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Taylor Capital Group 10-Q 2012 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2012 Commission File No. 0-50034
TAYLOR CAPITAL GROUP, INC. (Exact name of registrant as specified in its charter)
9550 West Higgins Road Rosemont, IL 60018 (Address, including zip code, of principal executive offices) (847) 653-7978 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark 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 (Section 232.405 of this chapter) 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: At April 30, 2012, there were 28,421,873 shares of Common Stock, $0.01 par value, outstanding.
Table of ContentsINDEX
Table of ContentsPart I. FINANCIAL INFORMATION Item 1. Financial Statements CONSOLIDATED BALANCE SHEETS (dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements (unaudited)
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Table of ContentsCONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) (dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements (unaudited).
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Table of ContentsCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (unaudited) (dollars in thousands)
See accompanying notes to consolidated financial statements (unaudited).
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Table of ContentsCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (unaudited) (in thousands, except per share data)
See accompanying notes to consolidated financial statements (unaudited).
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Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (dollars in thousands)
Consolidated Statements of Cash Flows continued on the next page See accompanying notes to consolidated financial statements (unaudited)
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Table of ContentsTAYLOR CAPITAL GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS – (unaudited) (Continued) (dollars in thousands)
See accompanying notes to consolidated financial statements (unaudited)
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Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. Basis of Presentation: These consolidated financial statements contain unaudited information as of March 31, 2012 and for the three month periods ended March 31, 2012 and March 31, 2011. The unaudited interim financial statements have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain disclosures required by accounting principles generally accepted in the United States of America are not included herein. In management’s opinion, these unaudited financial statements include all adjustments necessary for a fair presentation of the information when read in conjunction with the Company’s audited consolidated financial statements and the related notes. The statement of operations data for the three month period ended March 31, 2012 is not necessarily indicative of the results that the Company may achieve for the full year. Amounts in the prior years’ consolidated financial statements are reclassified whenever necessary to conform to the current year’s presentation. 2. Investment Securities: The amortized cost, gross unrealized gains, gross unrealized losses and estimated fair values of investment securities at March 31, 2012 and December 31, 2011 were as follows:
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Table of Contents
As of March 31, 2012, the Company had $1.21 billion (estimated fair value) of mortgage related investment securities which consisted of residential and commercial mortgage-backed securities and collateralized mortgage obligations. Residential mortgage-backed securities and collateralized mortgage obligations include securities collateralized by 1-4 family residential mortgage loans, while commercial mortgage-backed securities include securities collateralized by mortgage loans on multifamily properties. Of the total mortgage related investment securities, $1.20 billion (estimated fair value), or 99.5%, were issued by government sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac, and the remaining $5.2 million were private-label residential mortgage related securities. Other securities of $3.8 million at March 31, 2012 include preferred stock received as part of a loan workout arrangement. Investment securities with an approximate book value of $944.2 million at March 31, 2012 and $930.0 million at December 31, 2011, were pledged to collateralize certain deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (“FHLB”) advances, and for other purposes as required or permitted by law. During the first quarter of 2012, the Company recorded gains of $956,000 on the sales of available for sale investment securities. There were no sales of available for sale investment securities during the first quarter of 2011.
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Table of ContentsThe following table summarizes, for investment securities with unrealized losses as of March 31, 2012 and December 31, 2011, the amount of the unrealized loss and the related fair value. The securities have been further segregated by those that have been in a continuous unrealized loss position for less than twelve months and those that have been in a continuous unrealized loss position for twelve or more months.
At March 31, 2012, the Company had three securities in its investment portfolio that have been in an unrealized loss position for twelve or more months, with a total unrealized loss of $1.0 million. Each of the securities in an unrealized loss position was a private-label residential mortgage-backed security.
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Table of ContentsOf the three private-label residential mortgage related securities that were in an unrealized loss position for more than 12 months, one was in an unrealized loss position of less than 10% of amortized cost. As part of its normal process, the Company reviewed the security, considering the severity and duration of the loss and current credit ratings, and believes that the decline in fair value was not credit related but related to changes in interest rates and current illiquidity in the market for these types of securities. The other two private-label residential mortgage related securities had a total unrealized loss of $927,000, and were subject to further review for other-than-temporary impairment. For any securities that had been in an unrealized loss position that was greater than 10% and for more than 12 months, additional testing is performed to evaluate other-than-temporary impairment. For the two private-label residential mortgage-backed securities, the Company obtained fair value estimates from an independent source and performed a cash flow analysis, considering default rates, loss severities based upon the location of the collateral and estimated prepayments. Each of the private-label mortgage related securities had credit enhancements in the form of different investment tranches which impact how cash flows are distributed. The higher level tranches will receive cash flows first and, as a result, the lower level tranches will absorb the losses, if any, from collateral shortfalls. The Company purchased the private-label securities that were either of the highest or one of the highest investment grades, as rated by nationally recognized credit rating agencies. The cash flow analysis takes into account the Company’s tranche and the current level of support provided by the lower tranches. The Company believes that market illiquidity continues to impact the values of these private-label securities because of the continued lack of active trading. None of these securities contain subprime mortgage loans, but do include Alt-A loans, adjustable rate mortgages with initial interest only periods, and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. If this analysis shows that the Company does not expect to recover its entire investment, an other-than-temporary impairment charge would be recorded for the amount of the credit loss. Previously, the Company had recognized an other-than-temporary impairment loss on one of these two securities. The independent cash flow analysis performed at March 31, 2012 indicated that there was additional credit loss on this security and the Company recorded an additional $125,000 other-than-temporary-impairment charge in the first quarter of 2012. For the other private-label security reviewed, the independent cash flow analysis showed that the Company expects to recover its entire investment and, therefore, the decline in fair value was not due to credit, but was most likely caused by illiquidity in the market, and no other-than-temporary impairment charge was recorded. One additional investment security was evaluated for other-than-temporary impairment at March 31, 2012. This security is in the Company’s state and municipal obligation portfolio and was received in 2008 in a loan work out arrangement. Scheduled payments were received as agreed from 2008 until the May 2011 interest payment, which was not received. Previously, the Company had recognized other-than-temporary impairment loss on this security. The expected future annual cash flows were analyzed as of March 31, 2012 and no additional other-than-temporary impairment was recorded in the first quarter of 2012.
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Table of ContentsThe following table shows the contractual maturities of investment securities, categorized by amortized cost and estimated fair value, at March 31, 2012.
Investment securities do not include the Bank’s investment in Federal Home Loan Bank of Chicago (“FHLBC”) and Federal Reserve Bank (“FRB”) stock of $63.0 million at March 31, 2012 and $56.8 million at December 31, 2011. These investments are required for membership and are carried at cost. The Bank must maintain a specified level of investment in FHLBC stock based upon the amount of outstanding FHLB borrowings. The Company had a $51.4 million investment in FHLBC stock at March 31, 2012 and a $45.1 million investment at December 31, 2011. As of March 31, 2012, the Company believes that it will ultimately recover the par value of the FHLBC stock.
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Table of Contents3. Loans: Loans classified by type at March 31, 2012 and December 31, 2011 were as follows:
The total amount of loans transferred to third parties as loan participations at March 31, 2012 was $248.4 million, all of which has been recognized as a sale under the applicable accounting guidance in effect at the time of the transfers of the financial assets. The Company continues to have involvement with these loans through relationship management and servicing responsibilities. At March 31, 2012, loans held for sale of $210.0 million consisted entirely of residential mortgage loans originated by Cole Taylor Mortgage. The Company has elected to account for these loans under the fair value option in accordance with ASC 825 – Financial Instruments. The unpaid principal balance associated with these loans was $203.9 million at March 31, 2012. An unrealized gain on these loans of $6.1 million was included in mortgage banking revenues in noninterest income on the Consolidated Statements of Operations. None of these loans are 90 days or more past due or on a nonaccrual status. Interest income on these loans is included in net interest income and is not considered part of the change in fair value. Nonperforming loans include nonaccrual loans and interest-accruing loans contractually past due 90 days or more. Loans are placed on a nonaccrual basis for recognition of interest income when sufficient doubt exists as to the full collection of principal and interest. Generally, loans are to be placed on nonaccrual when principal and interest is contractually past due 90 days, unless the loan is adequately secured and in the process of collection.
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Table of ContentsThe following table presents the aging of loans by class at March 31, 2012 and December 31, 2011:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company uses the following definitions for risk ratings: Pass. Loans in this category range from loans that are virtually risk free to those where the borrower has an unstable operating history containing losses or adverse trends have weakened its financial condition that have not currently impacted repayment ability, but may in the future, if not corrected. Special Mention. Loans in this category have potential weaknesses which currently weaken the asset or inadequately protect the Bank’s credit position and if not immediately corrected will diminish repayment prospects. Substandard. Loans in this category relate to borrowers with deteriorating financial conditions and exhibit a number of well-defined weaknesses which currently inhibit normal repayment through normal operations. These loans require constant monitoring and supervision by Bank management. Nonaccrual. Loans in this category exhibit the same weaknesses as substandard however, the weaknesses are more pronounced and the loans are no longer accruing interest.
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Table of ContentsThe following table presents the risk categories of loans by class at March 31, 2012 and December 31, 2011:
Impaired loans include all nonaccrual loans, as well as certain accruing loans judged to have higher risk of noncompliance with the present repayment schedule for both interest and principal. Unless modified in a troubled debt restructuring, certain homogenous loans, such as residential mortgage and consumer loans, are collectively evaluated for impairment and are, therefore, excluded from impaired loans. The Company’s policy is to charge-off a loan when a loss is highly probable and clearly identified. For consumer loans, the Company follows the guidelines issued by its primary regulator which specify the number of days of delinquency to charge off a consumer loan by type of credit. For commercial loans, except for unsecured loans that are generally charged-off when a loan is 90 days past due, the Company does not have a policy to automatically charge-off a commercial loan when it reaches a certain status of delinquency. If a commercial loan is determined to have an impairment, the Company will either establish a specific valuation allowance or, if management deems a loss to be highly probable and clearly identified, reduce the recorded investment in that loan by taking a full or partial charge-off. In making the determination that a loss is highly probable and clearly identified, management evaluates the type, marketability and availability of the collateral along with any credit enhancements supporting the loan. In determining when to fully or partially charge-off a loan, management considers prospects for collection of assets, likely time frame for repayment, solvency status of the borrower, the existence of practical or reasonable collection programs, the existence of shortfalls after attempts to improve collateral position, prospects for near-term improvements in collateral valuations, and other considerations identified in its internal loan review and workout processes.
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Table of ContentsThe following table presents loans individually evaluated for impairment by class of loans as of March 31, 2012 and December 31, 2011:
Credit risks tend to be geographically concentrated in that the majority of the Company’s customer base lies within the Chicago area. Approximately 44% of the Company’s loan portfolio involves loans that are to some degree secured by real estate properties located primarily within the Chicago area as of March 31, 2012, compared to 46% as of December 31, 2011.
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Table of ContentsThe following table presents information regarding changes in the allowance for loan losses and the recorded investment in loans by class and based on impairment method as of March 31, 2012 and March 31, 2011:
A modified loan is considered a troubled-debt restructuring (“TDR”) when the borrower is experiencing documented financial difficulty and concessions are made by the Company that would not otherwise be considered for a borrower with similar credit characteristics at the outset of a new loan. The most common types of modifications include interest rate modifications, forbearance on principal and/or interest, partial charge-offs and changes in note structure. All loans modified in a TDR are evaluated for impairment in accordance with the Company’s allowance for loan loss methodology. For the commercial portfolio, loans modified in a TDR are separately evaluated for impairment at the time of restructuring and at each subsequent reporting date for as long as they are reported as TDRs. The impairment evaluation is generally measured by comparing the recorded investment in the loan to the fair value of the collateral net of estimated costs to sell if the loan is collateral dependent. The Company recognizes a specific valuation allowance equal to the amount of the measured impairment, if applicable. Commercial and consumer loans modified in a TDR are classified as impaired loans for a minimum of one year. After one year, a loan is no longer included in the balance of impaired loans if the loan was modified to yield a market rate for loans of similar credit risk at the time of restructuring and the loan is performing based on the terms of the restructuring agreement, although the loan continues to be reported as a TDR. Nonperforming restructured loans totaled $47.3 million at March 31, 2012 and $33.4 million at December 31, 2011. Performing restructured loans (TDRs that are not past due or in a nonaccrual status) totaled $14.8 million at March 31, 2012 and $14.2 million at December 31, 2011.
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Table of ContentsThe following table provides information on loans modified in a TDR during the quarter ended March 31, 2012. The Pre-Modification Outstanding Recorded Balance is equal to the outstanding balance immediately prior to modification. The Post-Modification Outstanding Balance is equal to the outstanding balance immediately after modification.
The following table provides information on TDRs that defaulted for the first time for the quarter ended March 31, 2012 and had been modified within the last twelve months.
4. Interest-Bearing Deposits: Interest-bearing deposits at March 31, 2012 and December 31, 2011 were as follows:
As of March 31, 2012, time deposits in the amount of $100,000 or more totaled $524.0 million compared to $562.3 million at December 31, 2011. Brokered certificates of deposit (“CDs”) are carried net of mark-to-market adjustments when they are the hedged item in a fair value hedging relationship and net of the related broker placement fees of $1.8 million at March 31, 2012 and $2.0 million at December 31, 2011, which
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Table of Contentsare amortized to the maturity date of the related brokered CDs. The amortization is included in deposit interest expense. As of March 31, 2012, the Company had four brokered CDs with a balance of $60.0 million that could be called after a lock-out period but before their stated maturity. During the first quarter of 2012 and the first quarter of 2011, the Company did not incur any expense associated with brokered CDs that were called before their stated maturity. 5. Borrowings: Short-Term: Short-term borrowings at March 31, 2012 and December 31, 2011 consisted of the following:
Customer repurchase agreements are collateralized financing transactions primarily executed with local Bank customers and with overnight maturities.
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Table of ContentsFHLB short-term advances at March 31, 2012 and December 31, 2011 consisted of the following:
Long-Term: As of March 31, 2012 and December 31, 2011, long-term borrowings consisted of the following:
Term structured repurchase agreements are collateralized financing transactions executed with broker/dealer counterparties with terms longer than overnight. In the first quarter of 2012, a FHLB long-term advance of $17.5 million was terminated. The Company incurred $1.0 million in early extinguishment of debt expense in the first quarter of 2012 related to this termination. This termination was executed to shift funding sources to lower cost alternatives.
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Table of ContentsCollateral: At March 31, 2012, the FHLB advances were collateralized by $893.5 million of investment securities and a blanket lien on $438.8 million of qualified first-mortgage residential, multi-family, home equity and commercial real estate loans. Based on the value of collateral pledged at March 31, 2012, the Bank had additional borrowing capacity at the FHLB of $304.7 million. In comparison, at December 31, 2011, the FHLB advances were collateralized by $782.1 million of investment securities and a blanket lien on $390.8 million of qualified first-mortgage residential and home equity loans with additional borrowing capacity of $277.3 million. The Bank participates in the FRB’s Borrower In Custody (“BIC”) program. At March 31, 2012, the Bank had pledged $618.1 million of commercial loans as collateral for an available $512.5 million of borrowing capacity at the FRB. At March 31, 2012, the Bank had no advances from the FRB. At December 31, 2011, the Bank pledged $569.2 million of commercial loans as collateral for available borrowing capacity of $463.3 million under the BIC program at the FRB, however, there were no advances from the FRB at December 31, 2011. 6. Stockholders’ Equity: On March 26, 2012, the Company and Prairie Capital IV, L.P. and Prairie Capital IV QP, L.P. (together, the “Prairie Funds”) entered into an Exchange Agreement to simplify the Company’s capital structure through the consolidation of all outstanding shares of two series of the Company’s preferred stock into a single newly-created series of preferred stock with substantially identical terms. Pursuant to the Exchange Agreement, the Company agreed to issue to each of the Prairie Funds, and each of the Prairie Funds agreed to acquire from the Company, one share of the Company’s newly-created Nonvoting Convertible Preferred Stock (the “Nonvoting Preferred”) in exchange for each share of the Company’s Nonvoting Convertible Preferred Stock, Series D (the “Series D Preferred”), and Non-Voting Convertible Preferred Stock, Series G (the “Series G Preferred”), held by the Prairie Funds (the “Exchange Transaction”). The Series D Preferred, Series G Preferred and Nonvoting Preferred are each nonvoting common stock equivalents having substantially identical terms as one another. The Company completed the Exchange Transaction on March 29, 2012, through the issuance of a total of 1,282,674 shares of Nonvoting Preferred in exchange for a total of 405,330 shares of Series D Preferred and 877,344 shares of Series G Preferred held by the Prairie Funds. As a result of the Exchange Transaction, no shares of Series D Preferred or Series G Preferred remain outstanding.
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Table of Contents7. Other Comprehensive Income (Loss): The following table presents other comprehensive income (loss) for the periods indicated:
8. Earnings Per Share: Earnings per share are calculated using the two-class method. The calculation of basic earnings per share requires an allocation of earnings to all securities that participate in dividends with common shares, such as unvested restricted stock and preferred participating stock, to the extent that each security may share in the entity’s earnings. Basic earnings per share are calculated by dividing undistributed earnings allocated to common stock by the weighted average number of common shares outstanding. Dilutive earnings per share considers the dilutive effect of all securities that participate in dividends with common shares, as well as common stock equivalents that do not participate in dividends with common stock, such as stock options and warrants to purchase shares of common stock. Dilutive earnings per share are calculated by dividing undistributed earnings allocated to common stockholders by the sum of the weighted average number of common shares outstanding and the weighted average number of common stock equivalents outstanding, provided those common stock equivalents are dilutive. Potentially dilutive common stock equivalents are excluded from the calculation of diluted earnings per share in periods in which the effect would reduce the loss per share or increase the income per share (i.e., when the common stock equivalents are antidilutive.) To the extent there is an undistributed loss for the period, that loss is allocated entirely to the weighted average number of common shares as the participating security holders have no contractual obligation to share in losses. For the three months ended March 31, 2012, common stock equivalents included in the calculation of diluted earnings per share were 78,644 stock options outstanding to purchase shares of common stock and 472,748 warrants to purchase shares of common stock. Weighted-average common stock equivalents that were considered antidilutive and were not included in the calculation of diluted earnings per share at March 31, 2012 were 446,024 stock options outstanding to purchase shares of common stock and 500,000 warrants to purchase shares of common stock.
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Table of ContentsDue to the net loss applicable to common stockholders for the quarter ended March 31, 2011, all common stock equivalents were considered antidilutive and were not included in the computation of basic or diluted earnings per share. At March 31, 2011, actual common stock equivalents consisted of 887,770 stock options outstanding to purchase shares of common stock, 3,800,147 warrants to purchase shares of common stock, convertible Series C preferred stock which could be converted into 2,598,697 shares of common, convertible Series D preferred stock which could be converted into 405,330 shares of common stock, convertible Series E preferred stock which could be converted into 455,049 shares of common stock and convertible Series G preferred stock which could be converted into 220,000 shares of common stock. The following table sets forth the computation of basic and diluted loss per common share for the periods indicated.
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Table of Contents9. Stock-Based Compensation: The Company’s Incentive Compensation Plan (the “Plan”) allows for the granting of stock options and stock awards. Under the Plan, the Company has only issued nonqualified stock options and restricted stock to employees and directors. Stock options, generally, are granted with an exercise price equal to the last reported sales price of the common stock on the Nasdaq Global Select Market on the date of grant. The Company uses the Black-Scholes option-pricing model to determine the fair value of stock options issued to employees and directors. No stock options were granted during the first quarter of 2012. Stock options previously granted vest over a four-year term (vesting 25% per year) and expire eight years following the grant date. Compensation expense associated with stock options is recognized over the vesting period, or until the employee or director becomes retirement eligible if that time period is shorter. The following is a summary of stock option activity for the three month period ended March 31, 2012:
As of March 31, 2012, the total compensation cost related to nonvested stock options that has not yet been recognized totaled $560,000 and the weighted average period over which these costs are expected to be recognized is approximately 1.8 years. Generally, the Company grants restricted stock awards that vest upon completion of future service requirements. However, for certain restricted stock awards granted in 2010, 2011 and 2012, vesting will be dependent on completion of service requirements and the repayment of the Series B preferred stock. The fair value of these awards is equal to the last reported sales price of the Company’s common stock on the date of grant. The Company recognizes stock-based compensation expense for these awards over the vesting period based upon the number of awards ultimately expected to vest.
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Table of ContentsThe following table provides information regarding nonvested restricted stock for the three month period ended March 31, 2012:
As of March 31, 2012, the total compensation cost related to nonvested restricted stock that has not yet been recognized totaled $3.0 million and the weighted average period over which these costs are expected to be recognized is approximately 2.0 years. 10. Derivative Financial Instruments: The Company uses derivative financial instruments to accommodate customer needs and to assist in interest rate risk management. The Company has used interest rate exchange agreements, or swaps, callable interest rate exchange agreements and interest rate corridors, floors and collars to manage the interest rate risk associated with its commercial loan portfolio, brokered CDs, cash flows related to FHLB advances and repurchase agreements and mortgage servicing associated with Cole Taylor Mortgage. The Company also has interest rate lock commitments and forward loan commitments associated with Cole Taylor Mortgage that are considered derivatives. Periodically, the Company will sell options to a bank or dealer for the right to purchase certain securities held within the Bank’s investment portfolios (covered call options).
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Table of ContentsThe following table describes the derivative instruments outstanding at March 31, 2012:
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Table of ContentsAt March 31, 2012, the Company had $106.9 million of notional amount interest rate swap agreements that were designated as fair value hedges against certain brokered CDs. These swaps are used to convert the fixed rate paid on the brokered CDs to a variable rate based upon 3-month LIBOR computed on the notional amount. The fair value of these hedging derivative instruments is reported on the Consolidated Balance Sheets in other assets and the change in fair value of the related hedged brokered CDs is reported as an adjustment to the carrying value of the brokered CDs. Total ineffectiveness on these interest rate swaps was $13,000 and was recorded in other derivative income in noninterest income in the first quarter of 2012. At March 31, 2012, the Company had $60.0 million of notional amount interest rate swap agreements that were designated as fair value hedges against certain callable brokered CDs. These swaps are used to convert the fixed rate paid on the callable brokered CDs to a variable rate based upon 3-month LIBOR computed on the notional amount. The fair value of these hedging derivative instruments is reported on the Consolidated Balance Sheets in other assets and the change in fair value of the related hedged callable brokered CDs is reported as an adjustment to the carrying value of the callable brokered CDs. Total ineffectiveness on these interest rate swaps was $147,000 and was recorded in other derivative income in noninterest income in the first quarter of 2012. At March 31, 2012, the Company also had $155.0 million of notional amount interest rate corridors which were designated as cash flow hedges against certain borrowings. The corridors are used to reduce the variability in the interest paid on the borrowings attributable to changes in 1-month LIBOR. The fair value of these hedging derivative instruments is reported on the Consolidated Balance Sheets in other assets and the change in fair value is recorded in other comprehensive income (“OCI”). There was no ineffectiveness on the interest rate corridors for the quarter ended March 31, 2012. We use derivative financial instruments to accommodate customer needs and to assist in interest rate risk management. At March 31, 2012, $813.0 million of derivative instruments were interest rate exchange agreements related to customer transactions, which are not designated as hedges. As of March 31, 2012, we had notional amounts of $406.5 million of interest rate swaps with customers in which we agreed to receive a fixed interest rate and pay a variable interest rate. In addition, as of March 31, 2012, we had offsetting interest rate swaps with other counterparties with a notional amount of $406.5 million in which we agreed to receive a variable interest rate and pay a fixed interest rate. The Company enters into interest rate swaps as a part of Cole Taylor Mortgage’s servicing business in order to minimize most of the price volatility of the mortgage services rights asset. At March 31, 2012, the Company had a notional amount of $52.5 million of interest rate swaps. These non-hedging derivatives are recorded at their fair value on the Consolidated Balance Sheets in other assets with changes in fair value recorded in noninterest income. The Company enters into interest rate lock and forward loan sale commitments as part of Cole Taylor Mortgage’s origination business. At March 31, 2012, the Company had notional amounts of $580.9 million of interest rate lock commitments and $574.4 million of forward loan sale commitments. These non-hedging derivatives are recorded at their fair value on the Consolidated Balance Sheets in other assets with changes in fair value recorded in noninterest income.
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Table of ContentsThe Company enters into covered call option transactions from time to time that are designed primarily to increase the total return associated with the investment securities portfolio. There were no covered call options outstanding as of March 31, 2012, and there were no premiums related to covered call options recognized in noninterest income in the first quarter 2012. 11. Fair Value Measurement: On January 1, 2010, the Company elected to account for held for sale residential mortgage loans originated by Cole Taylor Mortgage at fair value under the fair value option in accordance with ASC 825 – Financial Instruments. When the Company began to retain mortgage servicing rights (“MSR”) in 2011, an election was made to account for these rights under the fair value option. In addition, any purchased MSRs are accounted for under the fair value option. The Company has not elected the fair value option for any other financial asset or liability. In accordance with FASB ASC 820, the Company groups financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are defined as follows: Level 1 – Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date. Level 2 – Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data. Level 3 – Significant unobservable inputs that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability. The Company used the following methods and significant assumptions to estimate fair values: Available for sale investment securities: For these securities, the Company obtains fair value measurements from an independent pricing service, when available. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current ratings from credit rating agencies and the bond’s terms and conditions, among other things. The fair value measurements are compared to another independent source on a quarterly basis to review for reasonableness. In addition, the Company reviews the third-party valuation methodology on a periodic basis. Any significant differences in valuation are reviewed with members of management who have the relevant technical expertise to assess the results. The Company has determined that these valuations are classified in Level 2 of the fair value hierarchy. When the independent pricing service does not have fair value measurements available for a security, the Company has estimated the fair value based on specific information about each security. The Company has determined that these valuations are classified in Level 3 of the fair value hierarchy.
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Table of ContentsLoans held for sale: Loans held for sale included residential mortgage loans that have been originated by Cole Taylor Mortgage and for which the Company has elected to account for on a recurring basis under the fair value option. In prior periods, the Company had certain residential mortgage loans that it acquired in a bulk purchase transaction and nonaccrual commercial loans classified as held for sale. These loans were recorded at the lower of cost or fair value and were recorded at fair value on a nonrecurring basis. For all residential mortgage loans held for sale, the fair value is based upon quoted market prices for similar assets in active markets and is classified in Level 2 of the fair value hierarchy. Loans: The Company does not record loans at their fair value on a recurring basis, except for $5.6 million of mortgage loans originated by Cole Taylor Mortgage and transferred to the Company’s portfolio. The Company evaluates certain loans for impairment when it is probable the payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Once a loan has been determined to be impaired, it is measured to establish the amount of the impairment, if any, based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, less estimated cost to sell. If the measure of the impaired loan is less than the recorded investment in the loan, a valuation allowance is established. At March 31, 2012 and December 31, 2011, a portion of the Company’s total impaired loans were evaluated based on the fair value of the collateral. Generally, since the majority of our impaired loans are collateral-dependent real estate loans, the fair value is determined by a current appraisal. For impaired loans that are collateral dependent, our practice is to obtain an updated appraisal every nine to 18 months, depending on the nature and type of the collateral and the stability of collateral valuations, as determined by senior members of credit management. OREO and repossessed assets require an updated appraisal at least annually. We have established policies and procedures related to appraisals and maintain a list of approved appraisers who have met specific criteria. In addition, our policy for appraisals on real estate dependent commercial loans generally requires each appraisal to have an independent compliance and technical review by a qualified third party to ensure the consistency and quality of the appraisal and valuation. We discount appraisals for estimated selling costs and, when appropriate, consider the date of the appraisal and stability of the local real estate market when analyzing the estimated fair value of individual impaired loans that are collateral dependent. The individual impairment analysis also takes into account available and reliable borrower guarantees and any cross-collateralization agreements. Certain other loans are collateralized by business assets, such as equipment, inventory, and accounts receivable. The fair value of these loans is based upon estimates of realizability and collectability of the underlying collateral.
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Table of ContentsWhile impaired loans exhibit weaknesses that may inhibit repayment in compliance with the original note terms, the impairment analysis may not result in a related allowance for loan losses for each individual loan. In accordance with fair value measurements, only impaired loans for which an allowance for loan loss has been established based on the fair value of collateral require classification in the fair value hierarchy. As a result, a portion, but not all, of the Company’s impaired loans are classified in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or an estimate of fair value from an independent third-party real estate professional, the Company classifies the impaired loan as nonrecurring Level 2 in the fair value hierarchy. When an independent valuation is not available or there is no observable market price and fair value is based upon management’s assessment of the liquidation value of collateral, the Company classifies the impaired loan as nonrecurring Level 3 in the fair value hierarchy. Assets held in employee deferred compensation plans: Assets held in employee deferred compensation plans are recorded at fair value and included in other assets on the Company’s Consolidated Balance Sheets. The assets associated with these plans are invested in mutual funds and classified as Level 1, as the fair value measurement is based upon available quoted prices. The Company also records a liability included in accrued interest, taxes and other liabilities on its Consolidated Balance Sheets for the amount due to employees related to these plans. Derivatives: The Company has determined that its derivative instrument valuations, except for certain mortgage derivatives, are classified in Level 2 of the fair value hierarchy. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. In accordance with accounting guidance of fair value measurements, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings thresholds, mutual puts, and guarantees. In conjunction with the FASB’s fair value measurement guidance, the Company has elected to account for the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. Mortgage derivatives: Mortgage derivatives include interest rate swaps hedging mortgage servicing rights, interest rate lock commitments to originate held for sale residential mortgage loans for individual customers and forward commitments to sell residential mortgage loans to various investors. The fair value of the interest rate swaps used to hedge MSRs is classified in Level 2 of the hierarchy. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flows of each derivative. This
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Table of Contentsanalysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. In accordance with accounting guidance of fair value measurements, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral posting thresholds, mutual puts and guarantees. The fair value of forward loan sale commitments is based on quoted prices for similar assets in active markets that the Company has the ability to access and is classified in Level 2 of the hierarchy. The Company uses an internal valuation model to estimate the fair value of its interest rate lock commitments which is based on unobservable inputs that reflect management’s assumptions and specific information about each borrower transaction and is classified in Level 3 of the hierarchy. Mortgage servicing rights: The Company records its MSRs at fair value in other assets in the Consolidated Balance Sheets. MSRs do not trade in an active market with readily observable prices. Accordingly, the Company determines the fair value of MSRs by estimating the fair value of the future cash flows associated with the mortgage loans being serviced. Key economic assumptions used in measuring the fair value of MSRs include, but are not limited to, prepayment speeds, discount rates, delinquencies and cost to service. The assumptions used in the model are validated on a regular basis. The fair value is validated on a quarterly basis with an independent third party. Any discrepancies between the internal model and the third party validation are investigated and resolved by an internal committee. Due to the nature of the valuation inputs, MSRs are classified in Level 3 of the fair value hierarchy. Other real estate owned and repossessed assets: The Company does not record other real estate owned (“OREO”) and repossessed assets at their fair value on a recurring basis. At foreclosure or on obtaining possession of the assets, OREO and repossessed assets are recorded at the lower of the amount of the loan balance or the fair value of the collateral, less estimated cost to sell. Generally, the fair value of real estate is determined through the use of a current appraisal and the fair value of other repossessed assets is based upon the estimated net proceeds from the sale or disposition of the underlying collateral. Only assets that are recorded at fair value, less estimated cost to sell, are classified under the fair value hierarchy. When the fair value of the collateral is based upon an observable market price or an estimate of fair value from an independent third-party real estate professional, the Company classifies the OREO and repossessed asset as nonrecurring Level 2 in the fair value hierarchy. When an independent valuation is not available or there is no observable market price and fair value is based upon management’s assessment of liquidation of collateral, the Company classifies the OREO and repossessed assets as nonrecurring Level 3 in the fair value hierarchy.
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Table of ContentsAssets and Liabilities Measured on a Recurring Basis Assets and liabilities measured at fair value on a recurring basis are summarized below. There were no transfers of assets or liabilities measured at fair value on a recurring basis between Level 1 and Level 2 during the three months ending March 31, 2012.
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