ITEM 1. BUSINESS
Unless the context indicates otherwise, all references in this Form 10-K to “Citizens” or the “Corporation,” refer to Citizens Republic Bancorp, Inc. and its subsidiaries. References to the “Holding Company” refer to Citizens Republic Bancorp, Inc. alone. Citizens’ common stock is traded on the NASDAQ (“NASDAQ”) Capital Market® under the symbol “CRBC.” Citizens’ principal executive offices are located at 328 South Saginaw Street, Flint, Michigan 48502, and the telephone number is (810) 766-7500. Citizens maintains an internet website at www.citizensbanking.com where the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available without charge, as soon as reasonably practicable after Citizens files each such report with, or furnishes it to, the U.S. Securities and Exchange Commission (the “SEC”), which are also available at the SEC’s website www.sec.gov. The information on Citizens’ website does not constitute a part of this report. Investors may also contact Investor Relations at the corporate address listed above to receive copies of these reports without charge.
GENERAL
Citizens Republic Bancorp, Inc., incorporated in the State of Michigan in 1980 with roots dating back to 1871, is a diversified banking and financial services company that is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”). Citizens provides a full range of banking and financial services to individuals and businesses through its banking subsidiary, Citizens Bank (the “Bank”). These services include deposit products, loan products, and other consumer-oriented financial services such as safe deposit and night depository facilities, and Automated Teller Machines (“ATMs”). Among the services designed specifically to meet the needs of businesses are various types of specialized financing, treasury management services, and transfer/collection facilities. Citizens also provides wealth management services through Citizens Bank Wealth Management, N.A. (“CB Wealth Management”). The Corporation is not dependent upon any single or limited number of customers, the loss of which would have a material adverse effect on the Corporation. No material portion of the business is seasonal.
RECENT DEVELOPMENTS
On January 19, 2011, Citizens received a notice from The NASDAQ Stock Market stating that the minimum bid price of Citizens’ common stock continued to be below $1.00 per share and that Citizens had therefore not regained compliance with NASDAQ Marketplace Rule 5450(a)(1) following receipt of the previously disclosed initial notification of noncompliance from The NASDAQ Stock Market, dated July 19, 2010. The notification letter does not affect the listing of Citizens’ common stock on The NASDAQ Capital Market at this time and it will continue to trade under the symbol CRBC.
The notification letter states that Citizens will be afforded an additional 180 calendar days, or until July 18, 2011, to regain compliance with the minimum closing bid price requirement. To regain compliance, the closing bid price of Citizens’ common stock must meet or exceed $1.00 per share for at least ten consecutive business days. If Citizens does not regain compliance by July 18, 2011, NASDAQ will provide a written notification that Citizens’ common stock will be delisted. Citizens may appeal the determination to delist at that time and submit a plan of compliance to The NASDAQ Stock Market, which would temporarily stay any delisting action.
Citizens intends to actively monitor the bid price for its common stock and is considering available options to resolve the deficiency and regain compliance with the NASDAQ minimum bid price requirement.
On July 28, 2010, the Holding Company and Citizens Bank entered into a written supervisory agreement with their primary regulators, the Federal Reserve Bank of Chicago and the Michigan Office of Financial and Insurance Regulation as a follow up to recently concluded examinations of the Bank. For a detailed summary of the Written Agreement, see “- Supervision and Regulation”.
In April 2010, Citizens completed the sale of the stock of Citizens’ wholly owned subsidiary, F&M Bank-Iowa (“F&M”), to Great Western Bank whereby Great Western Bank paid $50.0 million in cash to the Holding Company. F&M served markets with low growth potential outside of Citizens’ primary footprint and generated additional marketing costs to maintain the separate branding. The sale proceeds improved the Holding Company’s capital and liquidity positions in a manner that was non-dilutive to Citizens’ shareholders.
As a result of the sale, the financial condition and operating results for this subsidiary have been segregated from the financial condition and operating results of Citizens’ continuing operations throughout this report and, as such, are presented as a discontinued operation. While all prior periods have been revised retrospectively to align with this treatment, these changes do not affect Citizens’ reported consolidated financial condition or operating results for any of the prior periods.
GEOGRAPHIC LOCATIONS
As of December 31, 2010, Citizens conducts operations through 218 offices and 252 ATM locations throughout Michigan, Wisconsin, Ohio, and Indiana with 2,026 full-time equivalent employees. In Michigan, the primary markets are concentrated in the Lower Peninsula, with a small presence in the Upper Peninsula. In Wisconsin, the primary markets include the greater Green Bay Metropolitan area, the Fox Valley region which extends from Appleton to Oshkosh, suburban Milwaukee, and also rural markets in southern and northern Wisconsin. In Ohio, the primary market is the greater Cleveland area. In Indiana, the only office is in Indianapolis.
PRINCIPAL SOURCES OF REVENUE
The Corporation’s primary source of revenue is interest income. The table below shows the amount of total consolidated revenues resulting from interest and fees on loans, interest and dividends on investment securities, money market investments, FHLB and Federal Reserve stock, and noninterest income for each of the last three years:
Citizens’ revenue tends to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, and competitive conditions within the marketplace, as well as residential housing markets in the communities Citizens serves.
LINES OF BUSINESS
Citizens’ performance is monitored by an internal profitability measurement system that provides line of business results and key performance measures. Citizens operates along five major business lines: Regional Banking, Specialty Consumer, Specialty Commercial, Wealth Management, and Other. The Regional Banking, Specialty Consumer, and Specialty Commercial business lines are involved in lending activity. Lending involves credit risk which is controlled and monitored through active asset quality management, the use of lending standards, and thorough review of potential borrowers. Credit risk management is discussed in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the captions “Critical Accounting Policies,” “Loan Portfolio,” “Credit Risk Management,” “Nonperforming Assets,” “Allowance for Loan Losses,” and “Contractual Obligations and Off-Balance Sheet Arrangements” and under Notes 1, 4, and 16 to the Consolidated Financial Statements.
Additional information regarding the business lines is incorporated herein by reference from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Line of Business Results” and in Note 15 of the Consolidated Financial Statements.
COMPETITION
The financial services industry is highly competitive. Citizens Bank competes with other commercial banks, many of which are subsidiaries of other bank holding companies, for loans, deposits, trust accounts and other business on the basis of interest rates, fees, convenience and quality of service. Major competitors include commercial banks, community banks, savings associations and thrifts, finance companies, mortgage banking companies, brokerage firms, insurance companies, credit unions and other organizations.
Mergers between financial institutions and the expansion of financial institutions both within and outside of the primary Midwest banking markets have provided significant competitive pressure in those markets. In addition, the passage of Federal interstate banking legislation has expanded the banking market and heightened competitive forces. The effect of this legislation is further discussed under the caption “Supervision and Regulation.”
Many of Citizens’ offices are located in small cities and rural areas that have diverse economies and a mix of manufacturing, service, retail and agricultural businesses. In many of these localities, Citizens is the largest bank, which is believed to be a competitive advantage. In other markets, Citizens’ competitors may enjoy a competitive advantage, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. Citizens’ competitors may also offer higher interest rates, which could decrease Citizens’ ability to retain existing deposits or attract new deposits or require Citizens to increase its rates to attract deposits.
Other factors such as employee relations and environmental laws also impact the Corporation’s competitiveness. Citizens maintains a favorable relationship with its employees and none of its employees are represented by a collective bargaining group.
SUPERVISION AND REGULATION
General
The banking industry is subject to extensive state and federal regulation and continues to undergo significant change. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in state legislatures, and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on Citizens are impossible to determine with any certainty. A change in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business, operations and earnings of Citizens. Citizens expects that the financial services industry will remain heavily regulated and that additional laws or regulations may be adopted. The following discussion summarizes certain aspects of the banking laws and regulations that affect Citizens. To the extent that the following information describes statutory or regulatory provisions, it is qualified entirely by reference to the particular statutory or regulatory provision.
The Holding Company is a bank holding company registered with the Federal Reserve Board (“FRB”) and is subject to regulation under the Bank Holding Company Act. The Bank Holding Company Act requires the FRB’s prior approval of an acquisition of assets or of ownership or control of voting shares of any bank or bank holding company if the acquisition would give the holder more than 10% of the voting shares of that bank or bank holding company. It also imposes restrictions, summarized below, on the assets or voting shares of non-banking companies that Citizens may acquire.
Under FRB policy, a bank holding company is expected to serve as a source of financial strength to each of its subsidiary banks and to stand prepared to commit resources to support each of them. There are no specific quantitative rules on a holding company’s potential liability. If the Bank were to encounter financial difficulty, the
FRB could invoke the doctrine and require a capital contribution from the Holding Company. In addition, and as a separate legal matter, a holding company is required to guarantee the capital plan of an undercapitalized subsidiary bank. See “Capital Adequacy and Prompt Corrective Action” below.
Citizens Bank is a state-chartered bank and is therefore subject to supervision, regulation and examination by the state banking regulator of the state in which it is chartered, the Michigan Office of Financial and Insurance Regulation (“OFIR”). Citizens Bank is also subject to supervision and examination by the FRB because it is a member of the Federal Reserve System and by the Federal Deposit Insurance Corporation (“FDIC”), because the FDIC insures its deposits to the extent provided by law. CB Wealth Management, a national non-depository trust bank, is subject to supervision, regulation and examination by the Office of the Comptroller of the Currency (“OCC”).
Written Agreement with FRBC and OFIR
As previously reported, the Holding Company and Citizens Bank entered into a written supervisory agreement (the “Written Agreement”) with the Federal Reserve Bank of Chicago (“FRBC”) and the OFIR, their respective primary regulators, as a follow up to recently concluded examinations of the Bank. The Written Agreement was executed by the regulators on July 28, 2010. The Written Agreement requires the boards of directors of the Holding Company and the Bank to undertake various assessments and submit a number of plans acceptable to the FRBC and OFIR in connection with the following matters.
By August 7, 2010, the boards of directors of the Holding Company and the Bank were required to address the following items:
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Allowance for Loan and Lease Losses - The Bank was required to eliminate from its books, by charge-off or collection, all assets or portions of assets classified as a loss in the most recent Asset Quality Examination and that had not already been previously collected in full or charged off. There were no such assets required to be eliminated at such date.
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Compliance Committee - The boards of directors were required to appoint a joint compliance committee (“Compliance Committee”) to monitor and coordinate compliance with the provisions of the Written Agreement. The Compliance Committee is required to meet, at a minimum, on a monthly basis and report its findings to the boards of directors.
By September 26, 2010, the boards of directors of the Holding Company and the Bank were required to address the following items:
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Management Staffing Needs - The boards were required to complete an assessment of the Bank’s management and staffing needs and within 30 days later, submit a plan to the FRBC and OFIR that included their findings and conclusions and the specific actions the boards will take to strengthen management.
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Credit Risk Management Practices - The Bank was required to submit a plan to strengthen credit risk management practices, including steps to reduce or mitigate the risk of concentrations of credit.
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Credit Administration - The Bank was required to submit a program to enhance credit administration that addresses, considers and includes, at a minimum, standards for the modification of construction loans and the appropriate use of deficiency notes.
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Asset Improvement - The Bank was required to submit a plan designed to improve Citizens’ position through repayment, amortization, liquidation, additional collateral or other means on other real estate owned (“OREO”) and on past due, classified or problem loans meeting certain conditions. Also, for any subsequently acquired OREO and any loans satisfying any of these conditions in the future, Citizens is required to submit a plan to improve Citizens’ position on the loan within 30 days of such acquisition or classification and must submit subsequent progress reports on all such plans within 30 days after the end of each calendar quarter.
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Allowance for Loan and Lease Losses - The Bank was required to review and revise the allowance for loan and lease losses (“ALLL”) methodology in order to ensure consistency with relevant supervisory guidance and submit a description of the revised methodology to the FRBC and OFIR.
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Capital Plan - The Holding Company and the Bank were required to submit an acceptable plan to maintain sufficient capital that addresses, considers, and includes, at a minimum, the Holding Company’s and the Bank’s current and future capital requirements, adequacy of the Bank’s capital, the source and timing of additional funds to fulfill the Holding Company’s and the Bank’s future capital requirements, and the requirement of the Holding Company to serve as a source of strength to the Bank.
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Liquidity Position Management - The Holding Company and the Bank were required to submit a plan to the regulators to enhance management of the Bank’s liquidity position and a revised contingency plan that identifies available sources of liquidity and includes adverse scenario planning.
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Interest Rate Management - The Holding Company and the Bank were required to submit a plan to improve interest rate risk management practices that are appropriate for the size and complexity of the organization.
By October 26, 2010, the boards of directors of the Holding Company and the Bank were required to address the following items:
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Allowance for Loan and Lease Losses - The Bank was required to submit an acceptable written program for the maintenance of an adequate ALLL, to be reviewed by the Bank’s board of directors on at least a quarterly basis with reports regarding the review submitted to the FRBC and OFIR within 30 days after the end of each calendar quarter.
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Earnings Plan and Budget - The Bank was required to submit a business plan and budget for the remainder of 2010 to improve the Bank’s earnings and overall condition.
All of the foregoing requirements were satisfied within the applicable time periods.
The Written Agreement also imposes various ongoing affirmative obligations and negative covenants.
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Criticized Loans - The Written Agreement requires additional internal review and approval of renewal, extension or restructurings of certain criticized credits and certification of such review and approval.
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Allowance for Loan and Lease Losses - The Bank is required, within 30 days from the receipt of any federal or state report of examination, to charge off all assets classified as loss unless otherwise approved in writing by the FRBC and OFIR.
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Capital Plan Compliance - Once the capital plan is approved by the regulators, the Holding Company and the Bank must notify the regulators within 30 days after the end of each calendar quarter in which any of their capital ratios fall below the minimum ratios set forth in the plan. Management is required to monitor adherence to the capital plan and make monthly reports to the boards of directors.
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Annual Business Plan and Budget - A business plan and budget for each calendar year subsequent to 2010 shall be submitted to the FRBC and OFIR in December prior to the beginning of that calendar year.
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Compliance with Laws - The Holding Company and the Bank must comply with applicable regulations relating to prior notice of director and senior executive officer appointments and relating to restrictions on indemnification and severance payments.
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Progress Reports - Within 30 days after the end of each calendar quarter, the Bank is required to submit to the FRBC and OFIR written progress reports detailing its compliance efforts.
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Negative Covenants - The Holding Company and the Bank are generally prohibited from paying dividends, the Holding Company is prohibited from paying interest or principal on subordinated debentures or trust preferred securities, the Bank is generally prohibited from transferring funds to the Holding Company, the Holding Company is prohibited from incurring, increasing, or guaranteeing debt and generally prohibited from purchasing or redeeming any shares of the Holding Company’s stock, in each case without prior regulatory approval.
The foregoing summary of the Written Agreement does not purport to be a complete description of all of the terms of the Written Agreement, and is qualified in its entirety by reference to a copy of the Written Agreement filed with the Securities and Exchange Commission as an exhibit to Citizens’ Form 10-Q for the quarter ended June 30, 2010.
On December 20, 2010, Citizens received a response from the FRBC and OFIR regarding the plans previously submitted under the Written Agreement. The response indicated that for most items, the submitted plans were acceptable and that either no further action was necessary or only continued monitoring or verification by Citizens board or the regulators was required. The response requested further enhancements to the ALLL methodology, which Citizens made and the revised methodology was submitted for further review. The nature of the enhancements primarily related to additional documentation and did not have an impact on the overall methodology or the recorded balance of the allowance for loan losses. The response also required modifications to the previously submitted capital plan by January 31, 2011. The modified capital plan was submitted within the required timeframe and Citizens is awaiting a response from the regulators.
The Written Agreement formalizes steps that were in several cases already underway at the Holding Company and the Bank, including, but not limited to improvements in our policies and procedures regarding: credit risk; credit administration; asset improvement; operating results; and liquidity position management. Citizens is committed to addressing and resolving the matters raised in the Written Agreement on a timely basis and maintaining the safety and soundness of the Bank. Because substantially all of the requirements of the Written Agreement relate to operational improvements or codify actions already being taken by Citizens at the time the Written Agreement became binding (in some cases based upon the informal advice of the regulators), Citizens does not anticipate that compliance with the Written Agreement will have any material adverse impact on its business, financial condition or results of operations.
Payment of Dividends
There are various statutory restrictions on the ability of the Bank to pay dividends or make other payments to the Holding Company. The Bank is subject to dividend limits under the laws of Michigan. In addition, the Bank is a member bank of the Federal Reserve System, subject to the dividend limits of the FRB. The FRB allows a member bank to make dividends or other capital distributions in an amount not exceeding the current calendar year’s net income, plus retained net income of the preceding two years. Distributions in excess of this limit require prior approval of the FRB. FRB policy provides that, as a matter of prudent banking, a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears to be consistent with the holding company’s capital needs, asset quality and overall financial condition.
As a national non-depository trust bank, CB Wealth Management is subject to the regulations of the OCC regarding limits on dividends paid to the Holding Company. Under such regulations, CB Wealth Management may declare dividends only from its undivided profits, dividends can not reduce surplus funds to a level less than common capital, and dividends may not be declared unless at least 10% of net income for a given time period has been carried to the surplus fund, depending on the frequency of dividend payments in a given year. Approval of the OCC is required if the total of all dividends declared by CB Wealth Management in any calendar year exceed the sum of its net income combined with its retained net income for the preceding two years.
On April 17, 2008, Citizens’ Board of Directors voted to suspend the common stock quarterly dividend. On December 12, 2008, Citizens issued fixed-rate cumulative perpetual preferred stock, Series A (the “TARP
Preferred Stock”) with liquidation value of $300 million to the U.S. Department of the Treasury (“Treasury”) as part of the Treasury’s Capital Purchase Program. Terms of the issuance prohibit the payment of dividends by the Holding Company without the prior approval of the Treasury until the earlier of December 12, 2011 or such time as Treasury no longer holds the preferred stock.
On January 28, 2010, Citizens announced that it was suspending the dividend payments on its trust preferred securities and on its TARP Preferred Stock, issued to the Treasury. Refer to “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity Risk Management” for additional information.
Capital Adequacy and Prompt Corrective Action
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) requires federal regulators to take prompt corrective action against any undercapitalized institution. FDICIA establishes five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Regulatory capital requirements for bank holding companies are evaluated using three capital measures: (i) leverage capital expressed as a percentage of total assets, (ii) risk-based capital expressed as a percentage of total risk-weighted assets, and (iii) Tier 1 risk-based capital expressed as a percentage of total risk-weighted assets.
The following table presents the regulatory capital requirements for the five categories.
(1)
Total Capital is comprised of Tier 1 Capital, a portion of the allowance for loan losses and qualifying subordinated debt. Tier 1 Capital is calculated as follows: total shareholders’ equity + trust preferred securities - goodwill - accumulated other comprehensive income (loss) - other intangible assets.
(2)
Tier 1 Capital to quarterly average assets.
If the FDIC determines that an institution is in unsafe or unsound condition or that the institution has not corrected a less than satisfactory rating received in its last examination for asset quality, management, earnings or liquidity, an institution may be treated as if it were in the next lower capital category. A depository institution is generally prohibited from making capital distributions, including paying dividends, or paying management fees to a holding company if the institution would thereafter be undercapitalized. Institutions that are adequately but not well-capitalized cannot accept, renew or rollover brokered deposits except with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or rollover brokered deposits.
The banking regulatory agencies are permitted or, in certain cases, required to take certain actions with respect to institutions falling within one of the three undercapitalized categories. Depending on the level of an institution’s capital, the agencies’ corrective powers include, among other things:
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prohibiting the payment of principal and interest on subordinated debt;
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prohibiting the holding company from making distributions without prior regulatory approval;
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placing limits on asset growth and restrictions on activities;
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placing additional restrictions on transactions with affiliates;
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restricting the interest rate the institution may pay on deposits;
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prohibiting the institution from accepting deposits from correspondent banks; and
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in the most severe cases, appointing a conservator or receiver for the institution.
A banking institution that is in any of the three undercapitalized categories is required to submit a capital restoration plan, and such a plan will not be accepted unless, among other things, the banking institution’s holding company guarantees the plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy.
FDICIA also contains a variety of other provisions that may affect Citizens’ operations, including reporting requirements, regulatory standards for real estate lending, “truth in savings” provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.
At December 31, 2010 and 2009, Citizens’ regulatory capital ratios were above “well-capitalized” standards. Information concerning capital adequacy guidelines for the Holding Company and Citizens Bank including their regulatory capital position at December 31, 2010 and maintenance of minimum average reserve balances by the Bank with the FRB is incorporated herein by reference from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the captions “Capital Resources” and “Liquidity Risk Management” and Note 18 to the Consolidated Financial Statements.
FDIC Insurance Assessments
The FDIC calculates deposit insurance based on a risk-based system that places a bank in one of four risk categories, principally on the basis of its capital level and an evaluation of the bank’s risk to the relevant deposit insurance fund, and bases premiums on the probability of loss to the FDIC with respect to each individual bank. Under the Federal Deposit Insurance Act, depository institutions such as Citizens’ subsidiary banks may not pay interest on indebtedness, if such interest is required to be paid out of net profits, or distribute any of its capital assets while it remains in default on any assessment due to the FDIC.
The calculation of the FDIC assessment includes the Financing Corporation (“FICO”) assessment. FICO was established to finance the Federal Savings and Loan Insurance Corporation resolution fund. All FDIC insured banks are required to pay into this resolution fund through the Deposit Insurance Fund (“DIF”).
On February 7, 2011 the FDIC Board approved a final rule that changes the assessment base from domestic deposits to average assets minus average tangible equity, adopts a new large-bank pricing assessment scheme, and sets a target size for the Deposit Insurance Fund. The changes will go into effect beginning with the second quarter of 2011 and will be payable at the end of September 2011. The rule would, in aggregate, increase the share of assessments paid by large institutions.
Temporary Liquidity Guarantee Program
On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLGP”). The TLGP was announced by the FDIC on October 14, 2008, as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or December 31, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008 and before October 31, 2009 and (ii) provide full FDIC deposit insurance coverage for noninterest bearing transaction deposit accounts, Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (“IOLTA”) accounts held at participating FDIC-insured institutions through its Transaction Account Guarantee Program (“TAGP”) through June 30, 2010. Coverage under the TAGP was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage was 10 basis points per quarter during 2009 on amounts in covered accounts exceeding $250,000 and increased for the first six months of 2010. While Citizens joined the TAGP at its inception, due to its significant liquidity levels and the cost of continued participation, Citizens opted-out of the TAGP as of July 1, 2010. Citizens’ clients will continue to receive standard deposit insurance coverage through the FDIC’s general deposit insurance fund, which covers deposit balances up to $250,000 per depositor.
Interstate Banking
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal Act”), as amended, a bank holding company may acquire banks in states other than its home state, subject to any state requirement
that the bank has been organized and operating for a minimum period of time (not to exceed five years) and the requirement that the bank holding company not control, prior to or following the proposed acquisition, more than 10% of the total amount of deposits of insured depository institutions nationwide or, unless the acquisition is the bank holding company’s initial entry into the state, more than 30% of such deposits in the state, or such lesser or greater amount set by the state. The Riegle-Neal Act also authorizes banks to merge across state lines, thereby creating interstate branches. Banks are also permitted to acquire and to establish de novo branches in other states where authorized under the laws of those states.
Transactions with Affiliates
Transactions between Citizens’ subsidiary banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. The affiliates of the banks include any entity controlled by Citizens. Generally, Sections 23A and 23B (i) limit the extent to which the subsidiary banks may engage in “covered transactions” with any one affiliate to an amount equal to 10% of the Corporation’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of the bank’s capital stock and surplus, (ii) require that a bank’s extensions of credit to such affiliates be fully collateralized (with 100% to 130% collateral coverage, depending on the type of collateral), (iii) prohibit the bank from purchasing or accepting as collateral from an affiliate any “low quality assets” (including nonperforming loans) and (iv) require that all “covered transactions” be on terms substantially the same, or at least as favorable, to the bank or its subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other types of similar transactions.
Loans to Insiders
The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal stockholders of banks. Under Section 22(h) of the Federal Reserve Act and its implementing regulations, loans to a director, an executive officer or a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank’s loan-to-one-borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed the bank’s unimpaired capital and unimpaired surplus. Section 22(h) and its implementing regulations also prohibit loans, above amounts prescribed by the appropriate federal banking agency to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. Section 22(h) generally requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.
Community Reinvestment Act
Under the Community Reinvestment Act (“CRA”) and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate income areas, consistent with safe and sound banking practice. Depository institutions are periodically examined for compliance with CRA and are periodically assigned ratings in this regard. Banking regulators consider a depository institution’s CRA rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiary.
Fair Lending and Consumer Laws
In addition to CRA, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that in some cases prospective borrowers experience unlawful discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against some depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial.
These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act. These factors include evidence that a lender discriminated on a
prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of certain loans to customers.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act of 1999 (the “GLBA”) covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions.
The GLBA repealed sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory CRA rating. Citizens has determined not to become certified as a financial holding company at this time. The Corporation may reconsider this determination in the future.
The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a non-discriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in specific areas identified under the law. The federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.
The GLBA repealed the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Securities Exchange Act of 1934, as amended. It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker,” and a set of activities in which a bank may engage without being deemed a “dealer.” Additionally, the law makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.
The GLBA also contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The new law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to “opt out” of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are more strict than those contained in the GLBA.
Anti-Money Laundering and the USA Patriot Act of 2001
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”) is designed to deny terrorists and criminals the ability to obtain access to the United States’ financial system and has significant implications for depository institutions, brokers, dealers, and other businesses involved in the transfer of money. The Patriot Act mandates that financial services companies implement policies and procedures with respect to additional measures designed to address the
following matters: money laundering, terrorist financing, identifying and reporting suspicious activities and currency transactions, and currency crimes.
The Patriot Act also substantially broadened existing anti-money laundering legislation, imposed new compliance and due diligence obligations, created new crimes and penalties, and compelled the production of documents located both inside and outside the United States. The Treasury has issued a number of regulations that apply some of these requirements to financial institutions such as Citizens Bank. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. Pursuant to the Patriot Act and the related regulations, Citizens has established anti-money laundering compliance and due diligence programs that include, among other things, the designation of a Bank Secrecy Act officer, employee training programs and an independent audit function to review and test the program.
EESA and Troubled Asset Relief Capital Purchase Program
In response to the financial crises affecting the financial markets and the banking system, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law and established the Troubled Asset Relief Program (“TARP”). On October 14, 2008, the Treasury announced the Capital Purchase Program (“CPP”) to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Under CPP, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of senior preferred stock and warrants which qualify as Tier 1 capital. On December 12, 2008, Citizens issued $300.0 million of TARP Preferred Stock and a warrant to purchase 17,578,125 shares of its common stock at $2.56 per share to the Treasury as part of this program. The TARP Preferred Stock pays a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The TARP Preferred Stock is callable at par after three years. Prior to the end of three years, the TARP Preferred Stock may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. Participating financial institutions were required to adopt the Treasury’s standard for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the CPP. These standards generally apply to our chief executive officer, chief financial officer, and our next three most highly compensated executive officers.
The Treasury has been given authority to promulgate regulations under the EESA. Any new regulations implemented by the Treasury under the EESA may be applied retroactively to recipients of TARP funding under the CPP. In addition, the U.S. government could in the future pass new legislation which may have a similar effect. In either case, any such new regulations or legislation may have the effect of imposing additional economic restrictions or obligations on Citizens under the TARP CPP, at least for as long as any of Citizens’ obligations under the CPP remain outstanding.
The Special Inspector General for the Troubled Asset Relief Program (“SIGTARP”) was established pursuant to Section 121 of the EESA, and has the duty among other things, to conduct, supervise, and coordinate audits and investigations of the purchase, management, and sale of assets by the Treasury under TARP and the CPP including the TARP Preferred Stock purchased from Citizens.
American Recovery and Reinvestment Act
The American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law on February 17, 2009. ARRA includes a wide variety of programs intended to stimulate the economy. In addition, ARRA imposes new executive compensation and expenditure limits on all previous and future TARP CPP recipients, such as Citizens, and expands the class of employees to whom the limits and restrictions apply. ARRA also provides the opportunity for additional repayment flexibility for existing TARP CPP recipients. The Treasury published interim final rules to implement the compensation and corporate governance provisions of the ARRA effective as of June 15, 2009.
Among other things, ARRA prohibits the payment of bonuses, other incentive compensation and severance to certain of Citizens’ most highly paid employees (except in the form of restricted stock subject to specified limitations and conditions), and requires each TARP recipient to comply with certain other executive compensation related requirements. These provisions modify the executive compensation provisions that were included in the EESA, and in most instances apply retroactively for so long as any obligation arising from financial
assistance provided to the recipient under TARP remains outstanding. The new ARRA guidelines generally supersede the executive compensation and corporate governance standards for TARP recipients set forth in the EESA.
In addition, the ARRA directs the Secretary of the Treasury to review previously-paid bonuses, retention awards and other compensation paid to the senior executive officers and certain other highly-compensated employees of each TARP recipient to determine whether any such payments were excessive, inconsistent with the purposes of the ARRA or the TARP, or otherwise contrary to the public interest. If the Secretary determines that any such payments have been made by a TARP recipient, the Secretary will seek to negotiate with the TARP recipient and the subject employee for appropriate reimbursements to the U.S. government (not the TARP recipient) with respect to any such compensation or bonuses. The ARRA also permits the Secretary, subject to consultation with the appropriate federal banking agency, to allow a TARP recipient to repay any assistance previously provided to such TARP recipient under the TARP, without regard to whether the TARP recipient has replaced such funds from any source, and without regard to any waiting period. Any TARP recipient that repays its TARP assistance pursuant to this provision would no longer be subject to the executive compensation provisions under the ARRA.
Dodd-Frank Wall Street Reform and Consumer Protection Act
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act will likely result in dramatic changes across the financial regulatory system, some of which became effective immediately and some of which will not become effective until various future dates. Implementation of the Dodd-Frank Act will require many new rules to be made by various federal regulatory agencies over the next several years. Uncertainty remains until final rulemaking is complete as to the ultimate impact of the Dodd-Frank Act, which could have a material adverse impact either on the financial services industry as a whole, or on Citizens’ business, results of operations, and financial condition. Provisions in the legislation that affect deposit insurance assessments, payment of interest on demand deposits, and interchange fees could increase the costs associated with deposits and place limitations on certain revenues those deposits may generate. The Dodd-Frank Act includes provisions that, among other things, will:
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Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining, and enforcing compliance with federal consumer financial laws.
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Create the Financial Stability Oversight Council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.
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Provide mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions.
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Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (“DIF”), and increase the floor on the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion.
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Make permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts at all insured depository institutions.
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Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions.
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Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.
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Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.
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Require or permit the federal banking agencies to adopt regulations affecting banking institutions’ capital requirements in a number of respects, including potentially more stringent capital requirements.
Basel III
The United States is a member of the Basel Committee on Banking Supervision (“the Basel Committee”), that provides a forum for regular international cooperation on banking supervisory matters. The Basel Committee develops guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Basel Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.
In December 2010, the Basel Committee released its new framework for strengthening international capital and liquidity regulation, now officially identified as “Basel III”. Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity.
Like the Dodd-Frank Act, Basel III requires or permits the Federal banking agencies to adopt regulations affecting banking institutions’ capital requirements in a number of respects. The U.S. banking agencies have indicated informally that they expect to propose regulations implementing Basel III in mid-2011 with final adoption of implementing regulations in mid-2012. Accordingly, the regulations ultimately applicable to Citizens and its bank subsidiary may be substantially different from the Basel III final framework as published in December 2010. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact Citizens’ operating results.
ECONOMIC FACTORS AND MONETARY POLICY
Citizens’ earnings and business are affected by the general economic and political conditions in the United States and abroad and by the monetary and fiscal policies of various federal regulatory authorities, including the Federal Reserve System. Citizens’ policy for addressing credit risk, the effect of the economy on credit risk in 2010, 2009, and 2008 and its potential effect on future periods is discussed in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations under the captions “Critical Accounting Policies,” “Loan Portfolio,” “Credit Risk Management,” “Nonperforming Assets,” and “Allowance for Loan Losses” and incorporated herein by reference. Through open market securities transactions, variations in the Federal Funds rate and the establishment of reserve requirements, the Board of Governors of the Federal Reserve System exerts considerable influence on interest rates and the supply of money and credit. Citizens strives to manage the effects of interest rates through its asset/liability management process but the effect of fluctuating economic conditions and federal regulatory policies on Citizens’ future profitability cannot be predicted with any certainty. The effect of the economy and changes in interest rates on Citizens’ net interest margin and net interest income in 2010, 2009, and 2008 and their potential effect on future periods is discussed in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Net Interest Income” and is incorporated herein by reference. Citizens’ sensitivity to changes in interest rates and the potential effect of changes in interest rates on net interest income is presented in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Risk” and incorporated herein by reference.
ENVIRONMENTAL MATTERS
Citizens’ primary exposure to environmental risk is through lending activities and trust services. In each instance, policies and procedures are in place to mitigate environmental risk exposures. With respect to lending activities, Citizens requires environmental site assessments at the time of loan origination to confirm collateral quality on commercial real estate parcels posing higher than normal potential for environmental impact, as determined by reference to present and past uses of the subject property and adjacent sites. Environmental assessments are also mandated prior to any foreclosure activity involving non-residential real estate collateral. In the case of trust services, Citizens utilizes various types of environmental transaction screening to identify actual and potential risks arising from any proposed holding of non-residential real estate for trust accounts. Consequently, the Corporation does not anticipate any material effect on capital expenditures, earnings or the competitive position of Citizens or any of its subsidiaries with regard to compliance with federal, state or local environmental protection laws or regulations. Additional information is provided in “Item 3. Legal Proceedings.”
ITEM 1A.
ITEM 1A. RISK FACTORS
Unless otherwise noted or the context indicates otherwise, all references in this Item to “we,” “us,” or “our,” refer to Citizens and its subsidiaries. An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that we believe affect us are described below. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are not aware of or focused on or currently deem immaterial may also impair business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and shareholders could lose all or part of their investment.
We face the risk that loan losses, including unanticipated loan losses due to changes in loan portfolios, fraud and economic factors, could exceed the allowance for loan losses and that additional increases in the allowance will be required. Additions to the allowance for loan losses would cause our operating results to decline and could have a negative impact on our capital and financial position.
Making loans is an essential element of our business, and there is a risk that customer loans will not be repaid. The risk of nonpayment is affected by a number of factors, including:
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the duration of the loan;
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credit risks of a particular borrower;
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changes in economic and industry conditions; and
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in the case of a collateralized loan, the potential inadequacy of the value of the collateral in the event of default, such as has resulted from the deterioration in commercial and residential real estate values.
We attempt to maintain an appropriate allowance for loan losses to provide for probable losses inherent in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors including, among others, the ongoing review and grading of the loan portfolio, consideration of past loan loss experience as well as that of the banking industry, trends in past due and nonperforming loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, the size and diversity of individual credits, and other qualitative and quantitative factors which could affect probable credit losses. We determine the amount of the allowance for loan losses by considering these factors and by using estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on our historical loss experience with additional qualitative factors for various issues, and estimates of necessary reserves for special situations that are unique to the measurement period such as anticipated problem loan resolution activities, along with consideration of current economic trends and conditions, all of which are susceptible to significant change and are inherently subjective. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly.
A significant portion of our loan portfolio is secured by commercial and residential real estate. These portfolios are comprised of borrowers primarily located in Michigan, Wisconsin, and Northern Ohio. The Michigan and Northern Ohio markets in particular have been adversely affected by job losses, declines in real estate value, declines in home sale volumes, and declines in new home building. Declining real estate values in our markets have resulted in sharp increases in losses on certain segments of our portfolio, particularly the land hold, land development, and construction loan portfolios. We have ceased extending land hold and land development loans and are working actively to manage our remaining land hold, land development, and construction portfolios. The credit performance of loans secured by commercial income producing properties has recently been negatively affected by tenant losses and reduced rental rates, contributing to the decline in values associated with the income producing loan portfolio. We may suffer further losses in these segments if our efforts to limit losses through execution of prudent workout strategies are unsuccessful. Although we do not engage in subprime lending, the credit performance of the residential mortgage portfolio has been negatively impacted by borrowers’ loss of or reduction in, income. The decline in the residential real estate values, particularly in Michigan and
Northern Ohio, and the extended time frame associated with the sale of repossessed residential properties has led to increased loss severity in this loan portfolio.
Increased stress on borrowers’ cash flow due to job loss, reduced rental income, higher interest rates or other factors could lead to even higher payment delinquencies and defaults. Continued declines in real estate values could lead to higher loss severity. Although our most significant loan losses to date have been concentrated in our commercial real estate and residential mortgage loan portfolios, continued adverse economic conditions could adversely affect other portions of our loan portfolio.
There is no precise method of predicting loan losses, and therefore we always face the risk that charge-offs in future periods will exceed our allowance for loan losses or that additional increases in the allowance for loan losses will otherwise be required. Additions to the allowance for loan losses would cause operating results to decline in the period(s) in which such additions occur and could also have a material adverse impact on our capital and financial position.
Our core lending and other businesses continue to be adversely affected by the historic weakness in the national and regional economies in which we operate, particularly Michigan. Our ability to generate earnings and maintain regulatory capital ratios at acceptable levels at our Holding Company and the Bank depends substantially on developments in those economies. Also, our potential inability to comply with applicable laws, regulations and regulatory policies or standards due to the effects of these conditions on our results of operations and financial condition may result in heightened regulatory scrutiny and require us to take actions to protect depositors that are not in the best interests of our shareholders.
Our businesses face substantial challenges for the foreseeable future, in particular:
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A substantial amount of our lending business originates in Michigan. Of our total portfolio loans, approximately 70% are to borrowers located, or secured by properties, in Michigan and approximately 10% are to borrowers located, or secured by properties, in Ohio. These states have been severely and disproportionately affected by the recent economic downturn. Unemployment rates in these states have been substantially higher than the national average and real estate collateral values have fallen significantly.
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Our ability to return to a positive net income is largely dependent upon our future credit costs. Our loan portfolios-particularly our commercial real estate and residential mortgage loan portfolios, which have accounted for a disproportionate amount of our loan loss provisions since the fourth quarter of 2008-continue to be adversely affected by economic conditions and the ongoing correction in real estate prices in our markets. Despite the progress made in the latter parts of 2010, a significant portion of our commercial loan portfolio continues to be classified as nonperforming loans or watchlist loans. The latter are loans that have migrated within our loan rating system to a level that requires increased oversight. We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolios. In view of the weakness and uncertainties in the national and regional economies in which we operate and the inherent difficulty in predicting future events, we may find it necessary to continue to take loan loss provisions in future periods in amounts that substantially exceed loan loss provisions in prior periods in order to maintain our allowance for loan losses at a level we deem appropriate.
As a result of the weakness in the economy nationally and particularly in our primary markets, and the effect of this weakness on unemployment rates and the value of real estate collateralizing many of our loans, we have incurred substantial losses, our charged-off loans have increased substantially and our capital levels have been adversely affected. These effects have, in turn, hampered our ability to comply with various standards and policies of our various banking regulators which are intended primarily for the protection of depositors and the FDIC, not shareholders or holders of subordinated debt or trust preferred securities. Any failure to comply with laws, regulations, or regulatory policies or standards, such as maintenance of capital ratios and reduction of nonperforming asset levels due to the deterioration in our financial condition and operating results, could also result in heightened regulatory scrutiny and in further sanctions by regulatory agencies (such as a memorandum of understanding, a change to our Written Agreement, a new written supervisory agreement or a cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business, could require us to raise additional capital or sell assets on terms that are not advantageous
to us or our shareholders and could have a material adverse effect on our business, financial condition, results of operations, and stock price.
As a follow up to recently concluded examinations of Citizens Bank, the Holding Company and Citizens Bank entered into a written supervisory agreement with the FRBC and OFIR, their primary regulators, as of July 28, 2010, which is summarized in “Item 1 Business -Supervision and Regulation” and which we refer to as the Written Agreement. The Written Agreement requires the Holding Company and the Bank to take various actions intended by the regulators to improve the operations of the Holding Company and the Bank, requires them to submit capital and liquidity plans to the regulators that are acceptable to the regulators, and prohibits them from taking certain actions, such as paying dividends and amounts owed in connection with their outstanding trust preferred securities, without regulatory approval. Although we do not currently anticipate that compliance with the Written Agreement will have a material adverse impact on our operations, we cannot provide any assurance as to the potential impact of such action on our business, financial condition and results of operations. The Written Agreement is designed to remediate certain deficiencies noted by the regulators for the protection of depositors rather than the benefit of shareholders or debt holders. Our regulators could subject us to various requirements limiting our ability to develop new business lines, mandating that we raise additional capital in a manner that would be dilutive to shareholders, and/or requiring the sale of certain assets and liabilities, any of which could have a material adverse effect on our business, financial condition, results of operations and stock price. Moreover, if we are unable to comply with the terms of the Written Agreement, we could become subject to additional heightened supervisory actions and orders, any of which could have a material adverse effect on our business, financial condition, results of operations and stock price.
Our business may be adversely affected by the highly regulated environment in which we operate. Changes in applicable laws, regulations, and regulatory practices at either the federal or state level may result in the imposition of additional costs or restrict our ability to operate our business in the manner most beneficial to our shareholders.
The banking industry is heavily regulated, and such regulations are intended primarily for the protection of depositors and the federal deposit insurance funds, not shareholders or holders of subordinated debt or trust preferred securities. As a bank holding company, the Holding Company is subject to regulation by the FRB. Citizens Bank is subject to federal regulation primarily by the FRB and is also subject to regulation by the OFIR. These regulations affect lending practices, capital structure, investment practices, dividend policy and growth. In addition, we have non-depository banking operating subsidiaries from which we derive income. CB Wealth Management engages in providing investment management and insurance brokerage services, which industries are also heavily regulated on both a state and federal level.
Various legislative and regulatory initiatives have been introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any impending regulations, would have on our financial condition and results of operation. A change in statutes, regulations or regulatory policies applicable to us could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things, any of which could have a material effect on our business.
In addition, changes in laws, regulations and regulatory practices affecting the financial services industry, including those relating to the Dodd-Frank Act and Basel III, could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could also result in heightened regulatory scrutiny and in sanctions by regulatory agencies (such as a memorandum of understanding, a change to our Written Agreement, a new written supervisory agreement or a cease and desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial
condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.
While we attempt to manage the risk from changes in market interest rates, interest rate risk management techniques are not exact. In addition, we may not be able to economically hedge our interest rate risk. A rapid or substantial increase or decrease in interest rates could adversely affect our net interest income and results of operations.
Our ability to generate net income depends primarily upon our net interest income. Net interest income is income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities and short-term investments. The amount of interest income is dependent on many factors including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates and the levels of nonperforming loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of noninterest-bearing demand deposits and equity capital.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest earning assets, or vice versa. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could reduce net interest income. We are unable to predict changes in market interest rates which are affected by many factors beyond our control including inflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, relationships between interest sensitive instruments and key driver rates, as well as balance sheet growth, client loan and deposit preferences and the timing of changes in these variables.
We attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate-sensitive assets and interest rate-sensitive liabilities. We continually review our interest rate risk position and modify our strategies based on projections to minimize the impact of future interest rate changes. We also use derivative financial instruments to modify our exposure to changes in interest rates. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect results of operations and financial performance.
The negative economic effects caused by terrorist attacks, potential attacks and other destabilizing events would likely contribute to the deterioration of the quality of our loan portfolio and could reduce our customer base, our level of deposits, and demand for our financial products such as loans.
High inflation, natural disasters, acts of terrorism, an escalation of hostilities or other international or domestic occurrences, and other factors could have a negative impact on the economy of the Upper Midwest regions in which we operate. An additional economic downturn in our markets would likely contribute to the deterioration of the quality of our loan portfolio by impacting the ability of our customers to repay loans, the value of the collateral securing loans, and may reduce the level of deposits in the Bank and the stability of our deposit funding sources. An additional economic downturn could also have a significant impact on the demand for our products and services. The cumulative effect of these matters on our results of operations and financial condition would likely be adverse and material.
If we are unable to continue to attract and retain core deposits, to obtain third party financing on favorable terms, or to have access to interbank or other liquidity sources (as a result of rating agency downgrades or other market factors), our cost of funds will increase, adversely affecting the ability to generate the funds necessary for lending operations, reducing net interest margin and negatively affecting results of operations.
The Bank derives liquidity through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. Additionally, the Bank has access to financial market borrowing sources
on an unsecured, and a collateralized basis for both short-term and long-term purposes including, but not limited to, the Federal Reserve, Federal Home Loan Banks of which the Bank is a member, and other correspondent banks. If these funding sources are not sufficient or available, we may have to acquire funds through higher-cost sources.
Our credit rating was downgraded by Moody’s Investor Service, Standard and Poor’s, Dominion Bond Rating Service, and Fitch Ratings throughout 2009 and 2010. During the first quarter of 2010, we submitted a letter to Standard & Poor’s requesting that Standard & Poor’s discontinue rating Citizens. Standard & Poor’s subsequently removed the ratings as did Dominion Bond Rating Service. In the first quarter of 2011, Fitch Ratings lowered our credit ratings. Although we currently have the ability to borrow funds on both a short-term and long-term basis as an additional source of liquidity, our ability to borrow funds at favorable rates may be negatively impacted if our ratings were to continue to be downgraded from their current level, and could adversely affect our results of operations and financial condition.
Increased competition with other financial institutions or an adverse change in our relationship with a number of major customers could reduce our net interest margin and net income by decreasing the number and size of loans originated, the interest rates charged on these loans and the fees charged for services to customers.
The Bank faces substantial competition in originating commercial and consumer loans. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Many of our competitors have competitive advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of the loans that we originate and the interest rates we charge on these loans.
In attracting business and consumer deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns and better brand recognition and more branch locations. These competitors may offer higher interest rates, which could decrease the deposits that we attract or require us to increase rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations which could increase our cost of funds.
We also compete for deposits with non-bank providers of financial services, such as brokerage firms, consumer finance companies, credit unions, insurance companies and governmental organizations which may offer more favorable terms. Some non-bank competitors are not subject to the same extensive regulations that govern banking operations. As a result, such non-bank competitors may have advantages over us in providing certain products and services. This competition may reduce or limit our margins on banking and non-banking services, reduce our market share and adversely affect our earnings and financial condition.
The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems.
Events such as significant adverse changes in the business climate, adverse action by a regulator, unanticipated changes in the competitive environment, and a decision to change our operations or dispose of an operating unit could have a negative effect on our goodwill or other intangible assets such that we may need to record an impairment charge, which could have a material adverse impact on our results of operations.
Under current accounting standards, goodwill and certain other intangible assets with indeterminate lives are assessed at least annually for impairment, or more frequently when impairment indicators are present. After evaluating goodwill and other intangible assets, we may determine that one or both are deemed to be impaired for accounting purposes. While a goodwill impairment charge was not required in 2010, we recorded an impairment of $256.3 million and $178.1 million in 2009 and 2008 respectively, which contributed significantly to our losses for those years. Further deterioration in the outlook for credit quality, changes in the value of the loan or deposit portfolios, or increases in the discount rates could have a material impact on future goodwill impairment testing results. If we identify any impairment, it would be reflected as a charge to earnings in the period during which such impairment is identified and could have a material adverse effect on our results of operations.
If the FDIC raises the assessment rate charged to its insured financial institutions, our FDIC insurance premium may increase and this could have a negative effect on our expenses and results of operations.
During 2008 and 2009, higher levels of bank failures and temporary programs increasing deposit insurance limits dramatically increased resolution costs for the FDIC and depleted its deposit insurance fund. In order to maintain a strong funding position and restore reserve ratios for the deposit insurance fund, the FDIC increased assessment rates for all insured institutions throughout 2010.
On February 7, 2011, the FDIC Board approved a final rule that changes the assessment base from domestic deposits to average assets minus average tangible equity, adopts a new large-bank pricing assessment scheme, and sets a target size for the Deposit Insurance Fund. The changes will go into effect beginning with the second quarter of 2011 and will be payable at the end of September 2011. The rule as mandated by the Dodd-Frank Act finalizes a target size for the Deposit Insurance Fund at 2 percent of insured deposits. It also implements a lower assessment rate schedule when the fund reaches 1.15 percent (so that the average rate over time should be about 8.5 basis points) and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2 percent and 2.5 percent. The rule would, in aggregate, increase the share of assessments paid by large institutions. The final rule also creates a scorecard-based assessment system for banks with more than $10 billion in assets. The scorecards include financial measures that the FDIC believes are predictive of long-term performance. Although, Citizens does not anticipate that this new rule will have a material impact, , any future increase in FDIC insurance premiums, alone or together with the other recent increases, may materially adversely affect our results of operations and financial condition.
If there are additional financial institution failures, we may be required to pay even higher FDIC insurance premiums than the recently increased levels. These announced increases and any future increase in FDIC insurance premiums may materially adversely affect our results of operations and financial condition.
We may not realize our deferred income tax assets and loss carryforwards.
The realization of our deferred income tax assets is dependent on utilizing taxable income in prior carryback years, generating future taxable income, executing tax planning strategies, and reversing existing taxable temporary differences. As of December 31, 2010, we maintained a full valuation allowance of $292.9 million. The valuation allowance may be adjusted as conditions change and the underlying tax assets remain available to potentially offset future taxable income. In the event that future taxable income does not occur in the manner projected, it could increase the valuation allowance and have a material impact on our financial position and results of operations.
In addition, under Section 382 of the Internal Revenue Code of 1986, as amended, if a change of ownership occurs with respect to a company with deferred income tax assets, that company’s use of the pre-change of ownership carryforward as well as the ability to use certain unrealized built-in losses would be substantially limited. A change of ownership occurred under Section 382 as a result of the exchange offers of common stock for long-term debt in the third quarter of 2009. Generally, under Section 382, the yearly limitation on our ability to utilize such deductions will be equal to the product of the applicable long-term tax exempt rate and the sum of the values of our common stock and our TARP Preferred Stock immediately before the ownership change. Our ability to utilize deductions related to credit losses during the twelve-month period following such an ownership change would also be limited under Section 382, together with net operating loss carryforwards, to the extent that such deductions reflect a net loss that was “built-in” to our assets immediately prior to the ownership change.
Because the exchange offers triggered an ownership change, our ability to use the net operating loss carryforwards and certain built-in losses existing at the time of the deemed change in ownership to offset future income will be substantially limited. Therefore, we may suffer higher than anticipated tax expense, and consequently lower net income and cash flow, in those future years. Moreover, any future change in ownership would further limit our ability to use our net operating loss carryforwards and certain built-in losses existing at the time of the future change in ownership.
Our stock price can be volatile.
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors including, among other things:
•
Actual or anticipated negative variations in quarterly results of operations;
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Negative recommendations by securities analysts;
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Poor operating and stock price performance of other companies that investors deem comparable to us;
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News reports relating to negative trends, concerns and other issues in the financial services industry;
•
Negative perceptions in the marketplace regarding us and/or our competitors;
•
New technology used, or services offered, by competitors;
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Adverse changes in interest rate;
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Adverse changes in the real estate market;
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Negative economic news;
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Adverse changes in government regulations;
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Delisting of our common stock from NASDAQ; and
•
Geopolitical conditions such as acts or threats of terrorism or military conflicts.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause our stock price to decrease regardless of operating results.
If our common stock fails to meet the listing requirements of NASDAQ and is delisted from trading on the NASDAQ, the market price of our common stock could be adversely affected.
Our common stock is currently listed on the NASDAQ Capital Market under the symbol “CRBC”. The NASDAQ’s listing requirements include a requirement that, for continued listing, an issuer’s common shares trade at a minimum bid price of $1.00 per share. This requirement is deemed breached when the bid price of an issuer’s common shares closes below $1.00 per share for 30 consecutive trading days. We were notified on July 19, 2010 that our shares failed to meet the requirement for the specified time period and NASDAQ’s Listing Qualifications Department notified us that they could initiate steps to delist our common stock from trading on the NASDAQ anytime after January 18, 2011 unless our closing bid price exceeds $1.00 per share for at least 10 consecutive trading days prior to that date. On January 19, 2011, Citizens was notified by the NASDAQ Listing Qualifications Department that Citizens had not regained compliance with NASDAQ Marketplace Rule 5450(a)(1). Citizens will be afforded an additional 180 calendar days, or until July 18, 2011, to regain compliance with the minimum closing bid price requirement. If Citizens is not in compliance with the listing requirement by July 18, 2011, the NASDAQ will issue a notification of delisting to the Corporation. Citizens may appeal the determination to delist at that time, pay a fee and submit a plan of compliance to the NASDAQ, which would temporarily stay any delisting action. Any such appeal may not be successful, however, and the Corporation’s common stock could be delisted from trading on the NASDAQ Capital Market.
Citizens intends to actively monitor the bid price for its common stock and is considering available options to resolve the deficiency and regain compliance with the NASDAQ minimum bid price requirement. Although we may take certain actions to increase our stock price prior to being delisted from NASDAQ or otherwise challenge any action by NASDAQ to delist our common stock, there can be no assurance that these actions will be successful in maintaining our listing on NASDAQ or the trading market for our stock. A delisting of our common stock from the NASDAQ could adversely affect the liquidity of the trading market for our stock and therefore the market price of our common stock.
An investment in our common stock is not an insured deposit.
Our common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you could lose some or all of your investment.
We may be adversely affected by the soundness of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on our financial condition and results of operations.
In order to maintain and strengthen our capital base, we may need to raise additional capital in transactions that may be highly dilutive to our common shareholders. If such capital becomes needed, our failure to raise additional capital could have serious consequences for our business.
We regularly perform a variety of analyses on our assets and the impact of credit losses on our capital base, including the preparation of stress case scenarios. Due to continuing economic conditions in the markets in which we operate and the challenges posed to our business, including those described in other Risk Factors, we may determine, based on these analyses, that we need to raise additional Tier 1 common equity to maintain and strengthen our capital base as the effects of these events impact our business over the coming months and years. Any potential capital raising transaction could be highly dilutive to our common shareholders. The market price of our common stock could decline as a result of the dilutive effect of the capital raising transactions we may enter into, or the perception that such transactions could occur.
In connection with the issuance of the TARP Preferred Stock, we also issued a warrant to Treasury to purchase approximately 17.6 million additional shares of our common stock at an initial per share exercise price of $2.56, subject to adjustment, which expires ten years from the issuance date. Even if we were to redeem the TARP Preferred Stock, we may not fully retire this warrant and, therefore, this warrant may be exercised, in whole or part, prior to its expiration date. Furthermore, the terms of the warrant provide that, if we issue common stock or securities convertible or exercisable into, or exchangeable for, common stock at a price that is less than 90% of the market price of such shares on the last trading day preceding the date of the agreement to sell such shares, the number and the per share price of common stock to be purchased pursuant to the warrant will be adjusted pursuant to its terms. As part of our potential capital raising efforts, we could issue securities convertible into or exercisable for our common stock, which may trigger the anti-dilution provisions of the warrant issued to the Treasury. If we issue such securities and they are subsequently exercised, converted into or exchanged for common stock such transactions would have a further dilutive effect on other holders of our common stock.
Also, if we determine that we need to raise additional capital, our capital raising efforts may not be successful, or we may be required to raise additional capital on terms that are unfavorable to us. A failure to maintain capital above “well-capitalized” levels could require us to further reduce the size of our business and would likely have serious negative consequences for our business.
We have agreements with derivative counterparties that contain a provision where if we fail to maintain our status as a well capitalized or adequately capitalized institution, then the counterparty could terminate the derivative positions and we would be required to settle our obligations under the agreements. A default under these agreements could have a material adverse effect on our business, results of operations and financial condition.
Our Holding Company may not have sufficient resources to make capital contributions to the Bank if required by bank regulatory agencies, or if we might otherwise wish to do so, in order to maintain the Bank’s capital ratios at acceptable levels.
Our Holding Company is required by banking regulation to act as a “source of strength” to the Bank. If losses at the Bank continue and regulatory capital levels at the Bank decline, our Holding Company may be required by the bank regulatory agencies to contribute additional capital to the Bank. Since January 1, 2009, the Holding Company contributed $174.0 million to Citizens Bank to bolster capital levels at the Bank, including $100.0 million during 2010. As of December 31, 2010, the Holding Company’s cash resources totaled $68.1 million. We may not have sufficient funds at our Holding Company level to make required capital contributions to the Bank if the weakness in the economies in which we operate continues over a substantial period of time and the Bank continues to incur losses.
As a bank holding company that conducts substantially all of our operations through our subsidiaries, the ability of our Holding Company to pay dividends, repurchase our shares or to repay our indebtedness depends upon the results of operations of our subsidiaries and their ability to pay dividends to our Holding Company. Dividends paid by these subsidiaries are subject to limits imposed by federal and state law and are restricted by a supervisory agreement with our regulators.
The Holding Company is a separate and distinct legal entity from our subsidiaries and it receives substantially all of its revenue from dividends from our subsidiaries and sales of our securities to investors. Dividends from subsidiaries are an important source of funds to pay dividends on common stock and interest and principal on debt. Various federal and/or state laws and regulations limit the amount of dividends that our subsidiaries may pay to the Holding Company. Also, our Holding Company’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. Because our subsidiaries are currently unable to pay dividends to our Holding Company, we may not be able to service debt, pay obligations or, should we have the ability to do so in the future, pay dividends on common stock. Payment of dividends by our Holding Company on the common stock, or by the Bank to our Holding Company, requires regulatory approval pursuant to the Written Agreement, which generally prohibits the Holding Company from paying interest or principal on subordinated debentures or trust preferred securities, taking any form of payment from Citizens Bank, incurring, increasing, or guaranteeing debt and purchasing or redeeming any shares of its stock. These restrictions will remain in effect until the FRBC and OFIR terminate the Written Agreement. In addition, the payment of dividends on the common stock or, except in limited circumstances, the repurchase of our common stock or other equity or capital securities by our Holding Company at any time prior to December 12, 2011 requires the approval of the United States Treasury pursuant to the terms of our TARP Preferred Stock unless we have redeemed all of the TARP Preferred Stock or Treasury has transferred all of the TARP Preferred Stock to a third party.
As of December 31, 2010, the Holding Company’s cash resources totaled $68.1 million. The Holding Company’s interest and preferred dividend payment obligations are $19.9 million annually. We have suspended the dividend payments on our trust preferred securities and on our TARP Preferred Stock issued to the Treasury, temporarily reducing our payment obligations to $6.5 million annually. However, there can be no assurance that the Holding Company’s cash resources will be sufficient to fulfill its obligations.
Our efforts to resolve problem assets in a manner beneficial to the Corporation may not be successful.
In an effort to reduce overall problem asset levels, Citizens resolved $466.2 million of problem assets in the fourth quarter of 2010 through a combination of bulk sales and individual workouts, resulting in a provision for loan losses of $131.3 million and net charge-offs of $159.3 million. Although we expect to substantially complete these efforts in the first quarter of 2011, clients may be unwilling or unable to repay Citizens on a timely basis or renegotiate their loans, there may be no market for Citizens to exit these loans or economic conditions could result in a more significant increase in nonperforming loans than expected. If any of these conditions occurs, Citizens may not be able to substantially complete the resolution of problem assets during the expected time frame, which could have a negative impact on its capital, results of operations and financial position, and could delay Citizens’ return to profitability.
We could face unanticipated environmental liabilities or costs related to real property owned or acquired through foreclosure. Compliance with federal, state and local environmental laws and regulations, including those related to investigation and clean-up of contaminated sites, could have a negative effect on expenses and results of operations.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on results of operations.
We are party to various lawsuits incidental to our business. Litigation is subject to many uncertainties such that the expenses and ultimate exposure with respect to many of these matters cannot be ascertained.
From time to time, customers and others make claims and take legal action pertaining to our performance of fiduciary responsibilities. Whether customer claims and legal action are legitimate or unfounded, if such claims and legal actions are not resolved in our favor they may result in significant financial liability and/or adversely affect the market perception of us and our products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
The financial services industry is undergoing rapid technological changes. If we are unable to adequately invest in and implement new technology-driven products and services, we may not be able to compete effectively, or the cost to provide products and services may increase significantly.
The financial services industry is undergoing rapid technological changes with frequent introduction of new technology-driven products and services. In addition to providing better customer service, the effective use of technology increases efficiency and enables financial service institutions to reduce costs. Our future success will depend, in part, upon our ability to address the customer needs by using technology to provide products and services to enhance customer convenience, as well as to create additional operational efficiencies. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services, which could reduce our ability to effectively compete and, in turn, have a material adverse effect on our financial condition and results of operations.
The products and services offered by the banking industry and customer expectations regarding them are subject to change. We attempt to respond to perceived customer needs and expectations by offering new products and services, which are often costly to develop and market initially. A lack of market acceptance of these products and services would have a negative effect on our financial condition and results of operations.
From time to time, we implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services we may invest significant time and resources. We may not achieve initial timetables for the introduction and development of new lines of business and/or new products or services and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition.
We may not be able to attract and retain skilled people. If we were to lose key employees, we may experience a disruption in our relationship with certain customers.
Our success depends, in large part, on our ability to attract and retain skilled people. Competition for the best people in most of our business activities can be intense, and we may not be able to hire sufficiently skilled people or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our markets, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.
Many of our key employees have extensive customer relationships. Loss of a key employee with such customer relationships may lead to the loss of customers if they were to follow that employee to a competitor. While we believe that our relationship with our key producers is good, we cannot guarantee that all of our key personnel will remain with us.
The recently enacted Dodd-Frank Act may adversely impact Citizens’ results of operations, financial condition or liquidity.
The Dodd-Frank Act, enacted in July 2010, represents the comprehensive overhaul of the financial services industry within the United States, establishes the new Federal Bureau of Consumer Financial Protection, and requires the bureau and other federal agencies to implement many new and significant rules and regulations. These rules and regulations, as well as the self-implementing provisions of the statute and the Durbin amendment could have adverse implications on the financial industry, the competitive environment and our ability to conduct business. The Durbin Amendment (the “Amendment”) to the Dodd-Frank Act, directs the Board of Governors of the Federal Reserve System to establish rules by April 21, 2011, required to take effect by July 21, 2011, related to debit-card interchange fees. The proposed rule released by the Federal Reserve on December 16, 2010 precludes the recovery of costs other than those permitted by the Amendment, and may have an adverse effect on Citizens’ average interchange rate after July 21, 2011. Citizens, as well as the broader financial services industry, has begun to assess the potential impact of the Dodd-Frank Act on its business and operations, but at this early stage, the likely impact cannot be ascertained with any degree of certainty. However, it is likely that compliance with these new laws and regulations will result in reduced revenue and additional costs, which could be significant, and may adversely impact Citizens’ results of operations, financial condition or liquidity.
New accounting or tax pronouncements or interpretations may be issued by the accounting profession, regulators or other government bodies which could change existing accounting methods. Changes in accounting methods could negatively impact our results of operations and financial condition.
Current accounting and tax rules, standards, policies, and interpretations influence the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. Events that may not have a direct impact on us, such as the bankruptcy of major U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, and various taxing authorities, responding by adopting and/or proposing substantive revision to laws, regulations, rules, standards, policies, and interpretations. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. A change in accounting standards may adversely affect reported financial condition and results of operations.
Our business continuity plans or data security systems could prove to be inadequate, resulting in a material interruption in, or disruption to, our business and a negative impact on our results of operations.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems, whether due to severe weather, natural disasters, acts of war or terrorism, criminal activity or other factors, could result in failures or disruptions in general ledger, deposit, loan, customer relationship management, and other systems. While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our results of operations.
Our vendors could fail to fulfill their contractual obligations, resulting in a material interruption in, or disruption to, our business and a negative impact on our results of operations.
We have entered into subcontracts for the supply of current and future services, such as data processing, mortgage loan processing and servicing, and certain property management functions. These services must be available on a continuous and timely basis and be in compliance with any regulatory requirements. Failure to do so could substantially harm our business.
We often purchase services from vendors under agreements that typically can be terminated on a periodic basis. There can be no assurance, however, that vendors will be able to meet their obligations under these agreements or that we will be able to compel them to do so. Risks of relying on vendors include the following:
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If an existing agreement expires or a certain service is discontinued by a vendor, then we may not be able to continue to offer our customers the same breadth of products and our operating results would likely suffer unless we are able to find an alternate supply of a similar service.
•
Agreements we may negotiate in the future may commit us to certain minimum spending obligations. It is possible we will not be able to create the market demand to meet such obligations.
•
If market demand for our products increases suddenly, our current vendors might not be able to fulfill our commercial needs, which would require us to seek new arrangements or new sources of supply, and may result in substantial delays in meeting market demand.
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We may not be able to control or adequately monitor the quality of services we receive from our vendors. Poor quality services could damage our reputation with our customers.
Potential problems with vendors such as those discussed above could have a significant adverse effect on our business, lead to higher costs and damage our reputation with our customers and, in turn, have a material adverse effect on our financial condition and results of operations.
Our controls and procedures may fail or be circumvented which could have a material adverse effect on our business, results of operations and financial condition.
We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
Our articles of incorporation and bylaws as well as certain banking laws may have an anti-takeover effect.
Provisions of our articles of incorporation and bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire our Holding Company, even if doing so would be perceived to be beneficial to shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
Citizens’ executive offices are located at 328 South Saginaw Street, Flint, Michigan in the main office building of Citizens Bank, the bank subsidiary. The bank subsidiary operates through 218 offices. Of these, 58 are leased and the remainder are owned and not subject to any material liens. Rent expense on the leased properties totaled $5.8 million in 2010. The banking offices are located in various communities throughout the states of
Michigan and Wisconsin, and in parts of Ohio, and Indiana and are used by all of Citizens’ business segments. At certain Citizens Bank locations a portion of the office buildings are leased to tenants.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Citizens is party to a number of lawsuits incidental to its business. Although litigation is subject to many uncertainties and the ultimate exposure with respect to many of these matters cannot be ascertained, Citizens does not believe the ultimate outcome of these matters will have a material adverse effect on its financial condition or liquidity.
From time to time, the Bank is notified by applicable environmental regulatory agencies, pursuant to state or federal environmental statutes or regulations, that they may be potentially responsible parties (“PRP”) for environmental contamination on or emanating from properties currently or formerly owned. Typically, exact costs of remediation of the contamination cannot be fully determined at the time of initial notification. While, as PRPs, the Bank is potentially liable for the costs of remediation, in most cases, a number of other PRPs have been identified as being jointly and severally liable for remediation costs. Additionally, in certain cases, statutory defenses to liability for remediation costs may be asserted based on the Bank’s status as a lending institution that acquired ownership of the contaminated property through foreclosure. Citizens is not presently aware of any environmental liabilities that pose a reasonable possibility of future material impact on its results of operations. It is Citizens’ policy to establish and accrue appropriate reserves for all such identified exposures during the accounting period in which a loss is deemed to be probable and the amount is determinable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Holding Company’s common stock is traded on NASDAQ under the symbol “CRBC”. There were approximately 38,000 shareholders of the Holding Company’s common stock as of December 31, 2010, which includes record holders and individual participants in security position listings.
Information regarding the Holding Company’s high and low stock prices during each quarter of the last two fiscal years is set forth in the table below. The Holding Company is currently prohibited from paying cash dividends or repurchasing shares of common stock without the prior written consent of certain banking regulators and the U.S. Treasury and none have been paid during the last two years. Restrictions on the Holding Company’s ability to pay dividends are described in Note 18 to the Consolidated Financial Statements and “Item 1 Business - Supervision and Regulation” and such descriptions are incorporated herein by reference.
In addition, the information under the caption “Equity Compensation Plan Information” under Item 12 of this Report is incorporated herein by reference.
Stock Performance Graph
The following graph summarizes the annual percentage change in the cumulative total shareholder return of the Holding Company’s common stock for the last five years compared with the Keefe, Bruyette & Woods Regional Banking Index (Ticker: KRX) and the S&P 500 Index (Ticker: SPX). The graph assumes the investment in Citizens’ common stock and each index was $100 on December 31, 2005 and the reinvestment of all dividends. The returns shown are not necessarily indicative of future performance.
The information furnished under the heading “Stock Performance Graph” shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section, and such information shall not be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended.
Issuer Repurchases of Equity Securities
(1)
Shares repurchased in connection with taxes due from employees as a result of the vesting of certain restricted share awards in accordance with the related grant agreements. These repurchases were not part of the repurchase program approved in October 2003.
(2)
In October 2003, the Board of Directors approved the repurchase of 3,000,000 shares of common stock from time to time in the market. There is no expiration date for the repurchase program. The repurchase of shares is generally prohibited, with certain exceptions, by the CPP Letter Agreement while Treasury continues to hold the related TARP Preferred Stock, by the Written Agreement and by the terms of Citizens’ outstanding trust preferred securities, and is also subject to limitations that may be imposed by applicable securities laws and regulations and the rules of NASDAQ. The timing of the purchases and the number of shares to be bought at any one time also depend on market conditions and Citizens’ capital requirements. There can be no assurance that Citizens will repurchase the remaining shares authorized to be repurchased.
The selected financial data presented below is derived from Citizens’ audited consolidated financial statements and should be read in conjunction with its Consolidated Financial Statements for the years ended December 31, 2010, 2009, and 2008, and notes thereto and “Item 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following presents management’s discussion and analysis of Citizens’ financial condition and results of operations for each of the past three years and should be read in conjunction with the accompanying Consolidated Financial Statements and Notes. The discussion highlights the principal factors affecting earnings (loss) for the years 2010, 2009, and 2008 and the significant changes in balance sheet items from December 31, 2009 to December 31, 2010 and is intended to help the reader understand, from management’s perspective, the consolidated financial statements, notes to financial statements, and the accompanying tables, charts and financial statistics appearing elsewhere in this report. Where applicable, this discussion also reflects management’s insights regarding known events and trends that have or may reasonably be expected to have a material effect on the Corporation’s operations and financial condition.
Forward-Looking Statements
Discussions and statements in this report that are not statements of historical fact, including without limitation statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “anticipate,” “estimate,” “project,” “intend,” and “plan,” and statements regarding Citizens’ future financial and operating results, plans, objectives, expectations and intentions, are forward-looking statements that involve risks and uncertainties, many of which are beyond Citizens’ control or are subject to change. No forward-looking statement is a guarantee of future performance and actual results could differ materially. Factors that could cause or contribute to such differences include, without limitation, risks and uncertainties detailed from time to time in Citizens’ filings with the SEC, including those listed in “Item 1A. Risk Factors” of this report.
Other factors not currently anticipated may also materially and adversely affect Citizens’ results of operations, cash flows, financial position, and prospects. There can be no assurance that future results will meet expectations. While Citizens believes that the forward-looking statements in this report are reasonable, the reader should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. Citizens does not undertake, and expressly disclaims any obligation to update or alter any statements, whether as a result of new information, future events or otherwise, except as may be required by applicable law.
OVERVIEW
Nature of Citizens’ Business
Citizens is a diversified banking and financial services company that provides a full range of banking and financial services to individuals and businesses through its subsidiary, Citizens Bank. The Corporation also provides wealth management services through CB Wealth Management. Citizens conducts operations through 218 offices and 252 ATM locations throughout Michigan, Wisconsin, Ohio, and Indiana. Citizens operates in five major business lines: Regional Banking, Specialty Consumer, Specialty Commercial, Wealth Management, and Other. Citizens’ performance is monitored by an internal profitability measurement system that provides line of business results as presented in “ - Line of Business Results” and Note 15 to the Consolidated Financial Statements, incorporated herein by reference.
The Corporation’s primary source of revenue is net interest income, which is the difference between interest income on earning assets (such as loans and securities) and interest expense on liabilities (such as interest-bearing deposits and borrowings) used to fund those assets. Net interest income is affected by fluctuations in the amount and composition of earning assets and funding sources and in the yields earned and rates paid, respectively, on these assets and liabilities. The Corporation measures the level of interest income relative to earning assets and interest bearing liabilities through two statistics - interest spread and net interest margin. The interest spread represents the difference between the taxable equivalent yields on earning assets and the rates paid for interest-bearing liabilities. The net interest margin is expressed as the percentage of taxable equivalent net interest income to average earning assets. Citizens’ sensitivity to changes in interest rates and the potential effect of changes in interest rates on net interest income is presented in more detail in “ - Interest Rate Risk”.
Proper management of the volume and composition of the Corporation’s earning assets and funding sources is essential for ensuring strong and consistent earnings performance, maintaining adequate liquidity and limiting exposure to risks caused by changing market conditions. Citizens’ investment securities portfolio is structured to provide a source of liquidity principally through the maturity of the securities held in the portfolio and to generate an income stream with relatively low levels of principal risk. Loans comprise the largest component of earning assets and are the highest yielding assets. Client deposits are the primary source of funding for earning assets while short-term debt and other managed sources of funds are utilized as market conditions and liquidity needs change.
The Corporation monitors and manages its liquidity position so that funds will be available at a reasonable cost to meet client cash flow needs, while maintaining funds available for loan and investment opportunities as well as to service debt, invest in subsidiaries, finance business expansion, satisfy other operating requirements and take advantage of unforeseen opportunities. Citizens derives its liquidity through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. The Corporation also has access to market borrowing sources for both short-term and long-term purposes.
Citizens’ other principal source of revenue is noninterest income, particularly fees and other revenue from financial services provided to customers. Citizens’ noninterest income includes service charges on deposit accounts, trust fees related to personal, institutional and employee benefit products and services, revenue related to loan products, including commercial loan fees and mortgage banking revenue, and fees for various other services, such as brokerage and investment services, ATM network use, and other financial services.
Use of Non-GAAP Financial Measures
In addition to results presented in accordance with U.S. generally accepted accounting principles (“GAAP”), this report includes non-GAAP financial measures such as net interest margin and the efficiency ratio, tangible equity to tangible assets ratio, tangible common equity to tangible assets ratio, Tier 1 common equity ratio, and pre-tax pre-provision profit. Citizens believes these non-GAAP financial measures provide additional information that is useful to investors in understanding the underlying performance of Citizens, its business, and performance trends and, to a lesser degree, such measures help facilitate performance comparisons with others in the banking industry. Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. Readers should be aware of these limitations and should be cautious as to their use of such measures. To mitigate these limitations, Citizens has procedures in place to ensure that these measures are calculated using the appropriate GAAP or regulatory components in their entirety and to ensure that Citizens’ performance is properly reflected to facilitate consistent period-to-period comparisons. Although Citizens believes the non-GAAP financial measures disclosed in this report enhance investors’ understanding of its business and performance, these non-GAAP measures should not be considered in isolation, or as a substitute for GAAP basis financial measures.
Net Interest Margin and Efficiency Ratio (non-GAAP financial measures)
In accordance with industry standards, certain designated net interest income amounts are presented on a taxable equivalent basis, including the calculation of net interest margin and the efficiency ratio. Citizens believes the presentation of net interest margin on a taxable equivalent basis using a 35% effective tax rate allows comparability of net interest margin with industry peers by eliminating the effect of the differences in portfolios attributable to the proportion represented by both taxable and tax-exempt investments. See the Selected Quarterly Information Table, the Non-GAAP Reconciliation Table, and the Average Balances/Net Interest Income/Average Rates Table later in this report for additional information.
Tangible Equity, Tangible Common Equity and Tier 1 Common Equity Ratios (non-GAAP financial measures)
Citizens believes the exclusion of goodwill and other intangible assets to create “tangible assets” and “tangible equity” facilitates the comparison of results for ongoing business operations. Citizens’ management internally assesses the company’s performance based, in part, on these non-GAAP financial measures. The tangible common equity ratio and Tier 1 common equity ratio have become a focus of some investors and management believes that these ratios may assist investors in analyzing Citizens’ capital position absent the effects of intangible assets and preferred stock. Because tangible common equity and Tier 1 common equity are not formally defined by GAAP or codified in the federal banking regulations, these measures are considered to be
non-GAAP financial measures. Because analysts and banking regulators may assess Citizens’ capital adequacy using tangible common equity and Tier 1 common equity, Citizens believes that it is useful to provide investors the ability to assess its capital adequacy on the same bases. Tier 1 common equity is often expressed as a percentage of net risk-weighted assets. Under the risk-based capital framework, a bank’s balance sheet assets and credit equivalent amounts of off-balance sheet items are assigned to one of four broad risk categories. The aggregated dollar amount in each category is then multiplied by the risk weight assigned to that category. The resulting weighted values from each of the four categories are added together and this sum is the risk-weighted assets total that, as adjusted, comprises the denominator of certain risk-based capital ratios. Tier 1 capital is then divided by this denominator (net risk-weighted assets) to determine the Tier 1 capital ratio. Adjustments are made to Tier 1 capital to arrive at Tier 1 common equity as shown in the Non-GAAP Reconciliation Table below. The amounts disclosed as net risk-weighted assets are calculated consistent with banking regulatory requirements.
Pre-tax Pre-Provision Profit (non-GAAP financial measure)
Pre-tax pre-provision profit (“PTPP”), as defined by Citizens’ management represents total revenue (total net interest income and noninterest income) excluding any securities gains/losses, fair-value adjustments on loans held for sale, interest rate swaps, and bank owned life insurance, less noninterest expense excluding any goodwill impairment charges, credit writedowns, fair-value adjustments and special assessments. While certain of these items are an integral part of Citizens’ banking operations, in each case, the excluded items are items that management believes are particularly impacted by economic stress or significant changes in the credit cycle and are therefore likely to make it more difficult to understand our underlying performance trends and the ability of our banking operations to generate revenue. Net interest income, noninterest income and noninterest expense are all calculated in accordance with GAAP and are presented in the Consolidated Statements of Operations. While noninterest income and noninterest expense are adjusted for the specific items listed above in the calculation of PTPP, these adjustments represent the excluded items in their entirety for each period presented to better facilitate period to period comparisons.
Viewed together with Citizens’ GAAP results, PTPP provides management, investors and others with a useful metric to evaluate and better understand trends in Citizens’ period-to-period earnings power and ability to generate capital to cover credit losses, in each case exclusive of the effects of the current and recent economic stress and the credit cycle. As recent results for the banking industry demonstrate, loan charge-offs, related credit provision, and credit writedowns can vary significantly from period to period, making a measure that helps isolate the impact of credit costs on profitability all the more important to investors. The “Credit Quality” section of this report isolates the challenges and issues related to the credit quality of Citizens’ loan portfolio and their impact on Citizens’ earnings as reflected in the provision for loan losses.
A portion of the compensation awarded to Citizens’ Named Executive Officers and certain other management employees for their performance in 2009 and 2010 is measured against a PTPP performance target as Citizens believes that PTPP is a key measurement that helps keep revenue generation as a focus for its business and a particularly valuable measure during challenging credit cycles. Based on 2009 full-year results, the total cash compensation award linked to PTPP was $0.1 million. Additionally during 2009, approximately 234,000 shares of restricted stock were granted, which vest only if both the PTPP performance condition and the GAAP net income performance condition are met. Based on 2010 full year results, the total potential cash compensation award linked to PTPP is $1.1 million, payable in early 2011. Additionally, during 2010, approximately 1,129,000 shares of restricted stock and restricted stock units were granted which have a two-year vesting period based partially on PTPP results and partially on total provision expense. The grants are designed so that a portion of the compensation is based on provision expense while the remainder does not depend on management’s performance with regard to managing loan losses, securities impairments, and other asset impairments.
Like all non-GAAP metrics, PTPP’s usefulness is inherently limited. Because Citizens’ calculation of PTPP may differ from the calculation of similar measures used by other bank holding companies, PTPP should be used to determine and evaluate period to period trends in Citizens’ performance and in comparison to Citizens’ loan charge-offs, related credit provision, and credit writedowns, rather than in comparison to non-GAAP metrics used by other companies. In addition, investors should bear in mind that income tax expense (benefit), the provision for loan losses, and the other items excluded from revenues and expenses in the PTPP calculation are recurring
and integral expenses to Citizens’ banking operations, and that these expenses will still accrue under GAAP, thereby reducing GAAP earnings and, ultimately, shareholders’ equity.
The following table displays the calculation for the past three years of these non-GAAP measures other than pre-tax pre-provision profit, the calculation of which is set forth in the “Performance Summary” section.
Performance Summary
An analysis of the major components of net income for 2010, 2009 and 2008 is presented below.
(1)
Amounts contained in line item “Other income” on Consolidated Statements of Operations
(2)
Amounts contained in line item “Other expense” on Consolidated Statements of Operations
Key factors behind the results for 2010 compared with 2009 were:
•
The increase in net interest income from 2009 was primarily a result of an increase in net interest margin from 2.90% to 3.31%, partially offset by a decrease of $964.4 million in average earning assets. The increase in net interest margin over the comparable period in 2009 was primarily the result of expanding commercial and consumer loan spreads, declining deposit costs, reductions in high-cost funding, and wholesale funding repricing to lower fixed rates, partially offset by the effect of replacing declining loan balances with lower-yielding investment securities and money market investments. The decrease in average earning assets was due to weak loan demand in the current Midwest economic environment and the effects of the accelerated problem asset resolution initiatives undertaken in 2010, partially offset by an increase in investment securities and money market investments.
•
The increase in the provision for loan losses over 2009 was primarily a result of higher net charge-offs primarily due to the additional charge-offs related to the bulk sales and individual workouts of nonperforming commercial and residential mortgage loans throughout 2010 as well as an incremental risk allocated
•
The decrease in noninterest expense from 2009 was primarily the result of the goodwill impairment charge of $256.3 million in the second quarter of 2009, lower losses on other real estate ($9.9 million), lower salaries and employee benefits ($9.0 million), and lower other loan expenses ($4.2 million), partially offset by higher other expense. The decline in losses on other real estate was primarily the result of fewer writedowns compared to 2009 to reflect fair-value declines for the underlying collateral. The decline in salaries and employee benefits was primarily due to lower staffing levels in 2010 and suspending employer contributions to the 401(k) plan in 2009. Lower other loan expense was primarily the result of lower commercial and residential mortgage origination volume and foreclosure-related expenses. Other expense increased primarily due to higher overall FDIC insurance.
•
The increase in the income tax expense from 2009 was primarily the result of alternative minimum tax calculations.
•
The increase in pre-tax pre-provision profit from 2009 was primarily the result of higher net interest income (primarily due to an increase in net interest margin), higher noninterest income (primarily due to interest rate swap income recognition) and lower noninterest expense (due to lower losses on other real estate and lower salaries and employee benefits, partially offset by higher FDIC insurance expense).
Citizens maintains a strong liquidity position, with on- and off-balance sheet liquidity sources and a stable funding base comprised of approximately 78% deposits, 11% long-term debt, 10% equity, and 1% short-term liabilities. Additionally, money market investments and securities available-for-sale could be sold for cash to provide liquidity, if necessary. Citizens continues to maintain a strong capital position, and its regulatory capital ratios are above “well-capitalized” standards.
CRITICAL ACCOUNTING POLICIES
Citizens’ Consolidated Financial Statements are prepared in accordance with GAAP and follow general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions, and complex judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, goodwill, fair value measurements, pension and postretirement benefits, income taxes, derivative financial instruments and hedging activities. Citizens believes that these estimates and the related policies discussed below are important to the portrayal of the Corporation’s financial condition and results of operations. Therefore, management considers them to be critical accounting policies and discusses them directly with the Audit Committee of the Board of Directors. Citizens’ significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements.
Allowance for Loan Losses
The allowance for loan losses represents Citizens’ estimate of probable losses inherent in the loan portfolio, the largest asset category on the consolidated balance sheet. Determining the amount of the allowance for loan losses is considered a critical accounting policy because it requires significant judgment and the evaluation of numerous factors including: the ongoing review and grading of the loan portfolio, consideration of past Citizens’ and relevant banking industry loan loss experience, trends in past due and nonperforming loans, risk
characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, the size and diversity of individual large credits, and other qualitative and quantitative factors which could affect probable credit losses. Other considerations include the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on Citizens’ historical loss experience and additional qualitative factors for various issues. Additionally, an allocation of reserves is established for special situations that are unique to the measurement period with consideration of current economic trends and conditions. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly.
The Corporation’s allowance for loan loss methodology is based on GAAP and SEC guidance. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. Refer to “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the caption “ - Allowance for Loan Losses” for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
The Corporation’s allowance for loan losses consists of three elements: (i) specific allocated allowances based on probable losses on specific commercial or commercial real estate loans, restructured residential mortgage or consumer loans; (ii) risk allocated allowance which is comprised of several loan pool valuation allowances based on Citizens’ historical quantitative loan loss experience for similar loans with similar risk characteristics, including additional qualitative risks determined by the judgment of management; and (iii) general valuation allowances based on existing regional and local economic factors, including deterioration in commercial and residential real estate values, a macroeconomic adjustment factor used to calibrate for the current economic cycle the Corporation is experiencing, and other judgmental factors supported by qualitative documentation such as the inherent imprecision of loan loss projection models.
Specific allocated allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate it is probable that Citizens will be unable to collect all amounts due according to the contractual terms of the loan. The specific allocated allowance is based on probable losses on specific commercial and industrial or commercial real estate loans as well as impairment on TDRs. The allowance allocated to nonperforming commercial loans is typically based on the underlying collateral’s appraised value, updated at least annually, less management’s estimates of cost to sell. Appraisals or broker’s price opinions are obtained more frequently if changes in the property or market conditions warrant. Deterioration in individual asset values, underlying commercial loans, evidenced by refreshed appraisals, is reflected in the specific allocated allowance for commercial nonperforming loans. Troubled debt restructures are evaluated for impairment under specific allocated reserve guidance.
Citizens’ risk allocated allowance, which is comprised of several loan pool valuation allowances is calculated based on historical data with additional qualitative risk determined by the judgment of management. Qualitative factors, both internal and external to the Corporation, considered by management include: (i) the experience, ability and effectiveness of Citizens’ lending management and staff; (ii) the effectiveness of the Corporation’s loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit; (vi) the impact of competition on loan structuring and pricing; (vii) the effectiveness of the internal loan review function; (viii) the impact of environmental risks on the portfolio (ix) the impact of rising interest rates on the portfolio and (x) the impact of loan modification programs. Citizens evaluates the degree of risk that these components have on the quality of the loan portfolio on a quarterly basis. Based upon the Corporation’s analysis, appropriate estimates for qualitative risks are established. Included in the qualitative valuations are allocations for groups of similar loans with risk characteristics that exceed certain concentration limits. Concentration risk guidelines have been established, among other things, for certain industry concentrations, large balance and highly leveraged credit relationships, and loans originated with policy exceptions. Qualitative allowances may also include estimates of inherent but undetected losses within the
portfolio due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition, the difficulty in identifying triggering events that correlate perfectly to subsequent loss rates, and risk factors that have not yet manifested themselves in loss allocation factors. The historical losses used may not be representative of actual losses inherent in the portfolio that have not yet been realized.
The general valuation allowance is based on management’s estimate of the effect of current general economic conditions on current loan pools and the inherent imprecision in loan loss projection models. The uncertainty surrounding the strength and timing of economic cycles, including concerns over the effects of the prolonged economic downturn for the Corporation’s business footprint in the current cycle, also affects the estimates of loss.
Continuous credit monitoring processes and the analysis of loss components are the principal methods relied upon by management to ensure that changes in estimated credit loss levels are reflected in Citizens’ allowance for loan losses on a timely basis. Citizens utilizes regulatory guidance and its own experience in this analysis. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require additions to the allowance based on their judgment on information available to them at the time of their examination.
Actual loss ratios experienced in the future may vary from those projected. In the event that management overestimates future cash flows or underestimates losses on loan pools, the Corporation may be required to increase the allowance for loan losses through the provision for loan losses, which would have a negative impact on the results of operations in the period in which the increase occurred. Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for loan losses, and a discussion of the factors driving changes in the amount of the allowance for loan losses from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” included under the caption “ - Allowance for Loan Losses.”
In December 2010, Citizens adopted ASU 2010-20, which requires new disclosures and clarifies existing disclosure requirements about an entity’s allowance for credit losses and credit quality of its financing receivables. The adoption did not have a material impact on Citizens’ financial condition, results of operations or liquidity, but did have an impact on Citizens’ credit disclosures. See Note 4 to the Consolidated Financial Statements.
Goodwill
Goodwill arises from business acquisitions and is initially measured as the excess of the cost of the acquired business over the sum of the amounts assigned to assets acquired less liabilities assumed. Citizens’ goodwill, which resides almost entirely in the Regional Banking reporting unit, is evaluated at least annually for impairment and Citizens performs this annual test on its major reporting units (which are equivalent to Citizens’ lines of business) as of October 1 of each year. Goodwill impairment analyses are performed on a more frequent basis if events or circumstances indicate that it is more likely than not that the fair values of the reporting units are below their respective carrying amounts. Such events could include a significant adverse change in legal factors or in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment, an unanticipated loss of key employees, a decision to change the operations or dispose of a reporting unit, cash or operating losses, significant revisions to forecasts, or a long-term negative outlook for the industry.
In Step 1 of the test, Citizens estimates the fair value of the reporting units using discounted cash flow models derived from internal earnings forecasts. The primary assumptions used by Citizens include ten-year earnings forecasts, terminal values based on estimated future growth rates, and discount rates based on capital asset pricing models. A Step 1 analysis is prepared for each reporting unit, including those without goodwill, in order to analyze the implied control premium, which measures the difference between the combined fair value of Citizens’ reporting units calculated in Step 1 and Citizens’ total market value. If the carrying amount of a reporting unit exceeds its estimated fair value, Step 2 is required for those reporting units that have goodwill to measure the amount of impairment, if any.
In Step 2 of the test, Citizens estimates the fair value of a reporting unit’s assets and liabilities in the same manner as if a purchase of the reporting unit was taking place using exit pricing, which includes estimating the fair
value of other implied intangibles. Any excess of this hypothetical purchase price over the fair value of the reporting unit’s net assets (excluding goodwill) represents the implied fair value of the goodwill. If the implied fair value of goodwill calculated in Step 2 is less than the carrying amount of goodwill, an impairment loss is charged to noninterest expense to reduce the carrying amount to the implied fair value. The writedown cannot exceed the carrying amount and goodwill cannot be adjusted upward for any subsequent reversal of previously recognized goodwill writedowns.
As of October 1, 2010, the annual impairment test was performed and Citizens concluded that no impairment existed. Step 2 of the analysis was required for Regional Banking, in which it was determined that the implied fair value of goodwill allocated to Regional Banking exceeded its carrying value by 28%. In estimating the fair value of the reporting units in the annual review, discount rates ranged from 11% to 14%, depending on the reporting unit. The discount rate for Regional Banking was 11%. The discount rates were estimated based on a capital asset pricing model, which considered the risk-free rate (20-year Treasury Bonds), market-risk premium, equity risk premium, and a size premium. Simulations were performed to evaluate the impact of discount rate changes on the fair value of the reporting unit. If the discount rate was to increase by 100 or 200 basis points the fair value would be expected to decrease by 16% ($63.8 million) and 29% ($113.7 million), respectively. Simulations for 100 and 200 basis point decreases in the discount rate were not performed as the results would increase the implied value of goodwill. The impact of increasing the discount rate has no effect on our impairment methodology. Citizens performed a review of events or circumstances that would require an additional analysis as of December 31, 2010. Citizens determined that no events or circumstances existed which indicated the need for an additional impairment test.
Citizens’ management believes that the estimates and assumptions used in its goodwill impairment analyses are reasonable. Further deterioration in the outlook for credit quality, changes in the value of the loan or deposit portfolios, or increases in the discount rates could have a material impact on future goodwill impairment testing results. Due to the ongoing uncertainty regarding market conditions, which may continue to negatively impact the performance of the Regional Banking line of business, Citizens will continue to monitor the goodwill impairment indicators and perform additional interim tests, if necessary. Since this evaluation process requires Citizens to make estimates and assumptions with regard to the fair value of the Corporation’s reporting units, actual values may differ significantly from these estimates. Such differences could result in future impairment of goodwill that would, in turn, negatively impact the Corporation’s results of operations and the business segments where the goodwill is recorded. For more information on goodwill, see Note 6 to the Consolidated Financial Statements.
Fair Value Measurements
A number of valuation techniques are used to determine the fair value of assets and liabilities in Citizens’ financial statements. These include quoted market prices for securities, interest rate swap valuations based upon the modeling of termination values adjusted for credit spreads with counterparties and appraisals of real estate from independent licensed appraisers, among other valuation techniques. Fair value measurements for assets and liabilities where there exists limited or no observable market data are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment will be recognized in the income statement. If an impairment is determined, it could limit the ability of Citizens Bank to pay dividends or make other payments to the Holding Company.
In January 2010, Citizens adopted new guidance that requires new disclosures and clarifies existing disclosure requirements about fair value measurement. See Note 10 to the Consolidated Financial Statements for more information on fair value measurements.
Pension and Postretirement Benefits
Pension liabilities are established and pension costs are charged to current operations based on actuarially determined present value calculations. The valuation of the pension obligation and net periodic pension expense is considered critical as it requires management to make estimates regarding the amount and timing of expected
future cash outflows including assumptions about employee mortality, assumed return on cash balances, assumed discount rate used to determine the current benefit obligation, and the long-term rate of return expected on plan assets. The long-term rate of return expected on plan assets is finalized after considering long-term returns in the general market, long-term returns experienced by the assets in the plan, and projected plan expenses. The assets are invested in certain investment funds administered by a third party. Citizens reviews its pension plan assumptions on an annual basis with an actuarial consultant to determine if the assumptions are reasonable and adjusts the assumptions to reflect changes in expectations. If Citizens were to determine that more conservative assumptions were necessary, costs would likely increase and have a negative impact on results of operations in the period in which the increase occurred.
The assumed future earnings on cash balance pension plan accounts were reduced from 5.00% for 2009 to 4.75% for 2010, which reflects the current rate environment, and will cause a slight decrease in pension expense for future periods. The determination of the discount rate used for calculating pension benefit and postretirement benefit obligations was based on a cash flow matching method. A spot yield curve for high quality bonds rated AA- or better was converted to zero coupon equivalent bond rates. These zero coupon bond rates were matched to the actuarially determined benefit obligation annual cash flows. The resulting single discount rate was rounded to a 25 basis point increment. Based on this methodology, the discount rate used for the pension obligation decreased to 5.00% at the end of 2010 from 5.75% and 6.00% at the end of 2009 and 2008, respectively, resulting in an increase to the associated liability for 2010. The discount rate used for the postretirement healthcare obligation as well as the supplemental pension benefit plans decreased to 4.50% at the end of 2010 from 5.25% and 6.00% at the end of 2009 and 2008, respectively, also resulting in an increase to the associated liabilities. Rates are set at the end of each year for use in determining the following year’s expense.
Citizens has recognized the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of its pension plan in the consolidated balance sheet, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income represents the net unrecognized actuarial losses and unrecognized prior service costs that will be subsequently recognized as net periodic pension cost pursuant to Citizens’ historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic pension cost. Note 11 to the Consolidated Financial Statements provides further discussion of the accounting for Citizens’ employee benefit plans and the estimates used in determining the actuarial present value of the benefit obligations and the net periodic pension expense.
Income Taxes
Income tax liabilities or assets are established for the amount of taxes payable or refundable for the current year. Deferred tax liabilities and assets are also established for the future tax consequences of events that have been recognized in the Corporation’s financial statements or tax returns. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and deductions that can be carried forward (used) in future years. Citizens assesses whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. For example, a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable and also restricts the amount of evidence on projections of future taxable income to support the recovery of deferred tax assets. As of December 31, 2010, Citizens held a $292.9 million valuation allowance. Despite the valuation allowance, these assets remain available to potentially offset future taxable income.
The valuation of current and deferred tax liabilities and assets is considered critical as it requires management to make estimates based on provisions of the enacted tax laws and other future events. The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. The Corporation believes its tax assets and liabilities are properly recorded in
the consolidated financial statements. For more information regarding income tax accounting, see Notes 1 and 13 to the Consolidated Financial Statements.
RECENT ACCOUNTING PRONOUNCEMENTS
Notes 1 and 2 to the Consolidated Financial Statements discuss new accounting policies adopted by Citizens during 2010 and 2009 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects Citizens’ financial condition, results of operations or liquidity, the impact is discussed elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
SIGNIFICANT DEVELOPMENTS IN 2010
On January 29, 2010, Citizens entered into a stock purchase agreement with Great Western Bank whereby Great Western Bank agreed to acquire all of the stock of Citizens’ wholly owned subsidiary, F&M Bank-Iowa (“F&M”). F&M served markets with low growth potential outside of Citizens’ primary footprint and generated additional marketing costs to maintain the separate branding. Therefore, Citizens decided to sell F&M at a price which represented approximately 25 times F&M’s average earnings and 1.10 times its tangible book value. On April 23, 2010, Citizens completed the stock sale in exchange for $50.0 million in cash. As a result, the sale proceeds improved the Holding Company’s capital and liquidity positions in a manner that was non-dilutive to Citizens’ shareholders.
As part of the stock purchase agreement, Citizens was required to exchange selected loans with F&M at or near the closing date for a cash payment equal to the book value of the specified loans less related allowance for loan losses. The loans exchanged had a net book value of $9.9 million.
The financial condition and operating results for this subsidiary have been segregated from the financial condition and operating results of Citizens’ continuing operations throughout this report and, as such, are presented as a discontinued operation. While all prior periods have been revised retrospectively to align with this treatment, these changes do not affect Citizens’ reported consolidated financial condition or operating results for any of the prior periods. For more information regarding the sale of F&M, see Note 20 to the Consolidated Financial Statements.
On July 28, 2010, Citizens and Citizens Bank entered into a written supervisory agreement with the FRBC and OFIR, their primary regulators, as a follow up to recently concluded examinations of the Bank. For a detailed summary of the Written Agreement, see “Item 1 Business - Supervision and Regulation.”
In an effort to reduce overall problem asset levels, Citizens resolved $466.2 million of problem assets in the fourth quarter of 2010 through a combination of bulk sales and individual workouts, recording a provision for loan losses of $131.3 million and net charge-offs of $159.3 million.
SIGNIFICANT DEVELOPMENTS IN 2009 AND 2008
Goodwill Impairment Charges
Citizens recorded a non-cash goodwill impairment charge of $256.3 million against the goodwill allocated to Regional Banking (which had no impact on regulatory capital ratios or Citizens’ overall liquidity) in 2009 and a non-cash goodwill impairment charge of $178.1 million, representing the entire amount of goodwill previously allocated to Specialty Commercial in 2008. The goodwill impairment charges were not tax deductible, did not impact Citizens’ tangible equity or regulatory capital ratios and did not adversely affect Citizens’ overall liquidity position. For more information regarding these goodwill impairment charges, see the “Goodwill” headings under “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and - Financial Condition” as well as Note 6 to the Consolidated Financial Statements.
Exchange of Common Stock for Long-Term Debt
On September 30, 2009, Citizens completed its exchange offers to issue common stock in exchange for its outstanding 5.75% Subordinated Notes due 2013 (the “Subordinated Notes”) and outstanding 7.50% Enhanced Trust Preferred Securities of Citizens Funding Trust I (the “Exchange Offers”). In aggregate, 268.2 million shares at a fair value of $219.9 million ($0.82 per common share as of the expiration date of the Exchange Offers) were issued in exchange for long term debt with a carrying value of $204.0 million. The consummation of the Exchange Offers created a net loss on the early extinguishment of debt totaling $15.9 million, which represented the difference between the fair value of Citizens’ common stock issued and the carrying value of the retired debt. After taking into account $6.4 million of issuance costs, the transaction resulted in an increase to common equity of $197.6 million. For more information regarding this transaction, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity Risk Management” and Notes 9 and 14 to the Consolidated Financial Statements.
Issuances of Capital in 2008
On June 11, 2008, Citizens issued $79.6 million of common stock and $120.4 million of contingent convertible perpetual non-cumulative preferred stock that together increased shareholders’ equity by $189.0 million (net of issuance costs and the underwriting discount). The preferred stock subsequently converted to common stock in September 2008 after shareholders approved a charter amendment to increase authorized common shares by 50 million.
On December 12, 2008, Citizens issued an aggregate of $300.0 million of TARP Preferred Stock and a ten-year warrant to purchase up to 17,578,125 shares of Citizens’ common stock to the Treasury as part of the Treasury’s Capital Purchase Program.
For more information regarding these issuances, see Note 14 to the Consolidated Financial Statements.
RESULTS OF OPERATIONS
NET INTEREST INCOME
An analysis of net interest income, interest spread and net interest margin with average balances and related interest rates for the full years of 2010, 2009, and 2008 is presented below.
Average Balances/Net Interest Income/Average Rates
(1)
Interest income is shown on an unadjusted basis and therefore does not include taxable equivalent adjustments.
(2)
Average rates include taxable equivalent adjustments to interest income of $10.6 million, $15.6 million, and $17.4 million for the years ended December 31, 2010, 2009, and 2008, respectively, based on a tax rate of 35%.
(3)
For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.
(4)
Nonaccrual loans are included in average balances for each applicable loan category.
(5)
The interest spread and net interest margin are presented on a tax-equivalent basis.
(6)
Because noninterest-bearing funding sources, demand deposits, other liabilities and shareholders’ equity also support earning assets, the net interest margin exceeds the interest spread.
2010 compared with 2009
The increase in net interest margin over 2009 was primarily the result of expanding commercial and consumer loan spreads, declining deposit costs, reductions in high-cost funding, and wholesale funding repricing to lower fixed rates, partially offset by the effect of replacing declining loan balances with lower-yielding investment securities and money market investments. The increase in net interest income was primarily the result of the higher net interest margin, partially offset by decreases in average earning assets. The decreases in average earning assets were due to weak loan demand in the current Midwest economic environment and the effects of the accelerated problem asset resolution initiatives undertaken in 2010, partially offset by increases in investment securities and money market investments.
2009 compared with 2008
The decrease in net interest margin was primarily a result of deposit price competition, the transfer of loans to nonperforming status during 2009, and an increase in short-term investments to provide additional on-balance sheet liquidity. The decrease was partially offset by expanding commercial and consumer loan spreads and retail
time deposits repricing to a lower rate. The decrease in net interest income was primarily a result of the lower net interest margin and a decrease in average earning assets due to a decline in loan portfolio balances caused by lower demand in the current Midwest economic environment, partially offset by the effects of an increase in investment securities and money market investments.
The table below shows changes in interest income, interest expense and net interest income due to volume and rate variances for major categories of earning assets and interest-bearing liabilities.
Analysis of Changes in Interest Income and Interest Expense
(1)
Changes are based on actual interest income and do not reflect taxable equivalent adjustments.
(2)
The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar amounts of the change in each.
2010 compared with 2009
The increase in net interest income reflects rate variances that were favorable in the aggregate and volume variances that were unfavorable in the aggregate. The favorable rate variance was primarily the result of liabilities repricing to lower rates as a result of lower market interest rates in 2010 and reduced deposit price competition and expanding commercial and consumer loan spreads, partially offset by lower market interest rates for investment securities. The unfavorable volume variance was primarily due to weak customer demand from credit worthy clients in all loan categories and the effects of the accelerated problem asset resolution initiatives undertaken in 2010, partially offset by an increase in the investment securities and money market investment portfolios and a decrease in brokered time deposits and long-term debt.
2009 compared with 2008
The decrease in net interest income reflects rate and volume variances that were unfavorable in the aggregate. The unfavorable rate variance was primarily the result of lower market interest rates in 2009 and deposit price competition, partially offset by expanding commercial and consumer loan spreads. The unfavorable volume variance was primarily due to weak customer demand from credit worthy clients in all loan categories, growth in the commercial on-balance sheet sweep product, and a strategic shift in the funding mix from wholesale borrowings to customer deposits. This was partially offset by an increase in the investment securities and money market investment portfolios as a result of using the proceeds from the preferred stock issuance in the fourth quarter of 2008 and a decrease in short-term borrowings and long-term debt due to the aforementioned shift in funding.
PROVISION FOR LOAN LOSSES
After determining what Citizens believes is an appropriate allowance for loan losses based on the risk in the portfolio, the provision for loan losses is calculated each quarter as a result of the net effect of the quarterly change in the allowance for loan losses and the quarterly net charge-offs. The increases in the provision for loan losses for 2010 as compared with 2009 was primarily due to the additional charge-offs related to the bulk sales and individual workouts of nonperforming commercial and residential mortgage loans during 2010 as well as the incremental risk allocated allowance recorded during the fourth quarter of 2010. The increase in 2009 as compared with 2008 was primarily a result of higher net charge-offs, and the continued migration of commercial real estate and residential mortgage loans to nonperforming status during 2009. This migration, and evaluation of the underlying collateral supporting these loans, caused an increase in the allowance for loan losses due to the higher likelihood that portions of these loans may eventually be charged-off. See “ - Critical Accounting Policies - Allowance for Loan Losses” and “ - Allowance for Loan Losses” for a discussion of the calculation of the allowance and the related methodology.
NONINTEREST INCOME
An analysis of the components of noninterest income is presented in the table below.
Noninterest Income
2010 compared with 2009
The increase in noninterest income was primarily due to higher gains on investment securities and the net loss on debt extinguishment in connection with the Exchange Offers completed in 2009, partially offset by lower service charges on deposit accounts and lower mortgage and other loan income. The decrease in mortgage and other loan income was primarily the result of lower residential mortgage origination volume while the decrease in service charges on deposit accounts was primarily the result of lower customer transaction volume along with the impact of Reg E implementation which occurred in the second half of 2010. Regulation E, requires that banks receive permission (“opt-in”) from consumers before they can charge a fee for overdrawing their account when they make withdrawals using an ATM card, or use their debit card (check card) for one-time purchases. Citizens received consent from a majority of clients with little negative impact. The increase in other income was primarily the result of higher swap income recognition.
2009 compared with 2008
The decrease in noninterest income was primarily due to a net loss on the early extinguishment of debt created when Citizens completed settlement of the Exchange Offers, higher net losses on loans held for sale, and to a lesser extent, lower service charges on deposit accounts, trust fees, and brokerage and investment fees. The increase in net losses on loans held for sale was primarily the result of higher writedowns to reflect market-value declines for the underlying collateral. The decrease in service charges on deposit accounts was primarily the result of a decline in customer transaction volume. The decline in trust fees as well as brokerage and investment fees were primarily the result of negative market conditions.
NONINTEREST EXPENSE
An analysis of the components of noninterest expense is presented in the table below.
Noninterest Expense
2010 compared with 2009
The decrease in noninterest expense was primarily the result of the goodwill impairment charge in 2009, lower losses on other real estate, lower salaries and employee benefits, lower other loan expenses, lower intangible asset amortization, and lower professional services partially offset by an increase in other expense and data processing services. The decline in losses on other real estate was primarily the result of fewer writedowns compared to 2009 to reflect fair-value declines for the underlying collateral. The decline in salaries and employee benefits was primarily due to lower staffing levels and suspending employer contributions to the 401(k) plan in the third quarter of 2009. Lower other loan expense was primarily the result of lower origination volume and foreclosure-related expenses. The decrease in intangible asset amortization is directly related to core deposit assets becoming fully amortized during the second quarter of 2009. The decline in professional services was primarily the result of various expense management initiatives implemented throughout the Corporation. Other expense increased primarily due to higher overall FDIC insurance. Data processing fees increased as a result of a conversion to remote capture of item processing.
2009 compared with 2008
The increase in noninterest expense was primarily the result of a higher goodwill impairment charge, as well as higher other expense, losses on other real estate, and other loan expenses, partially offset by lower salaries and employee benefits, as well as a net decline in all other noninterest expense categories. The increase in other expense was primarily the result of an increase in FDIC insurance premiums due to an industry-wide rate increase and special assessment. The increase in losses on other real estate was primarily the result of mark-to-market charges related to additional declines in market values on the ORE assets. The increase in other loan expense was primarily the result of higher foreclosure expenses associated with repossessing collateral underlying commercial and residential real estate loans. The decrease in salaries and employee benefits was primarily due to lower staffing levels and suspending employer contributions to the 401(k) plan in 2009. The net
decline in all other noninterest expense categories was primarily the result of various expense management initiatives implemented throughout the company.
FDIC insurance premiums
In December 2008, the FDIC increased the assessment rate for all insured institutions by seven cents for every $100 of qualifying deposits in order to maintain a strong funding position and restore reserve ratios for the deposit insurance fund. This increase was included in Citizens’ 2009 noninterest expense. Beginning April 1, 2009, additional rule changes required institutions, including Citizens, to pay their premiums using a risk-weighted factor. As a result, Citizens’ 2009 FDIC insurance premium increased again and this methodology is likely to further increase future insurance premiums.
Additionally, on May 22, 2009, the FDIC voted to amend the restoration plan and impose a special assessment of five cents for every $100 of Citizens assets less Tier 1 capital at June 30, 2009, which was payable on September 30, 2009. Citizens recorded $5.5 million for the assessment during 2009.
On February 7, 2011 the FDIC Board approved a final rule that changes the assessment base from domestic deposits to average assets minus average tangible equity, adopts a new large-bank pricing assessment scheme, and sets a target size for the Deposit Insurance Fund. The changes will go into effect beginning with the second quarter of 2011 and will be payable at the end of September 2011. The rule as mandated by the Dodd-Frank Act finalizes a target size for the Deposit Insurance Fund at 2 percent of insured deposits. It also implements a lower assessment rate schedule when the fund reaches 1.15 percent (so that the average rate over time should be about 8.5 basis points) and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2 percent and 2.5 percent. The rule would, in aggregate, increase the share of assessments paid by large institutions. The final rule also creates a scorecard-based assessment system for banks with more than $10 billion in assets. The scorecards include financial measures that the FDIC believes are predictive of long-term performance.
FEDERAL AND STATE INCOME TAXES
Citizens recorded an income tax expense of $12.9 million for 2010 compared with a tax benefit of $30.0 million for 2009 and expense of $71.0 million in 2008. The increase in the tax expense from 2009 was primarily the result of alternative minimum tax calculations. The decrease in the 2009 expense from 2008 was primarily the result of establishing the valuation allowance against deferred tax assets during the fourth quarter of 2008 as well as recognizing the tax impact of changes in other comprehensive income during 2009. The effective tax rate, computed by dividing the provision for income taxes by income before taxes, was (4.65%) in 2010, compared with 5.53% in 2009, and (21.93%) in 2008. Variances were primarily due to the relationships between the pre-tax losses as well as the adjustments for the valuation allowance and the goodwill impairment charges.
As of December 31, 2010, Citizens maintained a $292.9 million valuation allowance. Despite the valuation allowance, these assets remain available to potentially offset future taxable income. The deferred tax asset is analyzed quarterly for changes affecting realizability and the valuation allowance may be adjusted in future periods accordingly. In making such judgments, significant weight is given to evidence that can be objectively verified. Citizens analyzes changes in near -term market conditions and considers both positive and negative evidence as well as other factors which may impact future operating results in making the decision to adjust the valuation allowance.
During 2009, we incurred an ownership change within the meaning of Section 382 of the Internal Revenue Code. As a result, federal tax law places an annual limitation of approximately $17.7 million on the amount of certain loss carryforwards that may be used.
For further discussion of federal and state income taxes, see Note 13 to the Consolidated Financial Statements.
LINE OF BUSINESS RESULTS
Net (loss) income by line of business is presented in the table below. A description of each business line, important financial performance data and the methodologies used to measure financial performance are presented in Note 15 to the Consolidated Financial Statements. Certain amounts have been revised retrospectively for discontinued operations.
Net (Loss) Income by Line of Business
2010 compared with 2009
The net loss for Regional Banking decreased in 2010 primarily due to the goodwill charge taken in 2009 not recurring in 2010. Net interest income decreased due to the decrease in loan portfolio and the lower interest rate environment in 2010, while the increased provision for loan losses reflects the continuing stress in the commercial and industrial portfolio.
Net losses for Specialty Consumer decreased in 2010 primarily due to the increase in net interest income and lower noninterest expenses. Net interest income increased due to lower funding costs. The decrease in noninterest expenses was a result of lower losses on the sales of properties.
Net losses for Specialty Commercial increased in 2010 primarily due to the increase in the provision for loan losses. The provision for loan losses reflects additional losses incurred related to the accelerated nonperforming loan resolution program.
Net income for Wealth Management increased in 2010 primarily as a result of the increase in trust fees. That increase was a result of an increase in average market valuations for assets under administration, which were $2.3 billion at December 31, 2010, an increase of $0.2 billion over December 31, 2009.
Activities that are not directly attributable to one of the primary lines of business are included in the Other business line. Included in this category are the Holding Company; the shared services unit; Citizens’ treasury unit, including the securities portfolio, short-term borrowing and asset/liability management activities; inter-company eliminations; and the economic impact of certain assets, capital and support functions not specifically identifiable with the four primary lines of business. Net losses for the Other line of business for 2010 decreased primarily as a result of higher net interest income and higher noninterest income. The increase in net interest income was primarily the result of the internal profitability methodology utilized at Citizens that insulates the other lines of business from interest-rate risk and assigns the risk to the asset/liability management function, which is a component of this segment. The increase in noninterest income was primarily the result of the net gain on the investment securities sales. The income tax provision decreased in 2010 primarily due to changes in categories of income such as other comprehensive income.
2009 compared with 2008
Net income for Regional Banking declined primarily as the result of higher provision for loan losses, lower noninterest income and higher noninterest expense, partially offset by higher net interest income. The increase in the provision for loan losses was primarily due to higher net charge-offs. Noninterest income declined primarily due to lower service charges on deposit accounts. Noninterest expense increased primarily because of the aforementioned goodwill impairment charge in the second quarter of 2009 and the industry-wide increase in FDIC insurance rates. The increase in net interest income was primarily the result of expanding loan spreads, clients holding higher deposit balances in transaction accounts and declining deposit costs, partially offset by lower earning assets and increased nonaccrual commercial loans.
Net losses for Specialty Consumer increased primarily as the result of lower net interest income, higher provision for loan losses, and higher noninterest expense. The decrease in net interest income was primarily the result of lower residential mortgage loan balances as this portfolio is primarily in a runoff pattern as over 90% of new origination were sold into the secondary market during 2009. The increase in the loan loss provision was due to higher nonperforming residential mortgage loan levels throughout 2009. The increase in noninterest expense was primarily the result of higher expenses related to ORE properties.
Net losses for Specialty Commercial declined primarily as the result of lower noninterest expense, partially offset by higher provision for loan losses and lower noninterest income. The decrease in noninterest expense was primarily due to the effects of the aforementioned goodwill impairment charge in the second quarter of 2008. The increase in loan loss provision was due to higher nonperforming commercial loan levels throughout 2009. The decrease in noninterest income was primarily a result of higher net losses on loans held for sale.
Net income for Wealth Management increased primarily as the result of lower noninterest expense, partially offset by lower noninterest income. The decrease in noninterest expense was primarily due to lower salary expense as a result of lower staffing levels and commission-based compensation. The decrease in noninterest income was primarily due to lower trust fees as a result of declines in average market valuation for these assets, as well as a decrease in brokerage income due to lower demand for investment products. Trust assets under administration were $2.1 billion at December 31, 2009, an increase of $0.1 billion over December 31, 2008.
FINANCIAL CONDITION
TOTAL ASSETS
Total assets at December 31, 2010 were $10.0 billion, a decrease of $2.0 billion or 16.5% from December 31, 2009. The decline was primarily due to the sale of F&M during 2010 and reductions in total portfolio loans as a result of the accelerated resolution of problem assets, customer loan paydowns, loan charge-offs and weak customer demand.
MONEY MARKET INVESTMENTS AND INVESTMENT SECURITIES
Objectives in managing the securities portfolio are driven by the dynamics of the balance sheet, including growth, maturity, management of interest rate risk and maximizing return. Interest-bearing deposits with banks decreased $107.3 million in 2010. On October 6, 2008 the Federal Reserve announced that it would pay interest on required and excess reserve balances at rates close to the targeted federal funds rates. Citizens has chosen to utilize this program while adverse conditions exist in the credit markets. Securities are classified as available for sale or held to maturity and as of December 31, 2010, 81.2% of the securities in Citizens’ investment securities portfolio were classified as available for sale. A summary of investment securities balances at December 31, 2010, 2009 and 2008 is provided below.
Investment Securities
The increase in investment securities at December 31, 2010 over December 31, 2009 was primarily due to reinvesting a portion of the loan portfolio paydowns. Citizens substantially improved the risk profile of its investment securities portfolio during 2010 by reducing sponsored agency securities, municipal securities, and other mortgage-backed securities and increasing GNMA securities. Total investment securities at December 31, 2009 were essentially unchanged from December 31, 2008.
The collateralized mortgage obligations (“CMO”) sector includes securities where the underlying collateral consists of agency issued or whole loan mortgages. At December 31, 2010, the whole loan CMOs had a market value of $177.3 million with gross unrealized losses of $5.2 million. Citizens performs a thorough credit review on a quarterly basis on the underlying mortgage collateral as well as the supporting credit enhancement and structure. The results of the December 31, 2010 credit review demonstrated continued strength and no material degradation to the holdings. Additionally, Citizens determined there is no other-than-temporary impairment on the entire investment portfolio at December 31, 2010.
Maturities and average yields of investment securities at December 31, 2010 are presented in the table below.
Maturity Distribution of Investment Securities Portfolio (1)
(1)
This table excludes stock holdings of the Federal Home Loan Bank and Federal Reserve.
(2)
Yields are based on amortized cost.
(3)
Maturity distributions for collateralized mortgage obligations and mortgage-backed securities are based on estimated average lives.
(4)
Average yields on tax-exempt obligations have been computed on a tax equivalent basis, based on a 35% federal tax rate.
As of December 31, 2010, the estimated aggregate fair value of the investment securities portfolio was $26.0 million above amortized cost, consisting of gross unrealized gains of $44.4 million and gross unrealized losses of $18.4 million. A summary of estimated fair values and unrealized gains and losses for the major components of the investment securities portfolio is provided in Note 3 to the Consolidated Financial Statements. Citizens’ policies with respect to the classification of investments in debt and equity securities are discussed in Note 1 to the Consolidated Financial Statements.
LOAN PORTFOLIO
Citizens primarily extends credit within its local markets in Michigan, Wisconsin, and Ohio. Citizens generally lends to consumers and small to mid-sized businesses and, consistent with its emphasis on relationship banking, most of these credits represent core, multi-relationship customers who also maintain deposit relationships and utilize other banking services such as treasury management. The loan portfolio is diversified by borrower and industry, with no concentration within a single industry that exceeds 10% of total portfolio loans. Citizens has minimal loans to foreign debtors and does not actively solicit nationally syndicated loans or participate in highly leveraged transactions. Citizens seeks to limit its credit risk by establishing guidelines to review the aggregate outstanding commitments and loans to particular borrowers and industries. Citizens obtains and monitors collateral based on the nature of the credit and the risk assessment of the customer. See “-Underwriting” for a discussion of Citizens’ underwriting policies and practices.
Loan balances by category for the past five years and an analysis of the maturity and interest rate sensitivity of commercial and industrial, commercial real estate, and real estate construction loans at December 31, 2010 are presented below.
Portfolio Loans
Commercial Loan Maturities and Interest Rate Sensitivity at December 31, 2010
Decreases in all categories comprising total portfolio loans from December 31, 2009 reflect the efforts of the accelerated problem asset resolution initiatives undertaken during 2010, continued weak customer demand from credit-worthy clients, paydowns as a result of normal client activity, charge-offs, and the transfer of nonperforming residential mortgage loans to loans held for sale in 2010 that were subsequently sold.
Commercial and Industrial. The commercial and industrial loan portfolio includes a diverse group of loans largely to in-market business banking (relationships less than $3.0 million) and corporate banking (relationships over $3.0 million) companies in a variety of businesses across many industries. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment purchases. While some short-term loans may be made on an unsecured basis, the large majority are secured by the assets being financed with collateral margins consistent with the Corporation’s loan underwriting guidelines. Commercial and industrial loans are evaluated for adequacy of repayment sources at the time of approval and are regularly reviewed for any possible deterioration in the ability of the borrower to repay on agreed terms. Credit risk in commercial and industrial loans arises due to fluctuations in borrowers’ financial condition, deterioration in collateral values, and changes in market conditions.
Commercial Real Estate. The majority of this portfolio consists of commercial real estate intermediate-term loans to developers and owners of commercial real estate for single and multiple family residential as well as multi -unit commercial properties. These loans are viewed first as cash-flow loans and secondarily as loans secured by real estate.
Commercial real estate loans are subject to underwriting standards and processes specific to the risks embedded in each of the geographic markets served by Citizens, with approximately 34% of the portfolio located in southeast Michigan and 18% located in Ohio. Management monitors commercial real estate loans based on sustainable cash flow, collateral, geography, and risk rating criteria. As a general rule, the Corporation avoids financing single- purpose projects unless other underwriting factors are present to help mitigate risk. Management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied “investment” real estate loans. At December 31, 2010, approximately 37% of the Corporation’s commercial real estate loans were secured by owner-occupied properties.
The credit performance of loans secured by commercial income producing properties has recently been negatively affected by tenant losses and reduced rental rates contributing to the decline in values associated with the income producing loan portfolio. Citizens may suffer further losses in these segments if market conditions continue to deteriorate or do not improve and efforts to limit losses through execution of prudent workout strategies are unsuccessful.
Real Estate Construction. Loans in this classification are short-term interim loans that provide financing for the acquisition or development of commercial real estate, such as multifamily or other commercial development projects, including owner-occupied. Real estate construction loans are made to developers and project managers who are generally well known to the Corporation, have prior successful project experience, and are well-capitalized. Projects undertaken by these developers are carefully reviewed by the Corporation to ensure that they are economically viable and are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates, and financial analysis of the developers and property owners. Loans of this type are generally made to customers based in the Corporation’s markets in which the Corporation has a thorough knowledge of the local market economy. The credit risk associated with real estate construction loans is generally confined to specific geographic areas, but is also influenced by general economic conditions. These loans are considered to have higher risks than other real estate loans due to the inherent construction risk and their ultimate repayment being sensitive to interest rate changes, general economic conditions, absorption dynamics, and the availability of long-term financing. The Corporation controls the credit risk on these types of loans by making loans in familiar markets to developers, underwriting the loans to meet the requirements of institutional investors in the secondary market, reviewing the merits of individual projects, controlling loan structure, and monitoring project progress and construction advances. Sources of repayment for these types of loans may be pre-committed permanent take out loans from long-term lenders, residential mortgage financing, sales of developed property or an interim loan commitment from the Corporation until permanent financing is obtained.
This portfolio has been particularly adversely affected by job losses, declines in real estate value, declines in home sale volumes, and declines in new home building. Declining real estate values have resulted in sharp increases in losses, particularly in the land hold, land development, and construction loan portfolios. Since January 1, 2007, Citizens no longer underwrites new commercial real estate construction, land hold and land development construction loans and is actively managing the remaining portfolio. However, Citizens underwrites new construction loans supporting owner-occupied projects where these loans are viewed first as cash-flow loans and secondarily as loans secured by real estate.
Residential Mortgage Loans. The residential mortgage loan category is predominately comprised of owner-occupied residential properties of which over 85% were located in Michigan and Ohio. Residential mortgage loans are evaluated based on credit scores, debt-to-income ratios and loan-to-collateral value ratios.
In June 2008, Citizens entered into a master sales agreement to sell its residential mortgage originations to its third-party servicer at a fixed rate with no recourse. Under this agreement, Citizens sells more than 95% of new mortgage origination, resulting in minimal new loans being retained in the residential mortgage portfolio. During 2010, a total of $4.2 million in originated residential mortgage loans had characteristics (other than loan amount or new construction) that made them non-compliant with the underwriting standards of government-sponsored entities (“GSE”) Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”) and Government National Mortgage Association (“GNMA”), all of which loans were retained in the residential mortgage loan portfolio. These loans were underwritten with compensating factors such as mortgage insurance, maximum debt to income ratios, maximum loan-to-value ratios and minimum credit scores which Citizens believed offset the additional risks.
Prior to June 2008, when Citizens sold its residential mortgage originations to several secondary market participants, it made various standard representations and warranties. The specific representations and warranties made by Citizens depended on the nature of the transaction and the requirements of the buyer. In the event of a breach of the representations and warranties, Citizens may be required to either repurchase the mortgage loans (generally at unpaid principal balance plus accrued interest) with the identified defects or indemnify the investor. During 2010 and 2009, Citizens repurchased $2.2 million and $3.2 million of loans, respectively, pursuant to such provisions. Citizens recorded $3.8 million and $2.7 million in 2010 and 2009,
respectively, in Other Expense on the Consolidated Statements of Operations related to repurchasing or indemnifying such loans.
Residential Mortgage Loan Balances By Category
Residential Mortgage Loan Origination Volume
(1)
All construction mortgages are retained by Citizens in the residential mortgage portfolio.
The credit performance of the residential mortgage portfolio has been negatively impacted by borrowers’ loss of or reduction in income during 2009 and 2010. The decline in the residential real estate values, particularly in Michigan and Northern Ohio, and the extended time frame associated with the sale of repossessed residential properties has led to increased loss severity in this loan portfolio. Increased stress on borrowers’ cash flow due to job loss, reduced rental income, higher interest rates or other factors could lead to higher payment delinquencies and defaults. Continued declines in real estate values could lead to higher loss severity.
Direct Consumer. The direct consumer loan category includes home equity loans, and direct installment loans to individuals used to purchase boats, recreational vehicles, automobiles, and other personal items. Home equity loans consist of revolving lines of credit and fixed rate loans to consumers that are secured by residential real estate. Credit risks for these types of loans are influenced by general economic conditions, the financial strength of individual borrowers, and the value of the loan collateral. Credit risk in the direct consumer loan portfolio arises from the borrowers potentially being unable to repay the loan on agreed terms, or by a shortfall in the collateral value in relation to the outstanding loan balance in the event of default and subsequent liquidation of collateral.
The Corporation originates consumer loans utilizing a credit scoring model to supplement the underwriting process. To monitor and manage consumer loan risk, policies and underwriting guidelines are developed and modified as market conditions require. This monitoring activity, coupled with relatively small loan amounts spread across many individual borrowers, reduces risk. Additionally, trend and outlook reports are reviewed by management on a regular basis.
Indirect Consumer. The indirect consumer loan category includes indirect installment loans used by customers to purchase boats and recreational vehicles. Credit risks for these types of loans, are influenced by general economic conditions, the characteristics of individual borrowers, and the value of loan collateral. Additionally, credit risk may include the dealer’s ability to collect proper customer information, and adhere to appropriate lending guidelines, including but not limited to evaluating collateral value, accurately capturing property identification numbers, and following related documentation guidelines. Credit risk in the indirect consumer loan portfolio arises from a borrower’s potential inability to repay their loan and by a potential shortfall in the collateral value in relation to the outstanding loan balance in the event of default and subsequent liquidation of collateral. Credit risk is generally controlled by reviewing the creditworthiness of the borrowers as well as taking appropriate collateral and guaranty positions.
LOANS HELD FOR SALE
Loans that the Corporation has the intent and ability to sell are classified as held for sale and are carried at the lower of cost or fair value, net of estimated costs to sell. The fair value of commercial real estate loans held for sale is measured based on the fair value of the underlying collateral adjusted for management’s best estimate due to current market conditions. The fair value of residential mortgage loans originated for sale in the secondary market is based on purchase commitments or quoted prices for the same or similar loans. The fair value of nonperforming residential mortgage loans is based on the fair value of the underlying collateral adjusted for management’s best estimate due to current market conditions. Gains and losses on the sales of loans are determined using the specific identification method. Subsequent valuation adjustments to reflect current fair value, as well as gains and losses on disposal of these loans are charged to noninterest income as incurred.
Loans held for sale are comprised of commercial real estate and residential mortgage loans. Held for sale loans at December 31, 2010 totaled $40.3 million, a decrease of $39.9 million or 49.7% from December 31, 2009. The decrease reflects a decline in commercial loans held for sale due to the sale of commercial real estate loans, customer paydowns, workout activities, writedowns to reflect market-value declines for the underlying collateral and transfers to ORE.
UNDERWRITING
Citizens’ Commercial Credit Policy and Underwriting Guidelines and Citizens’ Consumer Loan Credit Policy and Underwriting Guidelines (together, the “Underwriting Guidelines”) are written in a manner that is consistent with prudent banking practices and regulatory guidance applicable to each loan product. Citizens’ Underwriting Guidelines outline loan requirements and structuring parameters to determine the borrower’s financial capacity to repay under the terms of the loan and evaluate the collateral pledged to secure the loan and are designed to provide an adequate margin of safety for full collection of both principal and interest, within contractual terms. The Underwriting Guidelines provide the framework to determine that the borrower has the financial capacity to fully repay the loan, structurally mitigate credit risks and monitor the loan’s credit performance over the term of the loan. Additionally, the Underwriting Guidelines are updated periodically in response to market and economic conditions and are reviewed by the Risk Management Committee of the Board as well as Citizens’ full Board of Directors.
The commercial Underwriting Guidelines outline product- and collateral-specific acceptable loan terms and conditions, including maximum loan to value ratios for real estate collateral, advance rates for non-real estate collateral, and debt service coverage. Acceptable credit management practices require that the borrower’s financial capacity to repay the loan be analyzed based on the most recent financial information as specified by the loan’s documented structure. It is Citizens’ general practice to obtain personal guarantees and underwrite the guarantor’s capacity to support the loan no less frequently than annually, and more frequently if changes occur in the borrower’s capacity to repay or in general economic conditions that might affect the borrower. Citizens’ Underwriting Guidelines for non-owner occupied commercial real estate loans delineates maximum terms, amortizations and loan to value ratios as well as minimum equity investments and debt service coverage ratios based on property type. Generally, maximum loan terms are five years, maximum amortizations are twenty five years, minimum equity requirements range from 10% to 25%, debt service coverage ratios range from 1.2 to 1.5 times and loan to value ratios range from 65% to 80%. Currently, new commercial land hold and land development loans are not being originated by Citizens. Citizens’ Real Estate Appraisal and Environmental Policy specifies the Bank’s requirements for obtaining appraisals from licensed or certified appraisers to assess the value of the underlying collateral. New variable rate commercial loans are underwritten at fully indexed rates. Additionally, variable rate commercial loan underwriting includes stress tests of the borrower’s debt service capabilities with higher than existing interest rates and fluctuations in the underlying cash flows available for repayment.
The consumer Underwriting Guidelines outline product- and collateral-specific loan terms and conditions, including maximum debt ratios and advance rates based on the borrower’s credit score. Residential mortgage loans are evaluated based on credit scores, debt-to-income ratios and loan-to-collateral value ratios. They are predominately originated in accordance with underwriting standards of FNMA, FHLMC and GNMA, which serve as the primary purchasers of loans sold in the secondary market by mortgage lenders. These underwriting standards generally require that the loans be collateralized by one-to-four family residential real estate. Automated underwriting engines deployed by a GSE are used to determine creditworthiness of the vast majority
of borrowers. Maximum allowable loan-to-value (“LTV”)/combined loan-to-value (“CLTV”) on these loan products generally do not exceed 95% at origination. Citizens has not offered “no-doc/low doc” and “stated income/stated asset” loans since January 1, 2007 and does not have any of these loans in its residential mortgage portfolio. Sub-prime, initial teaser rate and negative amortization loans were originated on an exception basis prior to 2007 and have not been offered since January 1, 2007. At December 31, 2010 and 2009, the outstanding balance of these loans was $1.9 million or 0.3% and $4.0 million or 0.4% of the total residential mortgage portfolio, respectively. The interest income associated with these loans was immaterial.
Direct consumer loans include home equity loans, and direct installment loans to individuals used to purchase boats, recreational vehicles, automobiles, and other personal items. Underwriting guidelines for these loans are heavily influenced by statutory requirements, which include, but are not limited to maximum loan-to-value ratios, credit scoring results, ability to service overall debt, and documentation requirements. Individual borrowers may be required to provide additional collateral or a satisfactory endorsement or guaranty from another person, depending on the creditworthiness of the borrower. Home equity loans consist of fully-indexed variable rate revolving lines of credit and fixed rate loans to consumers that are secured by residential real estate. Home equity loans are generally in a junior lien position and are originated through Citizens’ branches with cumulative loan-to-value ratios generally at or less than 80% of appraised collateral value. As of December 31, 2010, Citizens’ home equity portfolio totaled $855.6 million, and had an average loan size of $36,970 with average refreshed FICO score of 738. As of December 31, 2010, other direct installment loans totaled $189.9 million and had an average loan size of $18,560 with an average refreshed FICO score of 717.
Indirect consumer loans are originated throughout the Midwest through our centralized underwriting group that has established relationships with certain dealers which meet Citizens’ underwriting guidelines and adhere to prudent business practices. The dealers are evaluated on their creditworthiness and business practices with performance monitored on an annual basis. The dealers refer customers to the centralized underwriting group, which utilizes a credit scoring model to supplement the underwriting process, and then complete the loans utilizing Citizens’ loan documents. As of December 31, 2010, indirect consumer loans had an average loan size of $22,670 with an average refreshed FICO score of 732.
CREDIT RISK MANAGEMENT
Extending credit to businesses and consumers exposes the Corporation to credit risk, which is the risk that the principal balance of a loan and any related interest will not be collected under the original underwriting terms due to the inability or unwillingness of the borrower to repay the loan. Citizens lending policies and underwriting guidelines, discussed above, are designed to maximize loan income within an acceptable level of risk. Credit risk is mitigated through a comprehensive system of internal controls, which includes adherence to conservative lending practices, underwriting guidelines, collateral monitoring, and oversight of financial performance. Credit risk associated with fluctuations in economic conditions is mitigated through portfolio diversification that limits exposure to any single industry or customer. Lending policies and guidelines are reviewed by credit administration and modified on an ongoing basis as conditions change and new credit products are offered. The commercial and industrial and commercial real estate credit administration policies include a two-tier loan rating system that incorporates probability of default and loss given default to estimate a borrower’s ability to repay and the strength of the collateral supporting their loan obligation. To strengthen and monitor loan structuring and collateral position, collateral field audits are regularly performed on those credits that have a significant reliance on accounts receivable and inventory. Additionally, a reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potentially problematic loans. Citizens monitors its loans in an effort to proactively identify, manage, and mitigate any potential credit quality issues and losses.
The quality of Citizens’ loan portfolio is impacted by numerous factors, including the economic environment in the markets in which Citizens operates. Citizens carefully monitors its loans in an effort to identify and mitigate any potential credit quality issues and losses in a proactive manner. Citizens performs quarterly reviews of the non-watchlist commercial credit portfolio focusing on industry segments and asset classes that have or may be expected to experience stress due to economic conditions. This process seeks to validate each such credit’s risk rating, underwriting structure and exposure management under current and stressed economic scenarios while strengthening these relationships and improving communication with these clients.
The Corporation maintains an independent loan review department that reviews the quality, trends, collectability and collateral margins within the loan portfolio. The loan review department validates the credit risk profile on a regular basis by sampling loans using criteria such as loan size, delinquency status, loan officer coverage and other factors. This process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel. Results of these reviews are presented to management and to the Risk Committee of the Board of Directors.
As part of the overall credit underwriting and review process, Citizens carefully monitors commercial and industrial and commercial real estate credits that are current in terms of principal and interest payments but may deteriorate in quality as economic conditions change. Commercial relationship officers monitor their clients’ financial condition and initiate changes in loan ratings based on their findings. Loans that have migrated within the loan rating system to a level that requires increased oversight, at management’s discretion, are considered ‘watchlist’ loans (generally consistent with the regulatory definition of special mention, substandard, and doubtful loans) and include loans that are in accruing or nonperforming status. Citizens utilizes the watchlist process as a proactive credit risk management practice to help mitigate the migration of commercial loans to nonperforming status and potential loss. Once a loan is placed on the watchlist, it is reviewed quarterly by the chief credit officer, senior credit officers, senior market managers, and commercial relationship officers to assess cash flows, collateral valuations, guarantor liquidity, and other pertinent trends. During these reviews, action plans are developed to address emerging problem loans or to implement specific actions for alternatives to strengthen the credit and/or for removing the loans from the portfolio. Additionally, loans viewed as substandard or doubtful are transferred to Citizens’ special loans or small business workout groups and are subjected to an even higher level of monitoring and workout activity.
The following table illustrates the commercial loans on the watchlist at December 31, 2010, 2009, and 2008 that, while still accruing interest, may be at risk due to general economic conditions or changes in borrower’s financial status.
Commercial Watchlist
Accruing loans only
Watchlist credits as of December 31, 2010 declined $354.6 million from the previous year end, primarily due to the accelerated resolution of problem assets in 2010, along with a decrease in the level of new inflows. The increase in watchlist loans in 2009 from the previous year end was primarily the result of proactive commercial real estate downgrades as Citizens closely monitors borrowers’ repayment capacity in this environment and continued declines in commercial real estate values in Michigan and Northern Ohio.
The following table illustrates loans where the contractual payment is 30 to 89 days past due and interest is still accruing at December 31, 2010, 2009, and 2008. While these loans are actively worked to bring them current, past due loan trends may be a leading indicator of potential future nonperforming loans and charge-offs.
Delinquency Rates By Loan Portfolio
30 to 89 days past due
The decreases in total delinquencies were primarily the result of continued emphasis on proactively managing and resolving delinquent commercial and consumer loans.
NONPERFORMING ASSETS
Loans are placed on nonaccrual status when there is substantial doubt regarding collection of principal or interest based on Citizens’ credit policies and practices or when principal or interest is past due in excess of 90 days. When a loan is placed on nonaccrual status, interest that is accrued but not collected is reversed and charged against income. Nonperforming assets are comprised of nonaccrual loans, loans past due over 90 days and still accruing interest, restructured loans, nonperforming loans held for sale, and other repossessed assets acquired. Although these assets have more than a normal risk of loss, they may not necessarily result in future losses. A five-year history of nonperforming assets is presented below. The nonperforming commercial loans in this table are also reviewed as part of the watchlist process.
Nonperforming Assets and Past Due Loans
Nonperforming assets decreased in 2010 from the previous year end primarily due to our efforts to reduce overall problem asset levels and work through our stressed commercial real estate and residential mortgage portfolios.
Some of the nonperforming loans included in the nonperforming asset table above are considered to be impaired. A loan is considered impaired when Citizens determines that it is probable that all the contractual principal and interest due under the loan may not be collected. In most instances, impairment is measured based on the fair value of the underlying collateral. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. The Corporation measures impairment on all nonaccrual commercial and industrial and commercial real estate loans for which it has established specific reserves. This policy does not apply to large groups of smaller balance homogeneous loans, such as smaller balance commercial loans, direct and indirect consumer loans and residential mortgage loans, which are collectively evaluated for impairment, except for those loans restructured under a troubled debt restructuring. The Corporation maintains a valuation reserve for impaired loans as a part of the specific allocated allowance component of the allowance for loan losses. Cash collected on impaired nonaccrual loans is generally applied to outstanding principal.
Citizens recognizes that, in the current economic environment, elevated levels of unemployment and depressed real estate values have resulted in many customers facing difficult financial situations. Distressed homeowners are identified and offered assistance. In order to avoid foreclosure, residential mortgage loans may be restructured for certain qualified borrowers who have the ability to make payments under the new terms of the loan. Citizens’ residential mortgage foreclosure abatement program includes several different options to modify contractual payments. Modified consumer and residential mortgage loans are considered troubled debt restructures (“TDRs”) when the debt restructure, for economic or legal reasons related to the borrower’s financial difficulties, results in a concession to the debtor that otherwise would not be considered by the bank. Citizens classifies TDRs as nonperforming loans unless the loan qualified for accruing status at the time of the restructure, or the loan has performed according to the new contractual terms for at least six months. To qualify for accruing status at the time of the restructure, the original loan must have been less than 90 days past due at the time of the restructure and the modification must not have resulted in an impairment. At December 31, 2010, Citizens had $11.1 million of TDRs, 59.9% of which involved both reduced interest rate and term extensions and 40.1% of which involved only term extensions. Of the total TDRs, $6.5 million are considered impaired and carry a specific allocated reserve of $1.4 million and $4.6 million do not carry a specific allocated reserve. See Note 4 to the Consolidated Financial Statements in this report for information on impaired loans.
ALLOWANCE FOR LOAN LOSSES
A summary of Citizens’ loan loss experience for the past five years appears below.
Summary of Loan Loss Experience
(1)
Balances exclude loans held for sale.
Loan losses are charged against, and recoveries are credited to, the allowance for loan losses. The increase in net charge-offs for 2010 as compared with 2009 was primarily due to the additional charge-offs related to the bulk
sales and individual workouts of nonperforming commercial and residential mortgage loans throughout 2010 as well as the incremental risk allocated allowance recorded during 2010. Citizens also began to experience higher losses in the income producing and owner-occupied portfolios during 2009, which represents a shift in the risk profile in Citizens’ commercial real estate portfolio that was consistent with the experience of other financial institutions.
The allowance for loan losses represents management’s estimate of an amount appropriate to provide for probable credit losses inherent in the loan portfolio as of the balance sheet date. To assess the appropriateness of the allowance for loan losses, an allocation methodology is applied that focuses on changes in the size and character of the loan portfolio, changes in the levels of impaired or other nonperforming loans, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, underlying collateral, historical losses on each portfolio category and other qualitative and quantitative factors which could affect probable loan losses. General deterioration in real estate values was a significant factor considered when establishing valuation allowances in the allowance for loan losses. The evaluation process is inherently subjective, as it requires estimates that may be susceptible to significant change and have the potential to affect net income materially. During 2010, we further refined our allocation methodology which had virtually no impact on total allowance for loan losses. The methodology used for measuring the appropriateness of the allowance for loan losses relies on several key elements, which include specific allowances for identified impaired loans, a formula-based risk-allocated allowance for the remainder of the portfolio and a general valuation allowance calculation. Management also considers overall portfolio indicators, including trends in historical charge-offs, a review of industry, geographic and portfolio performance, and other qualitative factors. This methodology is discussed in “Critical Accounting Policies” and Note 1 to the Consolidated Financial Statements.
The ALLL as a percent of portfolio loans increased to 4.76% at December 31, 2010 from 4.35% at December 31, 2009 and 2.82% as of December 31, 2008. The ALLL decreased $42.9 million or 12.7% from December 31, 2009 to December 31, 2010. Net loans charged off as a percent of average portfolio loans at December 31, 2010 was 6.07%. The increase in charge-offs in 2010 was directly related to the resolution of certain problem assets through bulk sales and individual loan workouts. The ALLL is comprised of three parts: specific allocated, risk allocated, and general valuation. Nonperforming loans are reviewed under the specific allocated reserve for impairment analysis. Loss expectations are established based on specific impairment by loan. In an effort to reduce overall problem asset levels in 2010, Citizens resolved $466.2 million of problem assets in the fourth quarter of 2010 through a combination of bulk sales and individual workouts, reducing the nonperforming loans by 53.5% at December 31, 2010 from December 31, 2009. However, as a result of an incremental risk allocated allowance as well as other factors discussed in the risk allocated allowance below, loss reserves remain relatively stable.
The table below summarizes the allocation of the allowance for loan losses for specific allocated, risk allocated, and general valuation allowances by loan type and the proportion of total portfolio loans represented by each loan type.
Allocation of the Allowance for Loan Losses (1)
N/M - Not Meaningful
(1)
The allocation of the allowance for loan losses in the above table is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or precision of the specific amounts. Citizens does not view the allowance for loan losses as being divisible among the various categories of loans. The entire allowance is available to absorb any future losses without regard to the category or categories in which the charged-off loans are classified.
(2)
Related NPL amounts in risk allocated allowances include restructured loans and still accruing and loans 90+ days past due and still accruing but classified as nonperforming.
(3)
The portfolio balance of the loans with a specific allocated allowance is equal to the related NPL for said loans.
(4)
Portfolio loans only include loan balances evaluated for risk allocated allowance.
*
Prior to March 31, 2008, Citizens’ methodology for calculating the allowance for loan loss combined the commercial and industrial and commercial real estate loan types. As such, Citizens does not have the appropriate level of detail to accurately segregate the risk allocated allowance for these loan types for December 31, 2007 and December 31, 2006.
The following is a discussion of the three components of the ALLL.
Total Allowance for Loan Losses. The decrease in the total allowance as of December 31, 2010 as compared to December 31, 2009 was primarily the result of an overall decrease in loan balances, the continuing stability in both portfolio and economic trends, as well as lower reserves identified for specific commercial loans. These decreases were partially offset by an incremental risk allocated allowance recorded in 2010 associated with the accelerated workout of commercial real estate loans.
The allowance as a percentage of nonperforming loans at December 31, 2010 increased from December 31, 2009 primarily as a result of loss reserves having remained relatively stable while nonperforming loans declined 53.5%, as described in the discussion of the risk allocated allowance below.
Based on current conditions and expectations, Citizens believes that the allowance for loan losses is appropriate to address the estimated loan losses inherent in the existing loan portfolio at December 31, 2010. After determining what Citizens believes is an appropriate allowance for loan losses based on the risk in the portfolio, the provision for loan losses is calculated as a result of the net effect of the change in the allowance for loan losses and the net charge-offs.
Specific Allocated Allowance. The specific allocated allowance is based on probable losses on specific commercial and industrial or commercial real estate loans as well as impairment on TDRs. The allowance allocated to non-performing commercial loans is typically based on the underlying collateral’s appraised value, updated at least annually, less management’s estimates of cost to sell. Appraisals or broker’s price opinions are obtained more frequently if changes in the property or market conditions warrant. Deterioration in individual asset values, underlying commercial loans, evidenced by refreshed appraisals, is reflected in the specific allocated allowance for commercial nonperforming loans.
The fair value of non-performing residential mortgage loans is based on the underlying collateral’s value obtained through appraisals or broker’s price opinions, updated at least semi-annually, less management’s estimates of cost to sell. The allowance allocated to restructured nonperforming residential loans is typically based on the present value of the expected future cash flows discounted at the loan’s effective interest rate.
The decrease in the specific allocated allowance in amount of nonperforming loans from December 31, 2009 was primarily the result of a decline in the balances of loans evaluated, partially offset by a decline in the fair value of the underlying collateral.
Risk Allocated Allowance. The risk allocated allowance is comprised of several loan pool valuation allowances determined based on Citizens’ quantitative loan loss experience for similar loans with similar risk characteristics, including additional qualitative risks such as changes in asset quality; the experience, ability and effectiveness of Citizens’ lending management; the composition and concentrations of credit, changes in loss severity based on loan type, as well as other factors based upon the best judgment of management.
The risk allocated allowance decreased by $22.4 million or 8.0% from December 31, 2009. The decrease was primarily to the result of the decrease in the loan portfolio balances that are evaluated for this reserve. The risk allocated allowance did not decrease to the same extent as the portfolio balance, however, in light of other factors that affect the risk allocated allowance, such as credit metrics, delinquencies, the depressed real estate market and the accelerated workout of commercial real estate loans, that made it appropriate to maintain a higher proportionate allowance. This decrease was also partially offset by a $29.5 million incremental risk allocated allowance recorded in 2010 associated with the accelerated workout of commercial real estate loans.
General Valuation Allowance. The general valuation allowance is based on existing regional and local economic factors, a macroeconomic adjustment factor used to calibrate for the current economic cycle the Corporation is experiencing, and other judgmental factors. These factors could have a potentially negative impact on credit quality. Recognizing the inherent imprecision of any loan loss allocation model, management believes that the general valuation allowance at December 31, 2010 appropriately reflects probable inherent but undetected losses in the portfolio.
As discussed in “- Critical Accounting Policies”, nonperforming commercial and industrial and commercial real estate loans are generally charged off to the extent principal due exceeds the net realizable value of the collateral, with the charge-off occurring when the loss is reasonably quantifiable, but not later than when the loan becomes 180 days past due. Nonperforming residential mortgage loans are generally charged off to the extent principal exceeds the current appraised value less estimated costs to sell when the loan becomes 180 days past due. Nonperforming direct and indirect consumer loans (open and closed end) are generally charged off before the loan becomes 120 days past due. In adhering to its policy, as the current fair values continued to decline based on current appraisals and efforts were accelerated to resolve problem assets, net charge-offs significantly increased in 2010 from the prior periods. Because of the significant increase in charge-offs in 2010, due to the factors mentioned above, the allowance for loan losses decreased in 2010.
Based on current conditions and expectations, Citizens believes that the ALLL is appropriate at December 31, 2010.
GOODWILL
Goodwill at December 31, 2010 was $318.2 million, unchanged from December 31, 2009. As a result of announcing the sale of F&M on January 29, 2010, Citizens performed an interim goodwill analysis during the first quarter of 2010 and concluded that there was no impairment. Goodwill was allocated to F&M based on the relative value of F&M’s regional banking equity compared with the total fair value of equity for the Regional Banking reporting unit. The analysis indicated that approximately 3.8% of the fair value of the Regional Banking reporting unit resided in the Iowa franchise as of January 1, 2010. Therefore, Citizens allocated $12.6 million of goodwill to discontinued operations. Citizens will continue to perform evaluations on an interim basis if events or circumstances indicate that impairment may exist. There can be no assurance that such tests will not result in additional material impairment charges due to further developments in the banking industry or Citizens’ markets.
DEPOSITS
The table below provides a year-to-year comparison of average deposit balances over the last three years. Average, rather than period-end, balances can be more meaningful in analyzing deposit funding sources because of inherent fluctuations that occur on a monthly basis within most deposit categories.
Average Deposits
The increase in noninterest-bearing demand and interest- bearing demand balances over 2009 was primarily the result of customers holding higher balances in transaction accounts due to changes in FDIC coverage thresholds and a lack of compelling alternative investments in the current low rate environment. Average time deposits declined due to a shift in funding mix from time deposits to savings accounts and a decrease in brokered balances. Savings deposit balances remained relatively unchanged, as the aforementioned shift in funding mix was offset by a reduction in brokered balances. The decrease in the average cost of the deposit portfolio resulted from the lower interest rate environment, partially offset by competitive deposit pricing pressures.
As of December 31, 2010, certificates of deposit of $100,000 or more accounted for approximately 14.7% of total deposits. The maturities of these deposits are summarized below.
Maturity of Time Certificates of Deposit of
$100,000 or more at December 31, 2010
Citizens gathers deposits from the local markets of the Bank and has used brokered deposits from time to time when cost effective. Time deposits greater than $100,000 decreased by $700.9 million at December 31, 2010 over the prior year-end primarily as a result of a planned reduction in brokered deposits and a shift in funding mix from customer time deposits to core deposits. The Corporation will continue to evaluate the use of alternative funding sources such as brokered deposits to best meet its funding objectives. Citizens continues to promote relationship driven core deposit growth and stability through focused marketing efforts and competitive pricing strategies.
BORROWED FUNDS
Short-term borrowings are comprised of Federal funds purchased, securities sold under agreements to repurchase, other bank borrowings, and Treasury Tax and Loan borrowings. Short-term borrowings totaled $42.3 million at December 31, 2010 compared with $39.8 million at December 31, 2009. The increase from December 31, 2009 was primarily the result of an increase in short-term repurchase agreements offset by a decrease in Treasury Tax and Loan borrowings. See Note 8 to the Consolidated Financial Statements for additional information on short-term borrowings.
Long-term debt is comprised of FHLB debt, subordinated notes, other promissory notes and other borrowed funds. Long-term debt totaled $1.0 billion at December 31, 2010, compared with $1.5 billion at December 31, 2009. FHLB debt decreased $476.1 million or 36.5% to $0.8 billion at December 31, 2010, due to maturing advances not being replaced. During December 2010, $250.0 million in FHLB advances were restructured, resulting in a longer duration at lower interest rates. The average remaining term was extended to 4.5 years from 1.0 years and the average interest rate of that $250.0 million of advances was reduced from 4.90% to 2.78%. As of December 31, 2010, other borrowed funds decreased $4.2 million or 2.0% compared with December 31, 2009. See Note 9 to the Consolidated Financial Statements for additional information.
CAPITAL RESOURCES
Citizens continues to maintain a strong capital position which supports current needs and provides a sound foundation to support further expansion. Regulatory capital ratios for the Holding Company and the Bank have remained above the “well-capitalized” standards. The Corporation’s capital ratios for the past three years are presented below.
Shareholders’ equity at December 31, 2010 totaled $1.0 billion, a decrease of $319.3 million or 24.0% from December 31, 2009. The decrease was primarily the result of net losses incurred. Book value per common share at December 31, 2010 and 2009 was $1.85 and $2.69 respectively. The decrease in book value per common share from December 31, 2009 was primarily due to net losses incurred.
During 2010, the Holding Company did not purchase any shares of common stock pursuant to the Corporation’s share repurchase program and is not likely to do so for the foreseeable future. Information regarding the Corporation’s share repurchase program is set forth later in this report under Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
Contractual Obligations
In the ordinary course of business, Citizens has entered into certain contractual arrangements that require future cash payments and may impact liquidity. These obligations include deposits, issuance of debt to fund operations, purchase obligations to acquire goods or services, and property leases. The table below summarizes contractual obligations and future required minimum payments as of December 31, 2010. Refer to Notes to the Consolidated Financial Statements for further discussion of these contractual obligations.
Contractual Obligations
(1)
In the banking industry, interest-bearing obligations are principally utilized to fund interest-bearing assets. As such, interest charges on related contractual obligations were excluded from reported amounts as the potential cash outflows would have corresponding cash inflows from interest-bearing assets.
(2)
This schedule excludes all carrying value adjustments, such as purchase accounting fair value adjustments, hedge accounting fair value adjustments, and unamortized premiums and discounts, that will not affect future cash payments associated with the maturity of this debt.
At December 31, 2010, the Corporation’s liability for uncertain tax positions, including associated interest and penalties and net of related federal tax benefits, was $0.9 million. This liability represents an estimate of income taxes and other state taxes which may ultimately not be sustained upon examination by the tax authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, this estimated liability has been excluded from the contractual obligations table.
Citizens has obligations not included in the above table under its retirement plans as described in Note 11 to the Consolidated Financial Statements. At December 31, 2010, the under funded status of the Cash Balance Pension Plan for Employees, the Retirement Health Plan and the Supplemental Pension Plans is recognized in the Corporation’s Consolidated Balance Sheet as an accrued liability. Citizens does not anticipate making a contribution to the defined benefit pension plan during calendar year 2011.
Off-Balance Sheet Arrangements
In the normal course of business, in order to meet the financing needs of customers and to manage exposure to interest rate risk, Citizens enters into various transactions, which, in accordance with U.S. generally accepted accounting principles, are not included in its Consolidated Balance Sheets. These transactions include commitments to extend credit, standby letters of credit, commercial letters of credit, forward commitments to sell mortgage loans, and interest rate swaps. These transactions involve, to varying degrees, elements of credit risk,
market risk and liquidity risk in excess of the amount recognized in the Consolidated Balance Sheets, however, they do not represent unusual risks. The Corporation minimizes its exposure to loss under these transactions by subjecting them to credit approval and monitoring procedures.
The following table presents the total notional amounts and expected maturity of off-balance sheet financial instruments outstanding at December 31, 2010 and the notional amounts outstanding at December 31, 2009.
Off-Balance Sheet Financial Instruments
Commitments to extend credit are legally binding agreements to lend cash to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Commitments to extend credit at December 31, 2010 decreased from December 31, 2009 primarily as a result of the current economic climate and reduced customer demand.
Standby letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Corporation would be required to fund the commitment. The maximum potential amount of future payments the Corporation could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, the Corporation would be entitled to seek recovery from the customer. Standby letters of credit at December 31, 2010 decreased from December 31, 2009 primarily as a result of the current economic climate and reduced customer demand.
Commercial letters of credit are written conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. These guarantees are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party.
The credit risk associated with commitments to extend credit and letters of credit is essentially the same as that involved with direct lending. Therefore, these agreements are subject to loan review and approval procedures and credit policies. Based upon management’s credit evaluation of the counter-party, collateral may be required as security for the agreement, including real estate, accounts receivable, inventories, and investment securities. The maximum credit risk associated with these instruments is equal to their contractual amounts, assuming that the counter-party defaults and the collateral proves to be worthless. The total contractual amounts of commitments to extend credit and letters of credit do not necessarily represent future cash requirements, since many of these agreements may expire without being drawn upon. Citizens’ commitments to extend credit and letters of credit are described in further detail in Note 16 to the Consolidated Financial Statements.
Refer to Notes 1 and 17 to the Consolidated Financial Statements for further discussion of derivative instruments.
The Corporation has two active wholly owned trusts formed for the purpose of issuing securities which qualify as regulatory capital and are considered Variable Interest Entities (“VIEs”). The Corporation is not the primary beneficiary, and consequently, the trusts are not consolidated in the consolidated financial statements. Each of the two active trusts issued trust preferred securities to investors in 2006 and 2003, with respect to which there remain $48.7 million and $25.8 million in aggregate liquidation amounts outstanding, respectively. The trust
preferred securities held by these entities qualify as Tier 1 capital and are classified as “long-term debt” on the Consolidated Balance Sheets, with the associated interest expense recorded in “long-term debt” on the Consolidated Statements of Operations. The expected losses and residual returns of these entities are absorbed by the trust preferred stock holders, and consequently the Corporation is not exposed to loss related to these VIEs. Refer to Note 9 to the Consolidated Financial Statements for further discussion.
At December 31, 2010, the unpaid principal balance of mortgage loans serviced for others was $315.6 million. These loans are not recorded on the Consolidated Financial Statements. Capitalized servicing rights relating to the serviced loans were $1.5 million at December 31, 2010.
Assets held in a fiduciary or agency capacity are not included in the Consolidated Financial Statements because they are not assets of Citizens. The total assets managed or administered by Citizens through CB Wealth Management at December 31, 2010, in its fiduciary or agency capacity, were $2.3 billion.
LIQUIDITY RISK MANAGEMENT
Citizens monitors and manages its liquidity position so that funds will be available at a reasonable cost to meet financial commitments, to finance business expansion and to take advantage of unforeseen opportunities. Liquidity management involves projecting funding requirements and maintaining sufficient capacity to meet those needs and accommodate fluctuations in asset and liability levels due to changes in business operations or unanticipated events. Sources of liquidity include deposits and other customer-based funding, and wholesale market funding.
Citizens manages liquidity at two levels. The first level is at the Holding Company. The second level is at the Bank. The management of liquidity at both levels is essential because the Holding Company and the Bank have different funding needs and sources, and are subject to certain regulatory guidelines and requirements. The Asset Liability Committee is responsible for establishing a liquidity policy, approving operating and contingency procedures and monitoring liquidity on an ongoing basis. In order to maintain adequate liquidity through a wide range of potential operating environments and market conditions, Citizens conducts liquidity management and business activities in a manner designed to preserve and enhance funding stability, flexibility and diversity of funding sources. Key components of this operating strategy include a strong focus on customer-based funding, maximizing secured borrowing capacity, maintaining relationships with wholesale market funding providers, and maintaining the ability to liquidate certain assets if conditions warrant.
Credit ratings by the nationally recognized statistical rating agencies are an important component of Citizens’ liquidity profile. Credit ratings relate to the Corporation’s ability to issue debt securities and the cost to borrow money, and should not be viewed as an indication of future stock performance or a recommendation to buy, sell, or hold securities. Among other factors, the credit ratings are based on financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core deposits, and Citizens’ ability to access a broad array of wholesale funding sources. Adverse changes in these factors could result in a negative change in credit ratings and impact not only the ability to raise funds in the capital markets, but also the cost of these funds. Citizens’ credit rating was downgraded by Moody’s Investor Service, Standard & Poor’s, Dominion Bond Rating Service, and Fitch Ratings throughout 2009 and 2010. During 2010, at Citizens’ request, Standard & Poor’s discontinued rating Citizens as has Dominion Bond Rating Service. In the first quarter of 2011, Fitch Ratings lowered Citizens’ credit ratings. Ratings are subject to revision or withdrawal at any time and each rating should be evaluated independently of any other rating. The current credit ratings for the Holding Company and the Bank, the dates on which the ratings were last issued and the outlook watch status of the ratings are displayed in the following table. An explanation of these ratings may be obtained from the respective rating agency.
Ratings Watch Action Legend: (WP) Watch Positive, (WN) Watch Negative, (WU) Watch Uncertain, (WR) Watch Removed, (OP) Outlook Positive, (ON) Outlook Negative, (OS) Outlook Stable, (OD) Outlook Developing
The primary sources of liquidity for the Holding Company are dividends from and returns on investment in its subsidiaries and existing cash resources. Banking regulations limit the amount of dividends a financial institution may declare to a parent company in any calendar year. The Bank is subject to dividend limits under the laws of the state in which it is chartered and to the banking regulations previously discussed. Federal and national chartered financial institutions are generally allowed to make dividends or other capital distributions in an amount not exceeding the current calendar year’s net income, plus retained net income of the preceding two years. Distributions in excess of this limit require prior regulatory approval. The Written Agreement, however, requires prior regulatory approval for any dividend declared by Citizens Bank or the Holding Company. Since 2009, neither the Holding Company nor any of its subsidiaries has paid any dividends. As of January 1, 2011, CB Wealth Management had the capacity to pay dividends of $5.9 million to the Holding Company without prior regulatory approval. During 2010, the Holding Company received $50.0 million in cash as a result of completing the sale of F&M. The ability to borrow funds on both a short-term and long-term basis and to sell equity securities provides an additional source of liquidity for the Holding Company. The Holding Company’s cash totaled $68.1 million as of December 31, 2010. Citizens monitors the relationship between cash obligations and available cash resources, and believes that the Holding Company has sufficient liquidity to meet its currently anticipated short and long-term needs. Since January 1, 2009, the Holding Company contributed $174.0 million to Citizens Bank to bolster the Bank’s capital levels, including $100.0 million during 2010.
Discontinued operations are presented separately within the appropriate cash flow categories for the years ended December 31, 2010, 2009 and 2008, respectively. In 2010, discontinued operations provided cash of $10.7 million in operating activities, $312.4 million in investing activities and used $420.3 million in financing activities. The absence of cash flows from discontinued operations will not have a material impact on future liquidity and capital resources.
The primary source of liquidity for Citizens Bank is customer deposits raised through the branch offices. Additional sources are wholesale borrowing, unencumbered or unpledged investment securities, access to secured borrowing at the Federal Reserve Bank of Chicago and the Federal Home Loan Bank of Indianapolis and contributions of capital from the Holding Company.
Citizens maintains a strong liquidity position due to its on-balance sheet liquidity sources and very stable funding base comprised of approximately 78% deposits, 11% long-term debt, 10% equity, and 1% short-term liabilities. Citizens’ loan -to-deposit ratio, another measure of liquidity, continues to improve with levels of 80.5% and 91.6% at December 31, 2010 and December 31, 2009 respectively, as a result of the decrease in outstanding loans. Securities available-for-sale and money market investments can be sold for cash to provide additional liquidity, if
necessary. The Written Agreement requires prior regulatory approval for Citizens and CB Wealth Management to incur, increase, or guarantee any debt. The restrictions on borrowing have not had a negative effect on liquidity and borrowings.
In the fall of 2008, the Board of Directors of the Federal Deposit Insurance Corporation (“FDIC”) initiated the Temporary Liquidity Guarantee Program which, among other things, provided full FDIC deposit insurance coverage on noninterest-bearing transaction accounts and certain interest-bearing transaction accounts paying less than 0.5% interest per annum through its Transaction Account Guarantee Program (“TAGP”). Participation in TAGP was voluntary and if a depository institution joined the program in the fall of 2008 it was committed to the program through December 31, 2009 with subsequent voluntary extensions in six-month intervals. While Citizens joined the TAGP at its inception, due to its significant liquidity levels and the cost of continued participation, Citizens opted-out of the TAGP as of July 1, 2010. Citizens’ clients will continue to receive standard deposit insurance coverage through the FDIC’s general deposit insurance fund, which covers deposit balances up to $250,000 per depositor. In addition, from December 31, 2010 through December 31, 2012, customers’ noninterest-bearing transaction accounts will receive unlimited FDIC coverage as part of the Dodd-Frank Act.
In light of the net losses over the last several quarters, Citizens determined during the first quarter of 2010, in consultation with the Federal Reserve Bank of Chicago as required by regulatory policy, to defer regularly scheduled quarterly interest payments on its outstanding junior subordinated debentures relating to its two trust preferred securities and to suspend quarterly cash dividend payments on its TARP Preferred Stock. In addition, as of July 28, 2010, the Written Agreement now prohibits such payments without prior regulatory approval. Deferral of these payments, which is permitted pursuant to the underlying documentation, preserves a total of $19.7 million of cash annually, although such amounts will continue to accrue. Citizens reevaluates the deferral of these payments periodically and, in consultation with and subject to prior approval by its regulators, will reinstate these payments when appropriate. As of December 31, 2010, the amount of the arrearage (including interest on interest) on the dividend payments of the TARP Preferred Stock is $15.4 million and the amount of the arrearage (including interest on interest) on the payments on the subordinated debt associated with the trust preferred securities is $4.9 million.
The Corporation’s long-term debt to equity ratio was 102.1% as of December 31, 2010 compared with 113.7% at December 31, 2009. Changes in deposit obligations and short-term and long-term debt during 2010 are further discussed in the sections titled “ - Deposits” and “ - Borrowed Funds.” The Corporation believes that it has sufficient liquidity to meet presently known short and long-term cash-flow requirements arising from ongoing business transactions.
INTEREST RATE RISK
Interest rate risk refers to the risk of loss arising from changes in market interest rates. The risk of loss can be assessed by examining the potential for adverse changes in fair values, cash flows, and future earnings resulting from changes in market interest rates. Interest rate risk on Citizens’ balance sheet consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity or repricing timing of asset and liability portfolios. Option risk arises from embedded options present in many financial instruments such as loan prepayment options, deposit early withdrawal options, and interest rate options. These options allow certain of Citizens’ customers and counterparties of the investment and wholesale funding portfolios the opportunity to benefit when market interest rates change, which typically results in higher costs or lower revenues for the Corporation. Basis risk results when assets and liabilities reprice at the same time but based on different market rates or indices, which can change by different amounts, resulting in a narrowing of profit spread.
The asset/liability management process seeks to insulate net interest income from large fluctuations attributable to changes in market interest rates and to maximize net interest income within acceptable levels of risk through periods of changing interest rates. Accordingly, the Corporation’s interest rate sensitivity is monitored on an ongoing basis by its Asset Liability Committee, which oversees interest rate risk management and establishes risk measures, limits, and policy guidelines. A combination of complementary techniques is used to measure interest rate risk exposure, the distribution of risk, the level of risk over time, and the exposure to changes in certain interest rate relationships. These measures include static repricing gap analysis, simulation of earnings, and estimates of economic value of equity.
Static repricing gap analysis provides a measurement of reprice risk on the Corporation’s balance sheet as of a point in time. This measurement is accomplished through stratification of the Corporation’s rate sensitive assets and liabilities into repricing periods. The sums of assets and liabilities maturing or repricing in each of these periods are compared for mismatches within each time segment. Core deposits lacking contractual maturities or repricing frequencies are placed into repricing and maturity periods based upon historical experience. Repricing periods for assets include the effects of expected prepayments on cash flows.
Rate sensitive assets repricing within one year exceeded rate sensitive liabilities repricing within one year by $1.1 billion or 11.2% of total assets as of December 31, 2010 compared with $845.7 million or 7.4% of total assets at December 31, 2009. These results incorporate the impact of off-balance sheet derivatives and reflect interest rates consistent with December 31, 2010 levels. Repricing gap analysis is limited in its ability to measure interest rate sensitivity, as embedded options can change the repricing characteristics of assets, liabilities, and off-balance sheet derivatives in different interest rate scenarios, thereby changing the repricing position from that outlined above. Further, basis risk is not captured by repricing gap analysis.
Citizens utilizes a net interest income simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model measures the impact to net interest income relative to a base case scenario of hypothetical changes in interest rates over the next 12 months. These simulations incorporate assumptions including prepayment speeds on various loan and investment assets, cash flows and maturities of financial instruments, market conditions, balance sheet growth and mix, pricing, client preferences, and Citizens’ financial capital plans. These assumptions are inherently uncertain and subject to fluctuation and revision in a dynamic environment and as a result the model cannot perfectly forecast net interest income nor exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to the timing, magnitude, and frequency of balance sheet component and interest rate changes, and differences in client behavior, market conditions and management strategies, among other factors.
Net interest income simulations were performed as of December 31, 2010 to evaluate the impact of market rate changes on net interest income over the subsequent 12 months assuming expected changes in balance sheet composition over that time period. If market interest rates were to increase immediately by 100 or 200 basis points (a parallel and immediate shift of the yield curve) net interest income would be expected to increase by 0.7% and 1.4%, respectively, from what it would be if rates were to remain at December 31, 2010 levels. Net interest income simulation for 100 and 200 basis point parallel declines in market rates were not performed at December 31, 2010, as the results would not have been meaningful given the current levels of short-term market interest rates. These measurements represent similar exposure to rising interest rates compared to December 31, 2009. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, pricing spreads in relation to market rates, balance sheet growth, the mix of different types of assets and liabilities, and the timing of changes in these variables. Scenarios different from those outlined above, whether different by timing, level, or a combination of factors, could produce different results.
From time to time, derivative contracts are used to help manage or hedge exposure to interest rate risk and market value risk. Citizens enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Citizens’ derivative financial instruments are used to manage differences in the amount, timing, and duration of its known or expected cash receipts and expected cash payments principally related to certain variable-rate loan assets and fixed-rate borrowings. Citizens has agreements with its derivative counterparties that contain a provision where if Citizens defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, then it could also be declared in default on its derivative obligations. Citizens also has agreements with certain of its derivative counterparties that contain a provision where if it fails to maintain its status as a well or adequately capitalized institution, then the counterparty could terminate the derivative positions and Citizens would be required to settle its obligations under the agreements. Citizens has agreements with certain of its derivative counterparties containing provisions that require its debt to maintain an investment grade credit rating from each of the major credit rating agencies. As of August 6, 2009, Citizens was in breach of these provisions, although none of the
counterparties has taken action to enforce their rights thereunder. Further discussion of this and derivative instruments is included in Note 17 to the Consolidated Financial Statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is incorporated by reference from “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Risk.”
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated Balance Sheets
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Consolidated Statements of Operations
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Consolidated Statements of Changes in Shareholders’ Equity
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Consolidated Statements of Cash Flows
Citizens Republic Bancorp, Inc.
See notes to consolidated financial statements.
Citizens Republic Bancorp, Inc.
Notes To Consolidated Financial Statements
December 31, 2010, 2009, and 2008
Unless the context indicates otherwise, all references in this Form 10-K to “Citizens” or the “Corporation,” refer to Citizens Republic Bancorp, Inc. and its subsidiaries. References to the “Holding Company” refer to Citizens Republic Bancorp, Inc. alone. Citizens was incorporated in the State of Michigan in 1980, is a diversified banking and financial services company that is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. Citizens provides a full range of banking and financial services to individuals and businesses through its subsidiary Citizens Bank. These services include deposit products, loan products, and other consumer -oriented financial services such as safe deposit and night depository facilities, and Automated Teller Machines (“ATMs”). Among the services designed specifically to meet the needs of businesses are various types of specialized financing, treasury management services, and transfer/collection facilities. Citizens also provides wealth management services through Citizens Bank Wealth Management, N.A. The Corporation is not dependent upon any single or limited number of customers, the loss of which would have a material adverse effect on the Corporation. No material portion of the business of the Corporation is seasonal.
Note 1. Summary of Significant Accounting Policies
The accounting and reporting policies for Citizens conform to U.S. generally accepted accounting principles (“GAAP”). The following describes Citizens’ policies:
Basis of Financial Statement Presentation
The accompanying consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiaries. All material intercompany transactions have been eliminated in consolidation.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, loans held for sale, other real estate owned, goodwill and core deposit intangible assets, fair value measurements, pension and postretirement benefits, derivative instruments and income taxes.
The Corporation also determines whether it should consolidate other entities or account for them on the equity method of accounting depending on whether it has a controlling financial interest in an entity of less than 100% of the voting interest of that entity to determine if it is a Variable Interest Entity (“VIE”). A VIE is a corporation, partnership, trust or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. An entity that holds a variable interest in a VIE is required to consolidate the VIE if the entity is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the entity’s residual returns or both. VIE treatment is considered for entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make financial and operating decisions.
The Corporation has two active wholly owned trusts formed for the purpose of issuing securities which qualify as regulatory capital and are considered VIEs. The Corporation is not the primary beneficiary, and consequently, the trusts are not consolidated in the consolidated financial statements. Each of the two active trusts has issued separate offerings of trust preferred securities to investors in 2006 and 2003, with respect to which there remain $48.7 million and $25.8 million in aggregate liquidation amount outstanding, respectively, as of December 31, 2010. The gross proceeds from the issuances were used to purchase junior subordinated deferrable interest debentures issued by Citizens, which is the sole asset of each trust. The trust preferred securities held by these entities qualify as Tier 1 capital and are classified as “long-term debt” on the Consolidated Balance Sheets, with the associated interest expense recorded in “long-term debt” on the Consolidated Statements of Operations. The expected losses and residual
returns of these entities are absorbed by the trust preferred stock holders, and consequently the Corporation is not exposed to loss related to these VIEs.
Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase
Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest. Generally, U.S. government and Federal agency securities are pledged as collateral under these financing arrangements and cannot be sold or re-pledged by the secured party. The fair value of collateral either received from or provided to a third party is continually monitored and additional collateral is obtained or requested to be returned to Citizens as deemed appropriate.
Investment Securities
At the time of purchase, securities are classified as held to maturity or available for sale. Investment securities classified as held to maturity, which management has the positive intent and ability to hold to maturity, are reported at amortized cost, and adjusted for amortization of premiums and accretion of discounts, using the effective yield method. The amortized cost of debt securities classified as held to maturity or available for sale is adjusted for amortization of premiums and accretion of discounts, or in the case of mortgage-related securities, over the estimated life of the security. Such amortization and accretion is included in interest income from the related security. Available for sale securities are reported at fair value with unrealized gains and losses, net of related deferred income taxes, included in shareholders’ equity as a separate component of other comprehensive income. The cost of securities sold is based on the specific identification method. An investment is considered impaired if its fair value is less than its amortized cost. Impairment is considered temporary if there is no intent or requirement to sell the impaired security. Any security for which there has been an other-than-temporary impairment of value is written down to its estimated fair value through a charge to earnings for the amount representing the credit loss on the security and a charge recognized in other comprehensive income related to all other factors. Realized securities gains or losses and declines in value judged to be other-than-temporary representing credit losses are included in investment securities gains (losses) in the consolidated statements of operations.
In April 2009, Citizens adopted new guidance for determining whether an impairment is other than temporary to debt securities, which replaced existing requirements that Citizens’ management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis. Declines in fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income. The new guidance was effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Citizens adopted this guidance in the second quarter of 2009, and it did not have a material impact on Citizens’ financial condition, results of operations or liquidity.
Loans
Loans are reported at the principal amount outstanding, net of unearned income. Interest income is recognized on an accrual basis. Loan origination fees, certain direct and indirect costs, unamortized premiums and unearned discounts are deferred and amortized into interest income as an adjustment to the yield over the term of the loan. Loan commitment fees are generally deferred and amortized into fee income on a straight-line basis over the commitment period. Other credit-related fees, including letter and line of credit fees, are amortized into fee income on a straight-line basis over their contractual life.
Loans are placed on nonaccrual status when the collection of principal or interest is considered doubtful or payment of principal or interest is past due 90 days or more. When loans are placed on nonaccrual status, all interest previously accrued but unpaid is reversed against current year interest income. Loans are normally restored to accrual status if and when interest and principal payments are current and it is believed that the financial condition of the borrower has improved to the extent that future principal and interest payments will be met on a timely basis.
Nonperforming commercial and industrial and commercial real estate loans are generally charged off to the extent principal due exceeds the net realizable value of the collateral, with the charge-off occurring when the loss is reasonably quantifiable, but not later than when the loan becomes 180 days past due. Nonperforming residential mortgage loans are generally charged off to the extent principal exceeds the current appraised value less estimated costs to sell when the loan becomes 180 days past due. Nonperforming direct and indirect consumer loans (open and closed end) are generally charged off before the loan becomes 120 days past due.
Allowance for Loan Losses
The allowance for loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate appropriateness of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
The Corporation’s allowance for loan losses consists of three elements: (i) specific allocated allowances based on probable losses on specific commercial or commercial real estate loans or restructured residential mortgage or consumer loans; (ii) risk allocated allowance which is comprised of several loan pool valuation allowances based on Citizens’ historical quantitative loan loss experience for similar loans with similar risk characteristics, including additional qualitative risks determined by the judgment of management; and (iii) general valuation allowances determined based on existing regional and local economic factors, including deterioration in commercial and residential real estate values, a macroeconomic adjustment factor used to calibrate for the current economic cycle the bank is experiencing, and other judgmental factors supported by qualitative documentation such as the inherent imprecision of the loan loss projection models.
Based on internal credit rating, commercial and industrial and commercial real estate loans exceeding certain fixed dollar amounts are evaluated for impairment on a loan -by-loan basis whereby an allowance is established as a component of the allowance for loan losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan and the recorded investment in the loan exceeds its fair value. In most instances the fair value is measured based on the fair value of the collateral. Fair value may also be measured using the present value of expected future cash flows discounted at the loan’s effective interest rate.
In January 2010, Citizens partially adopted new guidance which requires new disclosures and clarifies existing disclosure requirements about an entity’s allowance for credit losses and credit quality of its financing receivables. The adoption did not have a material impact on Citizens’ financial condition, results of operations or liquidity; however, the adoption did have a significant impact on Citizens’ credit disclosures. Refer to Note 4 for additional disclosures.
Loans Held for Sale
Loans that the Corporation has the intent and ability to sell are classified as held for sale and are carried at the lower of cost or fair value, net of estimated costs to sell. The fair value of commercial real estate loans held for sale is measured individually based on the fair value of the underlying collateral adjusted for management’s best estimate due to current market conditions. The fair value of residential mortgage loans originated for sale in the secondary market is based on individual purchase commitments or quoted prices for the same or similar loans. The fair value of nonperforming residential mortgage loans is based on the fair value of the underlying collateral adjusted for management’s best estimate due to current market conditions. Gains and losses on the sales of loans are determined using the specific identification method. Subsequent valuation adjustments to reflect current fair value, as well as gains and losses on disposal of these loans are charged to noninterest income as incurred.
On December 10, 2007, Citizens entered into a contract with PHH Mortgage Corporation (“PHH”). In March 2008, PHH began performing mortgage loan processing, servicing, secondary market functions and other mortgage-related loan origination services. Citizens sells substantially all of its mortgage originations to PHH at a contractual price, generally within 10 days after closing. Prior to the PHH alliance, Citizens sold substantially all fixed-rate single-family mortgage loans originated, including adjustable-rate loans that convert to fixed-rate loans within 60 days after closing.
Premises and Equipment
Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation and amortization. Depreciation and amortization are computed principally on a straight-line basis and are charged to expense over the lesser of the estimated useful life of the assets or lease term. Useful lives range from three to seven years for furniture, fixtures, and equipment and seven to forty years for buildings and improvements. Maintenance and repairs are charged to expense as incurred. Gains and losses on dispositions are charged to income as incurred.
Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the expected undiscounted future cash flows of a long-lived asset are less than its carrying value. In that event, Citizens recognizes a loss for the difference between the carrying amount and the estimated fair value of the asset based on a quoted market price, if applicable, or a discounted cash flow analysis.
Other Real Estate Owned
Other Real Estate Owned is comprised of commercial and residential real estate properties acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure. These properties are carried at the lower of cost or fair value at the time of acquisition, net of estimated costs to sell, based upon current appraised value adjusted for management’s best estimate due to current market conditions. Losses arising from the initial acquisition of such properties are charged against the allowance for loan losses at the time of transfer. Subsequent valuation adjustments to reflect the lower of cost or fair value, as well as gains and losses on disposal of these properties are charged to noninterest expense as incurred.
Bank Owned Life Insurance
Bank Owned Life Insurance is recorded as an asset at the amount that could be realized under the insurance contracts as of the date of the consolidated balance sheets. The change in cash surrender value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contracts for the period. This change is recorded in noninterest income as cash surrender value of life insurance revenue.
Goodwill and Core Deposit Intangible Assets
Goodwill represents the excess of the cost of an acquisition over the fair value of net identifiable tangible and intangible assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability. Goodwill is tested at least annually for impairment and Citizens performs its annual impairment test as of October 1 each year. Evaluations are also performed on a more frequent basis if events or circumstances indicate that it is more likely than not that the fair values of the reporting units are below their respective carrying amounts. Such events could include a significant adverse change in legal factors or in the business climate, an adverse action by a regulator, an unanticipated change in the competitive environment, an unanticipated loss of key employees, a decision to change the operations or dispose of a reporting unit, cash or operating losses, significant revision to forecasts, or a long-term negative outlook for the industry.
Impairment of goodwill is evaluated by reporting unit, which is the equivalent to Citizens’ lines of business. In Step 1 of the analysis, Citizens estimates the fair value of the reporting units using discounted cash flow models derived from internal earnings forecasts. The primary assumptions used by Citizens include ten-year earnings forecasts, terminal values based on estimated future growth rates, and discount rates based on capital asset pricing models. A Step 1 analysis is prepared for each reporting unit, including those without goodwill, in order to analyze the implied control premium, which measures the difference between the combined fair value of Citizens’
reporting units calculated in Step 1 and Citizens’ total market value. If the carrying amount of a reporting unit exceeds its estimated fair value, the second step (Step 2) of the goodwill impairment test is required for those reporting units that have goodwill to measure the amount of impairment, if any. In Step 2 of the test, Citizens estimates the fair value of a reporting unit’s assets and liabilities in the same manner as if a purchase of the reporting unit was taking place using exit pricing, which includes estimating the fair value of other implied intangibles. Any excess of this hypothetical purchase price over the fair value of the reporting unit’s net assets (excluding goodwill) represents the implied fair value of goodwill. If the implied fair value of goodwill calculated in Step 2 is less than the carrying amount of goodwill, an impairment loss is charged to noninterest expense to reduce the carrying amount to the implied fair value. The writedown cannot exceed the carrying amount and goodwill cannot be adjusted upward for any subsequent reversal of previously recognized goodwill writedowns.
Core deposit intangible assets represent the present value of the cost savings obtained from funding associated with the purchase of core deposits through an acquisition. Core deposit intangible assets are valued using a discounted cost savings approach. All of Citizens’ core deposit intangible assets have finite lives, are amortized on an accelerated basis corresponding with the anticipated lives of the underlying deposits over varying periods not exceeding 10 years, and are subject to impairment testing.
Pension and Postretirement Benefits
Citizens has recognized the funded status (i.e. the difference between the fair value of plan assets and the projected benefit obligations) of its pension plan in the consolidated balance sheets, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income represents the net unrecognized actuarial losses and unrecognized prior service costs that will be subsequently recognized as net periodic pension cost pursuant to Citizens’ accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic pension cost.
Fair Value Measurements
Fair value is defined as the exit price in the principal market (or, if lacking a principal market, the most advantageous market) in which Citizens would complete a transaction. Fair value is based on management’s best estimate of the assumptions market participants would use when pricing an asset or liability and a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Citizens bases fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For assets and liabilities recorded at fair value, it is Citizens’ policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.
Fair value measurements for assets and liabilities where there exists limited or no observable market data are based primarily upon estimates which require significant judgment, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. The fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction and considers additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
In 2009, Citizens adopted new guidance to expand its fair value disclosures to include nonfinancial assets and liabilities, enhance its fair value disclosures for financial assets and liabilities, and provide disclosures on financial instruments in interim financial reports. Citizens discloses in the body or in the accompanying notes of its summarized financial information for interim reporting periods and in its financial statements for annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether
recognized or not recognized in the balance sheet. These changes did not have a material impact on Citizens’ financial condition, results of operations, or liquidity. Refer to Note 10 for additional disclosures.
In January 2010, Citizens adopted new guidance that requires new disclosures and clarifies existing disclosure requirements about fair value measurement. The adoption had no significant impact on Citizens’ fair value disclosures. See Note 10 to the Consolidated Financial Statements for more information on fair value measurements.
Derivative Instruments
Citizens enters into derivative transactions from time to time to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows. Under the guidelines of ASC Topic 815, all derivative instruments are required to be carried at fair value on the balance sheet. Topic 815 also provides special hedge accounting provisions. Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under Topic 815. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.
Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the balance sheet with corresponding offsets recorded in the income statement. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the interest income or expense recorded on the hedged asset or liability.
Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in other comprehensive income within shareholders’ equity, net of tax. Amounts are reclassified from other comprehensive income to the income statement in the period or periods the hedged forecasted transaction affects earnings.
Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in noninterest income.
Prior to the PHH alliance, Citizens sold substantially all fixed-rate single-family mortgage loans originated, including adjustable-rate loans that convert to fixed-rate loans. Citizens utilized mandatory forward commitments to protect against changes in interest rates and prices on its mortgage pipeline. These derivatives were marked to market through earnings. Citizens was also required to recognize certain contracts and commitments as derivatives when the characteristics of those contracts and commitments met the definition of a derivative. Citizens also recorded as derivatives, residential loan commitments associated with loans held for sale. These derivatives were marked to market through earnings.
Citizens enters into various derivative agreements with customers desiring protection from possible adverse future fluctuations in interest rates. As an intermediary, Citizens generally maintains a portfolio of matched offsetting derivative agreements. These contracts are marked to market through earnings.
In January 2009, Citizens adopted new guidance to enhance required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding (a) how and why an entity uses derivative instruments; (b) how derivative instruments and related hedged items are accounted for; and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Disclosures include objectives and strategies for using derivatives, quantitative disclosures about the fair value of, and gains and losses on, derivative instruments and disclosures about credit- risk-related contingent features in derivative instruments. Citizens records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether Citizens has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying
as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. Citizens may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. The adoption had no impact on Citizens’ financial condition, results of operations, or liquidity. In July 2010, Citizens adopted new guidance that clarifies the type of embedded credit derivative(s) that are exempt from embedded derivative bifurcation requirements. The adoption had no impact on Citizens’ financial condition, results of operations or liquidity. For more information on derivative financial instruments and hedge accounting, see Note 17 to the Consolidated Financial Statements.
Income Taxes
Amounts provided for income tax expense (benefit) are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable (receivable) under tax laws. Deferred income taxes, which arise principally from temporary differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they affect taxable income, are included in the amounts provided for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent on utilizing taxable income in prior carryback years, generating future taxable income, executing tax planning strategies, and reversing existing taxable temporary differences. Currently, the ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible.
The Corporation utilizes a two-step approach for evaluating tax positions. Recognition (step one) occurs when an enterprise concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination. Measurement (step two) is only addressed if the result of step one is that the position is more likely than not to be sustained. Under step two, the tax benefit is measured as the largest amount of benefit, determined on a cumulative probability basis, which is more likely than not to be realized on ultimate settlement.
The Corporation files a consolidated federal income tax return and various Holding Company and subsidiary state income tax returns. When income and expenses are recognized in different periods for tax purposes, applicable deferred taxes are provided in the Consolidated Financial Statements. Accordingly, amounts equal to the tax benefits of those subsidiaries having taxable federal losses or credits are offset by other subsidiaries that incur federal tax liabilities. Citizens recognizes interest and penalties accrued relative to unrecognized tax benefits in their respective federal or state income tax accounts.
Stock-Based Compensation
The compensation cost for share based awards is recognized in salaries and employee benefits based on the fair value at the date of grant and is recognized on a straight line basis over the requisite service period of the awards. The requisite service period is presumed to be the stated vesting period or the estimated time that will be required to satisfy any performance conditions. Restricted shares are included in outstanding stock totals, and are entitled to receive dividends and have voting rights. Restricted stock units have no voting or dividend rights but have dividend equivalent rights entitling them to additional shares at the time the units are settled for common stock. Forfeited and expired options and forfeited shares of restricted stock become available for future grants. Refer to Note 12 for additional disclosures.
Net Income per Common Share
Basic net income (loss) per common share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding in each period. Diluted net income per common share shows the dilutive effect of additional common shares issuable upon the assumed exercise of stock options granted under Citizens’ stock option plans, using the treasury stock method, and restricted stock awards granted but not yet vested. In January 2009, Citizens adopted new guidance which provides that unvested share-based
payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and are included in the computation of earnings per share pursuant to the two-class method, which was applied retrospectively to all periods presented. The adoption did not have a material impact on Citizens’ financial condition, results of operations, or liquidity. Refer to Note 14 for additional disclosures.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents are considered to include cash and due from banks, interest-bearing deposits in other financial institutions, federal funds sold and securities purchased under agreements to resell.
Reclassifications
Certain amounts have been reclassified to conform to the current year presentation.
Note 2. Pending Accounting Pronouncements
Accounting Standard Update (“ASU”)
Statements of Financial Accounting Standards (“SFAS”)
FASB ASU 2011-01, “Receivables (Topic 310): Deferral of the Effective Date of Disclosures
about Troubled Debt Restructurings in Update No. 2010-20”
The amendments in this ASU temporarily delay the effective date of the disclosures about troubled debt restructurings in ASU No. 2010-20. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011. The deferral in ASU 2011-01 was effective January 19, 2011 (date of issuance). Citizens does not expect the adoption of the amendments to have a material impact on Citizens’ financial condition, results of operations or liquidity; however, the adoption will have an impact on Citizens’ disclosures about troubled debt restructurings.
FASB ASU 2010-28, “Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts”
The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples, which require that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. ASU 2010-28 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Citizens does not expect the adoption of ASU 2010-28 to have a material impact on Citizens’ financial condition, results of operations or liquidity.
FASB ASU 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”
The portion of this ASU that was effective in 2010 requires new disclosure requirements about activity that occurs during a reporting period. Disclosure requirements about activity that occurs during a reporting period are effective the first fiscal quarter beginning after December 15, 2010. Citizens does not expect the adoption of the portion of this ASU to have a material impact on Citizens’ financial condition, results of operations or liquidity; however, the adoption will have an impact on Citizens’ credit disclosures.
FASB ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements”
The portion of this ASU not yet adopted by Citizens requires new disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures requirements
are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of these disclosures will not have a significant impact on Citizens’ fair value disclosures.
Note 3. Investment Securities
The amortized cost, estimated fair value and gross unrealized gains and losses of investment securities follow:
(1)
Amortized cost includes adjustments for the unamortized portion of unrealized gains on securities transferred from available for sale.
Securities with amortized cost of $0.8 billion at December 31, 2010, and $1.1 billion at December 31, 2009 were pledged to secure public deposits, repurchase agreements and other liabilities. Except for obligations of the U.S. Government and its agencies, no holdings of securities of any single issuer exceeded 10% of consolidated shareholders equity at December 31, 2010 or 2009.
In December 2010, Citizens transferred certain mortgage-back securities from the available-for-sale to the held-to-maturity category. Management determined that it had both the ability to hold these investments and the intent to do so. The securities transferred had a total amortized cost of $179.2 million and a fair value of $181.8 million. The unrealized gain of $2.6 million will be amortized over the remaining life of the security as an adjustment of the yield.
The amortized cost, estimated fair value, and weighted average yields of debt securities by maturity at December 31, 2010 are shown below. Maturities of mortgage-backed securities are based upon current industry prepayment schedules.
A total of 229 securities had unrealized losses at December 31, 2010 compared with 239 securities at December 31, 2009. These securities, with unrealized losses aggregated by investment category and length of time in a continuous unrealized loss position, are as follows:
Citizens performs a review of securities with unrealized losses at each reporting period. Citizens assesses each holding to determine whether and when a security will recover in value, whether it intends to sell the security and whether it is more likely than not that Citizens will be required to sell the security before the value is recovered. In assessing the recovery of value, the key factors reviewed include the length of time and the extent the fair value has been less than the carrying cost, adverse conditions, if any, specifically related to the security, industry or geographic area, historical and implied volatility of the fair value of the security, credit quality factors affecting the issuer or the underlying collateral, payment structure of the security, historical payment history of the security, changes to the credit rating of the security, recoveries or declines in value subsequent to the balance sheet date or any other relevant factors. Evaluations are performed on a more frequent basis as the degree to which fair value is below carrying cost or the length of time that the fair value has been continuously below carrying cost, increases. As of December 31, 2010, Citizens has concluded that all issuers have the ability to pay contractual cash flows. The unrealized losses displayed in the above table are believed to be temporary and thus no impairment loss has been realized in the Consolidated Statement of Operations. Citizens has not decided to sell securities with unrealized losses nor does Citizens believe it will be required to sell securities before the value is recovered, but may change its intent in response to significant, unanticipated changes in policies, regulations, statutory legislation or other aforementioned criteria.
The collateralized mortgage obligations (“CMO”) sector includes securities where the underlying collateral consists of agency issued or whole loan mortgages. At December 31, 2010, the whole loan CMOs had a market value of $177.3 million with gross unrealized losses of $5.2 million. Citizens performs a thorough credit review on a quarterly basis for the underlying mortgage collateral as well as the supporting credit enhancement and
structure. The results of the December 31, 2010 credit review demonstrated continued strength and no material degradation in the holdings.
Citizens has determined there is no other-than-temporary impairment at December 31, 2010.
For the year ending December 31, 2010, as part of its capital strategy Citizens sold $403.7 million of available for sale securities and recorded a net gain of $13.9 million. The proceeds from the sales were used to purchase GNMA securities which strengthened Citizens’ capital position by improving the risk profile of the investment portfolio. Citizens sold available for sale securities with proceeds of $1.9 million and recorded a loss of less than $0.1 million in 2009.
Note 4. Loans, Nonperforming Assets, Allowance for Loan Losses, and Loans Held for Sale
Citizens primarily extends credit within the Midwestern states of Michigan, Wisconsin, Ohio, and Indiana. In Michigan, the primary market is concentrated in the Lower Peninsula with a small presence in the Upper Peninsula. In Wisconsin, the primary markets include the greater Green Bay Metropolitan area, the Fox Valley region which extends from Appleton to Oshkosh, suburban Milwaukee, and also rural markets in southern and northern Wisconsin. In Ohio, the primary market is the greater Cleveland area. In Indiana, the sole office is located in Indianapolis. Citizens seeks to limit its credit risk by using established guidelines to review its aggregate outstanding commitments and loans to particular borrowers, industries and geographic areas. Collateral is secured based on the nature of the credit and management’s credit assessment of the customer. Total portfolio loans outstanding are recorded net of unearned income, unamortized premiums and discounts, deferred loan fees and costs, and fair value adjustments.
The majority of Citizens’ commercial real estate loans consist of mortgages on non-owner occupied properties. Those borrowers are involved in real estate business activities and the sources of repayment are dependent on the performance of the real estate market. In such cases, Citizens generally requires the borrower to have a proven record of success and to meet Citizens’ underwriting criteria for this type of credit risk. Citizens does not have a concentration in any single industry that exceeds 10% of total loans.
Past Due Loans, Nonaccrual Loans and Nonperforming Assets. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when the collection of principal or interest is considered doubtful or payment of principal or interest is past due 90 days or more. When loans are placed on nonaccrual status, all interest previously accrued but unpaid is reversed against current year interest income. Loans are normally restored to accrual status if and when interest and principal payments are current and it is believed that the financial condition of the borrower has improved to the extent that future principal and interest payments will be met on a timely basis. Nonperforming assets are comprised of nonaccrual loans, loans past due over 90 days and still accruing interest, restructured loans, nonperforming loans held for sale, and other repossessed assets acquired.
A summary of nonperforming assets by class of loans follows:
Citizens recognized $5.1 million of interest income on nonperforming loans during 2010. Had nonaccrual loans performed in accordance with their original contract terms, the Corporation would have recognized additional interest income of approximately $9.0 million in 2010. There were no significant commitments outstanding to lend additional funds to clients whose loans were classified as nonaccrual or restructured at December 31, 2010.
An age analysis of financing receivables, segregated by class, as of December 31, 2010 was as follows.
Impaired loans. A loan is considered impaired when Citizens determines that it is probable that all the contractual principal and interest due under the loan may not be collected. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Cash collected on nonaccrual loans is generally applied to outstanding principal. Impaired loans, or portions thereof, are charged off when deemed uncollectible.
A summary of impaired loans, segregated by class, as of December 31, 2010, are set forth in the following table.
Credit Quality Indicators. Citizens 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. Citizens analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $0.5 million and non-homogeneous loans, such as commercial and industrial and commercial real estate loans. Credit quality indicators are reviewed and updated as applicable on an ongoing basis in accordance with Citizens’ credit policy. The Company uses the following definitions for risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loans considered doubtful are evaluated for impairment as part of the specific allocated allowance.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of December 31, 2010, the risk category of loans by class is as follows.
For the residential and consumer loan class, Citizens evaluates credit quality based on the aging status of the loan and by payment activity. The following table presents the recorded investment in residential and consumer loans based on payment activity as of December 31, 2010.
Allowance for Loan Losses. The allowance for loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that will be incurred within the existing portfolio of loans. During 2010, we further refined our allocation methodology which had virtually no impact on total allowance for loan losses. The methodology used for measuring the appropriateness of the allowance for loan losses relies on several key elements, which include specific allowances for identified impaired loans, a formula-based risk-allocated allowance for the remainder of the portfolio and a general valuation allowance calculation. A summary of changes in the allowance for loan losses follows:
A summary of allowance for loan losses, segregated by portfolio segment, as of December 31, 2010 was as follows:
A summary of the recorded investment in loans, segregated by portfolio segment, as of December 31, 2010 was as follows:
Loans Serviced for Others. The Consolidated Financial Statements do not include loans serviced for others, which totaled $315.6 million, and $372.1 million at December 31, 2010 and 2009, respectively.
Loans Held for Sale. Loans held for sale are comprised of commercial real estate and residential mortgage loans. Held for sale loans at December 31, 2010 totaled $40.3 million, a decrease of $39.9 million or 49.7% from December 31, 2009. The decrease reflects a decline in commercial loans held for sale due to the sale of commercial and residential loans, customer paydowns, workout activities, writedowns to reflect further fair-value declines for the underlying collateral, and transfers to ORE.
Note 5. Premises and Equipment
A summary of premises and equipment follows:
Certain branch facilities and equipment are leased under various operating contracts. Total rental expense, including expenses related to these operating leases, was $6.0 million in 2010, $6.2 million in 2009, and $6.8 million in 2008. Future minimum rental commitments under non-cancelable operating leases are as follows at December 31, 2010:
Note 6. Goodwill and Core Deposit Intangible Assets
A summary of goodwill allocated to the lines of business as of December 31, 2010 and December 31, 2009 follows:
As of October 1, 2010, the annual impairment test described in Note 1 was performed using management’s most recent long-term financial projections and current risk-adjusted discount rates. The Step 1 analysis indicated that the carrying amount exceeded estimated fair value for the Regional Banking reporting unit; therefore, Step 2 testing was required. Citizens determined, as a result of the Step 2 analysis, that the remaining goodwill allocated to Regional Banking was not impaired due to the implied fair value of goodwill exceeding the carrying amount of goodwill by approximately 28%. No events (individually or in aggregate) have occurred since the annual goodwill impairment analysis that indicate a potential impairment of goodwill. As the key inputs and drivers remained consistent with those used as of the annual impairment testing date, Citizens concluded that no additional impairment was indicated.
As a result of announcing the sale of F&M on January 29, 2010, Citizens performed an interim goodwill analysis during the first quarter of 2010 and concluded that there was no impairment. Goodwill was allocated to F&M based on the relative value of F&M’s regional banking equity compared with the total fair value of equity for the Regional Banking reporting unit. The analysis indicated that approximately 3.8% of the fair value of the Regional Banking unit resided in the Iowa franchise as of January 1, 2010. Therefore, Citizens allocated $12.6 million of goodwill to discontinued operations.
During the second quarter of 2009, Citizens recorded a non-cash goodwill impairment charge against the goodwill allocated to the Regional Banking line of business of $256.3 million. The goodwill impairment charge was not tax deductible, did not impact Citizens’ tangible equity or regulatory capital ratios, and did not adversely affect Citizens’ overall liquidity position. Previously, Citizens recorded a goodwill impairment charge during the second quarter of 2008, when it determined that the fair value of the Specialty Commercial reporting unit was below its carrying value. At that time, Citizens recorded a non-cash, not tax-deductive goodwill impairment charge of $178.1 million, representing the entire amount of goodwill allocated to the Specialty Commercial reporting unit.
A summary of core deposit intangibles at December 31, 2010 and 2009 follows:
The following presents the estimated future amortization expense of core deposit intangible assets.
All of Citizens’ core deposit intangible assets have finite lives and are amortized on an accelerated basis corresponding with the anticipated lives of the underlying deposits over varying periods not exceeding 10 years. The weighted-average amortization period for core deposit intangible assets is 2.4 years.
Note 7. Deposits
Overdrafts on demand accounts are classified as loans, rather than deposits, on the face of the balance sheet and totaled $11.1 million and $10.2 million at December 31, 2010 and 2009, respectively. Time deposits over $100,000 totaled $1.1 billion at December 31, 2010, compared with $1.8 billion at December 31, 2009. The scheduled maturities for time deposits over $100,000 at December 31, 2010 were as follows:
Note 8. Short-Term Borrowings
Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase and other short-term borrowings (which consist primarily of Treasury, Tax and Loan borrowings). Federal funds purchased are overnight borrowings from other financial institutions. Securities sold under agreements to repurchase are secured transactions done principally with investment banks. Maturities of securities sold under agreements to repurchase are generally 90 days or less.
Information relating to federal funds purchased and securities sold under agreements to repurchase follows:
Note 9. Long-Term Debt
A summary of long-term debt follows:
On January 27, 2003, Citizens issued $125.0 million of 5.75% subordinated notes, maturing February 1, 2013. Issuance costs were capitalized and are included in the long-term debt total on the balance sheet. The issuance costs are being amortized over ten years as a component of interest expense. Under the risk-based capital guidelines, a portion of the subordinated debt currently qualifies as Tier 2 supplementary capital.
On June 26, 2003, Citizens issued $25.8 million of floating rate, 30 year trust preferred securities through an unconsolidated special purpose trust to unrelated institutional investors. The gross proceeds from issuance were used to purchase a floating rate junior subordinated deferrable interest debenture (the “Debenture”) issued by Citizens, which is the sole asset of the trust. The Debenture matures in thirty years and bears interest at an annual rate equal to the three-month LIBOR plus 3.10%, payable quarterly beginning in September, 2003. Interest is adjusted on a quarterly basis not to exceed 11.75%. The Debenture is an unsecured obligation of Citizens and is junior in right of payment to all future senior indebtedness of Citizens. Citizens has guaranteed that interest payments on the Debenture made to the trust will be distributed by the trust to the holders of the trust preferred securities. The trust preferred securities of the special purpose trust are callable at par and must be redeemed in thirty years after issuance. The issuance costs were amortized to the call date over five years as a component of interest expense, as Citizens believed this was the most probable life of these securities. Under the risk-based capital guidelines, the trust preferred securities currently qualify as Tier 1 capital.
On October 3, 2006, Citizens Funding Trust I (the “2006 Trust”) completed an offering of $150.0 million aggregate liquidation amount of enhanced trust preferred securities. The gross proceeds from issuance were used to purchase a junior subordinated deferrable interest debenture issued by Citizens, which is the sole asset of the 2006 Trust. The 2006 debentures rank junior to Citizens’ outstanding debt, including the other outstanding junior subordinated debentures. The enhanced trust preferred securities are listed on the New York Stock Exchange (NYSE symbol CTZ-PA). Distributions on the securities, which represent undivided beneficial interests in the assets of the 2006 Trust, accrue from the original issue date and are payable quarterly in arrears at an annual rate of 7.50%, beginning December 15, 2006. The securities are callable on or after September 15, 2011 and mature on September 15, 2066. Issuance costs of $5.1 million were capitalized and are amortized through the long-term debt total on the consolidated balance sheets. The issuance costs are amortized to the call date over five years as a component of interest expense. The proceeds were used to finance the cash portion of the consideration paid in Citizens’ merger with Republic and for general corporate purposes.
On September 30, 2009, Citizens exchanged shares of common stock for long-term debt with a carrying value of $204.0 million. The extinguished long-term debt was comprised of $107.8 million principal amount of its 5.75% subordinated notes ($104.2 million, net of early amortization of prior debt issuance costs) and $101.3 million aggregate liquidation amount of the 7.50% trust preferred securities of the 2006 Trust ($99.8 million, net of early amortization of prior debt issuance costs). Refer to Note 14 for additional information.
On January 28, 2010 Citizens announced that it was suspending the dividend payments on its trust preferred securities.
Citizens accrues for this obligation in other liabilities on the Consolidated Balanced Sheets and as of December 31, 2010, the total amount of the arrearage is $4.9 million.
As of December 31, 2010, advances from the FHLB are at fixed rates ranging from 2.51% to 6.93% and mature from 2011 through 2021. Citizens restructured $250.0 million in FHLB advances in December 2010. This restructuring resulted in the locking in of lower term funding rates. The average interest rate on these restructured advances was reduced to 2.78% from 4.90% and the average remaining term was extended to 4.5 years from 1.0 years. FHLB advances totaling $190.0 million may be put back to Citizens at the option of the FHLB. Advances totaling $639.0 million are non-convertible and subject to neither put nor call options. Citizens’ advances from the FHLB were collateralized at December 31, 2010 with $2.9 billion of residential and commercial loans secured by real estate and securities held for pledging.
As of December 31, 2010, $103.4 million of long-term repurchase agreements with interest rates up to 4.69%, maturing between August 2015 and May 2016 were outstanding. Long-term repurchase agreements are classified under Other borrowed funds.
The par value of long-term debt is scheduled to mature as shown in the table below. This schedule excludes all carrying value adjustments, such as purchase accounting fair value adjustments, hedge accounting fair value adjustments, and unamortized premiums and discounts, that will not affect future cash payments associated with the maturity of this debt.
Note 10. Fair Values of Assets and Liabilities
Fair value estimates are intended to represent the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Given that there is no active market for many of Citizens’ financial instruments, Citizens has made estimates using discounted cash flow or other valuation techniques. Inputs to these valuation methods are subjective in nature, involve uncertainties, and require significant judgment and therefore can not be determined with precision. Accordingly, the derived fair value estimates presented herein are not necessarily indicative of the amounts Citizens could realize in a current market exchange.
The fair value estimates are based on existing on- and off-balance sheet financial instruments and do not attempt to estimate the value of anticipated future business or the value of assets and liabilities that are not considered financial instruments. For example, Citizens has a substantial trust department that contributes net fee income annually. The trust department is not considered a financial instrument and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include Citizens’ brokerage network, net deferred tax assets (and the related valuation reserves), and premises and equipment. In addition, tax ramifications related to the recognition of unrealized gains and losses such as those within the investment securities portfolio can have a significant effect on estimated fair values and have not been considered in the estimates. For these reasons, the aggregate fair value should not be considered an indication of the value of the Corporation.
Citizens groups assets and liabilities which are recorded 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. An
asset or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). A brief description of each level follows.
Level 1 - Valuation is based upon quoted prices for identical instruments in active markets.
Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 - Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Valuation techniques include use of discounted cash flow models and similar techniques.
The estimated fair values of Citizens’ financial instruments follow.
(1)
Positive amounts represent assets, whereas negative amounts represent liabilities.
(2)
The carrying amount for letters of credit is part of the total carrying amount of net loans. It is shown here separately to disclose the estimated fair value which is based on a discounted cash flow method utilizing current market pricing. This amount is not included in the net loans estimate of fair value.
The carrying amount approximates fair value for cash, money market investments, FHLB stock, Federal Reserve stock, and accrued interest. The methods and assumptions used to estimate the fair value for other financial instruments are set forth below. There were no changes in the valuation methods used to estimate fair value during the twelve months ended December 31, 2010.
Securities Available for Sale. Fair value measurement is based upon quoted prices for similar assets, if available, or matrix pricing models. Matrix pricing is a mathematical technique widely used in the banking industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. The securities in the available for sale portfolio are priced by independent providers. In obtaining such valuation information from third parties, Citizens has evaluated its valuation methodologies used to develop the fair values in order to determine whether such valuations are representative of an exit price in Citizens’ principal markets. Further, Citizens has developed an internal, independent price verification function that performs testing on valuations received from third parties.
Citizens’ principal markets for its securities portfolios are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets.
Recurring Level 3 securities include auction rate securities issued by student-loan authorities and a taxable municipal Qualified Zone Academy Bond (“QZAB”). Due to the nature of the auction rate securities and the lack of a secondary market with active fair value indicators, Citizens used an income approach based on a discounted cash flow model utilizing significant unobservable inputs (Level 3) in the valuation process to estimate the transaction price between market participants for each group of securities as of the valuation date. The significant assumptions made in this modeling process included the discount rate, the term over which this discount rate would stabilize, and fail rate formulas utilizing assumed interest payments. Due to the current illiquid market for QZAB bonds, Citizens relies on models containing significant unobservable market-based inputs to determine the fair-value of these bonds. The primary unobservable pricing input was the assumption made regarding the ability of market participants to utilize the tax credits associated with this type of instrument.
Securities Held to Maturity. The fair value of securities classified as held to maturity are based upon quoted prices for similar assets, if available, or matrix pricing models.
FHLB and Federal Reserve Stock. The carrying amount of FHLB and Federal Reserve stock is used to approximate the fair value of these investments. These securities are not readily marketable, are recorded at cost (par value), and are evaluated for impairment based on the ultimate recoverability of the par value. Citizens considers positive and negative evidence, including the profitability and asset quality of the issuer, dividend payment history and recent redemption experience, when determining the ultimate recoverability of the par value. Citizens believes its investments in FHLB and Federal Reserve stock are ultimately recoverable at par.
Net Portfolio Loans. The fair value of loans and loan commitments is estimated based on discounted cash flows. The cash flows take into consideration current portfolio interest rates and repricing characteristics as well as assumptions relating to prepayment speeds. The discount rates take into consideration the current market interest rate environment, a credit risk component based on the credit characteristics of each loan portfolio, and a liquidity premium reflecting the liquidity or illiquidity of the market.
Deposits. The estimated fair value of demand deposits (e.g., noninterest and interest bearing demand, savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for certificates of deposit are based on the discounted value of contractual cash flows at current interest rates. The estimated fair value of deposits does not take into account the value of Citizens’ long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets, and not considered financial instruments.
Short-Term Borrowings. The carrying amounts of federal funds purchased, securities sold under agreement to repurchase and other short-term borrowings approximate their fair values because they frequently reprice to a market rate.
Long-Term Debt. The fair value is estimated using observable market prices and by discounting future cash flows using current interest rates for similar financial instruments.
Derivative Instruments. Substantially all derivative instruments held or issued by Citizens are traded in over-the-counter markets where quoted market prices are not readily available. Derivative instruments are priced by independent providers using observable market assumptions with adjustments based on widely accepted valuation techniques. For those derivatives, Citizens measures fair value with models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk (credit valuation adjustments). Citizens assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions, and determined that the credit valuation adjustments were not significant to the overall valuation of its derivatives.
Deferred Compensation Assets. Citizens has a portfolio of mutual fund investments which hedge the deferred compensation liabilities for various employees, former employees and directors. These investments are traded on active exchanges with valuations obtained from readily available pricing sources for market transactions
involving identical assets. Additionally, Citizens invests in a Guaranteed Income Fund which is valued based on similar assets in an active market.
Impaired Loans. A loan is considered to be impaired when it is probable that all of the principal and interest due under the original underwriting terms of the loan may not be collected. Impairment is typically measured based on the fair value of the underlying collateral. The fair value of the underlying collateral is determined, where possible, using market prices derived from appraisals or broker price opinions, which are considered to be Level 2. However, certain assumptions and unobservable inputs are currently being used by appraisers and brokers, therefore qualifying the assets as Level 3 in the fair-value hierarchy. Citizens measures impairment on all nonaccrual commercial and industrial and commercial real estate loans for which it has established specific reserves as part of the specific allocated allowance component of the allowance for loan losses.
Residential Mortgage Loans Held for Sale. Residential mortgage loans held for sale are comprised of loans originated for sale in the ordinary course of business and selected nonperforming residential mortgage loans. The fair value of residential mortgage loans originated for sale in the secondary market is based on purchase commitments or quoted prices for the same or similar loans and are classified as nonrecurring Level 2. The fair value of nonperforming residential mortgage loans is based on the fair value of the underlying collateral, net of estimated costs to sell, using market prices which utilize projected assumptions potential investors would make and are classified as nonrecurring Level 3.
Mortgage Servicing Rights. Mortgage servicing rights represent the value associated with servicing residential mortgage loans. The value is determined through a discounted cash flow analysis which uses interest rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management judgment. Adjustments are only made when the discounted cash flows are less than the carrying amount.
Other Real Estate. Other real estate (“ORE”) is comprised of commercial and residential real estate acquired through foreclosure proceedings or acceptance of a deed-in-lieu of foreclosure, and former branch locations. Commercial properties and former branch locations are carried at the lower of cost or market value at the time of acquisition based on the fair value of the underlying collateral, net of estimated costs to sell. This is determined using market prices derived from appraisals or broker price opinions, which are considered to be Level 2. However, certain assumptions and unobservable inputs are currently being used by appraisers and brokers, therefore qualifying the assets as Level 3 in the fair value hierarchy. Residential real estate is recorded at the fair value of the underlying collateral, net of estimated costs to sell, using market prices which utilize projected assumptions Citizens believes potential investors would make, broker price opinions or appraisals, and are classified as nonrecurring Level 3. Losses arising from the initial acquisition of such properties are charged against the allowance for loan losses at the time of transfer. Subsequent valuation adjustments to reflect the lower of cost or market value, as well as gains and losses on disposal of these properties, are charged to other expenses as incurred. Citizens records ORE properties as nonrecurring Level 3.
Repossessed Assets. Repossessed assets consist of consumer assets acquired to satisfy the consumer’s outstanding delinquent debt. These assets consist of automobiles, boats, recreational vehicles and other personal items. These assets are carried at the lower of cost or market value, net of estimated costs to sell, based on internally developed procedures.
Some of the assets and liabilities discussed above are measured on a recurring basis while others are measured on a nonrecurring basis, with the determination based upon applicable existing accounting pronouncements. For example, investment securities available for sale, derivative instruments and deferred compensation assets are recorded at fair value on a recurring basis. Other assets, such as mortgage servicing rights, loans held for sale, impaired loans, other real estate, and repossessed assets are recorded at fair value on a nonrecurring basis using the lower of cost or market value to determine impairment of individual assets. Goodwill and core deposit intangibles are measured for impairment on a nonrecurring basis and are written down when the value of the individual asset has declined.
The following table presents the balances of assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2010.
There were no transfers between levels within the fair value hierarchy during the 12 month period ended December 31, 2010. The following table presents the reconciliation of Level 3 assets held by Citizens on December 31, 2010.
(1)
Recorded through Interest Income on the Consolidated Statement of Operations.
The following table includes assets measured at fair value on a nonrecurring basis that have had a fair value adjustment as of December 31, 2010.
Note 11. Employee Benefit Plans
Pension and Postretirement Benefits: Citizens maintains a cash balance defined benefit pension plan. Pension retirement benefits are based on the employees’ length of service and salary levels. Under the defined benefit plan, employees are eligible for early retirement at age 55 with at least 3 years of service. It is Citizens’ policy to fund pension costs in an amount sufficient to meet or exceed the minimum funding requirements of applicable laws and regulations, plus such additional amounts as Citizens deems appropriate up to the level allowed by federal tax regulations. Actuarially determined pension costs are charged to current operations.
Effective December 31, 2006, Citizens’ defined benefit pension plan was “frozen,” preserving prior earned benefits but discontinuing the accrual of further benefits. Citizens did not make a cash contribution to the defined benefit pension plan during 2010 but reviews plan funding needs periodically and will make a contribution if appropriate.
Citizens also maintains nonqualified supplemental benefit plans for certain former key employees. These plans are provided for by charges to earnings sufficient to meet the projected benefit obligation under applicable accounting standards. Benefits under the nonqualified supplemental plans are based primarily on years of service, age and compensation before retirement. The defined pension benefits provided under these plans are unfunded and any payments to plan participants are made by Citizens. During 2010, Citizens contributed $0.5 million to the supplemental pension plans.
Citizens’ postretirement benefit plan provides postretirement health and dental care to full-time employees who retired with eligibility for coverage based on historical plan terms. Current employees are not eligible to participate in the bank subsidized plan. Citizens contributed $0.7 million to the postretirement benefit plan during 2010.
The estimated portion of balances included in accumulated other comprehensive income at December 31, 2010 and 2009 that have not been recognized prior to December 31 are presented below.
The amounts in Accumulated Other Comprehensive Income expected to be recognized as components of net periodic benefit costs during 2011 are amortization of prior service credits and net losses of $0.3 million and $3.1 million, respectively.
An actuarial measurement date of December 31 was utilized in the following table to determine the projected benefit obligations, fair value of plan assets, and accumulated benefit obligation at December 31, 2010 and 2009.
At December 31, 2010, the underfunded status of the Cash Balance Pension Plan for Employees, the Supplemental Pension Plans, and the Retirement Health Plan is recognized in the Corporation’s consolidated balance sheet as an accrued liability. No plan assets are expected to be returned to Citizens during the year ending December 31, 2011.
During the first quarter of 2009, Citizens recognized a curtailment charge as a result of a reduction in the expected years of future service for the supplemental pension plan participants.
The components of net periodic benefit cost charged to operations each year for all plans follow:
The assumptions used in determining the actuarial present value of the benefit obligations and the net periodic pension expense follow:
At December 31, 2010, the projected benefit payments for the employee benefit plans over the next ten years follow:
The projected payments were calculated using the same assumptions as those used to calculate the benefit obligations listed above. The projected benefit payments for the postretirement benefit plan are net of the projected Medicare Part D Subsidy.
Investment Policy and Strategy: Management’s investment policy and strategy for managing defined benefit plan assets is described as growth with income. Management analyzes the potential risks and rewards associated with the asset allocation strategies on a quarterly basis. Implementation of the strategies includes regular rebalancing to the target asset allocation. During 2009, management reduced the target allocation of assets to equities by 10%. This strategy was enacted to better match the current characteristics of the plan and reduce funding volatility. The mix remained at 60% equities and 40% fixed income debt securities and cash and cash equivalents during 2010. The long-term rate of return expected on plan assets is finalized after considering long-term returns in the general market, long-term returns experienced by the assets in the plan, and projected plan expenses.
The plans’ target asset allocation and the actual asset allocation at December 31, 2010 is presented below.
The pension plan assets for which Citizens determines fair value include short-term pooled money fund, equity, and fixed income securities, all of which fall into Level 2 in the fair value hierarchy at December 31, 2010. Citizens’ pension plan assets are invested solely in pooled separate account funds, which are managed by Prudential. The net asset values (NAV) are based on the value of the underlying assets owned by the fund, minus its liabilities, and then divided by the number of units outstanding. The NAV’s unit price of the pooled separate accounts is not quoted on any market; however, the unit price is based on the underlying investments which are traded in an active market and are priced by independent providers. Citizens has evaluated their valuation methodologies used to develop the fair values in order to determine whether such valuations are representative of an exit price in Citizens’ principal markets. Further, Citizens has developed an internal, independent price verification function that performs testing on valuations received from third parties. There are no significant restrictions on Citizens’ ability to sell any of the investments in the pension plan.
The estimated fair values of Citizens’ pension plan assets at December 31, 2010 are as follows:
(1)
This category is comprised of not actively managed low-cost equity index funds that track the S&P 500 and Russell 1000.
(2)
This category represents investment grade bonds of U.S. issuers from diverse industries.
Citizens does not anticipate making a contribution to the defined benefit pension plan during calendar year 2011. Citizens will review the funding of this plan during 2011 and will make a contribution, if appropriate. The Corporation anticipates making a contribution of $0.5 million to the nonqualified supplemental benefit plans during 2011. In addition, Citizens expects to pay $0.7 million in contributions to the postretirement healthcare benefit plan during 2011.
Prior service pension costs are amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits under the plans. For the postretirement health care benefit plan, Citizens assumed a 8.8% annual health care cost trend rate for 2010, which grades down to the ultimate trend of 5.0% by 2032. This assumption can have a significant effect on the amounts reported. A one-percentage-point change in assumed health care trend rates would have the following effects:
Defined Contribution Retirement and 401(k) Plans: Substantially all employees are eligible to contribute a portion of their pre-tax salary to a defined contribution 401(k) savings plan. Citizens suspended the 401(k) matching funds and annual discretionary contributions effective July 17, 2009.
Note 12. Stock-Based Compensation
Citizens has a stock-based compensation plan authorizing the granting of incentive and nonqualified stock options, non-vested stock awards (also known as restricted stock), restricted stock units, and performance awards to employees and non-employee directors. A plan amendment and restatement was approved by shareholders on May 4, 2010 that increased the number of shares reserved under the plan to 24,000,000, removed the 2,000,000 share sublimit for grants other than stock options and made various other changes. At December 31, 2010, Citizens had 17,171,355 shares of common stock reserved for future issuance under the current plan.
Under the provisions of the grants made pursuant to the Stock Compensation Plan in 2010, stock awards were divided between performance-based stock and time-based stock. The performance-based stock was measured
against annual metrics over a two year period. The time-based stock will vest three years after the grant date. Once vested, these shares will remain nontransferable until the Holding Company has redeemed all or a portion of the TARP Preferred Stock issued to Treasury pursuant to the Capital Purchase Program. A prorate portion of the vested shares become transferable upon redemption of the TARP Preferred Stock based on a predefined schedule established by the Treasury.
The compensation cost for share based awards is recognized in salaries and employee benefits based on the fair value at the date of grant and is recognized on a straight line basis over the requisite service period of the award. The requisite service period is presumed to be the stated vesting period or the estimated time that will be required to satisfy any performance conditions. Restricted shares are included in outstanding stock totals, and are entitled to receive dividends and have voting rights. Restricted stock units have no voting or dividend rights but have dividend equivalent rights entitling them to additional shares at the time the units are settled for common stock. Forfeited and expired options and forfeited shares of restricted stock become available for future grants.
The following table sets forth the total stock-based compensation expense resulting from stock options and restricted stock awards included in the Consolidated Statements of Operations.
(1)
The income tax benefit is calculated based on the statutory rate. Due to the fact that Citizens has a valuation allowance, the income tax benefit may not be realized. Refer to Note 13 for additional information.
During the first quarter of 2009, a pre-tax expense reversal of $1.3 million was made to stock-based compensation as a result of actual forfeitures exceeding the estimated forfeiture rate for restricted stock.
There were no stock options exercised during the years ended December 31, 2010 and 2009. Cash proceeds from the exercise of stock options during 2008 was $0.1 million. New shares are issued when stock options are exercised. Citizens presents excess tax benefits from the exercise of stock options, if any, as financing cash inflows and as operating cash outflows on the Consolidated Statement of Cash Flows.
The following table summarizes stock option activity for 2010, 2009 and 2008.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (i.e., the difference between Citizens’ average closing stock price as of December 31, 2010 and the exercise price, multiplied by the number of shares) that would have been received by the option holders had all option holders exercised those options on December 31, 2010 if the average closing stock price exceeded the exercise price. This amount fluctuates with changes in the fair value of Citizens’ stock. The total intrinsic value of options exercised during 2008 was less than $0.1 million. The fair value of options vested during 2010 and 2009 was less than $0.1 million and less than $0.2 million for 2008.
The following table sets forth the actual tax benefit realized for the tax deductions from vested stock options converted in the Republic acquisition and exercised.
As of December 31, 2010, $2.6 million of total unrecognized compensation cost related to stock options and restricted stock is expected to be recognized over a weighted average period of 1.8 years.
The following table summarizes restricted stock activity for 2010, 2009 and 2008.
The total fair value of restricted stock vested during 2010 and 2009 was $0.3 million each year and $0.9 million for 2008.
Note 13. Income Taxes
Significant components of income taxes from continuing operations are as follows:
Generally, the calculation for the income tax provision (benefit) does not consider the tax effects of changes in other comprehensive income (“OCI”), which is a component of shareholders’ equity on the balance sheet. However, an exception is provided in certain circumstances, such as when there is a pre-tax loss from continuing operations and income in other components of the financial statements. In such a case, pre-tax income from other categories (such as changes in OCI) is included in the calculation of the tax provision for the current year. For 2009, this resulted in an increase to the income tax benefit of $22.9 million.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Citizens’ deferred tax assets and liabilities as of December 31, 2010 and 2009 follow:
During 2010, Citizens reduced the carrying value of certain loss and credit carryforwards and the valuation allowance by $61.4 million to reflect the estimated realizability at year end. This adjustment was required due to limitations imposed by Section 382 of the Internal Revenue Code as further discussed below.
At December 31, 2010, taking into account the reduction in carrying value noted above, Citizens had gross federal loss carryforwards of $431.2 million that expire in 2028 through 2030, gross state loss carryforwards of $63.4 million that expire in 2014 through 2025, and $15.5 million of federal alternative minimum tax credits with an indefinite life.
Citizens reviewed its deferred tax assets and determined that, due to the pre-tax loss in 2010, the impact on cumulative pre-tax income, and the uncertain economic environment affecting estimates of future taxable income, it must continue to carry a valuation allowance against the entire net deferred tax asset, excluding the deferred tax liability for tax deductible goodwill.
The deferred tax assets are analyzed quarterly for changes affecting realizability and the valuation allowance may be adjusted in future periods accordingly. The ultimate realization of these deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Changes in existing tax laws could also affect actual tax results and the valuation of deferred tax assets over time. The accounting for deferred taxes is based on an estimate of future results. Differences between anticipated and actual outcomes of these future tax consequences could have an impact on Citizens’ consolidated results of operations or financial position.
During 2009, Citizens incurred an ownership change within the meaning of Section 382 of the Internal Revenue Code. As a result, federal tax law places an annual limitation of approximately $17.7 million on the amount of certain loss carryforwards that may be used.
Citizens’ effective tax rate differs from the statutory federal tax rate. The following is a summary of such differences:
A reconciliation of the beginning and ending amount of unrecognized tax benefits follows:
It is Citizens’ policy to recognize interest and penalties accrued relative to unrecognized tax benefits in their respective federal or state income tax accounts. Accrued interest as of December 31, 2010 and 2009 was $0.2 million and $0.4 million, respectively. Citizens recognized $0.2 million benefit of interest in 2010 and less than $0.1 million of interest expense in 2009. No penalties have been accrued.
During 2010, Citizens settled its 2006 through 2008 federal examinations and recognized a tax benefit of $0.5 million. During 2009, Citizens settled its 2004 and 2005 federal examinations and paid less than $0.2 million in interest expense as a result of changes in the timing of deductions between the two years.
Citizens and its subsidiaries file U.S. federal income tax returns, as well as various returns in the states where its banking offices are located. The following tax years remain subject to examination as of December 31, 2010:
Note 14. Shareholders’ Equity and Earnings Per Share
During the first quarter of 2010, Citizens suspended quarterly cash dividends on its TARP Preferred Stock. While Citizens accrues for this obligation, it is currently in arrears in the amount of $15.4 million with the dividend payments on the TARP Preferred Stock as of December 31, 2010.
On September 17, 2009, Citizens filed with the State of Michigan the amendment to its articles of incorporation approved by shareholders on September 16, 2009. The amendment increased the total authorized common shares from 150 million shares to 1.05 billion shares.
On September 30, 2009, Citizens completed the settlement of its exchange offers to issue common stock in exchange for its outstanding 5.75% Subordinated Notes due 2013 and outstanding 7.50% Enhanced Trust Preferred Securities of the 2006 Trust (the “Exchange Offers”). In aggregate, 268.2 million shares at a fair value of $219.9 million ($0.82 per common share as of the expiration date of the Exchange Offers) were issued in exchange for long term debt with a carrying value of $204.0 million. The consummation of the Exchange Offers created a net loss on the early extinguishment of debt totaling $15.9 million, which represented the difference between the fair value of Citizens’ common stock issued and the carrying value of the retired debt. After taking into account $6.4 million of issuance costs, the transaction resulted in an increase to common equity of $197.6 million.
In June 2008, Citizens issued $79.6 million of common stock and $120.4 million of contingent convertible perpetual non-cumulative preferred stock that together increased shareholders’ equity by $189.0 million (net of issuance costs and the underwriting discount). The preferred stock was converted into 30.1 million shares of common stock upon shareholder approval of a charter amendment authorizing 50 million additional shares of common stock in September 2008.
On December 12, 2008, Citizens issued 300,000 shares of Series A Preferred Stock to the Treasury as part of the Treasury’s Capital Purchase Program. In addition, Citizens issued a ten- year warrant to the Treasury to purchase up to 17,578,125 shares of Citizens’ common stock, no par value at an exercise price of $2.56 per share. The aggregate proceeds from the transaction were $300.0 million. The TARP Preferred Stock has no par value, carries a liquidation price of $1,000 per share, and pays cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Citizens cannot redeem the preferred securities during the first three years after issuance except with the proceeds from an offering of perpetual preferred or common stock that qualifies as and may be included in Tier 1 capital. After three years, Citizens may redeem the preferred stock at the liquidation price plus accrued and unpaid dividends. Citizens is accreting the book value of the preferred stock issued under the TARP using the effective interest method up to the par value of $300 million. The preferred shares are non-voting, other than class voting rights on matters that could adversely affect the shares. The preferred shares qualify as Tier 1 capital. The warrant is immediately exercisable, qualifies as Tier 1 capital and expires in December 2018.
Earnings per common share is computed using the two-class method. Basic earnings per common share is computed by dividing net income allocated to common shareholders by the weighted-average number of common shares outstanding, excluding outstanding participating securities. Participating securities include nonvested stock awards (also known as restricted stock) because holders of these securities have the right to receive non-forfeitable dividends at the same rate as holders of common stock and have voting rights. Diluted earnings per common share is computed based on the weighted-average number of common shares outstanding including the dilutive effect of stock-based compensation. Potential common stock that would be generated from restrictions lapsing on unvested shares as well as additional shares issued through the exercise of stock options and warrant were anti-dilutive and therefore excluded from the computation of dilutive earnings per share.
A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations follows:
Stock Repurchase Program: Citizens purchased shares under a board approved stock repurchase program initiated in October 2003. This program authorizes Citizens to repurchase up to 3,000,000 shares. 1,241,154 shares remain available for repurchase under the program. There were no shares purchased under this plan in 2009 or 2010. Shares deemed purchased in connection with the exercise of certain employee stock options and the vesting of certain share awards were not part of the repurchase program. In 2010, Citizens purchased 28,802 shares in connection with taxes due from employees as a result of the vesting of certain share awards.
The components of accumulated other comprehensive income (loss), net of tax, are presented below.
Note 15. Lines of Business
The financial performance of Citizens is monitored by an internal profitability measurement system, which provides line of business results and key performance measures. The profitability measurement system is based on internal management methodologies designed to produce consistent results and reflect the underlying economics of the businesses. The development and application of these methodologies is a dynamic process. Accordingly, these measurement tools and assumptions may be revised periodically to reflect methodology, product, and/or management organizational changes. Further, these policies measure financial results that support the strategic objectives and internal organizational structure of Citizens. Consequently, the information presented is not necessarily comparable with similar information for other institutions.
A description of each business line, selected financial performance and the methodologies used to measure financial performance are presented below.
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Regional Banking - Regional Banking provides a wide range of lending, depository, and other related financial services to both individual consumers and businesses. The products and services offered to consumer clients include: direct loans, home equity loans and lines of credit, checking, savings and money market accounts, certificates of deposit, and fixed and variable annuities, as well as private banking services for affluent clients. Citizens partners with outside providers to offer to consumer clients the availability of nationwide ATM, debit, and credit card networks as well as mortgage origination services. The transaction-based income and expense associated with these services are included in Regional Banking. The products and services offered to commercial and industrial clients include: term loans, revolving credit arrangements, inventory and accounts receivable financing, commercial mortgages, letters of credit, and small business
loans. Noncredit services for commercial clients include deposit accounts, treasury management, corporate cash management, international banking services, advice and assistance in the placement of securities, and financial planning.
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Specialty Consumer - Specialty Consumer includes the indirect consumer and the residential mortgage portfolios. The indirect lending team partners with dealerships across the Midwest to provide primarily marine and recreational vehicle loans to consumers. As nearly all of new mortgage volume is originated through the Regional Banking delivery channel and sold into the secondary market, the residential mortgage loan portfolio residing in Specialty Consumer consists primarily of historical loan production as well as the minimal new production that is retained.
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Specialty Commercial - Specialty Commercial provides a full range of lending, depository, and related financial services to commercial real estate developers, owners of multi-unit commercial properties, middle-market companies, local governments and municipalities. Products and services offered include commercial mortgages, real estate construction lending, term loans, revolving credit arrangements, inventory and accounts receivable financing, and letters of credit. Noncredit services for these customers include deposit accounts, treasury management, corporate cash management, international banking services, advice and assistance in the placement of securities, and financial planning.
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Wealth Management - Wealth Management offers a broad array of asset management, financial planning, estate settlement and administration, credit and deposit products and services. Trust and investment services include personal trust and planning, investment management, estate settlement and administration services. Retirement plan services focus on investment management and fiduciary activities with special emphasis on 401(k) plans. Brokerage and insurance delivers retail mutual funds, other securities, variable and fixed annuities, personal disability and life insurance products and discounted brokerage services.
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Other - The Other line of business includes activities that are not directly attributable to one of the primary business lines. Included in this category are the Holding Company; shared services unit; Citizens’ treasury unit, including the securities portfolio, short-term borrowing and asset/liability management activities; inter-company eliminations; and the economic impact of certain assets, capital and support functions not specifically identifiable with the four primary lines of business.
The accounting policies of the individual business units are the same as those of Citizens described in Note 1 to the Consolidated Financial Statements. Funds transfer pricing is used in the determination of net interest income by assigning a cost for funds used or credit for funds provided to assets and liabilities within each business unit. Assets and liabilities are match-funded based on their maturity, prepayment and/or repricing characteristics. As a result, the Regional Banking, Specialty Consumer, Specialty Commercial, and Wealth Management units are largely insulated from changes in interest rates. Changes in net interest income due to changes in interest rates are reported in Citizens’ treasury unit. The provision for loan losses is allocated based upon the actual net charge-offs of each respective line of business, adjusted for loan growth and changes in risk profile. Noninterest income and expenses directly attributable to a line of business are assigned to that business. Expenses for centrally provided services are allocated to the business lines as follows: product processing and technology expenditures are allocated based on standard unit costs applied to actual volume measurements; corporate overhead is allocated based on the ratio of a line of business’ noninterest expenses to total noninterest expenses incurred by all business lines. There are no significant intersegmental revenues. Selected segment information is included in the following table.
Note 16. Commitments, Contingent Liabilities and Guarantees
Commitments: The Consolidated Financial Statements do not reflect various loan commitments (unfunded loans and unused lines of credit) and letters of credit originated in the normal course of business. Loan commitments are made to accommodate the financial needs of clients. Generally, new loan commitments do not extend beyond 90 days and unused lines of credit are reviewed at least annually. Letters of credit guarantee future payment of client financial obligations to third parties. They are normally issued for services provided or to facilitate the shipment of goods, and generally expire within one year. Both arrangements have essentially the same level of credit risk as that associated with extending loans to clients and are subject to Citizens’ normal credit policies. Inasmuch as these arrangements generally have fixed expiration dates or other termination clauses, most expire unfunded and do not necessarily represent future liquidity requirements. Collateral is
obtained based on management’s assessment of the client and may include receivables, inventories, real property and equipment.
Amounts available to clients under loan commitments and letters of credit follow:
Commitments outstanding to extend credit include home equity credit lines which totaled $376.2 million and $453.0 million at December 31, 2010 and December 31, 2009, respectively.
At December 31, 2010 and 2009, a liability of $1.9 million and $3.1 million, respectively, was recorded for possible losses on commitments to extend credit. A liability of $1.5 million and $1.1 million was recorded at December 31, 2010 and December 31, 2009, respectively, representing the value of the guarantee obligations associated with certain letters of credit, which are amortized into income over the life of the commitments. These balances are included in other liabilities on the Consolidated Balance Sheets.
Contingent Liabilities and Guarantees: Citizens and its subsidiaries are parties to litigation arising in the ordinary course of business. Management believes that the aggregate liability, if any, resulting from these proceedings would not have a material effect on Citizens’ consolidated financial position or results of operations. Citizens has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements.
Prior to June 2008, when Citizens sold its residential mortgage originations to several secondary market participants, it made various standard representations and warranties. The specific representations and warranties made by Citizens depended on the nature of the transaction and the requirements of the buyer. In the event of a breach of the representations and warranties, Citizens may be required to either repurchase the mortgage loans (generally at unpaid principal balance plus accrued interest) with the identified defects or indemnify the investor. During 2010 and 2009, Citizens repurchased $2.2 million and $3.2 million of loans, respectively, pursuant to such provisions. Citizens recorded $3.8 million and $2.7 million in 2010 and 2009, respectively, in Other Expense on the Consolidated Statements of Operations related to repurchasing or indemnifying such loans.
Purchase Obligations: Citizens has entered into contracts for the supply of current and future services incurred in the ordinary course of business, such as data processing and certain property management functions. Citizens often purchases services from vendors under agreements that typically can be terminated on a periodic basis.
Change in Control Agreements: The Corporation has change-in-control agreements with certain executive officers. Under these agreements, each covered person could receive, upon the effectiveness of a change-in-control, up to two times (or in the case of the CEO, three times) (i) his or her base compensation plus (ii) up to two times (or in the case of the CEO, three times) the average of the annual bonuses paid to the executive in the last three years. Additionally, subject to certain conditions, each covered person’s medical and dental insurance benefits will continue for up to eighteen months after the termination and all long-term incentive awards will immediately vest. The provisions of the EESA and ARRA, and Treasury regulations promulgated thereunder, limit Citizens’ ability to make payments under these agreements while the preferred stock issued to Treasury remains outstanding.
Note 17. Derivatives and Hedging Activities
Risk Management Objective of Using Derivatives
Citizens is exposed to certain risks arising from both its business operations and economic conditions. Citizens manages economic risks, including interest rate, liquidity, and credit risk, primarily through the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, Citizens enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Citizens’ derivative financial instruments are used to manage differences in the amount, timing, and duration of its known or expected cash receipts and cash payments principally related to certain variable-rate loan assets and fixed-rate borrowings.
Fair Values of Derivative Instruments on the Consolidated Balance Sheets
The table below presents the fair value of Citizens’ derivative financial instruments as well as their classification on the Consolidated Balance Sheets for years ended December 31, 2010 and 2009.
Cash Flow Hedges of Interest Rate Risk
Citizens’ objectives in using interest rate derivatives are to add stability to interest income and to manage its exposure to interest rate movements. To accomplish this objective, Citizens primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for Citizens making variable-rate payments over the life of the agreements without exchange of the underlying notional amount. As of December 31, 2010 and December 31, 2009, Citizens had 3 interest rate swaps with an aggregate notional amount of $160.0 million and 13 interest rate swaps with an aggregate notional amount of $460.0 million, respectively, that were designated as cash flow hedges of interest rate risk.
The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2010 and 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime and LIBOR-based loan assets. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. For the years ended December 31, 2010 and 2009, Citizens recognized net gains of $0.3 million and a gain of less than $0.1 million, respectively related to hedge ineffectiveness attributable to mismatches between the swap notional amounts and the aggregate principal amounts of the designated loan pools.
In addition, during the years ended December 31, 2010 and 2009 Citizens terminated four and two swaps, respectively, because they failed to qualify for hedge accounting due to a mismatch between the swap notional and the aggregate principal amount of the designated loan. Accordingly, the change in fair value of these swaps was recognized directly into earnings. The changes in fair value for these swaps during the years ended December 31, 2010 and 2009 are disclosed under sections entitled “Derivatives Not Designated as Hedging Instruments” throughout this footnote.
Amounts reported in accumulated other comprehensive income related to derivatives are reclassified to interest income as interest payments are received on Citizens’ variable-rate assets. During the years ended December 31, 2010 and 2009 Citizens accelerated the reclassification of unrealized gains in accumulated other comprehensive income of $4.2 million and $0.2 million, respectively, to earnings as a result of the hedged forecasted transactions becoming probable not to occur. During the next twelve months, Citizens estimates that $3.2 million will be reclassified as an increase to interest income.
The following tables summarize the impact of cash flow hedges on the Consolidated Financial Statements for the years ended December 31, 2010 and 2009.
Fair Value Hedges of Interest Rate Risk
Citizens is exposed to changes in the fair value of certain of its fixed-rate obligations due to changes in LIBOR, the benchmark interest rate. Interest rate swaps designated as fair value hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for Citizens making variable-rate payments over the life of the agreements without the exchange of the underlying notional amount. As of December 31, 2010 and 2009, Citizens had 4 fair value interest rate swaps with an aggregate notional balance of $170.0 million and 8 fair value interest rate swaps with an aggregate notional balance of $385.0 million, respectively.
For derivatives that are designated and qualify as fair value hedges, the gain or loss on the derivative as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in earnings. Citizens includes the gain or loss on the hedged items in the same line item as the offsetting loss or gain on the related derivatives. During the years ended December 31, 2010 and 2009, Citizens recognized gains of $5.8 million and $6.3 million, respectively, in interest expense related to hedge ineffectiveness. Citizens also recognized a net reduction to interest expense of $7.2 million and $8.7 million for the years ended December 31, 2010 and 2009, respectively, related to Citizens’ fair value hedges, which includes net settlements on the derivatives, ineffectiveness and any amortization adjustment in the basis of the hedged items.
The following table summarizes the impact of fair value hedges on the Consolidated Financial Statements for the years ended December 31, 2010 and 2009.
Non-designated Hedges
Citizens does not use derivatives for trading or speculative purposes and does not use credit derivatives for any purpose. Derivatives not designated as hedges are used to manage Citizens’ exposure to interest rate movements and other identified risks but do not satisfy the conditions of ASC 815 for hedge accounting.
Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings. Additionally, Citizens holds interest rate derivatives, including interest rate swaps and option products, resulting from a service Citizens provides to certain clients. Citizens executes interest rate derivatives with commercial banking clients to facilitate their respective risk management strategies. Those derivatives are simultaneously hedged by offsetting derivatives that Citizens executes with a third party, such that Citizens minimizes its net risk exposure resulting from such transactions. As of December 31, 2010 and 2009, Citizens had 230 derivative transactions with an aggregate notional amount of $765.5 million and 284 derivative transactions with an aggregate notional amount of $1.0 billion, respectively, related to this program.
The following table summarizes the impact of derivatives not designated as hedges on the Consolidated Financial Statements for the years ended December 31, 2010 and 2009.
Credit-Risk Related Contingent Features
Citizens has agreements with its derivative counterparties that contain a provision where if Citizens defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, then it could also be declared in default on its derivative obligations. Citizens also has agreements with certain of its derivative counterparties that contain a provision where if it fails to maintain its status as a well/adequately capitalized institution, then the counterparty could terminate the derivative positions and Citizens would be required to settle its obligations under the agreements.
As of December 31, 2010, the fair value of derivatives in a net liability position with all counterparties, which includes accrued interest, but excludes any adjustment for non performance risk related to these agreements was $24.8 million. As of December 31, 2010, Citizens had minimum collateral posting with its derivative counterparties and assigned collateral of $20.6 million. If credit risk related contingent features underlying these agreements had been triggered as of December 31, 2010, Citizens would have been required to pledge $4.2 million in additional collateral.
In addition, if Citizens’ credit rating is reduced below investment grade, then a termination event shall be deemed to have occurred with one of its counterparties and the counterparty shall have the right to terminate all affected transactions under the agreement. Citizens has breached these provisions with respect to all rating agencies below investment grade at August 6, 2009 and may be required to settle its obligations under the agreements at the termination value. Citizens may be required to pay additional amounts due in excess of amounts previously posted as collateral. As of December 31, 2010, the aforementioned termination value approximated $0.9 million.
Citizens does not offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against recognized fair value amounts of derivatives executed with the same counterparty under a master netting agreement. The Corporation has the right to reclaim collateral assigned of $20.6 million.
Note 18. Regulatory Matters
Citizens Bank is required to maintain a combination of cash on hand and non-interest-bearing deposits with the Federal Reserve Bank (“FRB”) to meet regulatory reserve requirements. These reserve balances vary depending upon the level of client deposits in the subsidiary banks. During 2010 and 2009, the average reserve balances were $13.5 million and $27.7 million, respectively.
Citizens Bank is also subject to statutory limitations on extensions of credit to members of the affiliate group. Generally, extensions of credit are limited to 10% to any one affiliate and 20% in aggregate to all affiliates of a subsidiary bank’s capital and surplus (net assets) as defined.
The principal source of cash flows for the Holding Company is dividends from its subsidiaries. Citizens’ subsidiaries are state, federal or national chartered financial institutions. Banking regulations limit the amount of dividends a financial institution may declare to a parent company in any calendar year. Citizens’ Bank’s dividends may not exceed the retained net profit, as defined, of that year plus the retained net profit of the preceding two years, unless prior regulatory approval is obtained. As of January 1, 2011 Citizens Bank Wealth Management, N.A. was able to distribute dividends of $5.9 million to the Holding Company without prior regulatory approval.
The Holding Company and Citizens Bank, entered into a written supervisory agreement (the “Written Agreement”) with the Federal Reserve Bank of Chicago (“FRBC”) and the Michigan Office of Financial and Insurance Regulation (“OFIR”) as a follow up to recently concluded examinations of Citizens Bank. The Written Agreement was executed by the regulators on July 28, 2010 and announced by the regulators and posted on the Federal Reserve website on August 3, 2010. The Written Agreement formalizes steps that were in several cases already underway. The Holding Company and Citizens Bank are committed to addressing and resolving the matters raised in the Written Agreement on a timely basis and maintaining the safety and soundness of Citizens Bank. Citizens has complied with the requirements of the Written Agreement to date and is on target in meeting all other required deadlines included in the Written Agreement.
In light of the net losses over the last several quarters, Citizens determined during the first quarter of 2010, in consultation with the Federal Reserve Bank of Chicago as required by regulatory policy, to defer regularly scheduled quarterly interest payments on its outstanding junior subordinated debentures relating to its two trust preferred securities and to suspend quarterly cash dividend payments on its TARP Preferred Stock. In addition, the Written Agreement now prohibits such payments without prior regulatory approval. Deferral of these payments, which is permitted pursuant to the underlying documentation, preserves a total of $19.7 million of cash annually, although such amounts will continue to accrue. Citizens reevaluates the deferral of these payments periodically and, in consultation with and subject to prior approval by its regulators, will reinstate these payments when appropriate.
Citizens Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require Citizens Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 capital to risk-weighted assets (as defined in the regulations), and of Tier 1 capital to average assets (as defined). As of December 31, 2010, Citizens Bank met all capital adequacy requirements to which it is subject.
As of December 31, 2010, Citizens Bank’s and the Holding Company’s capital ratios exceeded well-capitalized levels under the regulatory framework for prompt corrective action. The table below sets forth the Total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios for the Holding Company and Citizens Bank. There are no conditions or events since December 31, 2010, that management believes would cause Citizens to fall below the well-capitalized level.
(1)
Total Capital is comprised of Tier 1 Capital, a portion of the allowance for loan losses and qualifying subordinated debt. Tier 1 Capital is calculated as follows: total shareholders’ equity + trust preferred securities - goodwill - accumulated other comprehensive income (loss) - other intangible assets.
(2)
Tier 1 Capital to quarterly average assets.
NOTE 19. Citizens Republic Bancorp (Parent Only) Statements
Balance Sheets
Citizens Republic Bancorp, Inc. (Parent Only)
Statements of Income
Citizens Republic Bancorp, Inc. (Parent Only)
Statements of Cash Flows
Citizens Republic Bancorp, Inc. (Parent Only)
Note 20. Discontinued Operations
On January 29, 2010 Citizens entered into a stock purchase agreement with Great Western Bank whereby Great Western Bank agreed to acquire all of the stock of Citizens’ wholly owned subsidiary, F&M Bank. F&M served markets with low growth potential outside of Citizens’ primary footprint and generated additional marketing costs to maintain the separate branding. Therefore, Citizens decided to sell F&M at a price which represented approximately 25 times F&M’s average earnings and 1.10 times its tangible book value. On April 23, 2010, Citizens completed the stock sale in exchange for $50.0 million in cash. As a result, the sale proceeds improved the Holding Company’s capital and liquidity positions in a manner that was non-dilutive to Citizens’ shareholders. Additionally, Citizens will not have a continuing cash flow from F&M. As of the transaction sale date, the assets and liabilities of F&M were removed from Citizens consolidated balance sheet.
The assets and liabilities for the discontinued operations as of December 31, 2009 were as follows:
The operating results for December 31, 2010, 2009 and 2008 follows:
In 2010 Citizens recognized an unrealized gain of $5.7 million associated with the F&M investment portfolio as of the transaction sale date. The loss from discontinued operations for 2009 included a $10.2 million goodwill impairment charge. Goodwill was allocated to F&M based on the relative value of F&M’s regional banking equity compared with the total fair value of equity for the Regional Banking reporting unit. The analysis indicated that approximately 3.8% of the fair value of the Regional Banking unit resided in the Iowa franchise as of January 1, 2010.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and the Shareholders of Citizens Republic Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Citizens Republic Bancorp, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of Citizens Republic Bancorp, Inc.’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Citizens Republic Bancorp, Inc. and subsidiaries at December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Citizens Republic Bancorp, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2011 expressed an unqualified opinion thereon.
Detroit, Michigan
March 1, 2011
SELECTED QUARTERLY INFORMATION (unaudited)
The table below sets forth selected quarterly financial information for each calendar quarter during 2010 and 2009.
Selected Quarterly Information
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rule 13a-15 of the Securities Exchange Act of 1934, that are designed to cause the material information required to be disclosed by Citizens in the reports it files or submits under the Securities Exchange Act of 1934 to be recorded, processed, summarized, and reported to the extent applicable within the time periods required by the Securities and Exchange Commission’s rules and forms. In designing and evaluating the disclosure controls and procedures, management recognized that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, with a company have been detected.
As of the end of the period covered by this report, Citizens performed an evaluation under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective at the reasonable assurance level.
Report on Management’s Assessment of Internal Control over Financial Reporting
The management of Citizens Republic Bancorp, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined under applicable Securities and Exchange Commission rules as a process designed under the supervision of the Corporation’s Chief Executive Officer and Chief Financial Officer and effected by the Corporation’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Corporation’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The Corporation’s internal control over financial reporting includes those policies and procedures that:
•
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Corporation;
•
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of management and the directors of the Corporation; and
•
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Corporation’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As of December 31, 2010, management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of the Corporation’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on the assessment, management determined that the Corporation’s internal control over financial reporting was effective as of December 31, 2010.
Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Corporation included in this Annual Report on Form 10-K, has issued a report on the Corporation’s internal control over financial reporting as of December 31, 2010. The report, which expresses an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2010, is included in this Item under the heading “Report of Independent Registered Public Accounting Firm on Effectiveness of Internal Control Over Financial Reporting.”
Lisa T. McNeely
Executive Vice President and Chief Financial Officer
Cathleen H. Nash
President and Chief Executive Officer
Changes in Internal Control over Financial Reporting
No changes were made to the Corporation’s internal control over financial reporting (as defined in Rule 13a-15 under the Securities Exchange Act of 1934) during the last fiscal quarter that materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and the Shareholders of Citizens Republic Bancorp, Inc.
We have audited Citizens Republic Bancorp, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Citizens Republic Bancorp, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on Citizens Republic Bancorp, Inc.’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Citizens Republic Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Citizens Republic Bancorp, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010 and our report dated March 1, 2011 expressed an unqualified opinion thereon.
Detroit, Michigan
March 1, 2011
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
Part III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item appears under the captions “Proposal 1 - Election of Directors” (excluding the information under the heading “Compensation of Directors”); “Corporate Governance - Executive Officers, - Meetings of Directors and Committees of the Board of Directors, - Shareholder Nomination of Director Candidates, and - Code of Ethics;” and “Section 16(a) Beneficial Ownership Reporting Compliance” in Citizens’ proxy statement for its 2011 annual meeting of shareholders (the “Proxy Statement”) and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item appears under the caption “Proposal 1 - Election of Directors - Compensation of Directors,” and under the caption “Executive Compensation” of the Proxy Statement, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item appears under the caption “Security Ownership” of the Proxy Statement, and is incorporated herein by reference.
Equity Compensation Plan Information
Citizens has a stock-based compensation plan authorizing the granting of incentive and nonqualified stock options, nonvested stock awards (also known as restricted stock), restricted stock units, and performance awards to employees and non-employee directors. A plan amendment and restatement was approved by shareholders on May 4, 2010 that increased the number of shares reserved under the plan to 24,000,000, removed the 2,000,000 share sublimit for grants other than stock options and made various other changes. At December 31, 2010, Citizens had 17,171,355 shares of common stock reserved for future issuance under the current plan.
In conjunction with the Republic merger in 2006, Citizens assumed Republic’s active stock-option plans which had previously been approved by Republic’s shareholders. Citizens has not made any awards under the assumed plans and treats these plans as if they are terminated as to future grants.
The following table sets forth, with respect to all of the stock-based compensation plans, (a) the number of shares of common stock to be issued upon the exercise of outstanding options, (b) the weighted average exercise price of outstanding options, and (c) the number of shares remaining available for future issuance, as of December 31, 2010.
At December 31, 2010
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item appears under the caption “Executive Compensation - Compensation Committee Interlocks and Certain Transactions and Relationships” of the Proxy Statement, and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this item appears under the captions “Proposal 4 - Appointment of Independent Certified Public Accountants” and “Corporate Governance - Meetings of Directors and Committees of the Board of Directors” of the Proxy Statement, and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
1. Financial Statements:
The following Consolidated Financial Statements of Citizens and Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements are incorporated by reference under Item 8 “Financial Statements and Supplementary Data” of this document:
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Selected Quarterly Information
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements
2. Financial Statement Schedules:
All schedules are omitted - see Item 15(c) below.
The exhibits listed on the “Exhibit Index” of this report are filed herewith and are incorporated herein by reference.
The exhibits listed on the “Exhibit Index” of this report are filed herewith and are incorporated herein by reference. At the request of any shareholder, the Corporation will furnish any exhibit upon the payment of a fee of $0.10 per page to cover the costs of furnishing the exhibit.
(c)
Financial Statement Schedules
All financial statement schedules normally required by regulation S-X are omitted since they are either not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CITIZENS REPUBLIC BANCORP, INC.
(Registrant)
by /s/ Cathleen H. Nash
Cathleen H. Nash
President and Chief Executive Officer
Date: March 1, 2011
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURES (continued)
/s/ Benjamin W. Laird
Director
March 1, 2011
Benjamin W. Laird
/s/ Stephen J. Lazaroff
Director
March 1, 2011
Stephen J. Lazaroff
/s/ Kendall B. Williams
Director
March 1, 2011
Kendall B. Williams
/s/ James L. Wolohan
Chairman of the Board
March 1, 2011
James L. Wolohan
Steven E. Zack
Director
March 1, 2011
Steven E. Zack
EXHIBIT INDEX
The following exhibits are filed as part of this report, or were previously filed and are incorporated herein by reference to the filing indicated. Exhibits not required for this report have been omitted. Citizens’ Commission file number is 001-33063.
EXHIBIT INDEX (continued)
EXHIBIT INDEX (continued)
EXHIBIT INDEX (continued)
EXHIBIT INDEX (continued)
*
Current management contracts or compensatory plans or arrangements.
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