategy to sell a large portion of the one-to-four family refinanced loans as well as normal paydowns. Commercial real estate loans and construction loans decreased $9.2 million or 13.8% due to the Banks efforts to reduce the size of the Bank and to reduce particular concentrations of the commercial loan portfolio including lessors of residential properties.
The allowance for loan losses was $5.2 million at September 30, 2011 compared to $6.9 million at December 31, 2010, a decrease of $1.7 million. Net charge-offs year to date totaled $2.0 million compared to $7.7 million for the same period a year ago. Net charge-offs year-to-date consisted of primarily one-to-four family residential mortgages. 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 $19.1 million, or 9.3%, from $206.0 million at December 31, 2010 to $186.9 million at September 30, 2011. The decline in deposits reflects the reduction in higher cost brokered certificates of deposit. During the first nine months of 2011, certificates of deposits decreased $21.0 million, interest bearing checking decreased $1.2 million and money market accounts decreased $4.0 million, offsetting an increase in demand and savings accounts of $7.1 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. However, due to the fact that the Banks regulatory capital ratios are less than the levels necessary to be considered well capitalized, we may not obtain new brokered funds as a funding source without prior approval of the FDIC 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 decreased $14.0 million to $22.3 million during the nine months ended September 30, 2011 compared $36.3 million at December 31, 2010. 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 decreased $59,000 at September 30, 2011 compared to December 31, 2010. The decrease in equity for the nine months ended September 30, 2011 was attributable to the decrease in the accumulated other comprehensive income of $199,000 due to the sale of securities in the third quarter and the accrued dividend payments on the Preferred stock of $257,000. Net earnings of $386,000 offset the change in accumulated other comprehensive income and accrued dividend. The annual 5% dividend on the Preferred Stock 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 par 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. At September 30, 2011 the dividend payable to the Treasury Department totaled $644,000. The suspension of dividend payments is permissible under the terms of the TARP Capital Purchase Program, but the dividend is a cumulative dividend and failure to pay dividends for six dividend periods could trigger board of director appointment rights for the holder of the Series A Preferred Stock. As of September 30, 2011 the Corporation has deferred the payment of six dividend payments and is subject to additional oversight.
RESULTS OF OPERATIONS
Net Interest Income
Net interest income before any provision for loan losses decreased $157,000 for the quarter ended September 30, 2011 compared to the same period in 2010. The net interest margin for the third quarter of 2011 increased 3 basis points to 2.99% compared to 2.96% for the same period in 2010. The improvement in the margin is largely due to the decline in cost of funds as management continues to monitor cost of funds. Management believes that the cost of funds will continue to decline as higher cost funding sources are eliminated or reduced. The decrease in nonperforming loans and the reduced associated nonaccrual interest adjustment have also significantly impacted the margin. The yield on loans has increased from 5.56% in the third quarter of 2010 to 5.74% for the same period in 2011.
Net interest income before any provision for loan losses decreased $495,000 for the nine months ended September 30, 2011 compared to the same period in 2010. The net interest margin increased 2 basis points to 2.98% compared to 2.96% for the same period in 2010. The yield on loans has increased to 5.82% for the nine months ended September 30, 2011 compared to 5.73% for the same period in 2010.
The Banks ability to maintain its net interest margin is heavily dependent on reduction of non-performing loans, 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.
The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume, which are changes in volume multiplied by the old rate, and (2) changes in rate, which are changes in rate multiplied by the old volume. Changes attributable to both rate and volume are shown as mixed.
Provision for Loan Losses
For the three months ended September 30, 2011, the Bank recorded a provision for loan losses of $41,000 compared to $2.7 million recorded in the third quarter of 2010. The reduced level of provision is reflective of managements efforts in previous periods to identify potential problem loans and establish adequate reserves and/or charge-offs to address those problems. The Corporation continues to monitor real estate dependent loans and focus on asset quality. Non-performing loans totaled $10.4 million at the end of the third quarter of 2011, a decrease of $3.7 million from December 31, 2010. Net charge offs for the quarter ended September 30, 2011 were $799,000 compared to $2.8 million for the same period in 2010.
The Bank recorded a provision for loan losses of $304,000 for the nine months ended September 30, 2011 compared to $11.6 million for the same period in 2010. Year to date 2011 net charge offs totaled $2.0 million compared to $7.7 million for the same period a year ago. Net charge offs year to date consisted of 65% one to four family residential mortgages, 32% commercial real estate including multifamily, and the remaining 3% included construction, commercial and industrial and consumer.
Nonperforming assets including the amount of real estate in judgment and foreclosed and repossessed properties, decreased from $17.0 million at the end of 2010 to $14.9 million as of September 30, 2011. This decrease was largely due to a decrease in nonperforming loans, specifically in commercial real estate loans.
The following table presents non-performing assets and certain asset quality ratios at September 30, 2011 and December 31, 2010.
Non-interest income for the quarter ended September 30, 2011 increased $341,000, or 38.75%, from $880,000 to $1.2 million compared to the same period a year ago. This increase is primarily attributable to the gain of $469,000 on the sale of $8.6 million in securities offsetting a decrease in other income which was due to the write down of the investment in a low cost housing project of $218,000.
Fees and Service charges increased $45,000 for the three months ended September 30, 2011 compared to the same period a year ago primarily due to an increase in fees from the late charges assessed on delinquent loans. Net gain on sale of loans increased $9,000 for the quarter ended September 30, 2011 compared to the same period a year ago. Other income decreased $138,000 compared to the same period a year ago due to the reason mentioned previously. Loan servicing fees decreased $5,000 for the quarter due to the decrease in the secondary market portfolio.
Non-interest income for the nine months ended September 30, 2011 increased $189,000, or 6.7%, compared to the same period in 2010. Fees and Service charges decreased $161,000 for the nine months ended September 30, 2011 compared to the same period a year ago primarily due to a decrease of $98,000 in nsf fee income. Loan servicing fees decreased $26,000 due to the decrease in the secondary market portfolio. An increase of $430,000 on the sale of investments compared to the same period a year ago was recognized in 2011 as management continues to replace securities to improve the overall quality of the portfolio. Net gain on sale of loans increased $90,000 for the nine months ended September 30, 2011 due to the addition of loan originators and to the implementation of a new lending approach. Other income decreased $107,000 primarily due to the write down of the low cost housing project.
Noninterest expense increased $181,000, or 7.3% for the quarter ended September 30, 2011 compared to the same period a year ago. Salaries and employee benefits increased $90,000. The increase in personnel expense was primarily attributable to the addition of loan originators for the new offices opened during the quarter. Foreclosed property expense increased $158,000 for the quarter due to increased expenses from maintenance costs and taxes on a higher level of properties in other repossessed property. Other general administrative expenses decreased $58,000 primarily due to a decrease in FDIC insurance premiums. All other expenses decreased $9,000.
Noninterest expense increased $43,000, or .58%, for the nine months ended September 30, 2011 compared to the same period ending a year ago. Foreclosed property expense increased $127,000 year to date for reasons mentioned previously. Data processing expense increased $30,000. Salaries and employee benefits decreased $11,000. Professional services decreased $62,000 primarily due to decreases in legal fees associated with nonperforming loans. Occupancy and equipment expense decreased $20,000. Other general and administrative expenses decreased $28,000 due to reasons mentioned previously. All other expenses increased $7,000.
Federal Income Tax Expense
An income tax benefit was not recognized for the first nine months of 2011. A $73,000 tax benefit for the nine months of 2011, primarily associated with the $386,000 net earnings before income taxes, was offset by a corresponding decrease in the valuation allowance on deferred tax assets.
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 September 30, 2011, 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 September 30, 2011 totaled $44.9 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 local core deposits, certificates of deposit gathered via the internet, Federal Home Loan Bank advances and securities available for sale. At September 30, 2011 and based on current collateral levels, the Bank could borrow an additional $8.8 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 increased by $653,000 during the nine months ended September 30, 2011 compared to a $4.9 million increase for the same period in 2010. The primary sources of cash for the nine months ended September 30, 2011 were $22.6 million in proceeds from the sale of mortgage loans, $8.6 million in the sale of available for sale securities, $1.5 million maturities of available-for-sale investment securities, and $24.7 of principal loan collections in excess of loan originations compared to $18.2 million in proceeds from the sale of mortgage loans, $4.8 million in the sale of available for sale securities, $3.6 million in the maturities of available-for-sale investment securities and $10.8 million of principal loan collections in excess of loan originations. The primary uses of cash for the nine months ended September 30, 2011 were $22.5 million of mortgage loans originated for sale, $14.0 million in repayments of FHLB advances and a decrease in deposits of $19.1 million compared to a decrease in deposits of $11.5 million, $18.0 million of mortgage loans originated for sale, $4.2 million in purchases of available-for-sale investment securities and $2.0 million in repayment of FHLB advances.
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 September 30, 2011, 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 September 30, 2011 were as follows: Tier 1 leverage ratio 5.17%, Tier 1 risk-based capital ratio 8.35%, and total risk-based capital 9.63%.
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 September 30, 2011, 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. For additional information, please refer to Note 2 to the Companys financial statements included in its Form 10-K for the year ended December 31, 2010 in connection with uncertainty about the Companys ability to continue as a going concern.
On September 21, 2010 the Company entered into a Written Agreement with the Federal Reserve Bank of Chicago (the FRB). Among other things, the Written Agreement requires that the Company obtain the approval of the FRB prior to paying a dividend; prohibits the Company from purchasing or redeeming any shares of its stock without the prior written approval of the FRB, and; requires the Company to submit cash flow projections for the Company to the FRB on a quarterly basis. A Form 8-K was issued on September 27, 2010 with the complete details of the Written Agreement.
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 NPV 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 September 30, 2011 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