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Tower Financial 10-K 2006 Documents found in this filing:UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-K
(Mark
One)
For
the
fiscal year ended December
31, 2005
OR
For
the
transition period from
to
Commission
file number 000-25287
TOWER
FINANCIAL CORPORATION
(Exact
name of registrant as specified in its charter)
Registrant’s
telephone number, including area code: (260)
427-7000
Securities
registered pursuant to Section 12(b) of the Act: NONE
Securities
registered pursuant to Section 12(g) of the Act: COMMON
STOCK, WITHOUT PAR VALUE
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined
in
Rule 405 of the Securities Act.
Yes
¨ No
x
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.
Yes
¨ No
x
Indicate
by check mark whether the registrant (1) has filed all reports required to
be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements
for
the past 90 days.
Yes
x No
¨
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this
Form 10-K. ¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer (See definition of “accelerated
filer or large accelerated filer as defined in Rule 12b-2 of the
Act).
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).
Yes
¨ No
x
Aggregate
market value of the voting and non-voting common stock held by nonaffiliates
of
the registrant based on the last sale price for such stock at June 30, 2005
(assuming solely for the purposes of this calculation that all directors and
executive officers of the registrant are “affiliates”): $59,313,309
Number
of
shares of Common Stock outstanding at February 10, 2006: 4,007,936
The
exhibit index required by Item 601(a) of Regulation S-K is included in Item
15
of Part IV of this Report
Document
Incorporated by Reference
Certain
portions of the Registrant’s definitive Proxy Statement for the 2006 Annual
Meeting of Shareholders are incorporated in Part III of this Report
TOWER
FINANCIAL CORPORATION
Fort
Wayne, Indiana
Annual
Report to Securities and Exchange Commission
December
31, 2005
PART
I
Company
Tower
Financial Corporation, collectively with its subsidiaries, the “Company”, was
incorporated as an Indiana corporation on July 8, 1998. The Company is a holding
company with one bank subsidiary, Tower Bank & Trust (or the “Bank”), a
newly formed (effective January 1, 2006) trust company, Tower Trust Company,
or
the “Trust Company,” and two unconsolidated subsidiary guarantor trusts, Tower
Capital Trust 1 and Tower Capital Trust 2. The Bank is an Indiana chartered
bank
with depository accounts insured by the Federal Deposit Insurance Corporation
(“FDIC”) and is a member of the Federal Reserve System. The Trust Company is an
Indiana Corporation, and Tower Capital Trust 1 and Tower Capital Trust 2 are
unconsolidated, wholly owned Delaware statutory business trusts formed in
November 2001 and December 2005, respectively for the exclusive purpose of
issuing and selling trust preferred securities.
The
Bank
opened on February 19, 1999 and provides a range of commercial and consumer
banking services from six locations in its market area comprised of the
metropolitan area of Fort Wayne and Allen County, Indiana. Those services
reflect the Bank’s strategy of focusing on small- to medium-sized businesses and
individual customers. The Bank’s lending strategy is focused on commercial and
commercial mortgage loans and, to a lesser extent, on consumer and residential
mortgage loans. The Bank offers a broad array of deposit products, including
checking, savings, and money market accounts, certificates of deposit and direct
deposit services. Prior to January 1, 2006, the trust investment and management
services were offered by the Bank and are now offered by Tower Trust
Company.
The
Bank’s and the Trust company’s main offices are located at 116 East Berry Street
in downtown Fort Wayne, Indiana, which also serves as the Company’s corporate
headquarters. The Bank also has four branch locations within its market area
and
a mortgage loan production office in Angola, Indiana. In December 2005, the
Bank
purchased ground on the southwest side of Fort Wayne and began construction
on a
fifth branch. The new branch is scheduled to be open for business in the summer
of 2006.
Forward-Looking
Statements
This
report includes "forward-looking statements." All statements regarding the
Company's anticipated results or expectations, including its business plan
and
strategies are intended to be forward-looking statements within the meaning
of
the safe harbor provisions for forward-looking statements contained in the
Private Securities Litigation Reform Act of 1995. Typically, forward looking
statements are predictive and are not statements of historical fact and the
words "anticipates," "believes," "estimates," "seeks," "expects," "plans,"
"intends," and similar expressions, as they relate to the Company, the Bank
or
its management, are intended to identify forward-looking statements. Although
the Company believes that the expectations reflected in these forward-looking
statements are reasonable and have based these expectations on its beliefs
as
well as assumptions it has made, these expectations may prove to be incorrect.
Important factors that could cause actual results to differ materially from
the
Company's expectations include, without limitation, the following:
· the
Company’s dependence on key banking and management personnel;
· the
risk
of losses due to loan defaults by larger commercial loan customers or a
significant number of borrowers;
· the
Company’s dependence on a favorable local economy in the Bank’s primary service
area;
· the
effect of banking regulation on the Bank’s ability to grow and
compete;
1
· the
effect of changes in federal economic and monetary policies and local
competition on the Bank’s ability to attract deposits, make loans and achieve
satisfactory interest spreads;
· general
changes in economic conditions, including interest rates and real estate values;
and
· restrictions
imposed on the Company by regulators or regulations of the banking
industry.
Readers
are also directed to the “Risk Factors” section of this report for additional
other risks and uncertainties.
Lending
Activities
Lending
The
Bank
makes loans to individuals and businesses located within its market area. The
Bank’s loan portfolio at December 31, 2005 consisted of commercial and
commercial real estate loans (78.7%), residential mortgage loans (11.2%) and
personal loans (10.1%). The Bank’s legal lending limit under applicable federal
banking regulations is approximately $8.3 million, based on the legal lending
limit of 15% of total risk based capital of the Bank.
Commercial
Loans.
The
Bank's lending activities focus primarily on providing small- and medium-sized
businesses in its market area with commercial loans. These loans are both
secured and unsecured and are made available for general operating purposes,
including acquisition of fixed assets such as real estate, equipment and
machinery, and lines of credit collateralized by inventory and accounts
receivable. Typically, the Bank's customers' financing requirements range from
$100,000 to $4.0 million. Approximately 41.1% of the Bank's commercial loans
are
commercial real estate loans secured by a first lien on the commercial real
estate. The majority of commercial loans that are not mortgage loans are secured
by a lien on equipment, inventory and/or other assets of the commercial
borrower. Commercial loans may also be further secured by junior liens on real
estate. The Bank's commercial loans have both fixed and floating interest rates
and typically have maturities of 1 to 5 years. Commercial and commercial real
estate loans comprised approximately 78.7% of the Bank's total loan portfolio
at
December 31, 2005.
Commercial
real estate lending involves more risk than residential lending because loan
balances are greater and repayment is dependent upon the borrower’s operations.
The Bank endeavors to reduce the risk associated with these transactions by
generally limiting its exposure to owner-operated properties of customers with
an established profitable history. In many cases, the Bank may further reduce
this risk by (i) limiting the amount of credit to any one borrower to an amount
less than the Bank’s legal lending limit and (ii) avoiding certain types of
commercial real estate financing.
Mortgage
Banking.
The
Bank provides both fixed and variable rate, long-term residential mortgage
loans
to its customers. The Bank's general policy, which is subject to review by
management as a result of changing market and economic conditions and other
factors, is to retain a portion of fixed rate balloon maturity mortgage loans
in
its loan portfolio and to sell or broker the balance of long-term, fixed rate
and variable rate loans in the secondary market. In late 2003, the Bank made
a
decision to no longer sell residential mortgage loans on the secondary market.
Loans are either retained in the Bank’s loan portfolio or direct brokered for a
another lending institution in which the loan is written on the other
institutions paper and the Company serves as sales agent only. The Bank does
not
retain servicing rights with respect to any of the residential mortgage loans
that it brokers or sells. During 2005, the Bank originated $12.4 million of
residential mortgage loans, of which all were retained, and none were sold
in
the secondary market. The Bank brokered $19.3 million of residential mortgage
loans during 2005. The following table reflects residential real estate mortgage
loans originated, sold and retained or brokered for the periods indicated.
2
Personal
Loans and Lines of Credit.
The
Bank makes personal loans and lines of credit available to consumers for various
purposes, such as the purchase of automobiles, boats and other recreational
vehicles, and to make home improvements and personal investments. The majority
of the Bank's personal loans are home equity loans and are secured by a second
lien on real estate. The Bank retains all of such loans in its loan portfolio.
Consumer
loans generally have shorter terms and higher interest rates than residential
mortgage loans and, except for home equity lines of credit, usually involve
more
credit risk than mortgage loans because of the type and nature of the
collateral. Consumer lending collections are dependent on a borrower’s
continuing financial stability and are thus likely to be adversely affected
by
job loss, illness and personal bankruptcy. In many cases, repossessed collateral
for a defaulted consumer loan will not provide an adequate source of repayment
of the outstanding loan balance because of depreciation of the underlying
collateral. The Bank strives to pursue a policy of conservative loan
underwriting, with an emphasis on the amount of the down payment, credit
quality, employment stability, and monthly income. These loans are generally
repaid on a monthly repayment schedule with the payment amount tied to the
borrower’s periodic income. The Bank believes that the generally higher yields
earned on consumer loans help to compensate for the increased credit risk
associated with such loans and that consumer loans are important to its efforts
to serve the credit needs of its customer base.
Lending
Policies
Loan
Policies.
Although the Bank takes a progressive and competitive approach to lending,
it
strives for high quality in its loans. Because of the Bank’s local nature,
management believes that quality control is achieved while still providing
prompt and personal service. The Bank is subject to written loan policies that
contain general lending guidelines and are subject to periodic review and
revision by the Bank’s Loan and Investment Committee and its Board of Directors.
These policies relate to loan administration, documentation, approval and
reporting requirements for various types of loans.
The
Bank’s loan policies include procedures for oversight and monitoring of the
Bank’s lending practices and loan portfolio. The Bank seeks to make sound loans,
while recognizing that lending money involves a degree of business risk. The
Bank’s loan policies are designed to assist in managing the business risk
involved in making loans. These policies provide a general framework for the
Bank’s loan operations, while recognizing that not all loan activities and
procedures can be anticipated. The Bank’s loan policies instruct lending
personnel to use care and prudent decision-making and to seek the guidance
of
the President or Chief Executive Officer of the Bank where
appropriate.
The
Bank’s loan policies provide guidelines for loan-to-value ratios that limit the
size of certain types of loans to a maximum percentage of the value of the
collateral securing the loans, which percentage varies by the type of
collateral. The Federal Deposit Insurance Corporation Improvement Act of 1991
establishes regulatory and supervisory loan-to-value limits. The Bank’s internal
loan-to-value limitations follow those limits and, in certain cases, are more
restrictive than those required by regulators.
The
Bank’s loan policies also establish an “in-house” limit on the aggregate amount
of loans to any one borrower. This limit is a guideline that currently does
not
exceed 75% of the Bank’s legal lending limit. This internal limit is subject to
review and revision by the Board of Directors from time to time. In addition,
the Bank’s loan policies provide guidelines for (i) personal guarantees, (ii)
loans to employees, executive officers and directors, (iii) problem loan
identification, (iv) maintenance of an allowance for loan losses and (v) other
matters relating to the Bank’s lending practices.
3
Loan
Review Policies.
To
ensure that lending practices adhere to loan policies and guidelines, and to
ensure that loans are risk rated correctly, the Bank established a Loan Review
Department. The primary activities of the Loan Review Department include
(i) conducting reviews of specific loans, (ii) assessing the adequacy
of loan ratings assigned by lending personnel, (iii) monitoring portfolio
concentrations, and (iv) monitoring loans subject to Regulation O. To
complete these activities, the Bank employs several management tools, primarily
a loan grading system, a loan review memorandum and a formalized watch
list.
Source
of Funds
Funding
Sources.
During
2004 the Company contributed $5 million to the Bank as capital to support the
Bank’s balance sheet growth. During 2003 and 2005, no contributions were made.
On an ongoing basis, the Bank funds its operations and loan growth primarily
with local deposits. Secondarily, the Bank uses alternative funding sources
as
needed, including advances from the Federal Home Loan Bank, out-of-market
deposits (including national market CDs and brokered CDs) and other forms of
wholesale financing.
Deposit
Generation.
The
Bank generates deposits primarily through offering a broad array of deposit
products to individuals, businesses, associations, financial institutions,
and
government entities in its primary market area. The Bank generally seeks a
comprehensive banking relationship from its lending customers, which has
contributed to its internal deposit growth. This often includes encouraging
new
customers to consider both business and personal checking accounts and other
deposit services. The Bank's deposit services include checking, savings, and
money market accounts, certificates of deposit, direct deposit services, and
telephone and Internet banking. The Bank also offers a courier service for
the
deposit convenience of its business customers as well as wholesale lockbox
and
other business deposit and cash management services. The Bank also generates
certificates of deposit through national, out-of-market sources developed during
2003, 2004, and 2005. These deposits include brokered deposits, which the Bank
began accepting during 2003. Prior to 2004, these out-of-market deposits were
generated by direct negotiation with out-of-market banks and credit unions
and
through negotiated transactions with brokers. Currently, the out-of-market
deposits are generated through negotiated transactions with brokers. As the
out-of-market deposits typically come in the form of Certificates of Deposits,
the interest expense associated with these deposits is normally higher than
interest paid on in-market deposits. In 2005, the average cost of funds on
out-of-market deposits was 3.32%, while the average cost of funds on in-market
deposits was 1.88%. At December 31, 2005, approximately 76.1% of the Bank’s
deposits were generated in-market, while 23.9% were out-of-market deposits.
Deposits at December 31, 2005, 2004 and 2003 are summarized as follows:
4
Investments
Funds
retained by the Company from time to time may be invested in various debt
instruments, including but not limited to obligations guaranteed by the United
States, general obligations of a state or political subdivision thereof,
bankers’ acceptance of deposit of United States commercial banks, or commercial
paper of United States issuers rated in the highest category by a nationally
recognized statistical rating organization. Although the Company is permitted
to
make limited portfolio investments in equity securities and to make equity
investments in subsidiary corporations engaged in certain non-banking activities
(which may include real estate-related activities such as mortgage banking,
community development, real estate appraisals, arranging equity financing for
commercial real estate, and owning or operating real estate used substantially
by the Bank or acquired for future use), the Bank at this time only has a
$20,000 investment in an economic development venture capital limited
partnership focusing on businesses located in Northeast Indiana, which was
recorded in other assets. The Company has plans to make an equity investment
of
$1 million in a limited partnership focused on financial related companies,
primarily bank holding companies. This will also be recorded in other
assets.
The
Bank
may invest its funds in a wide variety of debt instruments and may participate
in the federal funds market with other depository institutions. Real estate
acquired by the Bank in satisfaction of, or foreclosure upon, loans may be
held
by the Bank for no longer than 10 years after the date of acquisition without
the written consent of the Indiana Department of Financial Institutions (the
“Department”). The Bank is also permitted to invest an aggregate amount not in
excess of 50% of the “sound capital” of the Bank in such real estate and
buildings as are necessary for the convenient transaction of its business.
The
Bank’s Board of Directors may alter the Bank’s investment policy without
shareholders’ approval.
Trust
and Investment Management
New
Company: On
January 1, 2006, the Company formed a separate wholly owned subsidiary, Tower
Trust Company. The trust and investment management functions previously managed
by the Bank will thereafter be the responsibility of the new Trust Company.
The
description below is for services performed during 2005 and prior, which were
part of the Bank’s operations.
Investment
Management and Trust Services.
The
Bank's investment management and trust services (or “Trust Services”) department
offers a wide range of traditional personal trust services to customers in
its
market area. The Bank's Trust Services include estate planning and money
management. The Bank’s Trust Services products and services include traditional
revocable trusts, irrevocable trusts, charitable trusts, estate administration,
guardianship administration, IRA administration, personal and institutional
investment management, and custodial services. The Bank believes that by
offering Trust Services through personalized client service, an experienced
professional staff, and a tailored approach to investments that it can enhance
and leverage client relationships. The Bank believes that its approach to
investment management and trust services has contributed to growth in assets
under management to $438 million at December 31, 2005. More importantly, the
Bank believes that this approach should allow for continued growth in assets
under management and Trust Services revenues.
The
following table reflects assets under management and revenue of the Bank's
Trust
Services department for the periods indicated.
5
Tower
Investment Services:
In July
of 2004, the Bank began offering securities and insurance brokerage services
under the private label name of Tower Investment Services, through PrimeVest
Financial Services, Inc., an ING company. Tower Investment Services offers
the
Bank’s clients comprehensive brokerage capabilities. PrimeVest is a
self-clearing broker dealer that works exclusively with banks and financial
institutions. Tower Investment Services had $41.6 million in assets under
management at December 31, 2005, compared to $18.7 million at December 31,
2004.
The
following table reflects assets under management and revenues of the Bank’s
Investment Services department for the periods indicated.
Effect
of Government Monetary Policies
The
earnings of the Company and the Bank are affected by domestic economic
conditions and the monetary and fiscal policies of the United States government,
its agencies and the Federal Reserve Board. The Federal Reserve Board’s monetary
policies have had, and will continue to have, an important impact on the
operating results of commercial banks through its power to implement national
monetary policy in order to, among other things, curb inflation and avoid a
recession. The instruments of monetary policy employed by the Federal Reserve
Board include open market operations in United States government securities,
changes in the discount rate on member bank borrowing and changes in reserve
requirements against deposits held by all federally insured banks. In view
of
changing conditions in the national economy and in the money markets, as well
as
the effect of actions by monetary fiscal authorities including the Federal
Reserve Board, no prediction can be made as to possible future changes in
interest rates, deposit levels, loan demand or the business and earnings of
the
Bank.
Regulation
and Supervision
General.
Financial institutions and their holding companies are extensively regulated
under federal and state law. Consequently, the growth and earnings performance
of the Company and the Bank can be affected not only by management decisions
and
general economic conditions, but also by the statutes administered by, and
the
regulations and policies of, various governmental regulatory authorities. Those
authorities include but are not limited to the Federal Reserve Board, the FDIC,
the Department, the Internal Revenue Service and the state taxing authorities.
The effect of such statutes, regulations and policies can be significant and
cannot be predicted with any high degree of certainty. Federal and state laws
and regulations generally applicable to the Company and the Bank regulate among
other things:
The
system of supervision and regulation applicable to the Company and the Bank
establishes a comprehensive framework for their respective operations and is
intended primarily for the protection of the FDIC’s deposit insurance funds, the
depositors of the Bank and the public, rather than shareholders of the Company.
Any change in government regulation may have a material adverse effect on the
business of the Company and the Bank.
6
Bank
Holding Compay Regulation,
As
a bank
holding company, the Company is subject to regulation by the Federal Reserve
Board under the Federal Bank Holding Company Act of 1956, as amended (or the
“BHCA”). Under the BHCA, the Company is subject to examination by the Federal
Reserve Board and is required to file reports of its operations and such
additional information as the Federal Reserve Board may require. Under Federal
Reserve Board policy, the Company is expected to act as a source of financial
strength to the Bank and to commit resources to support the Bank in
circumstances where the Company might not do so absent such policy.
Any
loans
by a bank holding company to a subsidiary bank are subordinate in right of
payment to deposits and to certain other indebtedness of such subsidiary bank.
In the event of a bank holding company’s bankruptcy, any commitment by the bank
holding company to a federal bank regulatory agency to maintain the capital
of a
subsidiary bank will be assumed by the bankruptcy trustee and entitled to a
priority of payment.
With
certain limited exceptions, the BHCA prohibits bank holding companies from
acquiring direct or indirect ownership or control of voting shares or assets
of
any company other than a bank, unless the company involved is engaged in one
or
more activities which the Federal Reserve Board has determined to be so closely
related to banking or managing or controlling banks as to be incidental to
these
operations. Under current Federal Reserve Board regulations, including the
Company’s qualification as a financial holding company as described in the
following paragraph,, such permissible non-bank activities include such things
as mortgage banking, equipment leasing, securities brokerage, and consumer
and
commercial finance company operations. As a result of recent amendments to
the
BHCA, many of these acquisitions may be effected by bank holding companies
that
satisfy certain statutory criteria concerning management, capitalization, and
regulatory compliance, if written notice is given to the Federal Reserve within
10 business days after the transaction. In certain cases, prior written notice
to the Federal Reserve Board will be required.
The
Federal Reserve Board uses capital adequacy guidelines in its examination and
regulation of bank holding companies. If capital falls below minimum guidelines,
a bank holding company may, among other things, be denied approval to acquire
or
establish banks or non-bank businesses. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Capital
Sources."
Under
the
Gramm-Leach-Bliley Act (or "Gramm-Leach") which was signed into law on November
12, 1999 and authorizes bank holding companies that meet specified conditions
to
elect to become "financial holding companies" and thereby engage in a broader
array of financial activities than previously permitted. Such activities include
selling and underwriting insurance (including annuities), underwriting and
dealing in securities, and merchant banking. Gramm-Leach also authorizes banks
to engage through "financial subsidiaries" in certain of the activities
permitted for financial holding companies. Although the Company is registered
and qualified as a financial holding company, the Company has no current plans
to pursue any of the expanded activities available to financial holding
companies under Gramm-Leach.
Gramm-Leach
contains provisions intended to safeguard consumer financial information in
the
hands of financial service providers by, among other things, requiring these
entities to disclose their privacy policies to their customers and allowing
customers to "opt out" of having their financial service providers disclose
their confidential financial information to non-affiliated third parties,
subject to certain exceptions. Final regulations implementing the new financial
privacy regulations became effective during 2001. Similar to most other
consumer-oriented laws, the regulations contain some specific prohibitions
and
require timely disclosure of certain information. The Company was notified
by
its regulatory agency that it was in violation of certain aspects of Gramm-Leach
requirements during 2005. However, the Company was addressing these
violations during the regulatory exam, and since the exam to rectify any
significant issues. The violations did not result in any adverse consequences
to
the Company on this exam by the regulatory agencies, and the Company believes
it
is currently in substantial compliance with the requirements.
Bank
Regulation
The
Bank.
The Bank
is an Indiana banking corporation and a member of the Federal Reserve System.
As
a state-chartered member bank, the Bank is subject to the examination,
supervision, reporting and enforcement jurisdiction of the Department, as the
chartering authority for Indiana banks, and the Federal Reserve Board as the
primary federal bank regulatory agency for state-chartered member banks. The
Bank’s deposit accounts are insured by the Bank Insurance Fund of the FDIC,
which also has jurisdiction over Bank Insurance Fund insured banks. These
agencies, and federal and state law, extensively regulate various aspects of
the
banking business including, among other things:
7
Federal
law and regulations, including provisions added by the Federal Deposit Insurance
Corporation Improvement Act of 1991 (or “FDICIA”) and regulations promulgated
thereunder, establish supervisory standards applicable to the lending activities
of the Bank, including internal controls, credit underwriting, loan
documentation, and loan-to-value ratios for loans secured by real
property.
The
Bank
is subject to certain federal and state statutory and regulatory restrictions
on
any extension of credit to the Company or its subsidiaries, on investments
in
the stock or other securities of the Company or its subsidiaries, and on the
acceptance of the stock or other securities of the Company or its subsidiaries
as collateral for loans to any person. Limitations and reporting requirements
are also placed on extensions of credit by the Bank to its directors and
officers, to directors and officers of the Company and its subsidiaries, to
principal shareholders of the Company, and to “related interests” of such
persons. In addition, such legislation and regulations may affect the terms
upon
which any person becoming a director or officer of the Company or one of its
subsidiaries or a principal shareholder of the Company may obtain credit from
banks with which the Company maintains a correspondent relationship. Also,
in
certain circumstances, an Indiana banking corporation may be required by order
of the Department to increase its capital or reduce the amount of its
deposits.
The
federal banking agencies have published guidelines implementing the FDICIA
requirement that the federal banking agencies establish operational and
managerial standards to promote the safety and soundness of federally insured
depository institutions. The guidelines establish standards for internal
controls, information systems, internal audit systems, loan documentation,
credit underwriting, interest rate exposure, asset growth, and compensation,
fees and benefits. In general, the guidelines prescribe the goals to be achieved
in each area, and each institution is responsible for establishing its own
procedures to achieve those goals. If an institution fails to comply with any
of
the standards set forth in the guidelines, the institution’s primary federal
bank regulator may require the institution to submit a plan for achieving and
maintaining compliance. The preamble to the guidelines states that the agencies
expect to require a compliance plan from an institution whose failure to meet
one or more of the standards is of such severity that it could threaten the
safe
and sound operation of the institution. Failure to submit an acceptable
compliance plan, or failure to adhere to a compliance plan that has been
accepted by the appropriate regulator, would constitute grounds for further
enforcement action.
Insurance
of Deposit Accounts.
Under
FDICIA, as an FDIC-insured institution, the Bank is required to pay deposit
insurance premiums based on the risk it poses to Bank Insurance Fund. The FDIC
also has authority to raise or lower assessment rates on insured deposits to
achieve the statutorily required reserve ratios in insurance funds and to impose
special additional assessments. Each depository institution is assigned to
one
of three capital groups: "well capitalized," "adequately capitalized" or
"undercapitalized." An institution is considered well capitalized if it has
a
total risk-based capital ratio of 10% or greater, has a Tier 1 risk-based
capital ratio of 6% of greater, has a leverage ratio of 5% or greater and is
not
subject to any order or written directive to meet and maintain a specific
capital level. An "adequately capitalized" institution has a total risk-based
capital ratio of 8% or greater, has a Tier 1 risk-based capital ratio of 4%
or
greater, has a leverage ratio of 4% or greater and does not meet the definition
of a well capitalized bank. An institution is considered "undercapitalized"
if
it does not meet the definition of "well capitalized" or "adequately
capitalized." Within each capital group, institutions are assigned to one of
three supervisory subgroups: "A" (institutions with few minor weaknesses),
"B"
(institutions that demonstrate weaknesses which, if not corrected, could result
in significant deterioration of the institution and increased risk of loss
to
the insurance funds), and "C" (institutions that pose a substantial probability
of loss to the insurance funds unless effective corrective action is taken).
There are nine combinations of capital groups and supervisory subgroups to
which
varying assessment rates may apply. A bank's assessment rate depends on the
capital category and supervisory category to which it is assigned.
8
Consumer
and Other Laws
The
Bank’s business includes making a variety of types of loans to individuals. In
making these loans, the Bank is subject to state usury and regulatory laws
and
to various federal statutes, such as the Equal Credit Opportunity Act, the
Fair
Credit Reporting Act, the Truth in Lending Act, the Real Estate Settlement
Procedures Act and the Home Mortgage Disclosure Act, and the regulations
promulgated thereunder, which prohibit discrimination, specify disclosures
to be
made to borrowers regarding credit and settlement costs and regulate the
mortgage loan servicing activities of the Bank, including the maintenance and
operation of escrow accounts and the transfer of mortgage loan servicing. The
Riegle Act imposed new escrow requirements on depository and non-depository
mortgage lenders and services under the National Flood Insurance Program. In
receiving deposits, the Bank is subject to extensive regulation under state
and
federal law and regulations, including the Truth in Savings Act, the Expedited
Funds Availability Act, the Bank Secrecy Act, the Electronic Funds Transfer
Act,
and the Federal Deposit Insurance Act. Violation of these laws could result
in
the imposition of significant damages and fines upon the Bank, its directors
and
officers.
Under
the
Community Reinvestment Act (or “CRA”) and the implementing regulations, the Bank
has a continuing and affirmative obligation to help meet the credit needs of
its
local community, including low- and moderate-income neighborhoods, consistent
with the safe and sound operation of the institution. The CRA requires the
board
of directors of financial institutions, such as the Bank, to adopt a CRA
statement for each assessment area that, among other things, describes its
efforts to help meet community credit needs and the specific types of credit
that the institution is willing to extend. The Bank’s service area is designated
as all of Allen County, Indiana. The Bank’s offices are located in Allen County.
The Bank’s Board of Directors is required to review the appropriateness of this
delineation at least annually. The CRA also requires that all financial
institutions publicly disclose their CRA ratings. The Bank received a
"satisfactory" rating on its most recent CRA performance
evaluation.
USA
Patriot Act of 2001
On
October 6, 2001, the "Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot)
Act
of 2001" was enacted. The statute increased the power of the United States
Government to obtain access to information and to investigate a full array
of
criminal activities. In the area of money laundering activities, the statute
added terrorism, terrorism support, and foreign corruption to the definition
of
money laundering offenses and increased the civil and criminal penalties for
money laundering; applied certain anti-money laundering measures to United
States bank accounts used by foreign persons; prohibited financial institutions
from establishing, maintaining, administering or managing a correspondent
account with a foreign shell bank; provided for certain forfeitures of funds
deposited in United States interbank accounts by foreign banks; provided the
Secretary of the Treasury with regulatory authority to ensure that certain
types
of bank accounts are not used to hide the identity of customers transferring
funds and to impose additional reporting requirements with respect to money
laundering activities; and included other measures. On October 28, 2002,
the Department of Treasury issued a final rule concerning compliance by covered
United States financial institutions with the new statutory anti-money
laundering requirement regarding correspondent accounts established or
maintained for foreign banking institutions, including the requirement that
financial institutions take reasonable steps to ensure that correspondent
accounts provided to foreign banks are not being used to indirectly provide
banking services to foreign shell banks. The Company believes that compliance
with the new requirements has not had a material adverse impact on its
operations or financial condition.
Sarbanes-Oxley
Act of 2002
The
passage of the Sarbanes-Oxley Act of 2002 and subsequent actions of the
Securities and Exchange Commission and stock exchanges have had a significant
impact on the Company's corporate governance and related matters. In June 2003,
the Securities and Exchange Commission adopted final rules under
Section 404 of the Sarbanes-Oxley Act of 2002. Commencing with its 2007
Annual Report on Form 10-K, the Company will be required to include a
report of management on the Company's internal control over financial reporting.
The internal control report must include a statement of management's
responsibility for establishing and maintaining adequate control over financial
reporting as of year-end; of the framework used by management to evaluate the
effectiveness of the Company's internal control over financial reporting; and
that the Company's independent accounting firm has issued an attestation report
on management's assessment of the Company's internal control over financial
reporting, which report is also required to be filed as part of the Annual
Report.
9
Competition
All
phases of the business of the Bank are highly competitive. The Bank competes
with numerous financial institutions, including other commercial banks in the
greater Fort Wayne and Allen County metropolitan area. The Bank, along with
other commercial banks, competes with respect to its lending activities and
competes in attracting demand deposits. The Bank faces competition from thrift
institutions, credit unions and other banks as well as finance companies,
insurance companies, mortgage companies, securities brokerage firms, money
market funds, trust companies and other providers of financial services. Many
of
the Bank’s competitors have been in business for many years more than the Bank,
have established customer bases, and are larger and have larger lending limits
than the Bank. The Bank competes for loans principally through its ability
to
communicate effectively with its customers and understand and meet their needs.
The Bank offers personal attention, professional service, off-site ATM
capability and competitive interest rates. Management believes that its personal
service philosophy enhances the Bank’s ability to compete favorably in
attracting individuals and small- to medium-sized businesses.
Employees
As
of
December 31, 2005, the Company had 158 employees, including 150 full-time
equivalents. None of the Company’s employees is covered by a collective
bargaining agreement. Management believes that its relationship with the
Company’s employees is good.
Statistical
Disclosure
The
statistical disclosure concerning the Company and the Bank, on a consolidated
basis, is included in Item 7 of this report.
Available
Information
The
Company's annual reports on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are
available or may be accessed free of charge on the Securities and Exchange
Commissions website under the symbol “TOFC,” at www.sec.gov,
as well
as through the TOFC Investor Relations section of the Company's Internet website
at www.tofc.net.
The
following corporate governance documents are also available through the TOFC
Investor Relations section of the Company's Internet website or may be obtained
in print form by written request addressed to Secretary, Tower Financial
Corporation, 116 East Berry Street, Fort Wayne, Indiana 46802: Code of Business
Conduct and Ethics (the "Code"), Audit Committee Charter, Compensation Committee
Charter, and Nominating and Corporate Governance Committee Charter. The Company
intends to post any amendments to the foregoing documents on its website and
will report any waivers of the Code for directors and executive officers on
a
Current Report on Form 8-K.
Risks
Associated with Tower Financial Corporation
We
have relatively high amounts of commercial, commercial real estate and
development loans, and these loans have more credit risk than residential
mortgage loans.
We
generally invest a greater proportion of our assets in loans secured by business
assets and commercial real estate than financial institutions that invest a
greater proportion of their assets in loans secured by single-family residences.
Commercial real estate, commercial business and development loans generally
involve a higher degree of credit risk than residential mortgage lending, due
primarily to the relatively larger amounts loaned to individual borrowers.
Moreover, many of our borrowers also have more than one commercial real estate,
commercial business or development loan outstanding with us. Consequently,
an
adverse development with respect to one loan or one credit relationship could
expose us to a significantly greater risk of loss and could have a material
adverse impact on our business and results.
Changes
in market interest rates could adversely affect our financial condition and
results of operations.
10
Our
financial condition and results of operations are significantly affected by
changes in market interest rates. Our results of operations depend substantially
on our net interest income, which is the difference between the interest income
that we earn on our interest-earning assets and the interest expense that we
may
pay on our interest-bearing liabilities. Our interest-bearing assets generally
reprice or mature more quickly than our interest-earning liabilities. Prior
to
June 30, 2004, interest rates had been at historically low levels.
Subsequent to that date, the U.S. Federal Reserve has increased its target
federal funds rate from 1.00% to 4.25%.
In
a
rising interest rate environment, our net interest margin can be adversely
impacted to the extent of our fixed rate loans that do not reprice
(approximately 30% as of 12/31/05), while rates paid on non-term deposit
accounts will rise, thus decreasing our margin. Additionally, deposit customers
may move funds from savings accounts to higher rate certificate of deposit
accounts.
In
a
falling interest rate environment, however, our net interest margin could be
negatively affected, as competitive pressures might keep us from further
reducing rates on our deposits. Such movements, therefore, could cause a
decrease in our interest rate spread and net interest margin.
We
are
also subject to reinvestment risk associated with changes in interest rates.
Changes in interest rates may affect the average life of loans and
mortgage-related securities. Decreases in interest rates often result in
increased prepayments of loans and mortgage-related securities, as borrowers
refinance their loans to reduce borrowing costs. Under these circumstances,
we
are subject to reinvestment risk to the extent that we are unable to reinvest
the cash received from such prepayments in loans or other investments that
have
interest rates that are comparable to the interest on our existing loans and
securities. Additionally, increases in interest rates may decrease loan demand
and/or may make it more difficult for borrowers to repay adjustable rate
loans.
Changes
in interest rates also affect the value of our interest earning assets and,
in
particular, our securities portfolio held for investment. Generally, the value
of securities fluctuates inversely with changes in interest rates. Decreases
in
the fair value of securities available for sale, therefore, could have an
adverse effect on stockholders’ equity.
Our
loan growth has historically outpaced our ability to generate lower cost
in-market deposits, and this has required us to find alternative funding
sources, which has adversely affected our net interest margin.
Our
loan
growth has historically outpaced our ability to fund that loan growth with
in-market deposits, and accordingly, we have been required to go to alternative
funding sources, such as out-of-market deposits; (typically certificates of
deposit) purchased from brokers, borrowings from the Federal Home Loan Bank,
and/or from the issuance of Trust Preferred Securities. Our average cost of
in-market deposits for 2005 was 2.6% and the average cost of alternative funds
was 3.6%. Accordingly, our interest margins are adversely affected to the extent
that we must access such alternative funding sources.
Technological
advances may adversely impact Tower Financial Corporation’s business.
The
banking industry is undergoing technological changes with frequent introductions
of new technology-driven products and services. In addition to improving
customer services, the effective use of technology increases efficiency and
enables financial institutions to reduce costs. Tower Financial Corporation’s
future success will depend, in part, on its ability to address the needs of
its
customers by using technology to provide products and services that will satisfy
customer demands for convenience as well as to create additional efficiencies
in
its operations. Many of its competitors have substantially greater resources
than Tower Financial Corporation does to invest in technological improvements.
Tower Financial Corporation may not be able to effectively implement new
technology-driven products and services or successfully market such products
and
services to its customers.
A
breach of information security could adversely affect our
earnings.
Increasingly,
we depend upon data processing, communication and information exchange on a
variety of computing platforms and networks, and over the internet. We cannot
be
certain that all of our systems are entirely free from vulnerability to attack,
despite safeguards we have instituted. In addition, we rely on the services
of a
variety of vendors to meet our data processing and communication needs. If
information security is breached, information can be lost or misappropriated,
resulting in financial lost or costs to us or damages to others. These costs
or
losses could materially exceed the amount of insurance coverage, if any, which
could adversely affect our earnings.
11
Strong
competition within the Bank’s market area could hurt our profits and slow
growth.
Competition
in the banking and financial services industry, both in making loans and in
attracting deposits, is intense, and our profitability depends upon our
continued ability to successfully compete. We compete in Allen County, Indiana,
our primary market area, with numerous commercial banks, savings and loan
associations, credit unions, finance companies, mutual funds, insurance
companies, and brokerage and investment banking firms. Many of these competitors
have substantially greater resources and lending limits than we do and may
offer
certain services that we do not or cannot provide.
Price
competition for loans and deposits might result in the Bank earning less on
loans and paying more for deposits, which would reduce net interest income
and
aversely affect our results. Competition also may make it more difficult to
attract deposits and, consequently, to grow loans.
Our
continuing concentration of loans in our primary Allen County, Indiana market
area may increase our risk.
Our
success depends primarily on the general economic condition within the
metropolitan Fort Wayne and Allen County, Indiana market area in which we
conduct our business. Unlike large banks that are more geographically
diversified, we provide banking and financial services to customers primarily
in
our market area. Local economic conditions in our market area therefore have
a
significant impact on our loans, the ability of the borrowers to repay these
loans, and the value of the collateral securing these loans. A significant
decline in general economic conditions caused by the loss of manufacturing
and
other jobs, unemployment or other factors beyond our control, which affects
local economic conditions, could adversely affect our financial condition and
results of operations. Additionally, because we have a significant amount of
commercial real estate development and construction loans, decreases in housing
demand brought about by a loss of jobs, an increase in homes available for
sale
on the market and a reduction in demand for new housing may also have a negative
affect on the ability of some of our borrowers to make timely repayment of
their
loans, which could have an adverse impact on our earnings.
We
operate in a highly regulated environment and we may be adversely affected
by
changes in laws and regulations.
We
are
subject to extensive regulation, supervision and examination by the Indiana
Department of Financial Institutions, our chartering authority, by the Federal
Deposit Insurance Corporation, as insurer of our deposits, and by the Board
of
Governors of the Federal Reserve System, as regulator of our Bank and holding
company. Such regulation and supervision governs the activities in which a
banking institution and its holding company may engage, and are intended
primarily for the protection of the insurance fund and depositors. Regulatory
authorities have extensive discretion in their supervisory and enforcement
activities, including the imposition of restrictions on our operations, the
classification of our assets and determination of the level of our allowance
for
loan losses. Any change in such regulation and oversight, whether in the form
of
regulatory policy, regulations, legislation or supervisory action, may have
a
material impact on our operations.
We
are subject to heightened regulatory scrutiny with respect to Bank Secrecy
and
Anti-Money Laundering statutes and regulations.
Recently,
regulators have intensified their focus on the USA Patriot Act’s Anti-Money
Laundering and Bank Secrecy Act compliance requirements. There is also increased
scrutiny of our compliance with the rules enforced by the Office of Foreign
Assets Control. In order to comply with regulations, guidelines and examination
procedures in this area, we are required to adopt new policies and procedures
and to install new systems. We cannot be certain that the policies, procedures
and systems we have in place or may in the future put in place are or will
be
flawless. Therefore, there is no assurance that in every instance we are and
will be in full compliance with these requirements.
Shares
eligible for public sale could adversely affect our stock
price.
12
The
future sale of a substantial number of our shares of common stock in the public
market, or the perception that such sales could occur, could adversely affect
our stock price, which, in turn, could also make it more difficult for us to
raise funds through future equity offerings or to use our common stock in
acquisitions. As of December 31, 2005, we had 4,007,936 shares of common
stock outstanding, with an average daily trading volume for the four weeks
prior
to December 31 of 6,478 shares. As of December 31, 2005, our officers
and directors held options to purchase 184,607 shares of our common stock,
at
exercise prices considerably below current market values, which the majority
of
expire and, therefore, must either be exercised or forfeited between December
2008 and January 2009. If a substantial number of these shares, or shares held
by institutional or other large investors, are sold within a short period of
time, the number of shares offered for sale on the market, in relation to our
normal trading volumes, may result in a supply and demand imbalance, which
could
have a material adverse affect on our stock price.
Tower
Financial Corporation depends heavily on its key banking and management
personnel.
Tower
Financial Corporation’s success depends in part on its ability to attract and
retain key executives and to attract and retain qualified and productive banking
officers, who have experience both in sophisticated banking matters and in
operating small to mid-size banks. These qualities are essential both for
effective executive management and also for the growth and expansion of the
Bank’s customer base for loans and deposits. Competition for such personnel is
strong in the local banking industry, and we compete with many other banks
and
financial institutions, some of them with financial resources and benefits
greater than ours, for such individuals. In this market environment, we may
not
be successful in attracting or retaining the personnel we require for future
growth. Tower Financial Corporation expects to effectively compete in this
area
by offering financial packages that include incentive-based compensation and
the
opportunity to join in the rewarding work of building a growing
bank.
Not
applicable.
The
Company is leasing the entire first and second floors, along with a portion
of
the fifth floor, of the Lincoln Tower, a landmark building located at 116 East
Berry Street in downtown Fort Wayne, Indiana, for use as its headquarters and
the Bank’s main office. The headquarters facility consists of drive-up banking
windows and approximately 33,400 square feet of usable office space. The lease
had an initial term of 10 years, with one renewal option for an additional
10
years. During 2001, the original lease term was extended to 15 years with an
expiration date of December 2013 and the same renewal option as prior to the
extension. In March 2004 the Company signed an additional amendment to the
lease
to occupy an additional 8,336 square feet of space on the first floor at rates
similar to the original lease. The amendment also contains a right of first
refusal to buy the entire building in the event the landlord wishes to sell
the
property. In May 2005, the Company signed a one-year lease for 2,099 square
feet
on space ofn the fifth floor. This lease expires in May 2006, however the
Company is anticipating signing an amendment to add this space to the original
lease under the same terms and conditions of the original lease.
The
Bank
leases a bank branch office location in the northwest section of Fort Wayne
at
1545 W. Dupont Road. The branch office occupies 2,600 square feet of space
and
has two drive-up lanes. The lease had an initial term of five years, expired
May
2005 and has two consecutive five-year renewal options. During 2005, the Bank
exercised the first of its two five-year renewal options. The renewed lease
expires in May 2010. The Bank also leases a bank branch office location in
the
southwest section of Fort Wayne at 10373 Illinois Road. The branch office
occupies 2,400 square feet and has two drive-up lanes. The lease has an initial
term of 10 years, expires January 2011 and has two consecutive five-year renewal
options. The Bank leases 600 square feet of office space in Angola, Indiana
for
use as a mortgage loan production office. The office space is leased on a
month-to-month basis.
The
bank
was leasing a branch office located in the south side of Fort Wayne in the
Waynedale area. The branch occupies 2,600 square feet of space and has two
drive-up lanes. The lease began January 2004 and had a term of 10 years. In
July
2005, the Bank exercised its right to purchase the property and now owns the
branch outright, along with .33 acres of land.
13
The
Bank
owns a bank branch on 1.4 acres of land in northeast Fort Wayne at 4303 Lahmeyer
Road. This branch office contains 3,000 square feet of space and has two
drive-up lanes.
In
November 2005, the Bank purchased 0.7 acres of land at 6430 West Jefferson
Blvd
in Southwest Fort Wayne. Construction began in December 2005 on a 3,000 square
foot branch. The branch is expected to open in early summer of
2006.
The
Bank
may be involved from time to time in various routine legal proceedings
incidental to its business. Neither the Company nor the Bank is engaged in
any
legal proceeding that is expected to have a material adverse effect on the
results of operations or financial position of the Company or the
Bank.
None.
PART
II
SECURITIES.
Market
Information
The
Company’s common stock is traded on the Nasdaq National Market System under the
symbol “TOFC.” As of February 10, 2006, there were 612 shareholders of record
and approximately 2,084 beneficial owners of the common stock.
The
following table also presents the high and low sales prices for the common
stock
on the Nasdaq National Market System by quarter for 2005 and 2004.
High/Low
Stock Price
14
Dividends
The
Company has not paid cash dividends on its common stock from its inception
through Calendar 2005. In December 2005, the Company’s board of directors has
approved the payment of dividends commencing in calendar 2006. This was based
on
an analysis of the Company’s liquidity needs, regulatory and capital
requirements, and results of operations. In January 2006, the Company’s board of
directors formally approved the payment of a dividend of $0.04/share commencing
in the first quarter 2006.
Because
the Company is a holding company and substantially all of its assets were held
by the Bank at the end of calendar year 2005 the Company’s primary source for
dividends is the Bank, and payments and extensions of credit to the Company
from
the Bank are subject to legal and regulatory limitations, generally based on
capital levels and profits, imposed by law and regulatory agencies with
authority over the Bank. The ability of the Bank to pay dividends is also
subject to its profitability, financial condition, capital expenditures and
other cash flow requirements. In addition, under the terms of the debentures
issued in connection with certain trust preferred securities due in 2031 and
2036, the Company would be precluded from paying dividends on its common stock
(other than dividends in the form of additional shares of common stock) if
it is
in default under these debentures, if it exercised its right to defer payments
of interest on these debentures, or if certain related defaults occurred. As
part of the regulatory process, the Trust Company may also only pay dividends
to
the Company with regulatory approval through calendar 2008. Therefore, the
Company's ability to pay dividends to its shareholders will depend primarily
on
the Bank's ability to pay dividends to the Company.
15
Consolidated
Summary of Operations and Selected Statistical Data
n/a
- not applicable
16
Introduction
The
following discussion presents management’s discussion and analysis of the
consolidated financial condition and results of operations of the Company as
of
December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004
and
2003. This discussion should be read in conjunction with the Company’s audited
consolidated financial statements and the related notes appearing elsewhere
in
this report. Dollar figures in the following tables and discussion are shown
and
referred to in thousands, except for share data.
Forward-Looking
Statements
This
report includes "forward-looking statements." All statements regarding the
Company's anticipated results or expectations, including its business plan
and
strategies are intended to be forward-looking statements within the meaning
of
the safe harbor provisions for forward-looking statements contained in the
Private Securities Litigation Reform Act of 1995. Typically, forward looking
statements are predictive and are not statements of historical fact and the
words "anticipates," "believes," "estimates," "seeks," "expects," "plans,"
"intends," and similar expressions, as they relate to the Company, the Bank
or
its management, are intended to identify forward-looking statements. Although
the Company believes that the expectations reflected in these forward-looking
statements are reasonable and have based these expectations on its beliefs
as
well as assumptions it has made, these expectations may prove to be incorrect.
Important factors that could cause actual results to differ materially from
the
Company's expectations include, without limitation, the following:
· the
Company’s dependence on key banking and management personnel;
· the
risk
of losses due to loan defaults by larger commercial loan customers or a
significant number of borrowers;
· the
Company’s dependence on a favorable local economy in the Bank’s primary service
area;
· the
effect of banking regulation on the Bank’s ability to grow and
compete;
· the
effect of changes in federal economic and monetary policies and local
competition on the Bank’s ability to attract deposits, make loans and achieve
satisfactory interest spreads;
· general
changes in economic conditions, including interest rates and real estate values;
and
· restrictions
imposed on the Company by regulators or regulations of the banking
industry.
Readers
are also directed to the “Risk Factors” section of this report for additional
other risks and uncertainties.
17
Critical
Accounting Policies
The
discussion and analysis of the Company's financial condition and results of
operations are based upon its consolidated financial statements, which have
been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
the Company to make estimates and judgments that affect the reported amount
of
assets and liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities at the date of its financial statements.
Actual results may differ from these estimates under different assumptions
or
conditions. Certain policies inherently have a greater reliance on the use
of
estimates, and as such have a greater possibility of producing results that
could be materially different than originally reported. Critical accounting
policies are defined as those that are reflective of significant judgments
and
uncertainties, and potentially result in materially different results under
different assumptions and conditions. Management believes that its critical
accounting policies are limited to those described below. For a detailed
discussion on the application of these and other accounting policies, see Note
1
-- Summary of Significant Accounting Policies to the audited consolidated
financial statements included in this report.
Allowance
for Loan Losses.
The
Company’s allowance for loan losses represents management’s estimate of probable
incurred losses inherent in the loan portfolio at the balance sheet date.
Additions to the allowance may result from recording provision for loan losses
and recoveries, while charge offs are deducted from the allowance. Allocation
of
the allowance is made for analytical purposes only, and the entire allowance
is
available to absorb any loan charged off.
The
Company has an established process for determining the adequacy of the allowance
for loan losses that relies on various procedures and pieces of information
to
arrive at a range of probable outcomes. No single statistic or measurement,
in
itself, determines the adequacy of the allowance. The allowance has two
components: identified specific allocations and a percentage allocation based
on
loss history for different loan groups.
To
determine the allocated component of the allowance, the Company combines
estimated allowances required for specifically identified loans that are
analyzed individually and loans that are analyzed on a group basis. First,
management allocates specific portions of the allowance for loan losses based
on
identifiable problem loans. Problem loans are identified through a loan risk
rating system and monitored through watchlist reporting. Specific allocations
of
allowance for loan losses are determined for each identified credit based on
delinquency rates, collateral and other risk factors identified for that credit.
Second, management’s evaluation of the allowance for different loan groups is
based on consideration of actual loss experience, the present and prospective
financial condition of borrowers, industry concentrations within the loan
portfolio and general economic conditions, and absent the availability of some
of those factors, based upon peer industry data of comparable banks. Lastly,
the
unallocated component of the allowance is maintained to supplement the allocated
component and to recognize the imprecision of estimating and measuring loss
when
evaluating loss allocations for individual loans or pools of loans. The
allocated and the unallocated components represent the total allowance for
loan
losses that would adequately cover losses inherent in the loan portfolio.
The
determination of the level of allowance and, correspondingly, the provision
for
loan losses, rests upon estimates and assumptions, including past loan loss
experience, the nature and volume of the portfolio, information about specific
borrower situations and estimated collateral values, economic conditions and
other factors. Loan losses are charged against the allowance when management
believes the uncollectibility of a loan is confirmed. A loan is impaired when
full payment under the loan terms is not expected. Impairment is evaluated
in
the aggregate for smaller-balance loans of a similar nature such as residential
mortgage and consumer loans, and on an individual loan basis for other loans.
Commercial loans and mortgage loans secured by other properties are evaluated
individually for impairment. When analysis of a borrower's operating results
and
financial condition indicates that underlying cash flows of the borrower's
business are not adequate to meet its debt service requirements, the loan is
evaluated for impairment. If a loan is impaired, a portion of the allowance
is
allocated so that the loan is reported, net, at the present value of estimated
future cash flows using the loan's existing interest rate or at the fair value
of collateral if repayment is expected solely from the collateral.
There
are
many factors affecting the allowance for loan losses; some are quantitative
while others require qualitative judgment. Although management believes its
process for determining the allowance adequately considers all of the potential
factors that could potentially result in credit losses, the process includes
subjective elements and may be susceptible to significant change. To the extent
actual outcomes differ from management estimates, additional provision for
loan
losses could be required that could adversely affect earnings or financial
position in future periods.
18
Financial
Condition
The
Company experienced significant growth during 2005. Total assets of the Company
were $557,821 at December 31, 2005 compared to $481,117 at December 31, 2004,
an
increase of $76,704 or 15.9%. The significant increase in assets was mainly
attributable to growth in the loan portfolio and was funded by a significant
growth in deposits and FHLB advances. Asset growth has been substantial during
each year since the Bank began operations. Management anticipates that, in
the
near-term, assets will increase at a rate similar to the Bank's historical
trends as management continues to market its institution, products and banking
expertise, deliver a high level of customer service and develop its branch
network.
Earning
Assets.
The
Company’s loan portfolio experienced another year of significant growth during
2005. Loans were $450,391 at December 31, 2005 compared to $400,510 at December
31, 2004, an increase of $49,881, or 12.5%. The loan portfolio, which equaled
85.3% and 86.3% of earning assets at December 31, 2005 and 2004, respectively,
was primarily comprised of commercial and commercial real estate loans at both
dates. At December 31, 2005, commercial and commercial real estate loans were
approximately 78.7% of the loan portfolio and represented loans to business
interests generally located within the Bank’s market area. Approximately 46.4%
of the loan portfolio at December 31, 2005 consisted of general commercial
and
industrial loans primarily secured by inventory, receivables and equipment,
while 32.3% of the loan portfolio consisted of commercial loans primarily
secured by real estate. The largest concentrations of credit within the
commercial category are represented by owner-occupied and investment real estate
at $217,217 or 48.2% of total loans, and building, development and general
contracting at $73.7 million, or 16.4% of total loans. The concentration and
growth in commercial credits is in keeping with the Bank’s strategy of focusing
a substantial amount of efforts on commercial banking. Business banking is
an
area of expertise for the Bank’s management and lending team. Residential
mortgage and home equity lending, while only 17.9% of loans at December 31,
2005, also experienced significant growth. Consumer loans, while only 3.4%
of
total loans at December 31, 2005, reflected an increase of 25.7% during 2005
from 2004 levels. Management believes that loan growth should continue as the
Bank expands its distribution network during 2006; however, the Company’s main
strategy for growth and profitability is expected to come largely from the
commercial loan sector. The following table presents loans outstanding as of
December 31, 2005, 2004, 2003, 2002 and 2001.
Loans
Outstanding
The
following table presents the maturity of total loans outstanding as of December
31, 2005, according to scheduled repayments of principal and also based upon
repricing opportunities.
19
Maturities
of Loans Outstanding
The
Bank’s credit policies establish guidelines to manage credit risk and asset
quality. These guidelines include loan review and early identification of
problem loans to provide effective loan portfolio administration. The credit
policies and procedures are meant to minimize the risk and uncertainties
inherent in lending. In following these policies and procedures, the Bank must
rely on estimates, appraisals and evaluation of loans and the possibility that
changes could occur because of changing economic conditions. Identified problem
loans, which exhibit characteristics (financial or otherwise) that could cause
the loans to become nonperforming or require restructuring in the future, are
included on an internal “watchlist.” Senior management reviews this list
regularly and adjusts for changing conditions. At December 31, 2005, there
were
$33,723 of potential problem loans outstanding classified on the watchlist.
At
December 31, 2004, there were $29,591 of potential problem loans outstanding
classified on the watchlist.
Nonperforming
loans at December 31, 2005 were $2,196, including $1,332 of loans placed on
nonaccrual status and categorized as impaired, one $744 loan past due 90 days
and still accruing but categorized as impaired, and $120 of loans past due
90
days and still accruing which are not categorized as impaired. Total impaired
loans are $5,579, which includes all nonaccrual loans plus commercial loans
deemed impaired with a balance of $4,247 that are still accruing but
restructured. Gross interest for 2005 for nonaccrual loans would have been
$203.
Interest actually received on nonaccrual loans was $39 resulting in lost
interest to date of $164. Nonperforming loans at December 31, 2004 were $2,257,
including $1,580 of loans placed on nonaccrual status and categorized as
impaired and $677 of loans past due 90 days and still accruing which are not
categorized as impaired. Total impaired loans are $5,095, which includes all
nonaccrual loans plus commercial loans impaired of $3,515 that are still
accruing but restructured. Gross interest for 2004 for nonaccrual loans would
have been $147. Interest actually received on nonaccrual loans was $43 resulting
in lost interest to date of $104. Nonperforming loans at December 31, 2003
were
$1,905, including $1,615 of loans placed on nonaccrual status and categorized
as
impaired and $290 of loans past due 90 days and still accruing which are not
categorized as impaired. Gross interest for 2003 for nonaccrual loans would
have
been $102. Total impaired loans are $2,156, which includes all nonaccrual loans
plus commercial loans impaired of $541 that are still accruing but
restructured.
During
2005, the Bank experienced $2,355 in net charged-off loans compared to $2,011
of
net charge-offs in 2004 and $1,671 in 2003. The 2005 ratio of net charge-offs
to
total average loans was 0.55%. Of the loans charged off in 2005, $500 was
attributable to one commercial credit. Of the loans charged off during 2004,
$1,000 was attributable to one commercial credit. Of the loans charged off
during 2003, $600 was attributable to the unauthorized mortgage activity loss
and $563 was attributable to one commercial credit, which was identified during
the year and restructured at year-end.
In
each
quarter, the allowance for loan losses is adjusted by management to the amount
management believes is necessary to maintain the allowance at adequate levels.
Management allocates specific portions of the allowance for loan losses to
specifically identified problem loans. Management’s evaluation of the allowance
is further based on consideration of actual loss experience, the present and
prospective financial condition of borrowers, industry concentrations within
the
portfolio and general economic conditions. Management believes that the present
allowance is adequate, based on the broad range of considerations listed above,
and further, based upon peer industry data of comparable banks.
20
The
following table illustrates the breakdown of the allowance for loan losses
by
loan type.
Allocation
of the Allowance for Loan Losses
($
in
thousands)
See
Note
3 to the Consolidated Financial Statements for detail of activity in allowance
for loan losses
The
primary risk element considered by management with respect to each installment
and residential real estate loan is lack of timely payment. Management has
a
reporting system that monitors past due loans and has adopted policies to pursue
its creditor’s rights in order to preserve the Bank’s position. The primary risk
elements with respect to commercial loans are the financial condition of the
borrower, the sufficiency of collateral, and lack of timely payment. Management
has a policy of requesting and reviewing periodic financial statements from
its
commercial loan customers, and periodically reviews the sufficiency of
collateral and its value.
Although
management considers the allowance for loan losses to be adequate to absorb
losses that are incurred, there can be no assurance that charge-offs in future
periods will not exceed the allowance. Additionally, banking regulators can
require an increase to the allowance for loan losses if they deem necessary
to
satisfy regulatory safety and soundness concerns. The Company experienced $2,483
of charge-offs and $128 of recoveries during 2005. The Company experienced
$2,057 of charge-offs and $46 of recoveries during 2004 and $1,705 of
charge-offs and $34 of recoveries during 2003. Prior to 2003, the Company only
experienced an aggregate amount of $505 in loan charge-offs during its first
four years of operations.
Securities
available for sale at fair value increased during 2005, and totaled $50,642
at
December 31, 2005 compared to $35,025 at December 31, 2004 and $24,325 at
December 31, 2003. The Company maintains a modest securities portfolio to
provide for secondary liquidity and for interest rate risk management. During
both 2005 and 2004, the Company again expanded the size and length of maturity
of the portfolio as it continued to develop a more diversified portfolio. The
portfolio will continue to include some short-term liquid holdings from time
to
time as loan demand remains strong and more liquidity is needed. Since the
inception of the Company, all securities have been designated as “available for
sale” as defined in Statement of Financial Accounting Standards (“SFAS”) No.115
Accounting
for Certain Investments in Debt and Equity Securities.
Securities designated as available for sale are stated at fair value, with
the
unrealized gains and losses, net of income tax, reported as a separate component
of stockholders’ equity. A net unrealized loss on this portfolio was recorded at
December 31, 2005 in the amount of $(340) compared to a net unrealized gain
in
the amount of $34 at December 2004, and a net unrealized gain of $42 at December
31, 2003. There were no interest-bearing deposits with other banks at December
31, 2005, 2004, or 2003. The table above presents the total securities portfolio
as of December 31, 2005, 2004 and 2003. During 2005, the Company sold $2,999
of
available for sale agency securities and recorded a $(34) loss from the sales.
During 2004, the Company sold $6,507 of available for sale agency securities
and
recorded a $154 gain from the sales. During 2003, the Company sold $3,175 of
available for sale agency securities and recorded a $191 gain from the
sales.
21
Federal
funds sold, consisting of excess funds sold overnight to correspondent banks,
and short-term investments and interest-bearing deposits, consisting of
certificates of deposit with maturities less than 90 days and interest-bearing
accounts at correspondent banks, are used to manage daily liquidity needs and
interest rate sensitivity. Together, these short-term assets, which recorded
a
decrease of $1,732 during 2005, were $23,582 and $25,314 at December 31, 2005
and 2004, respectively. At December 31, 2005 and 2004, these short-term assets
were approximately 4.1% and 5.5% of earning assets, respectively.
Source
of Funds
The
Bank’s major source of funds is from core deposits of local businesses,
governmental and municipal public fund entities, and consumers within the market
area. The Bank also generates certificates of deposit through national
out-of-market sources (outside Allen and surrounding counties) developed during
2004 and 2005. The out-of-market deposits are generated through negotiated
transaction with brokers. Total deposits were $460,951 at December 31, 2005
and
$386,380 at December 31, 2004, an increase of $74,571, or 19.3%.
Noninterest-bearing
deposits totaled $66,743 at December 31, 2005, a 15.5% increase from $57,800
at
December 31, 2004. At December 31, 2005, noninterest-bearing deposits were
approximately 14.5% of total deposits, a decrease from the 2004 level of 15.0%.
Noninterest-bearing deposits at December 31, 2005 were comprised of $62,016
in
business checking accounts, $645 in public funds and $4,082 in consumer
accounts.
Interest-bearing
deposits grew during 2005 and were $394,208 at December 31, 2005, a 20.0%
increase over $328,580 at December 31, 2004. Interest-bearing deposits at
December 31, 2005 were comprised of approximately 19.4% in money market
accounts, 11.9% in interest-bearing checking and savings accounts, and 68.7%
in
certificates of deposit. The December 31, 2005 percentages reflect a modest
change in the deposit mix from 2004, when the percentages were 22.5%, 12.4%,
and
65.1%, respectively. In 2005, all deposit categories reflected balance increases
over 2004 levels with the exception of certificates of deposits less than $100.
The most significant increase from 2004 was in of certificates of deposit over
$100. CDs under $100 decreased by $4,660 from 2004 year-end levels and CDs
$100
and over increased by $61,824. The balance of money market accounts at December
31, 2005 was $76,438 compared to $74,018 at December 31, 2004, an increase
of
$2,420. While total interest-bearing deposits increased $65,629 from 2004,
mainly a result of new accounts established in the business and consumer
sectors, the shift in interest-bearing deposits from money markets to CDs was
reflective of the low interest rate environment as customers from all segments
sought better returns. The total of interest-bearing deposits at December 31,
2005 reflected $189,332 in business accounts, $181,719 in consumer accounts
and
$23,157 in public fund accounts compared to $158,158, $133,724 and $36,698,
respectively, at December 31, 2004. As of December 31, 2005, the Company had
$206,444 in certificates of deposit of $100 or more, of which $57,887 mature
within three months; $49,549 mature over three months through twelve months;
and
$ 99,008 mature over twelve months.
Short-term
borrowings at December 31, 2005 were $0, a decrease from $200 at December 31,
2004. The balance at December 31, 2004 was entirely comprised of overnight
federal funds purchased from one correspondent bank. This borrowing was paid
off
in full during the first quarter of 2005. In addition to federal funds
purchased, the Company also had borrowings in the amount of $34,700 in Federal
Home Loan Bank (“FHLB”) callable and bullet advances at December 31, 2005
compared to $45,000 at December 31, 2004. The decrease of $10,300 in FHLB
borrowings from the 2004 levels was a result of the Company’s efforts to
diversify its funding base and desire to lock in funding costs. The FHLB bullet
advances mature in various years from March 2006 to June 2010. There was $2,500
in FHLB callable advances outstanding at December 31, 2005. The callable advance
matures in 2011, and contains a quarterly call feature.
22
The
Company had $11,856 and $3,608 aggregate principal amount in junior subordinated
debenture outstanding at December 31, 2005 and 2004, respectively. The Company’s
has two statutory trust subsidiaries. TCT1 sold a private placement offering
of
$3,500 in Trust Preferred Securities on November 16, 2001. TCT2 sold a private
placement offering of $8,000 in Trust Preferred Securities on December 5, 2005.
The proceeds were loaned to the Company in exchange for junior subordinated
debentures with similar terms to the Trust Preferred Securities. These
securities are considered Tier I capital (with certain limitations applicable)
under current regulatory guidelines.
The
junior subordinated debentures are subject to mandatory redemption, in whole
or
in part, upon repayment of the Trust Preferred Securities at maturity or their
earlier redemption at the par amount. The maturity date of the Trust Preferred
Securities issued by TCT1 is November 15, 2031. Subject to the Company having
received prior approval of the Federal Reserve Bank, if then required, the
Trust
Preferred Securities are redeemable prior to the maturity date beginning
November 15, 2006 and each year thereafter at the option of the Company. The
Company anticipates redeeming these securities on November 15, 2006. The
maturity date of the Trust Preferred Securities issued by TCT2 is December
4,
2035. Subject to the Company having received prior approval of the Federal
Reserve Bank, if then required, the Trust Preferred Securities are redeemable
prior to the maturity date beginning December 4, 2010 and each year thereafter
at the option of the Company.
Stockholders’
equity was $47,268 at December 31, 2005 and $44,013 at December 31, 2004. The
increase of $3,255 was mainly attributable to 2005 net income of $3,439 and
$54
from the net exercise of stock options. The only other item affecting
stockholders’ equity was a $(238) change in net unrealized
appreciation/(depreciation) on securities available for sale, net of tax. At
December 31, 2005, the Company had a balance of $9,479 in retained earnings
while at December 31, 2004 the balance was $6,040, an increase of $3,439 from
2004 due to net income generated during 2005. See “Results of
Operations.”
Results
of Operations
Summary.
The
Company reported net income of $3,439, or $.84 per diluted share, for the year
ended December 31, 2005. This reflects an increase in net income from $2,479
in
2004 and net income of $1,800 posted during 2003. Net income per diluted share
reflects a $0.23 increase from the $.61 reported in 2004 and a $.39 increase
from the $.45 posted in 2003.
The
2005
results reflected a 38.7% growth in net income compared to 2004. The improvement
in net income over 2005 was mainly the result of substantial revenue growth
due
to loan volume growth along with increases in interest rates. Net interest
income in 2005 was $17,563 compared to $14,316 in 2004, an increase of $3,247
due mainly from an increase in loans outstanding and the increase in interest
rates. Noninterest income in 2005 was $4,183 compared to $4,274 in 2004, a
decrease of $91. The decrease was due primarily an $860 insurance settlement
received during the fourth quarter 2004. Taking the insurance settlement into
consideration, all noninterest income categories increased during 2005 except
for loan broker fees which decreased by $62. Loan broker fees decreased due
to a
conscious decision by the Company to keep more residential loans in its own
portfolio versus brokering them for a third party. Loan production volume was
virtually the same as in 2004. Offsetting the improvements in revenue during
2005 was a slight $32 increase from 2004 in the provision for loan losses and
a
$1,682 increase in noninterest expenses related mainly to infrastructure growth
costs for compensation, occupancy and equipment. Loan and professional expenses
decreased by $459 during 2005 due primarily to the settlement and payment of
administrative expenses relating to the insurance settlement activity during
2004.
The
asset
growth of the Company is expected to result in an increased level of net
interest income, which, coupled with noninterest income, is expected to exceed
the growth and level of noninterest expense and provision for loan losses.
Net
Interest Income. Net
interest income, the difference between revenue generated from earning assets
and the interest cost of funding those assets, is the Company’s primary source
of earnings. Interest income and interest expense for the year ended December
31, 2005 were $29,056 and $11,493, respectively, netting $17,563 in net interest
income. Interest income and interest expense for the year ended December 31,
2004 were $20,965 and $6,649, respectively, resulting in $14,316 in net interest
income. Interest income and interest expense for the year ended December 31,
2003 totaled $17,826 and $6,060, respectively, providing for net interest income
of $11,765. The substantial increase of $3,247 in net interest income in 2005
from 2004 and the increase over net interest income from 2003 were primarily
attributable to an increase in the loans outstanding in both years, as well
as
an increase in the prime-lending rate during 2004 and 2005.
23
The
net
yield on average earning assets during 2005 was 3.70% compared to 3.31% for
2004
and 3.04% for 2003. The increase in margin during 2005 was attributable to
net
interest spread expansion caused by the increase in general interest rates
and
its effects on the Company’s mostly variable rate mix of loans. Management
anticipates that margins will continue to slightly improve due to the Company’s
current asset-sensitive balance sheet, assuming interest rates increase. The
Company is also planning to increase its percentage of fixed rate loans and
shorten the term of any out of market deposits and borrowings during 2006 to
help offset any potential negative effects of interest rate
decreases.
The
level
of net interest income is primarily a function of asset size, as the
weighted-average interest rate received on earning assets is greater than the
weighted average interest cost of funding sources; however, factors such as
types of assets and liabilities, interest rate risk, liquidity, and customer
behavior also impact net interest income as well as the net yield.
The
following table reflects the average balance, interest earned or paid, and
yields or costs of the Company’s assets, liabilities and stockholders’ equity
during 2005, 2004 and 2003.
24
(1)
Computed on a tax equivalent basis for tax equivalent securities using a 34%
statutory tax rate.
The
following table shows the changes in interest income, interest expense, and
net
interest income due to variances in rate and volume of average earning assets
and interest-bearing liabilities. The change in interest not solely due to
changes in rate or volume has been allocated in proportion to the absolute
dollar amounts of the change in each.
25
Changes
in Net Interest Income Due
To
Rate and Volume
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