ITEM 1. Business
This Annual Report contains forward-looking statements, which can be identified by the use of words such as “estimate,” “project,” “believe,” “intend,” “anticipate,” “plan,” “seek,” “expect,” “will,” “may” and words of similar meaning. These forward-looking statements include, but are not limited to:
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statements of our goals, intentions and expectations;
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statements regarding our business plans, prospects, growth and operating strategies;
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statements regarding the asset quality of our loan and investment portfolios; and
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estimates of our risks and future costs and benefits.
These forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. We are under no duty to and do not take any obligation to update any forward-looking statements after the date of this Annual Report.
The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements:
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general economic conditions (including real estate values, loan demand, inflation, commodity prices and employment levels), either nationally or in our market areas, that are different than expected;
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competition among depository and other financial institutions;
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our ability to improve our asset quality even as we increase our non-residential lending;
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our success in increasing our commercial real estate and commercial business lending, including agricultural lending;
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changes in the interest rate environment that reduce our margins or reduce the fair value of our financial instruments and real estate;
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adverse changes in the securities markets;
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changes in laws or government regulations or policies affecting financial institutions, including changes in deposit insurance premiums, regulatory fees, capital requirements and consumer protection measures, which increase our compliance costs;
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our ability to enter new markets successfully and capitalize on growth opportunities;
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our ability to successfully grow our Morris operations;
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changes in consumer spending, borrowing and savings habits;
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changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board, the Securities and Exchange Commission and the Public Company Accounting Oversight Board;
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changes in our organization, compensation and benefit plans;
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loan delinquencies and changes in the underlying cash flows of our borrowers;
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changes in our financial condition or results of operations that reduce capital available to pay dividends; and
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changes in the financial condition or future prospects of issuers of securities that we own, including our stock in the FHLB of Chicago.
Because of these and a wide variety of other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.
Harvard Savings Bank
Harvard Savings Bank is an Illinois-chartered savings bank headquartered in Harvard, Illinois. Harvard Savings Bank was organized in 1934, and reorganized into the mutual holding company structure in 2005 by forming Harvard Savings, MHC.
In April 2008, Morris Building & Loan, s.b., a mutual institution, merged into Harvard Savings Bank. Morris Building & Loan, s.b., which had $36 million in assets at the time of the merger, currently operates as a branch of Harvard Savings Bank. We provide financial services to individuals, families and businesses through our three banking offices located in the Illinois counties of McHenry and Grundy. See “Business of Harvard Savings Bank.”
On April 8, 2010, Harvard Savings, MHC converted from mutual to stock form and, as part of that transaction, Harvard Savings Bank became a wholly owned subsidiary of Harvard Illinois Bancorp, Inc.
Harvard Savings Bank’s executive offices are located at 58 North Ayer Street, Harvard, Illinois 60033. Our telephone number at this address is (815) 943-5261.
Harvard Illinois Bancorp, Inc.
Harvard Illinois Bancorp, Inc. (sometimes referred to herein as “we” or “us”) was incorporated as a Maryland corporation on September 14, 2009 and owns all of the outstanding shares of common stock of Harvard Savings Bank as a result of the conversion from mutual to stock form of Harvard Savings, MHC on April 8, 2010. Harvard Illinois Bancorp, Inc. has not engaged in any business to date other than owning the common stock of Harvard Savings Bank.
On April 8, 2010, Harvard Illinois Bancorp, Inc. completed its initial public offering of common stock. In the offering, Harvard Illinois Bancorp, Inc. issued a total of 784,689 shares of its common stock for an aggregate of $7,846,890 in total offering proceeds.
Information in this Annual Report on Form 10-K prior to the completion of our initial public offering on April 8, 2010, including consolidated financial data presented as of and for the periods ended December 31, 2009 and earlier, refers to Harvard Savings, MHC, its direct subsidiary (Harvard Illinois Financial Corporation) and its indirect subsidiary (Harvard Savings Bank).
Our executive offices are located at 58 North Ayer Street, Harvard, Illinois 60033. Our telephone number at this address is (815) 943-5261. Our website address is www.harvardsavingsbank.com. Information on our website is not incorporated into this Annual Report and should not be considered part of this Annual Report.
Market Area and Competition
We conduct business through our main office and one branch office located in Harvard, Illinois and an additional branch office located approximately 80 miles away in Morris, Illinois. All three of our offices are located in McHenry and Grundy Counties, Illinois. Harvard, Illinois is located approximately 70 miles to the Northwest of Chicago while Morris, Illinois is located approximately 60 miles to the Southwest of Chicago.
Our primary market area consists of McHenry, Grundy and, to a lesser extent, Boone counties, Illinois, and Walworth county, Wisconsin. This area includes small towns, rural communities as well as bedroom communities of Chicago. The regional economy is fairly diversified, with services, wholesale/retail trade, manufacturing and government providing the primary support for the area economy. Although Harvard is a small, relatively rural community with a relatively small population base, it is located next to faster-growing commercial and bedroom communities near the Northwest collar counties of Chicago. Morris also is a small town with a relatively small population base, located close to faster-growing commercial and bedroom communities near the Southwest collar counties of Chicago.
The local economy has been significantly affected by the recession. McHenry and Grundy Counties’ and Illinois’ respective December 2010 unemployment rates were 8.4%, 12.0% and 8.8%, as compared to U.S. unemployment rate of 9.1%. In 2009, according to published sources, per capita income for McHenry and Grundy Counties were $34,218 and $27,938, respectively, and the median household incomes were $83,224 and $66,608, respectively, compared to per capita income for the United States and the State of Illinois of $27,277 and $28,587, respectively, and median household income of $54,719 and $60,823, respectively.
We face competition within our market area both in making loans and attracting deposits. Our market area has a significant concentration of financial institutions including large money center and regional banks, community banks and credit unions. Some of our competitors offer products and services that we currently do not offer, such as trust services and private banking. As of June 30, 2010, based on the most recent available FDIC data, our market share of deposits represented 1.1% and 3.2% of FDIC-insured deposits in McHenry and Grundy Counties, Illinois, respectively.
Competition for financial services in our primary market area is significant, particularly in light of the large number of institutions that maintain a presence in the counties. Among our competitors are much larger and more diversified institutions, which have greater resources than we maintain. Financial institution competitors in our primary market area include other locally based thrifts and banks, as well as regional, super regional and money center banks. To meet our competition, we seek to emphasize our community orientation, local and timely decision making and superior customer service.
Lending Activities
Our principal lending activity is originating one- to four-family residential mortgage loans and, to a lesser extent, commercial real estate, commercial and industrial, home equity, construction, agricultural
and other loans. Historically, we also have purchased a significant number of indirect automobile loans, although during 2008 we determined to substantially reduce our purchases due to loan concentration issues and economic conditions. In recent years, we have expanded and expect to continue to expand our commercial real estate and commercial and industrial loan portfolios in an effort to diversify our overall loan portfolio, increase the yield of our loans and shorten asset duration. In addition, in December 2009, we hired an experienced agricultural lending officer and commenced an agricultural lending program. We have focused our efforts in this area on borrowers seeking loans in the $1.0 million or less range. As a long-standing community lender, we believe we can effectively compete for this business by emphasizing superior customer service and local underwriting, which differentiates us from larger commercial banks in our primary market area. Subject to future market, economic and regulatory conditions, we expect commercial real estate and commercial and industrial lending and agricultural lending will continue to be an area of loan growth.
Loan Portfolio Composition. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.
Contractual Maturities and Interest Rate Sensitivity. The following table sets forth the contractual maturities of our total loan portfolio at December 31, 2010. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. The table presents contractual maturities and does not reflect repricing or the effect of prepayments. Actual maturities may differ.
The following table sets forth our fixed and adjustable-rate loans at December 31, 2010 that are contractually due after December 31, 2011.
Loan Approval Procedures and Authority. Pursuant to applicable law, the aggregate amount of loans that we are permitted to make to any one borrower or a group of related borrowers is generally limited to 25% of our total capital plus the allowance for loan losses. At December 31, 2010, our loan-to-one-borrower limit was approximately $4.9 million. Our largest loan totaled $2.6 million and was secured by a mortgage on an auto dealership in the Chicagoland area. At December 31, 2010, this loan was performing in accordance with its terms.
Our lending is subject to written underwriting standards and origination procedures. Decisions on loan applications are made on the basis of detailed applications submitted by the prospective borrower and property valuations (consistent with our appraisal policy) prepared by outside independent licensed appraisers approved by our board of directors as well as internal evaluations, where permitted by regulations. The loan applications are designed primarily to determine the borrower’s ability to repay the requested loan, and the more significant items on the application are verified through use of credit reports, financial statements and tax returns.
Under our loan policy, the individual processing an application is responsible for ensuring that all documentation is obtained prior to the submission of the application to an officer for approval. An officer then reviews these materials and verifies that the requested loan meets our underwriting guidelines described below.
All one- to four-family residential loans up to $500,000, vacant land loans up to $250,000, and any consumer loans require approval of our loan committee consisting of three officers. All such loan approvals are reported at the next board meeting following said approval. All secured commercial loans, including agricultural loans, up to $1,500,000 and unsecured loans up to $250,000 must be approved by our commercial credit management committee, which currently consists of our Chief Executive Officer, Executive Vice President and our Vice President - Commercial Loan Officer. These approvals are reported at the next board meeting following said approval. All other loans must be approved by the board.
Generally, we require title insurance or title searches on our mortgage loans as well as fire and extended coverage casualty insurance in amounts at least equal to the principal amount of the loan or the value of improvements on the property, depending on the type of loan.
One- to Four-Family Residential Real Estate Lending. The cornerstone of our lending program has long been the origination of long-term permanent loans secured by mortgages on owner-occupied one- to four-family residences. At December 31, 2010, $45.6 million, or 39.60% of our total loan portfolio consisted of permanent loans on one- to four-family residences. At that date, our average outstanding one- to four-family residential loan balance was $96,000. Virtually all of the residential loans we originate are secured by properties located in our market area. See “-Originations, Sales and Purchases of Loans.”
Due to consumer demand in the current low market interest rate environment, many of our recent originations are 10- to 30-year fixed-rate loans secured by one- to four-family residential real estate. We generally originate our fixed-rate one- to four-family residential loans in accordance with secondary market standards to permit their sale. During the last several years, consistent with our asset-liability management strategy, we have sold most of the fixed rate one- to four-family residential loans we originated with original terms to maturity in excess of ten years.
During recent years, as a part of our asset/liability management policy, we have also originated seven-year balloon loans with up to 30-year amortization schedules secured by one- to four-family real estate. At December 31, 2010, we had $16.7 million of such loans.
In order to reduce the term to repricing of our loan portfolio, we also originate adjustable-rate one- to four-family residential mortgage loans. However, our ability to originate such loans is limited in the current low interest rate environment due to low consumer demand. Our current adjustable-rate mortgage loans carry interest rates that adjust annually at a margin over the one year U.S. Treasury index. Many of our adjustable-rate one- to four-family residential mortgage loans have fixed rates for initial terms of three to five years. Such loans carry terms to maturity of up to 30 years. The adjustable-rate mortgage loans currently offered by us generally provide for a 200 basis point annual interest rate change cap and a lifetime cap of 600 basis points over the initial rate.
Although adjustable-rate mortgage loans may reduce to an extent our vulnerability to changes in market interest rates because they periodically reprice as interest rates increase, the required payments due from the borrower also increase (subject to rate caps), increasing the potential for default by the borrower. At the same time, the marketability of the underlying collateral may be adversely affected by higher interest rates. Upward adjustments of the contractual interest rate are also limited by the maximum periodic and lifetime rate adjustments permitted by our loan documents. Moreover, the interest rates on many of our adjustable-rate loans do not adjust for the first three to five years. As a result, the effectiveness of adjustable-rate mortgage loans may be limited during periods of rapidly rising interest rates. At December 31, 2010, $5.0 million, or 11.08% of our one- to four-family residential loans, had adjustable rates of interest.
We evaluate both the borrower’s ability to make principal, interest and escrow payments and the value of the property that will secure the loan. Our one- to four-family residential mortgage loans do not currently include prepayment penalties, are non-assumable and do not produce negative amortization. Our one- to four-family residential mortgage loans customarily include due-on-sale clauses giving us the right to declare the loan immediately due and payable in the event that, among other things, the borrower sells the property subject to the mortgage. We currently originate residential mortgage loans for our portfolio with loan-to-value ratios of up to 75% for one- to four-family homes, with higher limits applicable to loans with private mortgage insurance on owner-occupied residences.
At December 31, 2010, we had $1.4 million of one- to four-family residential mortgage loans that were 60 days or more delinquent.
Commercial Real Estate Lending. In recent years, in an effort to enhance the yield and reduce the term to maturity of our loan portfolio, we have sought to increase our commercial real estate loans. At December 31, 2010, we had $26.7 million in commercial real estate loans, representing 23.21% of our total loan portfolio. Subject to future economic, market and regulatory conditions, we intend to continue to focus on this kind of lending.
Most of our commercial real estate loans have balloon loan terms of three to ten years with amortization terms of 15 to 25 years and fixed interest rates. The maximum loan-to-value ratio of our commercial real estate loans is generally 75%. At December 31, 2010, our largest commercial real estate loan totaled $2.6 million and was secured by a mortgage on an automobile dealership outside our market area in Cook County, Illinois. At December 31, 2010, this loan was performing in accordance with its terms.
Set forth below is information regarding our commercial real estate loans at December 31, 2010
We consider a number of factors in originating commercial real estate loans. We evaluate the qualifications and financial condition of the borrower, including credit history, profitability and expertise, as well as the value and condition of the property securing the loan. When evaluating the qualifications of the borrower, we consider the financial resources of the borrower, the borrower’s experience in owning or managing similar property and the borrower’s payment history with us and other financial institutions. In evaluating the property securing the loan, the factors we consider include the net operating income of the mortgaged property before debt service and depreciation, the ratio of the loan amount to the appraised value of the mortgaged property and the debt service coverage ratio (the ratio of net operating income to debt service). All commercial real estate loans are appraised by outside independent appraisers approved by the board of directors or by internal evaluations, where permitted by regulation. Personal guarantees are generally obtained from the principals of commercial real estate loans.
Loans secured by commercial real estate generally are larger than one- to four-family residential loans and involve greater credit risk. Commercial real estate loans often involve large loan balances to single borrowers or groups of related borrowers. Repayment of these loans depends to a large degree on the results of operations and management of the properties securing the loans or the businesses conducted on such property, and may be affected to a greater extent by adverse conditions in the real estate market or the economy in general, including today’s economic recession. Accordingly, the nature of these loans makes them more difficult for management to monitor and evaluate.
In December 2009, we hired a commercial loan officer with over 20 years of agricultural and commercial lending experience in the Harvard community. With this hire, we intend to increase our origination of real estate loans for the purchase of farmland in our market area. See our discussion of our lending for the purchase of farmland under the heading “Farmland” below.
Multi-Family Real Estate Lending. We make a limited number of loans on multi-family residences in our market area. Such loans have terms and are underwritten similarly to our commercial real estate loans and are subject to similar risks.
Home Equity Lending. We originate variable-rate home equity lines-of-credit and, to a lesser extent, fixed- and variable-rate loans secured by liens on the borrower’s primary residence. Our home equity products are limited to 75% of the property value less any other mortgages. Prior to 2009, we originated home equity loans up to 90% of the property value to our customers where we serviced their first lien mortgage loan. As of December 31, 2010, we had no home equity loans that were originated at loan to value ratios above 90%. We use the same underwriting standards for home equity lines-of-credit and loans as we use for one- to four-family residential mortgage loans. Our home equity line-of-credit product carries an interest rate tied to the prime rate published in the Wall Street Journal. The product has a rate ceiling of 18%. Our home equity line-of-credit loans originated in 2009 have a rate floor of 4 - 4.25%. In 2010, we increased the floor on these loans to 4.50%. We currently offer home equity loans with fixed-rate terms that amortize over a period of up to 15 years. Our home equity lines-of-credit provide for an initial draw period of up to five years, with monthly payments of interest calculated on the outstanding balance. At the end of the initial five years, the line may be paid in full or restructured at our then current home equity program.
At December 31, 2010, we had $11.4 million or 9.90% of total loans in home equity loans and outstanding advances under home equity lines and an additional $6.7 million of funds committed, but not advanced, under the home equity lines-of-credit. We intend to continue promoting the equity line-of-credit product as an important piece of our loan portfolio and to help us manage our asset/liability position.
Construction and Land Lending. We make construction loans to builders and developers for the construction of one- to four- and multi-family residential units and to individuals for the construction of their primary or secondary residence. We also make a limited amount of land loans to developers, primarily for the purpose of developing residential subdivisions.
At December 31, 2010, we had one outstanding one- to four-family construction loan commitment for $12,000.
The application process includes a submission to us of plans, specifications and costs of the project to be constructed or developed. These items are used as a basis to determine the appraised value of the subject property. Loans are based on the lesser of current appraised value and/or the cost of construction (land plus building). Our construction loan agreements generally provide that loan proceeds are disbursed in increments as construction progresses. Outside independent licensed appraisers or title company representatives under a construction loan escrow agreement inspect the progress of the construction of the dwelling before disbursements are made.
We occasionally make loans to builders and developers “on speculation” to finance the construction of residential property. At December 31, 2010, we had no construction loan secured by a one- to four-family residential property built on speculation.
We also make construction loans for commercial development projects such as multi-family, apartment and other commercial buildings. These loans generally have an interest-only phase during construction then convert to permanent financing. Disbursements of construction loan funds are at our discretion based on the progress of construction. The maximum loan-to-value ratio limit applicable to these loans is generally 75%. At December 31, 2010, we had no construction loans outstanding which were secured by commercial property. At December 31, 2010, we also had one land development loan totaling $450,000 representing 0.39% of our total loan portfolio. This loan was to a developer on a commercial property in our market area.
We also make loans to builders and developers for the development of one- to four-family lots in our market area. These loans have terms of five years or less. Land loans are generally made in amounts up to a maximum loan-to-value ratio of 65% on raw land and up to 75% on developed building lots based upon an independent appraisal. We obtain personal guarantees for our land loans. At December 31, 2010, we had two land development loans totaling $1.1 million to builders/developers representing 0.98% of our total loan portfolio on residential development properties. These loans were located in our market area.
Loans to individuals for the construction of their residences typically run for up to seven months and then convert to permanent loans. These construction loans have rates and terms comparable to one- to four-family residential loans offered by us. During the construction phase, the borrower pays interest only at a fixed rate. The maximum loan-to-value ratio of owner-occupied single-family construction loans is 75%. Residential construction loans are generally underwritten pursuant to the same guidelines used for originating permanent residential loans.
The following table sets forth the composition of our portfolio of construction, land and land development loans by loan type at December 31, 2010.
Construction and land lending generally affords us an opportunity to receive higher origination and other loan fees. In addition, such loans are generally made for relatively short terms. Nevertheless, construction and land lending to persons other than owner-occupants is generally considered to involve a higher level of credit risk than one- to four-family residential lending due to the concentration of principal in a limited number of loans and borrowers and the effects of general economic conditions (including the current recessionary economy and adverse real estate market) on construction projects, real estate developers and managers. In addition, the nature of these loans is such that they are more difficult to evaluate and monitor. Our risk of loss on a construction or land loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project and the estimated cost (including interest) of the project. If the estimate of value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project with a value which is insufficient to assure full repayment and/or the possibility of having to make substantial investments to complete and sell the project. Because defaults in repayment may not occur during the construction period, it may be difficult to identify problem loans at an early stage. When loan payments become due, the cash flow from the property may not be adequate to service the debt. In such cases, we may be required to modify the terms of the loan.
We have significantly decreased our construction loan originations in light of adverse conditions in our local real estate market and economy.
Farmland. At December 31, 2010, our loans secured by farmland amounted to $3.6 million or 3.15% of the total loan portfolio. These loans are primarily secured by farmland located in our market area. Our adjustable rate farmland loans have interest rates that generally adjust every one, three or five years in accordance with a designated index and are generally amortized over 15-25 years. Our fixed rate farmland loans generally are for terms of up to 15 years, although many are amortized over longer periods, and include a balloon payment at maturity. Our lending policies on such loans generally limit the maximum loan-to-value ratio to 75% of the lesser of the appraised value or purchase price of the property.
While we may earn higher yields on agricultural mortgage loans than on single-family residential mortgage loans, agricultural-related lending involves a greater degree of risk than single-family residential mortgage loans because of the typically larger loan amounts and potential volatility in the market. In addition, repayments on agricultural loans are substantially dependent on the successful operation of the underlying business and the value of the property collateralizing the loan, both of which are affected by many factors, such as weather and changing market prices, outside the control of the borrower. Finally, some commentators believe that the recent sharp increases in farm land prices could make a price correction more likely.
Substantially all our farmland loans are underwritten to conform to agency guidelines to qualify for a government guarantee of up to 90% of the original loan amount, which in turn qualifies them to be sold to a variety of investors in the secondary market. Once the government guarantee is secured from Farmers Home Loan Administration, the guarantee covers up to 90% of any loss on the loan. We may sell into the secondary market longer-term fixed rate agricultural mortgage loans, which we service for the secondary market purchaser.
Commercial and Industrial Lending. We originate commercial and industrial loans and lines of credit to small- and medium-sized companies in our primary market area. Our commercial and industrial loans are generally used for working capital purposes or for acquiring equipment, inventory or furniture. Our commercial and industrial loans generally carry a floating-rate indexed to the prime rate as published in The Wall Street Journal and a one-year term. All of our commercial and industrial loans are secured. Subject to future economic, market and regulatory conditions, we intend to focus on this kind of lending.
The following table sets forth the composition of our commercial and industrial loan portfolio by loan type at December 31, 2010. The balance set forth below do not include $1.4 million committed but undrawn lines of credit on commercial and industrial loans.
When making commercial and industrial loans, we consider the financial statements of the borrower, the lending history of the borrower, the debt service capabilities of the borrower, the projected cash flows of the business, the value of the collateral, if any, and whether the loan is guaranteed by the principals of the borrower. Commercial and industrial loans are generally secured by accounts receivable, inventory, equipment and personal guarantees.
Commercial and industrial loans generally have a greater credit risk than residential mortgage loans. Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment and other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial and industrial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial and industrial loans may be substantially dependent on the success of the business itself. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. We seek to minimize these risks through our underwriting standards and personal guarantees.
At December 31, 2010, our largest commercial and industrial loan relationship was $867,000 with a food manufacturing company in our market area. At December 31, 2010, those loans were performing in accordance with their terms.
Agricultural Lending. In December 2009, we hired a commercial loan officer with over 20 years of agricultural lending experience to increase our origination of agricultural operating lines of credit and intermediate-term loans. Our agricultural operating lines of credit generally have terms of one year and are secured by growing crops, livestock and equipment, and mortgages on the farmland. Our intermediate-term loans have terms of 2-7 years and will be secured by machinery and equipment. Generally these loans are extended to farmers in our market area for the purchase of equipment, seed, fertilizer, insecticide and other purposes in connection with agricultural production. The maximum term for equipment secured loans is tied to the useful life of the underlying collateral but cannot exceed 10 years. The interest rate is generally increased with respect to the longer terms loans due to the rate exposure of these loans. The amount of the commitment is based on management’s review of the borrower’s business plan, prior performance, marketability of crops, and current market prices. We examine recent financial statements and evaluate cash flow analysis and debt-to-net worth, and liquidity ratios. Loans for crop production generally require 75% or more crop insurance coverage. At December 31, 2010, we had $13.7 million in agriculture loans, representing 11.94% of our total loan portfolio.
The repayment of agricultural business loans generally is dependent on the successful operation of a farm and can be adversely affected by fluctuations in crop prices, increase in interest rates, and changes in weather conditions. These developments may result in smaller harvests and less income for farmers which may adversely affect such borrower’s ability to repay a loan. Many of our borrowers also have more than one agricultural business loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan. Finally, if we foreclose on an agricultural commercial loan, our holding period for the collateral, if any, typically is longer than for one- to four-family residential mortgage loans because there are fewer potential purchasers of the collateral.
The following table sets forth the composition of our agricultural loan portfolio by loan type at December 31, 2010.
Consumer Lending. We make secured and unsecured loans to consumers. However, during recent years, we have focused most of our consumer lending efforts on purchases of indirect automobile loans.
In an effort to expand and diversify our loan portfolio and increase the overall yield on our loan portfolio, since 1999 we have purchased indirect loans on new and used automobiles located primarily in Cook County, Illinois. Although we do not separately underwrite each purchased loan, we thoroughly review the knowledge and experience of the originators’ management teams, their underwriting standards, and their historical loss rates. In 2008, we dramatically reduced new indirect automobile loan purchases based on the risk concentration in our portfolio, liquidity requirements, and current economic conditions. We may resume purchases in the future depending on our portfolio concentrations, other lending opportunities and the economic environment.
Under the loan purchase arrangement, on a monthly basis the seller aggregates indirect automobile loans into separate loan pools. The pools are then segregated into risk categories with each category having predefined limits as to the maximum amounts allowed. Generally, the pools are sold without recourse. We receive a listing of the individual loans in the pool, including loan and borrower information prior to funding the purchase but we are not generally permitted to substitute loans in a pool or purchase part of a pool.
The seller is responsible for dealer relationships and the monitoring of their performance. The seller performs all servicing functions including the collection of principal, interest, and fees as well as repossessions and recoveries. Thus, we are not involved in the sale of repossessed vehicles.
We perform semi-annual reviews of newly purchased loan files and review operational procedures as part of our internal audit function. We purchased no such loans in 2010 or 2009. At December 31, 2010, we had approximately $5.9 million of purchased indirect automobile loans outstanding, representing 5.13% of our gross loan portfolio. Included in the balance at December 31, 2010 was $1.7 million of automobile loans with no credit score or a credit score below 660 (which loans are considered by the FDIC to have certain features of subprime lending).
Consumer loans may entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances as well as the current slowing economy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. For the years ended December 31, 2010 and December 31, 2009, we had net charge-offs of $84,000 and $231,000, respectively, on consumer loans. At December 31, 2010 and 2009, we had nonperforming consumer loans of $34,000 and $62,000, respectively. At December 31, 2010, we had $71,000 of repossessed automobiles. In addition, on the same date, there were purchased indirect automobile loans totaling $127,000 and other consumer loans totaling $8,000 that were delinquent 30 days or more.
Originations, Purchases and Sales of Loans
We originate real estate and other loans through marketing efforts, our customer base, walk-in customers and referrals from real estate brokers, builders and attorneys. All loans originated by us are underwritten pursuant to our policies and procedures.
We may sell certain of the loans we originate into the secondary market. We consider our own balance sheet as well as market conditions in making decisions as to whether to hold the mortgage loans we originate for investment or to sell such loans to investors, choosing the strategy that is most advantageous to us from a profitability and risk management standpoint. We generally do not make loan sale commitments until we receive a corresponding borrower commitment. To date, all of our loan sales have been on a servicing-retained basis. At December 31, 2010, we serviced $65.2 million of loans held by other institutions.
From time to time, to diversify our risk, we purchase interests in various types of loans. We underwrite our participation portion of the loan according to our own underwriting criteria and procedures. At December 31, 2010, we had $8.8 million in loan participation interests, only $1.3 million or 14.8% of which are in our market area.
Delinquencies and Non-Performing Assets
Delinquency Procedures. When a borrower fails to make a required monthly loan payment by the last day of the month, a late notice is generated stating the payment and late charges due. Our policies provide that borrowers that become 60 days or more delinquent are contacted by phone or mail to determine the reason for nonpayment and to discuss future payments. If repayment is not possible or doubtful, the loan will be brought to the board of directors for possible foreclosure. Once the board of directors declares a loan due and payable, a certified letter is sent to the borrower explaining that the entire balance of the loan is due and payable. If the loan is reinstated, foreclosure proceedings will be discontinued and the borrower will be permitted to continue to make payments. If the borrower does not respond, we will initiate foreclosure proceedings.
When we acquire real estate as a result of foreclosure or by deed in lieu of foreclosure, the real estate is classified foreclosed real estate until it is sold. The real estate is recorded at estimated fair value at the date of acquisition less estimated costs to sell, and any write-down resulting from the acquisition is charged to the allowance for loan losses. Estimated fair value is based on a new appraisal which is obtained as soon as practicable, typically after the foreclosure process has begun but no later than 30 days after acquisition. Subsequent decreases in the value of the property are charged to operations through the creation of a valuation allowance. After acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of estimated fair value less estimated costs to sell.
While delinquencies and repossession of purchased indirect automobile loans are handled by the loan seller, we selectively audit this process to ensure that our interests are protected.
Troubled Debt Restructurings. We periodically modify loans to extend the term or make other concessions to help a borrower stay current on his or her loan and to avoid foreclosure. We generally do not forgive principal or interest on loans. We will modify the terms of loans to lower interest rates (which may be at below market rates), and/or to provide for longer amortization schedules (up to 40 years), and/or provide for interest-only terms. These modifications are made only when there is a reasonable and attainable workout plan that has been agreed to by the borrower and that is in our best interests. At December 31, 2010, we had two nonaccrual loans for $1.4 million that were classified as troubled debt restructurings.
Delinquent Loans. The following table sets forth our loan delinquencies, including non-accrual loans, by type and amount at the dates indicated.
Classified Assets. Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered by the Federal Deposit Insurance Corporation to be of lesser quality, as “substandard,” “doubtful” or “loss.” An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard,” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated as “special mention” by our management.
When an insured institution classifies problem assets as either substandard or doubtful, it may establish general allowances in an amount deemed prudent by management to cover probable accrued losses. General allowances represent loss allowances which have been established to cover probable accrued losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies problem assets as “loss,” it is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge-off such amount. An institution’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the regulatory authorities, which may require the establishment of additional general or specific loss allowances.
In connection with the filing of our periodic reports and in accordance with our classification of assets policy, we regularly review the problem loans in our portfolio to determine whether any loans require classification in accordance with applicable regulations. Loans are listed on the “watch list”
initially because of delinquency status, typically when a loan becomes 60 days past due and collection proceedings begin, or if a loan possesses weaknesses although currently performing. The watch list describes the action plan and nature and type of underlying collateral for each problem loan, as well as the date and amount of the most recent appraisal for real estate loans. Management reviews the status of each loan on our watch list on a monthly basis and then with the board of directors. If a loan deteriorates in asset quality, the classification is changed to “special mention,” “substandard,” “doubtful” or “loss” depending on the circumstances and the evaluation. Generally, loans 90 days or more past due are placed on nonaccrual status and classified substandard, unless the loan is well secured and in the process of collection.
On the basis of this review of our assets, our classified and special mention and other watch assets at the dates indicated were as follows:
Non-Performing Assets. We generally cease accruing interest on our loans when contractual payments of principal or interest have become 90 days past due or management has serious doubts about further collectibility of principal or interest, even though the loan is currently performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income is reversed. Interest received on nonaccrual loans generally is applied against principal. Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectibility of the total contractual principal and interest is no longer in doubt. Restructured loans are restored to accrual status when the obligation is brought current, has performed in accordance with the revised contractual terms for a reasonable period of time (typically six months) and the ultimate collectibility of the total contractual principal and interest is reasonably assured.
The following table sets forth information regarding our nonperforming assets, including troubled debt restructurings, at the dates indicated. Troubled debt restructurings include loans for which either a portion of interest or principal has been forgiven, or for loans modified at interest rates materially less than current market rates.
(1) Troubled debt restructurings included in nonaccrual loans totaled $1.4 million and $0 at December 31, 2010 and 2009, respectively.
Non-accrual one- to four-family real estate loans totaled $1.2 million at December 31, 2010 and consisted of three non-owner-occupied properties totaling $215,000 and twelve owner-occupied single-family homes totaling $991,000. All of the non-owner-occupied properties are located in Northern Illinois. A new appraisal was obtained for one of the properties in 2009, which is in the process of foreclosure. The appraisal resulted in a partial charge-off of $18,000 in 2009. We have established impairment allowances totaling $12,000 on the other nonperforming non-owner-occupied one- to four-family real estate loans at December 31, 2010.
All of the owner-occupied one- to four-family real estate loans are located in our market area. Nine of those twelve properties totaling $564,000 are in the process of collection. We have established impairment allowances for those loans of $27,000 at December 31, 2010, based on their original appraisals adjusted for certain factors, including evidence of housing price depreciation in our local market. The other three owner-occupied one- to four-family loans totaling $427,000 are in the process of foreclosure. New appraisals were obtained on those loans which resulted in partial charge-offs of $33,000 in 2010. We have established impairment allowances of $21,000 on those loans at December 31, 2010.
Nonaccrual commercial real estate loans totaled $1.1 million at December 31, 2010. One troubled debt restructuring, a commercial real estate loan secured by a retail strip mall located in McHenry County, in which only 25% of the mall is currently leased, was placed on nonaccrual in June 2010. The loan had a balance of $688,000 at December 31, 2010, net of a partial charge-off in 2010 of $100,000. We have established an impairment allowance of $162,000, based on a new appraisal, adjusted for certain factors. In September 2010, another commercial real estate loan secured by an owner-occupied retail strip center in McHenry County was placed on nonaccrual after the borrower stated that no more payments would be made and foreclosure proceedings were initiated. The loan has been determined to be impaired and had a balance of $386,000 at December 31, 2010, net of a partial charge-off taken in 2010 of $95,000. We have established an impairment allowance of $12,000 on that loan at December 31, 2010.
In December 2010, a residential subdivision real estate loan with a balance at December 31, 2010 of $666,000 was refinanced in a troubled debt restructuring. No lots have been sold since the loan was originated in 2008, and the loan balance exceeded the value of the underlying collateral based on a new appraisal obtained in July 2010. The restructuring resulted in a partial charge-off of $42,000 in December 2010, and we have established an impairment allowance of $275,000 on the restructured loan at December 31, 2010.
At December 31, 2010, we had $127,000 of purchased indirect automobile loans that were past due 30 days or more, including $33,000 that were classified as non-performing loans. We have established allowances of $32,000 on those loans at December 31, 2010.
Other nonperforming loans totaled $194,000 at December 31, 2010. We have established impairment allowances of $36,000 on those loans at December 31, 2010.
Other real estate owned totaled $696,000 at December 31, 2010, which consisted of eight single-family homes in our market area. The properties are carried at estimated fair value less costs to sell, based upon new appraisals obtained in 2009-2010. In addition, we had $71,000 of repossessed automobiles at December 31, 2010.
Interest income that would have been recorded for the year ended December 31, 2010, had nonaccruing loans been current according to their original terms amounted to $81,000. Interest of $169,000 was recognized on these loans and is included in net income for the year ended December 31, 2010.
Allowance for Loan Losses
Analysis and Determination of the Allowance for Loan Losses. Our allowance for loan losses is the amount considered necessary to reflect probable incurred losses in our loan portfolio. We evaluate the need to establish allowances against losses on loans on a quarterly basis. When additional allowances are necessary, a provision for loan losses is charged to earnings.
Our methodology for assessing the appropriateness of the allowance for loan losses consists of two key elements: (1) specific allowances for identified problem loans; and (2) a general valuation allowance on the remainder of the loan portfolio. Although we determine the amount of each element of the allowance separately, the entire allowance for loan losses is available for the entire portfolio.
We identify loans that may need to be charged off as a loss by reviewing all delinquent loans, classified loans, and other loans about which management may have concerns about collectability. For individually reviewed loans, the borrower’s inability to make payments under the terms of the loan as well as the shortfall in collateral value would result in our charging off the loan or the portion of the loan that was impaired.
Among other factors, we consider current general economic conditions, including current housing price depreciation, in determining the appropriateness of the allowance for loan losses for our residential real estate portfolio. We use evidence obtained from our own loan portfolio as well as published housing data on our local markets from third party sources we believe to be reliable as a basis for assumptions about the impact of housing depreciation. We have increased general and specific allowances for our residential real estate loans over the past several quarters, in part, because the values of residential real estate in our local markets securing our portfolio have declined significantly and may continue to decline.
Substantially all of our loans are secured by collateral. At December 31, 2010, 78.48% of our loan portfolio was secured by real estate including 50.74% that was secured by residential real estate. Loans 90 days past due and other classified loans are evaluated for impairment and general or specific allowances are established. Typically for a nonperforming real estate loan in the process of collection, the value of the underlying collateral is estimated using the original independent appraisal, adjusted for current economic conditions and other factors, and related general or specific reserves are adjusted on a quarterly basis. If a nonperforming real estate loan is in the process of foreclosure and/or there are serious doubts about further collectability of principal or interest, and there is uncertainty about the value of the underlying collateral, we will order a new independent appraisal. Any shortfall would result in immediately charging off the portion of the loan that was impaired.
Specific Allowances for Identified Problem Loans. We establish a specific allowance when loans are determined to be impaired. Loss is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. Factors in identifying a specific problem loan include: (1) the strength of the customer’s personal or business cash flows; (2) the availability of other sources of repayment; (3) the amount due or past due; (4) the type and value of collateral; (5) the strength of our collateral position; (6) the estimated cost to sell the collateral; and (7) the borrower’s effort to cure the delinquency. In addition, for loans secured by real estate, we consider the extent of any past due and unpaid property taxes applicable to the property serving as collateral on the mortgage.
General Valuation Allowance on Certain Identified Problem Loans. Groups of loans with similar risk characteristics, including individually evaluated loans not determined to be impaired, are collectively evaluated for impairment based on the group’s historical loss experience adjusted for changes in trends, conditions, and other relevant factors that affect repayment of the loans. Accordingly, we
generally do not separately identify individual residential and consumer loans for impairment measurements. Instead, we provide for general valuation allowances on certain homogeneous pools of residential and consumer loans classified as substandard.
General Valuation Allowance on the Remainder of the Loan Portfolio. We establish a general allowance for loans that are not classified as substandard to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, has not been allocated to particular problem assets. This general valuation allowance is determined by segregating the loans by loan category and assigning allowance percentages based on our historical loss experience, delinquency trends and management’s evaluation of the collectibility of the loan portfolio. The allowance may be adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. These significant factors may include changes in lending policies and procedures, changes in existing general economic and business conditions affecting our primary market area, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, recent loss experience in particular segments of the portfolio, duration of the current business cycle and bank regulatory examination results. The applied loss factors are re-evaluated quarterly to ensure their relevance in the current real estate environment.
As an integral part of their examination process, the Federal Deposit Insurance Corporation and the Illinois Department of Financial and Professional Regulation periodically review our allowance for loan losses. Such agencies may require that we recognize additions to the allowance based on their judgments of information available to them at the time of their examination.
Allowance for Loan Losses. The following table sets forth activity in our allowance for loan losses for the years indicated.
The allowance as a percent of total loans increased to 1.63% at December 31, 2010 from 1.29% at December 31, 2009, primarily due to the impact of qualitative factors to reflect further deterioration in the economy, and higher levels of impaired loans, and a significant increase in agriculture loans in 2010. Loan categories experiencing the most charge-offs in 2010 involved owner-occupied one- to four-family residential real estate, commercial real estate, and purchased indirect automobile loan categories.
Allocation of Allowance for Loan Losses. The following table sets forth the allowance for loan losses allocated by loan category, the percent of allowance in each loan category to the total allowance, and the percent of loans in each category to total loans at the dates indicated. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.
At December 31, 2010, our allowance for loan losses represented 1.63% of total loans and 58.88% of nonperforming loans. The allowance for loan losses increased to $1.9 million at December 31, 2010 from $1.4 million at December 31, 2009, due to a provision for loan losses of $904,000, offset by net charge-offs of $457,000.
Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while we believe we have established our allowance for loan losses in conformity with accounting principles generally accepted in the United States of America, regulators, in reviewing our loan portfolio, may request us to increase our allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, the existing allowance for loan losses may not be adequate and increases may be necessary should the quality of any loan deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations.
Investment Activities
General. The goals of our investment policy are to provide and maintain liquidity to meet deposit withdrawal and loan funding needs, to help mitigate our interest rate risk, and to generate a favorable return on idle funds within the context of our interest rate and credit risk objectives.
Our board of directors is responsible for adopting our investment policy. The investment policy is reviewed annually by management and any changes to the policy are recommended to and subject to the approval of the board of directors. Authority to make investments under the approved investment policy guidelines is delegated to our Chief Executive Officer and Chief Financial Officer. All investment transactions are reviewed at regularly scheduled monthly meetings of the board of directors.
Our current investment policy permits, with certain limitations, investments in securities issued by the United States Government and its agencies or government sponsored enterprises, mortgage-backed securities and, to a lesser extent, corporate debt securities, commercial paper, certificates of deposits in other financial institutions, investments in bank-owned life insurance, collateralized mortgage obligations, asset-backed securities, real estate mortgage investment conduits, securities sold under agreements to repurchase, and debt securities of state and political subdivisions.
With the exception of obligations of the U.S. Treasury and other U.S. government agencies and corporations, we held no securities at December 31, 2010, that exceeded 10% of our total stockholders’ equity.
U.S. Government and Federal Agency Obligations. At December 31, 2010, our U.S. Government and federal agency securities portfolio totaled $4.1 million. While these securities generally provide lower yields than other investments in our securities investment portfolio, we maintain these investments, to the extent appropriate, for liquidity purposes, as collateral for borrowings and for prepayment protection.
Mortgage-Backed Securities. At December 31, 2010, our mortgage-backed securities portfolio totaled $590,000. Mortgage-backed securities are securities issued in the secondary market that are collateralized by pools of mortgages. Certain types of mortgage-backed securities are commonly referred to as “pass-through” certificates because the principal and interest of the underlying loans is “passed through” to investors, net of certain costs, including servicing and guarantee fees. Mortgage-backed securities typically are collateralized by pools of one- to four-family or multifamily mortgages, although we invest primarily in mortgage-backed securities backed by one- to four-family mortgages. The issuers of such securities pool and resell the participation interests in the form of securities to investors such as Harvard Savings Bank. The interest rate of the security is lower than the interest rates of the underlying loans to allow for payment of servicing and guaranty fees. Mortgage-backed securities are more liquid than individual mortgage loans since there is an active trading market for such securities. In addition, mortgage-backed securities may be used to collateralize our borrowings.
Ginnie Mae, a United States Government agency, and government-sponsored enterprises, such as Fannie Mae and Freddie Mac, either guarantee the payments or guarantee the timely payment of principal and interest to investors. In September 2008, the Federal Housing Finance Agency placed Freddie Mac and Fannie Mae into conservatorship. The U.S. Treasury Department has established financing agreements to ensure that Freddie Mac and Fannie Mae meet their obligations to holders of mortgage-backed securities that they have issued or guaranteed. These actions have not affected the markets for mortgage-backed securities issued by Freddie Mac or Fannie Mae.
Investments in mortgage-backed securities involve a risk that actual payments will be greater or less than the prepayment rate estimated at the time of purchase, which may require adjustments to the amortization of any premium or accretion of any discount relating to such interests, thereby affecting the net yield on our securities. Current prepayment speeds determine whether prepayment estimates require modification that could cause amortization or accretion adjustments.
Collateralized Mortgage Obligations. Collateralized mortgage obligations are backed by mortgages but differ from pass through mortgage-backed securities because the principal and interest payments of the underlying mortgages are financially engineered to be paid to the security holders of pre-determined classes or tranches of these securities at a faster or slower pace. The receipt of these principal
and interest payments, which depends on the proposed average life for each class, is contingent on a prepayment speed assumption assigned to the underlying mortgages. Variances between the assumed payment speed and actual payments can significantly alter the average lives of such securities. To quantify and mitigate this risk, we undertake a high level of payment analysis before purchasing these securities. The collateralized mortgage obligations in our portfolio have been packaged by U.S. financial institutions. We invest only in seasoned AAA-rated senior CMO classes or tranches in which the payments on the underlying mortgages are passed along at a pace fast enough to provide an average life of one to ten years with no change in market interest rates. At December 31, 2010, our CMO portfolio, which are all classified held-to-maturity and still rated AAA, had a book value and fair value of $1.9 million and $2.1 million, respectively.
State and Political Subdivision Debt Securities. At December 31, 2010, our state and political subdivision securities portfolio totaled $472,000. We have purchased bank-qualified general obligation and revenue bonds of certain state and political subdivisions which provide interest income that is exempt from federal income taxation. Our investment policy permits purchases of these securities so long as they are rated in the top three investment grades, with maximum term to maturity and duration of 15 and ten years, respectively.
Mutual Funds and Other Equity Securities. Purchases of mutual funds and other equity securities are not permitted by our current investment policy; however, such purchases were permitted prior to 2009. At December 31, 2010, our mutual fund portfolio totaled $436,000, all of which was classified as available-for-sale and all of which was invested in two Shay Asset Management mutual funds, the AMF Ultra Short Mortgage Fund and AMF Ultra Short Fund. Both funds invest primarily in mortgage-related securities. For the years ended December 31, 2010 and 2009, we recognized a loss for other-than-temporary impairment on our mutual funds of $11,000 and $35,000, respectively, due to a decline in the fair value of these funds below our cost.
At December 31, 2010, we held common stock of Fannie Mae and Freddie Mac and community banks with a total fair value of $35,000, all of which were classified as available-for-sale. For the years ended December 31, 2010 and 2009, we recognized a loss for other-than-temporary impairment on these equity securities of $16,000 and $24,000, respectively, due to a decline in fair value below our cost.
Federal Home Loan Bank Stock. We hold common stock of the Federal Home Loan Bank of Chicago in connection with our borrowing activities totaling $6.5 million at December 31, 2010. The common stock of such entity is carried at cost and classified as restricted equity securities.
On October 10, 2007, the Federal Home Loan Bank of Chicago entered into a consensual cease and desist order with the Federal Housing Finance Board, now known as the Federal Housing Finance Agency. Under the terms of the order, capital stock repurchases and redemptions, including redemptions upon membership withdrawal or other termination, are prohibited unless the Federal Home Loan Bank of Chicago receives the prior approval of the Director of the Office of Supervision of the Federal Housing Finance Agency. The order also provides that dividend declarations are subject to the prior written approval of such Director and required the Federal Home Loan Bank of Chicago to submit a Capital Structure Plan to the Federal Housing Finance Agency. As of December 31, 2010, the Federal Home Loan Bank of Chicago had not paid any dividends since the order was issued and it had not received approval of a Capital Structure Plan. In July 2008, the Federal Housing Finance Agency amended the order to permit the Federal Home Loan Bank of Chicago to repurchase or redeem newly-issued capital stock to support new advances, subject to certain conditions set forth in the order. Our Federal Home Loan Bank of Chicago common stock is not newly-issued and is not affected by this amendment.
Recent published reports indicate that certain member banks of the Federal Home Loan Bank System could have materially lower regulatory capital levels due to the application of certain accounting rules and asset quality issues. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the Federal Home Loan Bank of Chicago, could be substantially diminished or reduced to zero. Our FHLBC common stock is accounted for in accordance with the AICPA Statement of Position (“SOP”) No. 01-6, Accounting by Certain Entities that Lend to or Finance the Activities of Others, as codified within ASC Topic 942. ASC Topic 942 provides that, for impairment testing purposes, the value of long term investments such as our Federal Home Loan Bank of Chicago common stock is based on the “ultimate recoverability” of the par value of the security without regard to temporary declines in value. Management performed an analysis as of December 31, 2010, and deemed its investment in Federal Home Loan Bank stock was not other than temporarily impaired. However, if future events give rise to substantial doubt about the ultimate recoverability of the par value of our Federal Home Loan Bank of Chicago common stock, this investment could be deemed to be other-than-temporarily impaired, and the impairment loss that we would be required to record would cause our earnings to decrease by the after-tax amount of the impairment loss.
Bank-Owned Life Insurance. We invest in bank-owned life insurance to provide us with a funding source for our benefit plan obligations. Bank-owned life insurance also generally provides us non-interest income that is non-taxable. The purchase of bank-owned life insurance is limited as outlined in the Interagency Statement on the Purchase and Risk Management of Life Insurance (“Statement”), which highlights five areas of guidance for use by institutions in the purchase and ongoing risk management of bank-owned life insurance (“BOLI”). These areas include a comprehensive risk management process, effective senior management and board oversight, policies and procedures with risk limits, sound pre-purchase analysis, and an ongoing monitoring of BOLI risks. The Statement also recommends limiting BOLI holdings to 25% or less of Tier 1 capital. We performed a comprehensive pre-purchase analysis prior to the purchase of our BOLI assets. Our Board of Directors has adopted policies and procedures that prohibit our purchase of additional BOLI until our holdings decrease to 25% or less of Tier 1 capital and the value of policies, and limits our BOLI holdings from any one insurance carrier to 15% of Tier 1 capital. As of December 31, 2010, we held approximately $4.1 million in cash surrender value of life insurance issued by six separate insurance companies, which totaled 24% of Tier 1 capital. We also conduct an annual risk assessment and monitor the performance of our insurance carriers on a regular basis.
Securities Purchased Under Agreements to Repurchase. At December 31, 2010, we held securities under agreements to repurchase totaling $13.9 million. These agreements represent a short-term cash investment alternative. These agreements are over-collateralized at 103% with collateral consisting of securities guaranteed by the “full faith and credit” of the United States Government.
Securities Portfolio Composition. The following table sets forth the amortized cost and fair value of our securities portfolio at the dates indicated. Securities available for sale are carried at fair value, while securities held to maturity are carried at amortized cost.
(1) All mortgage-backed securities held were issued by government sponsored enterprises.
(2) Other equity securities include Freddie Mac and Fannie Mae common stock, and shares in other financial institutions.
Securities Portfolio Maturities and Yields. The following table sets forth the stated maturities and weighted average yields of our securities at December 31, 2010. Securities held to maturity are carried at amortized cost, and securities available for sale are carried at fair value. Mortgage-backed securities, including collateralized mortgage obligations, are anticipated to be repaid in advance of their contractual maturities as a result of projected mortgage loan repayments. Certain securities have interest rates that are adjustable and will reprice annually within the various maturity ranges. These repricing schedules have not been reflected in the table below.
(1) All mortgage-backed securities held were issued by government sponsored enterprises.
(2) Other equity securities include Freddie Mac and Fannie Mae common stock, and shares in other financial institutions.
Sources of Funds
General. Deposits have traditionally been our primary source of funds for use in lending and investment activities. We also use borrowings, primarily Federal Home Loan Bank of Chicago advances, to supplement cash flow needs, lengthen the maturities of liabilities for interest rate risk purposes and to manage the cost of funds. In addition, we receive funds from scheduled loan payments, investment maturities, loan prepayments, retained earnings and income on earning assets. While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows can vary widely and are influenced by prevailing interest rates, market conditions and levels of competition.
Deposits. Our deposits are generated primarily from residents within our primary market area. We offer a selection of deposit accounts, including demand accounts, NOW accounts, money market accounts, savings accounts and certificates of deposit. Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate. We occasionally utilize brokered deposits to fund our operations based on our analysis of available rates and maturities, alternative sources of funds and investment opportunities. At December 31, 2010, the Bank had $1.5 million of brokered deposits that mature in November 2012. The Bank anticipates that it can renew or replace those deposits at competitive rates.
Interest rates paid, maturity terms, service fees and withdrawal penalties are established on a periodic basis. Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals. Personalized customer service, long-standing relationships with customers, and the favorable image of Harvard Savings Bank in the community are relied upon to attract and retain deposits.
The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. Our ability to gather deposits is impacted by the competitive market in which we operate which includes numerous financial institutions of varying sizes offering a wide range of products. We often use promotional rates to meet asset/liability and market segment goals.
The variety of deposit accounts offered allows us to be competitive in obtaining funds and responding to changes in consumer demand. Based on our experience, we believe that statement savings, demand, NOW and money market accounts may be somewhat more stable sources of deposits than certificates of deposits. Also, we believe that our deposits allow us a greater opportunity to connect with our customers and offer them other financial services and products. As a result, we have used marketing and other initiatives to increase such accounts. However, it can be difficult to attract and maintain such deposits at favorable interest rates under current market conditions.
The following table sets forth the distribution of total deposits by account type, at the dates indicated.
As of December 31, 2010, the aggregate amount of all our certificates of deposit in amounts greater than or equal to $100,000 was approximately $27.3 million. The following table sets forth the maturity of these certificates as of December 31, 2010.
The following table sets forth all our certificates of deposit classified by interest rate as of the dates indicated.
The following table sets forth the amount and maturities of all our certificates of deposit by interest rate at December 31, 2010.
Borrowings. We may obtain advances from the Federal Home Loan Bank of Chicago upon the security of our capital stock in the Federal Home Loan Bank of Chicago and certain of our mortgage loans. Such advances may be made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. To the extent such borrowings have different terms to repricing than our deposits, they can change our interest rate risk profile.
From time to time during recent years, we have utilized short-term borrowings to fund loan demand. To a limited extent, we have also used borrowings where market conditions permit to purchase securities of a similar duration in order to increase our net interest income by the amount of the spread between the asset yield and the borrowing cost. From time to time, we have obtained advances with terms of more than one year to extend the term of our liabilities.
The following table sets forth certain information regarding our borrowed funds at and for the periods indicated. Average balances are predominantly derived from daily balances, and to a lesser extent, from month end balances. Management does not believe that the limited use of month end balances rather than daily balances has caused any material differences in the information presented.
The following table sets forth certain information regarding our borrowed funds that mature in one year or less. Average balances are predominantly derived from daily balances, and to a lesser extent, from month end balances. Management does not believe that the limited use of month end balances rather than daily balances has caused any material differences in the information presented.
Subsidiary and Other Activities
Harvard Illinois Bancorp, Inc. owns 100% of the outstanding shares of common stock of Harvard Savings Bank. Harvard Savings Bank has no subsidiaries.
SUPERVISION AND REGULATION
General
Harvard Savings Bank is examined and supervised by the Division of Banking of the Illinois Department of Financial and Professional Regulation and the Federal Deposit Insurance Corporation. This regulation and supervision establishes a comprehensive framework of activities in which an institution may engage and is intended primarily for the protection of the Federal Deposit Insurance Corporation’s deposit insurance fund and depositors. These regulators are not, however, generally charged with protecting the interests of shareholders of Harvard Illinois Bancorp, Inc. Under this system of state and federal regulation, financial institutions are periodically examined to ensure that they satisfy applicable standards with respect to their capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. Harvard Savings Bank also is a member of and owns stock in the Federal Home Loan Bank of Chicago, which is one of the twelve regional banks in the Federal Home Loan Bank System. Harvard Savings Bank’s relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in matters concerning the ownership of deposit accounts and the form and content of Harvard Savings Bank’s mortgage documents.
The Illinois Department of Financial and Professional Regulation and the Federal Deposit Insurance Corporation have extensive enforcement authority over Illinois-chartered savings banks, such as Harvard Savings Bank. This enforcement authority includes, among other things, the ability to issue cease-and-desist or removal orders, to assess civil money penalties and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe and unsound banking practices.
The Illinois Department of Financial and Professional Regulation has established a schedule for the assessment of “supervisory fees” for all Illinois savings banks to fund the operations of the Illinois Department of Financial and Professional Regulation. These supervisory fees are computed on the basis of each savings bank’s total assets (including consolidated subsidiaries) and are payable at the end of each calendar quarter. A schedule of fees has also been established for certain filings made by Illinois savings banks with the Illinois Department of Financial and Professional Regulation. The Illinois Department of Financial and Professional Regulation also assesses fees for examinations conducted by the Illinois Department of Financial and Professional Regulation’s staff, based upon the number of hours spent by the
staff performing the examination. During the year ended December 31, 2010, Harvard Savings Bank paid approximately $22,000 in supervisory fees and $20,000 in examination fees. The Federal Deposit Insurance Corporation does not assess fees for its examination and supervisory activities.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) made extensive changes in the regulation of depository institutions and their holding companies. Under the Dodd-Frank Act, the Office of Thrift Supervision, which currently regulates savings and loan holding companies such as Harvard Illinois Bancorp, Inc., will be eliminated. Responsibility for the regulation and supervision of savings and loan holding companies will be transferred to the Federal Reserve Board, which currently supervises bank holding companies. Responsibility for the supervision and regulation of federal savings banks will be transferred to the Office of the Comptroller of the Currency, which is the agency that is currently primarily responsible for the regulation and supervision of national banks. The transfer of regulatory functions will take place over a transition period of up to one year from the Dodd-Frank Act enactment date of July 21, 2010, subject to a possible six-month extension.
Additionally, the Dodd-Frank Act creates a new Consumer Financial Protection Bureau as an independent bureau of the Federal Reserve Board. The Consumer Financial Protection Bureau will assume responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations, a function currently assigned to prudential regulators, and will have authority to impose new requirements. However, institutions of less than $10 billion in assets, such as Harvard Savings Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the primary enforcement authority of, their prudential regulator rather than the Consumer Financial Protection Bureau.
In addition to eliminating the Office of Thrift Supervision and creating the Consumer Financial Protection Bureau, the Dodd-Frank Act, among other things, directs changes in the way that institutions are assessed for deposit insurance, mandates the imposition of consolidated capital requirements on savings and loan holding companies, requires originators of securitized loans to retain a percentage of the risk for the transferred loans, establishes rate-setting for certain debit card interchange fees, repeals restrictions on the payment of interest on commercial demand deposits and contains a number of reforms related to mortgage originations. Many of the provisions of the Dodd-Frank Act are subject to delayed effective dates and/or require the issuance of implementing regulations. Their impact on operations cannot yet be fully assessed. However, there is significant possibility that the Dodd-Frank Act will, at a minimum, result in increased regulatory burden, compliance costs and interest expense for Harvard Savings Bank and Harvard Illinois Bancorp, Inc.
Certain regulatory requirements applicable to Harvard Savings Bank and Harvard Illinois Bancorp, Inc. are referred to below or appear elsewhere in this Annual Report on Form 10-K. The regulatory discussion, however, does not purport to be an exhaustive treatment of applicable laws and regulations and is qualified in its entirety be reference to the actual statutes and regulations. Any change in these laws or regulations, whether by the Federal Deposit Insurance Corporation, the Illinois Department of Financial and Professional Regulation, the Office of Thrift Supervision or Congress, could have a material adverse impact on Harvard Illinois Bancorp, Inc. and Harvard Savings Bank, and their operations.
Savings Bank Regulation
As an Illinois savings bank, Harvard Savings Bank is subject to federal regulation and supervision by the Federal Deposit Insurance Corporation and to state regulation and supervision by the Illinois Department of Financial and Professional Regulation. Harvard Savings Bank’s deposit accounts are insured by Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation. Harvard Savings Bank is not a member of the Federal Reserve System.
Both federal and Illinois law extensively regulate various aspects of the banking business such as reserve requirements, truth-in-lending and truth-in-savings disclosures, equal credit opportunity, fair credit reporting, trading in securities and other aspects of banking operations. Current federal law also requires savings banks, among other things, to make deposited funds available within specified time periods.
Under Federal Deposit Insurance Corporation regulations, an insured state-chartered bank, such as Harvard Savings Bank, is prohibited from engaging as principal in activities that are not permitted for national banks, unless: (i) the Federal Deposit Insurance Corporation determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the bank is, and continues to be, in compliance with all applicable capital standards.
Branching and Interstate Banking. The establishment of branches by Harvard Savings Bank is subject to approval of the Illinois Department of Financial and Professional Regulation and Federal Deposit Insurance Corporation and geographic limits established by state laws. Federal law facilitates the interstate expansion and consolidation of banking organizations by permitting, among other things, (i) bank holding companies that are adequately capitalized and managed to acquire banks located in states outside their home state regardless of whether such acquisitions are authorized under the law of the host state, (ii) the interstate merger of banks, subject to the right of individual states to “opt out” of this authority, and (iii) the establishment of de novo branches on an interstate basis provided that the law of the host state authorizes banks chartered by it to similarly branch within its borders.
Qualified Thrift Lender Test. In order for Harvard Illinois Bancorp, Inc. to be regulated as a savings and loan holding company by the Office of Thrift Supervision (rather than as a bank holding company by the Board of Governors of the Federal Reserve System), Harvard Savings Bank must qualify as a “qualified thrift lender” under Office of Thrift Supervision regulations or satisfy the “domestic building and loan association” test under the Internal Revenue Code. Under the qualified thrift lender test, an institution is required to maintain at least 65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) goodwill and other intangible assets; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed and related securities) in at least nine out of each 12 month period. Harvard Savings Bank currently maintains the majority of its portfolio assets in qualified thrift investments and has met the qualified thrift lender test in each of the last 12 months.
Transactions with Related Parties. A savings bank’s authority to engage in transactions with its affiliates is limited by Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated by the Board of Governors of the Federal Reserve System. An affiliate is generally a company that controls, is controlled by, or is under common control with an insured depository institution such as Harvard Savings Bank. Harvard Illinois Bancorp, Inc. is an affiliate of Harvard Savings Bank. In general, transactions between an insured depository institution and its affiliates are subject to certain quantitative and collateral requirements. In addition, applicable regulations prohibit a savings bank from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary. Finally, transactions with affiliates must be consistent with safe and sound banking practices, not involve low-quality assets and be on terms that are as favorable to the institution as comparable transactions with non-affiliates. Applicable regulators require savings banks to maintain detailed records of all transactions with affiliates.
Harvard Savings Bank’s authority to extend credit to its directors, executive officers and 10% or greater stockholders, as well as to entities controlled by such persons, is governed by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O promulgated by the Board of Governors of the Federal Reserve System. Among other things, these provisions require that extensions of credit to insiders:
(i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and
(ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Harvard Savings Bank’s capital.
In addition, extensions of credit in excess of certain limits must be approved in advance by Harvard Savings Bank’s Board of Directors.
Capital Requirements. Under Federal Deposit Insurance Corporation regulations, state-chartered banks, such as Harvard Savings Bank, are required to maintain a minimum leverage capital requirement consisting of a ratio of Tier 1 capital to total assets of 3% if the Federal Deposit Insurance Corporation determines that the institution is not anticipating or experiencing significant growth and has well-diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings, and in general, a strong banking organization, rated composite 1 under the Uniform Financial Institutions Rating System (the CAMELS rating system) established by the Federal Financial Institutions Examination Council. For all but the most highly rated institutions meeting the conditions set forth above, the minimum leverage capital ratio is 4%. Tier 1 capital is the sum of common shareholders’ equity, noncumulative perpetual preferred stock (including any related surplus) and minority interests in consolidated subsidiaries, minus all intangible assets (other than certain mortgage servicing assets, purchased credit card relationships, credit-enhancing interest-only strips and certain deferred tax assets), identified losses, investments in certain financial subsidiaries and non-financial equity investments.
In addition to the leverage capital ratio (the ratio of Tier I capital to total assets), state chartered banks must maintain a minimum ratio of qualifying total capital to risk-weighted assets of at least 8%, of which at least half must be Tier 1 capital. Qualifying total capital consists of Tier 1 capital plus Tier 2 capital (also referred to as supplementary capital) items. Tier 2 capital items include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and preferred stock with a maturity of over 20 years, certain other capital instruments and up to 45% of pre-tax net unrealized holding gains on equity securities. The includable amount of Tier 2 capital cannot exceed the institution’s Tier 1 capital. Qualifying total capital is further reduced by the amount of the bank’s investments in banking and finance subsidiaries that are not consolidated for regulatory capital purposes, reciprocal cross-holdings of capital securities issued by other banks, most intangible assets and certain other deductions. Under the Federal Deposit Insurance Corporation risk-weighted system, all of a bank’s balance sheet assets and the credit equivalent amounts of certain off-balance sheet items are assigned to one of four broad risk-weight categories from 0% to 100%, based on the risks inherent in the type of assets or item. The aggregate dollar amount of each category is multiplied by the risk weight assigned to that category. The sum of these weighted values equals the bank’s risk-weighted assets.
Dividend Limitations. Harvard Illinois Bancorp, Inc. is a legal entity separate and distinct from Harvard Savings Bank. The primary source of Harvard Illinois Bancorp, Inc.’s cash flow, including cash flow to pay dividends on Harvard Illinois Bancorp, Inc.’s common stock, is the payment of dividends to
Harvard Illinois Bancorp, Inc. by Harvard Savings Bank. Under Illinois law, Harvard Savings Bank may pay dividends of so much of its undivided profits (generally, earnings less losses, bad debts, taxes and other operating expenses) as is considered expedient by Harvard Savings Bank’s board. However, Harvard Savings Bank must obtain the approval of the Illinois Department of Financial and Professional Regulation for the payment of a dividend if the total of all dividends declared by Harvard Savings Bank during the current year, including the proposed dividend, would exceed the sum of retained net income for the year to date plus its retained net income for the previous two years. For this purpose, “retained net income” means net income as calculated for call report purposes, less all dividends declared for the applicable period. Also, the Federal Deposit Insurance Corporation has the supervisory authority to prohibit Harvard Savings Bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound banking practice in light of the financial condition of Harvard Savings Bank. In addition, since Harvard Savings Bank is a subsidiary of a savings and loan holding company, Harvard Savings Bank must file a notice with the Office of Thrift Supervision at least 30 days before the board declares a dividend or approves a capital distribution.
Insurance of Deposit Accounts. Deposit accounts in Harvard Savings Bank are insured by the Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation. In view of the recent economic crisis, the Federal Deposit Insurance Corporation temporarily increased the general individual deposit insurance available on deposit accounts from $100,000 to $250,000. The Dodd-Frank Act made that level of coverage permanent. In addition, pursuant to a provision of the Dodd-Frank Act, certain non-interest-bearing transaction accounts are fully insured, regardless of the dollar amount, until December 31, 2012.
The Federal Deposit Insurance Corporation imposes an assessment for deposit insurance against all depository institutions. That assessment is based on the risk presented by the institution to the Deposit Insurance Fund, as measured by the FDIC’s assessment system. The FDIC first establishes an institution’s initial base assessment rate. That initial base assessment rate ranges, depending on the risk category of the institution, from 12 to 45 basis points. The FDIC then adjusts the initial base assessment (higher or lower) to obtain the total base assessment rate. The adjustments to the initial base assessment rate are based upon an institution’s levels of unsecured debt, secured liabilities and brokered deposits. The total adjusted assessment rate ranges from 7 to 77.5 basis points of the institution’s assessable deposits.
On May 22, 2009, in view of stress on the Deposit Insurance Fund, the Federal Deposit Insurance Corporation issued a final rule that imposed a special five basis point assessment on each FDIC-insured depository institution’s assets, minus its Tier 1 capital, on June 30, 2009. That was collected on September 30, 2009. The special assessment was capped at 10 basis points of an institution’s domestic deposits.
The Federal Deposit Insurance Corporation also adopted a rule pursuant to which all insured depository institutions were required to prepay their estimated assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012. That pre-payment, which was due on December 30, 2009, amounted to $773,000 for Harvard Savings Bank. The assessment rate for the fourth quarter of 2009 and for 2010 was based on each institution’s total base assessment rate for the third quarter of 2009, modified to assume that the assessment rate in effect on September 30, 2009 had been in effect for the entire third quarter. The assessment rate for 2011 and 2012 was assumed to have increased an additional three basis points. In addition, a deposit institution’s assessment for each period was calculated using its third quarter assessment base, adjusted quarterly for an estimated 5% annual growth rate through the end of 2012. The pre-payment has been recorded as a prepaid expense at December 31, 2009 and will be amortized to expense as used.
Most recently, the Dodd-Frank Act required the Federal Deposit Insurance Corporation to revise its assessment procedures to base it on average total assets less tangible capital, rather than deposits. The FDIC has issued a final rule that will implement that directive effective April 1, 2011.
The Dodd-Frank Act increased the minimum target Deposit Insurance Fund ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The Federal Deposit Insurance Corporation must seek to achieve the 1.35% ratio by September 30, 2020. Insured institutions with assets of $10 billion or more are supposed to fund that increase. The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the Federal Deposit Insurance Corporation. The Federal Deposit Insurance Corporation has recently exercised that discretion by establishing a long range fund ratio of 2%.
Insurance of deposits may be terminated by the Federal Deposit Insurance Corporation upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the Federal Deposit Insurance Corporation. We do not currently know of any practice, condition or violation that might lead to termination of our deposit insurance.
In addition to the Federal Deposit Insurance Corporation assessments, the Financing Corporation (“FICO”) is authorized to impose and collect, with the approval of the Federal Deposit Insurance Corporation, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. The bonds issued by the FICO are due to mature in 2017 through 2019. For the quarter ended December 31, 2010, the annualized FICO assessment was equal to 1.02 basis points for each $100 in domestic deposits maintained at an institution.
Temporary Liquidity Guarantee Program. On October 14, 2008, the Federal Deposit Insurance Corporation announced a new program - the Temporary Liquidity Guarantee Program. This program had two components. One guaranteed newly issued senior unsecured debt of a participating organization, up to certain limits established for each institution, issued between October 14, 2008 and June 30, 2009, later extended until October 31, 2009. The Federal Deposit Insurance Corporation would pay the unpaid principal and interest on a Federal Deposit Insurance Corporation-guaranteed debt instrument upon the uncured failure of the participating entity to make a timely payment of principal or interest in accordance with the terms of the instrument. The guarantee will remain in effect until no later than December 31, 2012. In return for the Federal Deposit Insurance Corporation’s guarantee, participating institutions will pay the Federal Deposit Insurance Corporation a fee based on the amount and maturity of the debt. We opted to participate in this component of the Temporary Liquidity Guarantee Program.
The other component of the program provided full federal deposit insurance coverage for non-interest bearing transaction deposit accounts, regardless of dollar amount, until December 31, 2009, later extended until December 31, 2010. A fee was charged for that coverage. We opted to participate in this component of the Temporary Liquidity Guarantee Program. The Dodd-Frank Act extended unlimited coverage for certain non-interest bearing transaction accounts from January 1, 2011 through December 31, 2012. There is no opportunity to opt out of that extension and the cost of the unlimited coverage is part of the usual deposit insurance assessment.
Federal Home Loan Bank System. Harvard Savings Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions as well as other entities involved in home mortgage lending. As a member of the Federal Home Loan Bank of Chicago, Harvard Savings Bank is required to acquire and hold shares of capital stock in the Federal Home Loan Bank. As of December 31, 2010, Harvard Savings Bank was in compliance with this requirement.
Community Reinvestment Act. Under the Community Reinvestment Act (“CRA”), Harvard Savings Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the Federal Deposit Insurance Corporation in connection with its examination of Harvard Savings Bank, to assess its record of meeting the credit needs of its community and to take that record into account in its evaluation of certain applications by Harvard Savings Bank. For example, the regulations specify that a bank’s CRA performance will be considered in its expansion (e.g., branching) proposals and may be the basis for approving, denying or conditioning the approval of an application. As of the date of its most recent regulatory examination, Harvard Savings Bank was rated “satisfactory” with respect to its CRA compliance.
Prompt Corrective Regulatory Action. The Federal Deposit Insurance Corporation Improvement Act requires, among other things, that federal bank regulatory authorities take “prompt corrective action” with respect to institutions that do not meet minimum capital requirements. For these purposes, the statute establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.
The Federal Deposit Insurance Corporation may order savings banks that have insufficient capital to take corrective actions. For example, a savings bank that is categorized as “undercapitalized” would be subject to growth limitations, could generally not make capital distributions, including paying dividends, and would be required to submit a capital restoration plan, and a holding company that controls such a savings bank would be required to guarantee that the savings bank complies with the restoration plan. A “significantly undercapitalized” savings bank would be subject to additional restrictions. Savings banks deemed by the Federal Deposit Insurance Corporation to be “critically undercapitalized” would be subject to the appointment of a receiver or conservator.
Harvard Savings Bank is “well capitalized” under the prompt corrective action rules.
Other Regulations
Interest and other charges collected or contracted for by Harvard Savings Bank are subject to state usury laws and federal laws concerning interest rates. Harvard Savings Bank’s operations are also subject to federal and state laws applicable to credit transactions, such as the:
•
Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
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Home Mortgage Disclosure Act, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
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Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
•
Fair Credit Reporting Act, governing the use and provision of information to credit reporting agencies;
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Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;
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Truth in Savings Act;
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Illinois High Risk Home Loan Act, which protects borrowers who enter into high risk home loans;
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Illinois Predatory Lending Database Program, which helps provide counseling for homebuyers in connection with certain loans; and
•
rules and regulations of the various federal and state agencies charged with the responsibility of implementing such laws.
The operations of Harvard Savings Bank also are subject to the:
•
Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;
•
Electronic Funds Transfer Act and Regulation E promulgated thereunder, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services;
•
Check Clearing for the 21st Century Act (also known as “Check 21”), which gives “substitute checks,” such as digital check images and copies made from that image, the same legal standing as the original paper check;
•
The USA PATRIOT Act, which requires savings banks operating to, among other things, establish broadened anti-money laundering compliance programs, due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements, also applicable to financial institutions, under the Bank Secrecy Act and the Office of Foreign Assets Control regulations; and
•
The Gramm-Leach-Bliley Act, which places limitations on the sharing of consumer financial information by financial institutions with unaffiliated third parties. Specifically, the Gramm-Leach-Bliley Act requires all financial institutions offering financial products or services to retail customers to provide such customers with the financial institution’s privacy policy and provide such customers the opportunity to “opt out” of the sharing of certain personal financial information with unaffiliated third parties.
Holding Company Regulation
General. Harvard Illinois Bancorp, Inc. is a non-diversified unitary savings and loan holding company within the meaning of the Home Owners’ Loan Act. As such, Harvard Illinois Bancorp, Inc. is registered with the Office of Thrift Supervision and subject to Office of Thrift Supervision regulations, examinations, supervision and reporting requirements. In addition, the Office of Thrift Supervision has enforcement authority over Harvard Illinois Bancorp, Inc. and its subsidiaries. Among other things, this authority permits the Office of Thrift Supervision to restrict or prohibit activities that are determined to be
a serious risk to the subsidiary savings institution. The Dodd-Frank Act transfers to the Federal Reserve Board the responsibility for regulating and supervising savings and loan holding companies. The Federal Reserve Board will assume that responsibility on July 21, 2011 (subject to a possible six-month extension).
Permissible Activities. Under present law, the business activities of Harvard Illinois Bancorp, Inc. are generally limited to those activities permissible for financial holding companies under Section 4(k) of the Bank Holding Company Act of 1956, as amended, or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance as well as activities that are incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the Office of Thrift Supervision, and certain additional activities authorized by Office of Thrift Supervision regulations.
Federal law prohibits a savings and loan holding company, including Harvard Illinois Bancorp, Inc., directly or indirectly, or through one or more subsidiaries, from acquiring more than 5% of another savings institution or holding company thereof, without prior written approval of the Office of Thrift Supervision. It also prohibits the acquisition or retention of, with certain exceptions, more than 5% of a nonsubsidiary company engaged in activities that are not closely related to banking or financial in nature, or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the Office of Thrift Supervision must consider the financial and managerial resources, future prospects of the company and institution involved, the effect of the acquisition on the risk to the federal deposit insurance fund, the convenience and needs of the community and competitive factors.
The Office of Thrift Supervision is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions:
(i) the approval of interstate supervisory acquisitions by savings and loan holding companies; and
(ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisition.
The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.
Savings and loan holding companies are not currently subject to specific regulatory capital requirements. The Dodd-Frank Act, however, requires the promulgation of consolidated capital requirements for depository institution holding companies that are no less stringent, both quantitatively and in terms of components of capital, than those applicable to institutions themselves. That will eliminate the inclusion of certain instruments from tier 1 capital that are currently includable for bank holding companies, such as trust preferred securities. Instruments issued before May 19, 2010, by holding companies with fewer than $15 billion in total assets on December 3, 2009 are grandfathered. There is a five year transition period from the July 21, 2010 date of enactment of the Dodd-Frank Act before the capital requirements will apply to savings and loan holding companies.
Federal Securities Laws
Our common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. We are subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.
The registration under the Securities Act of 1933 of shares of common stock issued in the recent stock offering does not cover the resale of those shares. Shares of common stock purchased by persons who are not our affiliates may be resold without registration. Shares purchased by our affiliates will be subject to the resale restrictions of Rule 144 under the Securities Act of 1933. If we meet the current public information requirements of Rule 144 under the Securities Act of 1933, each affiliate of ours that complies with the other conditions of Rule 144, including those that require the affiliate’s sale to be aggregated with those of other persons, would be able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of 1% of our outstanding shares, or the average weekly volume of trading in the shares during the preceding four calendar weeks. In the future, we may permit affiliates to have their shares registered for sale under the Securities Act of 1933.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. As directed by the Sarbanes-Oxley Act, our Chief Executive Officer and Chief Financial Officer will be required to certify that our quarterly and annual reports do not contain any untrue statement of a material fact. The rules adopted by the Securities and Exchange Commission under the Sarbanes-Oxley Act have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of our internal control over financial reporting; they have made certain disclosures to our auditors and the audit committee of the Board of Directors about our internal control over financial reporting; and they have included information in our quarterly and annual reports about their evaluation and whether there have been changes in our internal control over financial reporting or in other factors that could materially affect internal control over financial reporting.
TAXATION
Federal Taxation
General. Harvard Illinois Bancorp, Inc. and Harvard Savings Bank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize material federal income tax matters and is not a comprehensive description of the tax rules applicable to Harvard Illinois Bancorp, Inc. and Harvard Savings Bank.
Method of Accounting. For federal income tax purposes, we currently report our income and expenses on the accrual method of accounting and use a tax year ending December 31st for filing our consolidated federal income tax returns. The Small Business Protection Act of 1996 eliminated the use of the reserve method of accounting for bad debt reserves by savings institutions, effective for taxable years beginning after 1995.
Minimum Tax. The Internal Revenue Code of 1986, as amended, imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences, referred to as “alternative minimum taxable income.” The alternative minimum tax is payable to the extent alternative minimum taxable income is in excess of an exemption amount. Net operating losses can, in
general, offset no more than 90% of alternative minimum taxable income. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. At December 31, 2010, we had approximately $28,000 in minimum tax credit carryforwards.
Net Operating Loss Carryovers. We may carry back net operating losses to the preceding five taxable years, with certain limits in the fifth year, and forward to the succeeding 20 taxable years. At December 31, 2010, we had net operating loss carryforwards for federal income tax purposes totaling $1.1 million which expire in varying amounts between 2024 and 2029.
General Business Tax Credit Carryover. We have an unused general business tax credit carryover of approximately $13,000 related to $1 million of qualifying expenditures from the rehabilitation of our home office in 2008. The general business tax credit carryover may be used to offset regular tax liabilities in future years, and has no expiration date.
Corporate Dividends. We may exclude from our income 100% of dividends received from Harvard Savings Bank as a member of the same affiliated group of corporations.
Audit of Tax Returns. Our federal income tax returns have not been audited in the most recent five-year period.
State Taxation
Illinois State Taxation. We are required to file Illinois income tax returns and pay tax at a stated tax rate of 7.30% of Illinois taxable income. The tax rate has been raised to 9.5% for 2011. For these purposes, Illinois taxable income generally means federal taxable income subject to certain modifications, primarily the exclusion of interest income on United States obligations. As of December 31, 2010, we have net operating losses of approximately $3.4 million that are being carried forward and available to reduce future taxable income. These carryforwards expire beginning 2015 through 2021. In 2011, the use of these net operating losses has been suspended for calendar years 2011-2013. Management has not recorded a deferred tax asset for the State portion of its net operating loss carryforwards.
Personnel
As of December 31, 2010, we had 33 full-time equivalent employees. Our employees are not represented by any collective bargaining group. Management believes that we have good relations with our employees.
Availability of Annual Report on Form 10-K
This Annual Report on Form 10-K is available on our website at www.harvardsavingsbank.com. Information on the website is not incorporated into, and is not otherwise considered a part of, this Annual Report on Form 10-K.
ITEM 1A.
ITEM 1A. Risk Factors
The presentation of Risk Factors is not required for smaller reporting companies like Harvard Illinois Bancorp, Inc.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments
Not applicable.
ITEM 2.
ITEM 2. Properties
As of December 31, 2010, the net book value of our office properties was $3.4 million. The following table sets forth information regarding our offices.
We believe that our current facilities are adequate to meet our present and foreseeable needs, subject to possible future expansion.
ITEM 3.
ITEM 3. Legal Proceedings
At December 31, 2010, we were not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business which, in the aggregate, involve amounts which management believes will not materially adversely affect our financial condition, our results of operations and our cash flows.
ITEM 4.
ITEM 4. Reserved.
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
(a) Market, Holder and Dividend Information. Our common stock is traded on the OTC Bulletin Board under the symbol “HARI.” The approximate number of holders of record of Harvard Illinois Bancorp, Inc.’s common stock as of March 17, 2011, was 294. Certain shares of Harvard Illinois Bancorp, Inc. are held in “nominee” or “street” name and accordingly, the number of beneficial owners of such shares is not known or included in the foregoing number. Shares of Harvard Illinois Bancorp, Inc. common stock did not begin trading until April 9, 2010.
Harvard Illinois Bancorp, Inc. does not currently pay cash dividends on its common stock. Dividend payments by Harvard Illinois Bancorp, Inc. are dependent on dividends it receives from Harvard Savings Bank, because Harvard Illinois Bancorp, Inc. has no source of income other than dividends from Harvard Savings Bank, earnings from the investment of proceeds from the sale of shares of common stock retained by Harvard Illinois Bancorp, Inc. and interest payments with respect to Harvard Illinois Bancorp, Inc.’s loan to the Employee Stock Ownership Plan. See “Item 1. Business-Supervision and Regulation-Federal Banking Regulation-Capital Distributions.”
(b) Sales of Unregistered Securities. Not applicable.
(c) Use of Proceeds. On July 23, 2009, the Board of Directors of Harvard Savings, MHC adopted a plan of conversion and reorganization, pursuant to which Harvard Savings, MHC would convert from the mutual to the stock form of ownership, and Harvard Illinois Bancorp, Inc. would sell shares of common stock to the public. On September 15, 2009, Harvard Illinois Bancorp, Inc. filed a Registration Statement on Form S-1 with the Securities and Exchange Commission (File No. 333-161931) with respect to the shares to be offered and sold pursuant to the stock issuance plan. Harvard Illinois Bancorp, Inc. registered for offer and sale 1,256,375 shares of common stock, par value $0.01 per share, at a sales price of $10.00 per share. The registration statement was declared effective by the Securities and Exchange Commission on February 12, 2010.
The public stock offering closed on April 8, 2010, and on April 9, 2010 the common stock began trading on the OTC Bulletin Board under the symbol “HARI.”
In accordance with the plan of conversion and pursuant to the registration statement, the shares of common stock were offered to eligible depositors of Harvard Savings Bank and certain borrowers of Morris Building & Loan, s.b., Harvard Savings Bank’s employee stock ownership plan and members of the general public. Keefe, Bruyette & Woods, Inc. was engaged to assist in the marketing of the common stock. For their services, Keefe, Bruyette & Woods, Inc. received a management fee of $30,000 and a success fee of $140,000 for shares sold in the subscription offering, excluding shares sold to the employee stock ownership plan, the 401(k) plan and to our officers, employees and directors and members of their immediate families. In addition, Keefe, Bruyette & Woods, Inc. received a success fee of 2.5% of the dollar amount of the shares sold in the community offering, with the total success fee capped at $180,000. The success fee was reduced by the management fee.
The stock offering resulted in gross proceeds of $7,846,890 through the sale of 784,689 shares at $10.00 per share. Expenses related to the offering were approximately $1.0 million, including a fee of $180,000 paid to Keefe, Bruyette & Woods, Inc. Harvard Illinois Bancorp, Inc. received net proceeds from the initial public offering of $6.8 million and loaned $627,750 to Harvard Savings Bank’s employee stock ownership plan to enable it to purchase 62,775 shares of common stock in the offering. The remaining net proceeds were $6.2 million, of which $6.0 million was contributed to Harvard Savings Bank in the form of additional paid in capital, and the remainder has been retained by Harvard Illinois Bancorp, Inc. to be utilized for general corporate purposes.
(d) Securities Authorized for Issuance Under Equity Compensation Plans. See “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
(e) Stock Repurchases. Not applicable.
(f) Stock Performance Graph. Not required for smaller reporting companies.
ITEM 6.
ITEM 6. Selected Financial Data
Not required for smaller reporting companies.
ITEM 7.
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Harvard Illinois Bancorp, Inc. (Company) is a savings and loan holding company and is subject to regulation by the Office of Thrift Supervision. The Company’s business activities are limited to oversight of its investment in Harvard Savings Bank (Bank).
The Bank is primarily engaged in providing a full range of banking and mortgage services to consumer and business customers in McHenry, Grundy, and to a lesser extent Boone counties, Illinois and Walworth County in Wisconsin. The Bank is subject to regulation by the Federal Deposit Insurance Corporation and the Illinois Department of Financial and Professional Regulation.
On April 8, 2010, the Company reorganized from a two-tier mutual holding company to a stock holding company and completed its initial public offering. A total of 784,689 shares, par value of $0.01 per share, were sold at $10 per share, raising $6.8 million of proceeds, net of conversion expenses. The Company established an employee stock ownership plan that purchased 8% of the total shares, or a total of 62,775 shares in the offering, for a total of $627,750. The Company’s common stock began trading on the over-the-counter market under the symbol “HARI” on April 9, 2010.
Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of loans, investment securities and other interest-earning assets, and the interest paid on our interest-bearing liabilities, consisting primarily of savings and transaction accounts, certificates of deposit, and Federal Home Loan Bank of Chicago advances. Our results of operations also are affected by our provision for loan losses, noninterest income and noninterest expense. Noninterest income consists primarily of customer service fees, brokerage commission income, net realized gains on loan sales, loan servicing fees, and net income on bank-owned life insurance, offset by impairment charges on securities. Noninterest expense consists primarily of compensation and benefits, occupancy, data processing, professional fees, marketing, office supplies, federal deposit insurance premiums, indirect automobile servicing fees, and foreclosed assets. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
During recent years, in order to reduce our vulnerability to changes in interest rates and enhance our net interest spread, we increased our originations and purchases of commercial real estate and commercial and industrial loans, purchased indirect automobile loans, sold most of our fixed rate one- to four-family loan production, and increased our core deposits (which we consider to be deposits other than certificates of deposit). In connection with the continued execution of our business strategy, we hired a commercial loan officer with over 20 years of agricultural and commercial lending experience in the Harvard community, in December 2009. With this hire, we have increased our origination of agricultural operating lines of credit and intermediate-term loans, and real estate loans for the purchase of farmland in our market area. Agricultural loans totaled $17.4 million or 15.1% of total loans at December 31, 2010, compared to $1.2 million or 1.1% of total loans at December 31, 2009.
As further discussed in Note 20 to the financial statements included herein, the Company entered into a memorandum of understanding (the “MOU”) with the Office of Thrift Supervision (the “OTS”). Among other provisions, this informal enforcement action prohibits the Company from declaring or paying dividends, or repurchasing any Company stock without the prior written non-objection of the OTS. The Company has taken the relevant actions to comply with the terms of the agreement and believes it will be able to maintain compliance. The requirements of the MOU will remain in effect until the OTS decides to terminate, suspend or modify it.
Our net income for the year ended December 31, 2010 was $149,000, compared to our net loss of $262,000 for the year ended December 31, 2009. The increase in net income was due to an increase in net interest income and a decrease in the provision for loan losses, partially offset by decreases in noninterest income and the benefit for income taxes, and an increase in noninterest expense.
The national economy, and the local economies within our market areas, remain weak. The economy has been marked by high unemployment rates, rising numbers of foreclosures, and contractions in business and consumer credit. The national and local unemployment rates have shown some improvement in 2010, but remain high. These conditions have had a significant negative impact on real estate and related industries, which has led to decreases in commercial and residential real estate sales, construction and property values. We have experienced high levels of non-performing loans and net charge-offs. At December 31, 2010, non-performing loans, including troubled debt restructurings, represented 2.77% of total loans, compared to 2.95% at December 31, 2009. Net charge-offs to average loans were 0.38% in 2010 and 0.63% in 2009. The higher levels of non-performing loans, including troubled debt restructurings, and net charge-offs has resulted in provisions for loan losses of $904,000 and $1.1 million for the years ended December 31, 2010 and 2009, respectively.
Should the housing market and economic conditions in our market area stagnate or continue to deteriorate, it will continue to have a material negative effect on the Company’s business and results of operation.
At December 31, 2010, the Bank was categorized as “well capitalized” under regulatory capital requirements.
Critical Accounting Policies and Use of Significant Estimates
In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in preparing our financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ significantly from those estimates under different assumptions and conditions. Management believes the following discussion addresses our most critical accounting policies and significant estimates, which are those that are most important to the portrayal of our financial condition and results and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
Allowance for Loan Losses. Our allowance for loan losses is the estimated amount considered necessary to reflect probable incurred credit losses in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged against income. In determining the allowance for loan losses, management makes significant estimates and has identified this policy as one of the most critical for the Company. The methodology for determining the allowance for loan losses is considered a critical accounting policy by management due to the high degree of judgment involved, the subjectivity of the assumptions utilized, and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses.
Since a substantial amount of our loan portfolio is collateralized by real estate, appraisals of the underlying value of property securing loans and discounted cash flow valuations of properties are critical in determining the amount of the allowance required for specific loans. Assumptions for appraisals and discounted cash flow valuations are instrumental in determining the value of properties. Overly
optimistic assumptions or negative changes to assumptions could significantly impact the valuation of a property securing a loan and the related allowance determined. The assumptions supporting such appraisals and discounted cash flow valuations are carefully reviewed by management to determine that the resulting values reasonably reflect amounts realizable on the related loans.
Management performs a quarterly evaluation of the allowance for loan losses. Consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the value of the underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision based on changes in economic and real estate market conditions.
The analysis of the allowance for loan losses has two components: specific and general allocations. Specific allocations are made for loans that are determined to be impaired. Impairment loss is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. The general allocation is determined by segregating classified loans from the remaining loans, and then categorizing each group by type of loan. Loans within each type exhibit common characteristics including terms, collateral type, and other risk characteristics. We also analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general allocations. The Illinois Department of Financial and Professional Regulation and the Federal Deposit Insurance Corporation require the recognition of adjustments to the allowance for loan losses based on their judgment of information available to them at the time of their examinations. Actual loan losses may be significantly more than the allowance for loan losses we have established, which could have a material negative effect on our financial results.
Other Real Estate Owned. Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the property is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a charge to operations through noninterest expense is recorded. Operating costs associated with the asset after acquisition are also recorded as noninterest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other noninterest expense.
Deferred Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance is established. These judgments and estimates are reviewed on a continual basis as regulatory and business factors change.
Additionally, we review our uncertain tax positions annually. An uncertain tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. A significant amount of
judgment is applied to determine both whether the tax position meets the “more likely than not” test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.
Comparison of Financial Condition at December 31, 2010 and December 31, 2009
Assets. Total assets at December 31, 2010 increased $10.2 million or 6.5% to $167.8 million from $157.6 million at December 31, 2009. Cash and cash equivalents increased $2.6 million to $18.0 million at December 31, 2010 from $15.4 million at December 31, 2009. Cash and cash equivalents includes securities purchased under agreements to resell which increased $2.1 million to $13.9 million at December 31, 2010 from $11.8 million at December 31, 2009. These agreements represent short-term cash investment alternatives that are over-collateralized with collateral that is guaranteed by the “full faith and credit” of the United States government. Interest-bearing deposits increased $2.7 million to $10.8 million at December 31, 2010 from $8.1 million at December 31, 2009. These deposits are certificates of deposit we have placed with other financial institutions with terms from three months to four years; all are fully covered by FDIC insurance. Available-for-sale securities increased $1.8 million to $5.0 million at December 31, 2010 from $3.2 million at December 31, 2009. This increase was primarily due to $6.8 million in purchases of U.S. government and federal agency debt securities, offset by pay-downs, maturities and sales of $5.0 million on those securities. Held-to-maturity securities totaled $2.5 million at December 31, 2010, a decrease of $1.3 million from $3.8 million at December 31, 2009 as a result of $1.3 million in maturities and pay-downs on those securities and no purchases. The investment in those deposits and securities were based on liquidity and yield considerations. This investment as well as loan growth in 2010 was funded primarily by the $8.3 million increase in deposits during the year and the $6.2 million in proceeds, net of conversion expenses and the ESOP, from the issuance of common stock in our initial public offering completed April 8, 2010.
The net loan portfolio increased $4.3 million or 3.9% to $113.2 million at December 31, 2010 from $108.9 million at December 31, 2009. In 2010, loan originations, advances and purchases were $54.2 million, which were offset by $22.1 million in loans sold, $26.1 million of loan repayments and payoffs, net of $506,000 in charge offs, a net increase in allowance for loan losses of $447,000 and transfers to foreclosed assets of $774,000. The increase in loans during 2010 was due primarily to increases of $13.0 million, $3.2 million and $6.6 million in the agriculture, farmland and commercial real estate loan portfolios, respectively. This activity reflects the Company’s strategy to reduce asset duration and loan concentrations by expanding our commercial and agriculture lending activity to enhance yields and reduce concentrations in our residential mortgage and purchased indirect automobile loan portfolios. The Company hired an experienced agriculture lender in December 2009. Substantially all the commercial and agriculture loan activity during 2010 were loans in our market area. These increases were offset primarily by decreases in total one- to four-family loans of $8.2 million and purchased indirect automobile loans, net of dealer reserve, of $5.1 million. The decrease in our one- to four-family loans during 2010 was primarily due to repayments, early payoffs and $18.8 million in loans sold to Fannie Mae from refinancing activity, which generated $213,000 in net gains on loan sales, offset by loan originations of $21.1 million. The decrease in the one- to four-family loan portfolio reflects our strategy to sell substantially all our conforming one-to four-family loans based on yield and duration considerations. Our portfolio of one- to four-family loans serviced for others increased $6.0 million or 10.1% to $65.2 million at December 31, 2010 from $59.2 million at December 31, 2009. The decrease in our purchased indirect automobile loan portfolio in 2010 was primarily due to normal amortization, payoffs, and our strategy to reduce our concentration in purchased indirect automobile loans under current market conditions.
All other assets, consisting of premises and equipment, Federal Home Loan Bank stock, foreclosed assets held for sale, accrued interest receivable, deferred income taxes, bank-owned life insurance, mortgage servicing rights and other increased $74,000 to $18.3 million at December 31, 2010 from $18.2 million at December 31, 2009. The largest component of other assets was our investment in Federal Home Loan Bank stock, which was unchanged at $6.5 million at December 31, 2010. The largest change was in other assets, which decreased $716,000 to $664,000 at December 31, 2010, and was primarily due to $548,000 in expenses advanced in 2009 by Harvard Savings Bank for the Company’s initial public offering. Deferred income taxes increased $48,000 to $1.3 million at December 31, 2010 from $1.2 million at December 31, 2009. At December 31, 2010, the Company’s deferred tax asset relating to unused capital loss carryovers and unrealized capital losses on other than temporary impairment of equity securities totaled $540,000. Management has established a valuation allowance for portions of that deferred tax asset of $496,000 at December 31, 2010, an increase of $6,000 over the December 31, 2009 balance of $490,000.
Liabilities. Deposits increased $8.3 million or 6.6% to $132.6 million at December 31, 2010 from $124.4 million at December 31, 2009. Certificates of deposit, excluding brokered certificates increased $8.4 million or 11.9% to $79.0 million at December 31, 2010 from $70.6 million at December 31, 2009. Savings, NOW and money market accounts totaled $47.9 million at December 31, 2010 compared to $47.0 million at December 31, 2009, an increase of $890,000 or 1.9%. These increases were due to competitive pricing and promotional interest rates offered during 2010 to generate more liquidity to fund our operations in the current interest rate environment, and lessen our reliance on borrowed funds while still managing interest rate risk. Federal Home Loan Bank advances decreased to $13.7 million from $18.1 million at December 31, 2010 from December 31, 2009, a decrease of $4.4 million or 24.3%. The Bank maintained sufficient liquidity levels to allow these advances to mature without renewal. Non-interest bearing liabilities increased $85,000 to $2.9 million at December 31, 2010 from $2.8 million. The largest component of non-interest bearing liabilities is deferred compensation which increased $75,000 in 2010 to $2.2 million at December 31, 2010.
Stockholders’ Equity. Total stockholders’ equity increased by $6.3 million or 51.2% to $18.6 million at December 31, 2010 from $12.3 million at December 31, 2009. The increase largely resulted from the $6.2 million in net cash proceeds on the sale of our common stock in 2010, and net income of $149,000 for the year ended December 31, 2010, partially offset by a decrease in accumulated other comprehensive income in 2010 of $69,000 to a loss of $4,000 at December 31, 2010.
Comparison of Operating Results for the Years Ended December 31, 2010 and December 31, 2009
General. Net income for the year ended December 31, 2010 was $149,000, compared to a net loss of $(262,000) for the year ended December 31, 2009, an increase of $411,000. This increase in net income was due to an increase in net interest income of $651,000 and a decrease in the provision for loan losses of $243,000, partially offset by decreases in noninterest income of $94,000 and the benefit for income taxes of $151,000 and an increase in noninterest expense of $238,000.
Interest and Dividend Income. Total interest and dividend income decreased $172,000 or 2.2% to $7.7 million for the year ended December 31, 2010 from $7.9 million for the same period in 2009. Average interest-earning assets increased $3.0 million to $152.2 million for the year ended December 31, 2010 from $149.2 million in 2009, was more than offset by the average yield which decreased 22 basis points to 5.09% from 5.31%. The decrease in market interest rates during 2010 contributed to the downward re-pricing of a portion of our existing assets and lower rates for new assets. Interest and fees on loans increased $83,000 in 2010 as the average balance of loans, which increased $5.4 million to $120.3 million primarily due to agricultural lending activity, more than offset the impact of the average yield on loans, which decreased 21 basis points to 5.97% from 6.18%. The lower average yield on our
loan portfolio reflected the impact of decreases in market interest rates on our adjustable-rate loan products, as well as decreased rates on newly originated loans with interest rates based on lower market interest rates.
Interest income on securities and other interest-earning assets decreased $255,000 for the year ended December 31, 2010 compared to the year ago period as average balances decreased $2.4 million to $31.9 million, as the Company generated liquidity to fund loans and reduce advances from the Federal Home Loan Bank during the period, and the average yield on those assets decreased 62 basis points to 1.75% from 2.37%, due to the lower interest rate environment. In 2007, the Federal Home Loan Bank of Chicago suspended paying dividends on its common stock, resulting in no dividend income on our $6.5 million investment in that stock for the years ended December 31, 2010 and 2009.
Interest Expense. Total interest expense decreased $823,000 or 21.6% to $3.0 million for the year ended December 31, 2010 from $3.8 million for the same period in 2009. Interest expense on deposit accounts decreased $537,000 or 18.5% to $2.4 million for the year ended December 31, 2010 from $2.9 million for the same period in 2009. This decrease was primarily due to a decrease in interest expense on certificates of deposit and brokered certificate accounts of $281,000 during the period while interest expense on savings, NOW and money market accounts decreased $256,000. Average savings, NOW and money market accounts decreased $2.5 million to $46.2 million while the cost of these deposits decreased 50 basis points to 0.48% during the year ended December 31, 2010 from the same period in 2009. The average balance in certificates of deposits and brokered certificates of deposit increased $6.2 million to $77.5 million between the years ended December 31, 2010 and 2009, respectively, while the cost of these deposits decreased 64 basis points to 2.77% during the same periods. The movement in deposit accounts was the result of our competitive pricing and promotional events pricing to increase our liquidity while decreasing our utilization of Federal Home Loan Bank advances. Interest expense on Federal Home Loan Bank advances decreased $286,000 or 31.6% to $620,000 for the year ended December 31, 2010 from $906,000 for the year ended December 31, 2009. The average balance of the advances decreased $5.1 million to $16.5 million for the year ended December 31, 2010 from the comparable period in 2009, while the average cost of the advances decreased 44 basis points to 3.75%. The decrease in the average balance of advances was due to adhering to our capital and liquidity plans to lessen our reliance on advances. The decrease in the cost of these funds reflected the re-pricing in response to interest rate cuts initiated by the Federal Reserve Board during 2009 and the lower market interest rates resulting from such cuts.
Net Interest Income. Net interest income increased $651,000 or 15.9% to $4.8 million for the year ended December 31, 2010 from $4.1 million for the year ended December 31, 2009, primarily as a result of an increase in our net interest rate spread of 34 basis points to 2.96% from 2.62%. The ratio of our average interest-earning assets to average interest-bearing liabilities increased to 108.52% for the year ended December 31, 2010 from 105.28% for the same period in 2009. Our net interest margin also increased 37 basis points to 3.12% in 2010 from 2.75% in 2009. The increases in our net interest rate spread and net interest margin was primarily due to the re-pricing of all deposit products at lower interest rates.
Provision for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when we believe the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
We evaluate the allowance for loan losses on a regular basis and the provision is based upon our periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. The factors we considered in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. We determine the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial loans by either the present value of expected future cash flows discounted at the loans effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent.
Groups of loans with similar loan characteristics, including individually evaluated loans not determined to be impaired, are collectively evaluated for impairment based on the group’s historical loss experience adjusted for changes in trends, conditions and other relevant factors that affect repayment of the loans. Accordingly, we do not separately identify individual consumer and residential loans for impairment measurements.
Based upon our evaluation of these factors, a provision of $904,000 was recorded for the year ended December 31, 2010, a decrease of $243,000 or 21.2% from $1.1 million for the year ended December 31, 2009. The provision for loan losses reflected net charge offs of $457,000 for the year ended December 31, 2010, compared to $721,000 for the year ended December 31, 2009. The allowance for loan losses was $1.9 million, or 1.63% of total loans at December 31, 2010, compared to $1.4 million, or 1.29% of total loans at December 31, 2009. At December 31, 2010, we had identified substandard loans totaling $3.3 million, all of which were considered impaired, and established an allowance for loan losses of $577,000. At December 31, 2009, we considered all substandard loans totaling $3.8 million to be impaired and established an allowance for loan losses of $431,000. Impaired loans were significantly impacted by declining real estate values collateralizing these loans.
We used the same methodology in assessing the allowance for each period. We increased the impact of qualitative factors to reflect continued weakness in the economy and declining real estate values during 2010, which resulted in an increase in the general allowance for loan losses for most loan categories. For real estate loans secured by farmland and other agricultural loans for which we had little or no specific loss experience, we utilized loss factors associated with our commercial real estate and other commercial loans, respectively, until specific loss experience is determined.
To the best of our knowledge, we have recorded all losses that are both probable and reasonably estimable for the years ended December 31, 2010 and 2009, respectively.
Noninterest Income. Noninterest income decreased $94,000 or 10.4% to $809,000 for the year ended December 31, 2010 from $903,000 for the year ended December 31, 2009. The decrease was primarily related to net gains on loan sales which decreased $96,000 to $213,000 for the year ended December 31, 2010, compared to $309,000 for 2009. Proceeds from loan sales decreased $6.3 million or 22.0% to $22.3 million for the year ended December 31, 2010 from $28.6 million for 2009. The loan sales were executed to generate additional liquidity and manage interest rate risk for the Bank. Gains on loan sales included the net increase in fair value of mortgage servicing rights of $27,000 in 2010 compared to the net increase in fair value of mortgage servicing rights of $97,000 in 2009, a decrease of $70,000
primarily due to the larger volume of loans sales and increase in size of our mortgage servicing portfolio in 2009, and decrease in value in 2010. Losses on other than temporary impairment of equity securities decreased $32,000 or 54.2% to $27,000 for the year ended December 31, 2010, compared to $59,000 for the same period in 2009. The other than temporary impairment of equity securities in 2010 and 2009 were related to our investment in common stock of other community banks, Fannie Mae and Freddie Mac common stock, and Shay Asset Management mutual funds.
Other noninterest income categories decreased by $30,000, or 4.6%, to $623,000 in 2010 from $653,000 in 2009. The decrease was primarily related to a $38,000 decrease in brokerage commissions in 2010 to $43,000 from $81,000 in 2009 due to lower sales volume.
Noninterest Expense. Noninterest expense increased $238,000 or 5.6% to $4.5 million for the year ended December 31, 2010 from $4.3 million for the year ended December 31, 2009. The increase in noninterest expense was primarily due to increases in compensation and benefits, professional fees, net losses on foreclosed assets and other noninterest expense of $139,000, $125,000, $40,000 and $105,000, respectively, for the year ended December 31, 2010 compared to the same period in 2009. The increase in compensation and benefits was primarily due to higher benefit costs, including a new ESOP plan, and higher compensation costs related to a larger staff as personnel were added to the commercial loan and accounting departments. The increases in professional fees and other noninterest expense were primarily the result of the Company becoming a public company in 2010. The increase in net losses on foreclosed assets reflects the increased foreclosure activity in our one-to four-family real estate loan portfolio, and write-downs of other real estate owned of $115,000 in 2010 due to the impact of further deterioration in home prices in 2010. These increases were partially offset by decreases in marketing, FDIC insurance premiums and indirect automobile servicing fees of $39,000, $57,000 and $78,000, respectively for the year ended December 31, 2010, compared to the same period in 2009. The decrease in marketing in 2010 was primarily due to the added costs of our 75th anniversary promotions in 2009. The decrease in FDIC insurance premiums in 2010 was due to a special assessment of $74,000 charged in the second quarter of 2009. The decrease in indirect automobile servicing fees in 2010 was due to the decrease in our purchased indirect automobile loan portfolio which resulted from normal amortization, payoffs and our strategy to reduce our concentration in that portfolio under current market conditions.
Benefit for Income Taxes. The benefit for income taxes was $13,000 for the year ended December 31, 2010 compared to a benefit of $164,000 for the year ended December 31, 2009. The effective tax benefit as a percent of pre-tax income or loss was 9.6% and 38.5% for the years ended December 31, 2010 and 2009, respectively. The benefit for income taxes in 2010 and 2009 were offset by an increase in valuation allowances recorded for deferred tax assets related to capital losses on equity securities of $6,000 and $42,000, respectively.
Analysis of Net Interest Income
Net interest income represents the difference between the income we earn on interest-earning assets and the interest expense we pay on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them. The following tables set forth average balance sheets, average yields and costs, and certain other information at or for the periods indicated. Average balances are predominantly derived from daily average balances, and to a lesser extent, from month end balances. Management does not believe that the limited use of month end balances rather than daily balances has caused any material differences in the information presented. Non-accrual loans were included in the computation of average balances, but have been reflected in the tables as loans carrying a zero yield. No tax equivalent yield adjustments have been made. The yields set forth below include the effect of loan fees, discounts and premiums that are amortized or accreted to interest income.
(1) Securities include unamortized premiums and unaccreted discounts. Securities include both available-for-sale and held-to-maturity securities. Fair value adjustments on available-for-sale securities have been included in the average balance for non-interest earning assets.
(2) The allowance for loan losses has been included in the average balance for non-interest earning assets.
(3) The interest rate spread represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of interest-bearing liabilities.
(4) The net interest margin represents net interest income as a percent of average interest-earning assets.
Rate/Volume Analysis
The following table presents the dollar amount of changes in interest income and interest expense for the major categories of our interest-earning assets and interest-bearing liabilities for the years ended December 31, 2010 and 2009. Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to (i) changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate) and (ii) changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
Management of Market Risk
Our most significant form of market risk is interest rate risk because, as a financial institution, the majority of our assets and liabilities are sensitive to changes in interest rates. Therefore, a principal goal of our operations is to manage interest rate risk and limit the exposure of our net interest income to changes in market interest rates.
Our board of directors is responsible for the review and oversight of our asset/liability strategies. The Asset/Liability Committee of the board of directors meets quarterly and is charged with developing an asset/liability management plan. Our board of directors has established an Asset/Liability Management Committee, consisting of senior management. This committee meets twice per month to review pricing and liquidity needs and to assess our interest rate risk. This committee is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the board of directors.
Among the techniques we are currently using to manage interest rate risk are: (i) selling into the secondary mortgage market a significant portion of our fixed-rate one- to four-family residential mortgage loan originations; (ii) expanding our commercial real estate, commercial and industrial and agricultural real estate and production loans as they generally reprice more quickly than one- to four-family residential mortgage loans; and (iii) emphasizing less interest rate sensitive and lower-cost “core deposits.” We also maintain a portfolio of short term or adjustable rate assets and from time to time have used fixed-rate Federal Home Loan Bank advances and brokered deposits to extend the term to repricing of our liabilities.
While we believe these strategies have helped manage our interest rate exposure, they do pose risks. For example, commercial real estate, commercial and industrial, agricultural real estate and production and indirect automobile loans generally present a higher level of credit risk than residential one- to four-family loans. In addition, core deposit accounts generally cost more to maintain and market than certificates of deposit.
An important measure of interest rate risk is the amount by which the net present value of an institution’s cash flow from assets, liabilities and off balance sheet items changes in the event of a range of assumed changes in market interest rates. We have utilize a computer simulation model to provide an analysis of estimated changes to our net portfolio value (“NPV”) under the assumed parallel instantaneous changes in the United States treasury yield curve. The financial model uses a discounted cash flow analysis and an option-based pricing approach to measuring the interest rate sensitivity of the NPV.
Set forth below is an analysis of the changes to the economic value of our equity that would occur to our NPV as of December 31, 2010 in the event of designated changes in the United States treasury yield curve. At December 31, 2010, our economic value of equity exposure related to these hypothetical changes in market interest rates was within the current guidelines we have established.
(1) Present value of assets represents the discounted present value of incoming cash flows on interest-earning assets.
(2) Estimated NPV assumes an instantaneous uniform change in interest rates at all maturities.
(3) NPV is the discounted present value of expected cash flows from assets, liabilities and off balance sheet contracts.
(4) NPV Ratio represents NPV divided by the present value of assets.
In addition to modeling changes in NPV, we also analyze estimated changes to net interest income (“NII”) for a prospective twelve-month period under the interest rate scenarios set forth above. The following table sets forth our NII model as of December 31, 2010.
(1) Estimated net interest income assumes an instantaneous uniform change in interest rates at all maturities.
(2) Estimated net interest income is before provisions for loan losses.
Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement. Modeling changes in net portfolio value requires making certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the tables presented assume that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration or repricing of specific assets and liabilities. The tables also do not measure the changes in credit and liquidity risk that may occur as a result of changes in general interest rates. Accordingly, although the tables provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our NPV and net interest income and will differ from actual results.
Our policies do not permit hedging activities, such as engaging in futures, options or swap transactions, or investing in high-risk mortgage derivatives, such as collateralized mortgage obligation residual interests, real estate mortgage investment conduit residual interests or stripped mortgage backed securities.
Liquidity and Capital Resources
Our primary sources of funds are deposits, principal and interest payments on loans and securities, proceeds from maturities and calls of securities, and Federal Home Loan Bank advances. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions, and competition. Our most liquid assets are cash and short-term investments including securities repurchase agreements. The levels of these assets are dependent on our operating, financing, lending, and investing activities during any given period.
Our cash flows are comprised of three primary classifications: cash flows from operating activities, investing activities, and financing activities. Net cash provided by (used in) operating activities were $1.6 million and $(412,000) for the years ended December 31, 2010 and 2009, respectively. Net cash from investing activities consisted primarily of disbursements for loan originations and the purchase of securities and interest-bearing deposits in other financial institutions, offset by principal collections on loans, and proceeds from maturing securities and pay downs on mortgage-backed securities. Net cash provided by (used in) investing activities were $(9.0) million and $2.7 million for the years ended December 31, 2010 and 2009, respectively. Net cash provided by financing activities consisted primarily of the activity in deposit accounts and proceeds from Federal Home Loan Bank advances and the net proceeds from issuance of common stock in 2010, offset by repayment of Federal Home Loan Bank advances. The net cash provided by (used in) financing activities was $10.0 million and $($915,000) for the years ended December 31, 2010 and 2009, respectively.
At December 31, 2010, the Bank exceeded all of our regulatory capital requirements with a Tier 1 (core) capital level of $16.8 million, or 10.2% of adjusted total assets, which is above the required level of $6.6 million, or 4.0%; and total risk-based capital of $18.3 million, or 15.8% of risk-weighted assets, which is above the required level of $9.3 million, or 8.0%. Accordingly Harvard Savings Bank was categorized as well capitalized at December 31, 2010. Management is not aware of any conditions or events since the most recent notification that would change our category.
At December 31, 2010, we had outstanding commitments to originate loans of $6.2 million, and commitments under unused lines of credit of $11.3 million. In addition, we had outstanding letters of credit of $125,000 at December 31, 2010. We anticipate that we will have sufficient funds available to meet our current loan origination commitments. Certificates of deposit that are scheduled to mature in less than one year from December 31, 2010 totaled $37.5 million. Management expects that a substantial portion of the maturing certificates of deposit will be renewed. However, if a substantial portion of these deposits is not retained, we may utilize Federal Home Loan Bank advances or raise interest rates on deposits to attract new accounts, which may result in higher levels of interest expense.
Off-Balance Sheet Arrangements. In the normal course of operations, we engage in a variety of financial transactions that, in accordance with U.S. generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, lines of credit and standby letters of credit. For information about our loan commitments, unused lines of credit and standby letters of credit, see Note 18 of the Notes to our Consolidated Financial Statements.
We have not engaged in any other off-balance-sheet transactions in the normal course of our lending activities.
Recent Accounting Pronouncements
For a discussion of the impact of recent accounting pronouncements, see Note 1 of the notes to our consolidated financial statements.
Impact of Inflation and Changing Prices
The financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles in the United States of America which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. The primary impact of inflation on our operations is reflected in increased operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates, generally, have a more significant impact on a financial institution’s performance than does inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk
Not required for smaller reporting companies.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
The Company’s Consolidated Financial Statements are presented in this Annual Report on Form 10-K beginning at page.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A.(T) Controls and Procedures
(a) An evaluation was performed under the supervision and with the participation of the Company’s management, including the President and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended) as of December 31, 2010. Based on that evaluation, the Company’s management, including the President and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective.
During the quarter ended December 31, 2010, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
(b) Management’s annual report on internal control over financial reporting.
This Annual Report does not include management’s report on internal control over financial reporting or an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting due to a transition period established by rules of the Securities and Exchange Commission for newly public companies such as Harvard Illinois Bancorp, Inc.
ITEM 9B.
ITEM 9B. Other Information
None.
PART III
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance
The Company has adopted a Code of Ethics that applies to the Company’s principal executive officer, principal financial officer, principal accounting officer or controller or persons performing similar functions. The Code of Ethics is posted on the Company’s website at www.harvardsavingsbank.com. A copy of the Code will be furnished without charge upon written request to the Secretary of the Company, 58 North Ayer Street, Harvard, Illinois 60033.
Information concerning directors and executive officers of the Company and certain board committee members is incorporated herein by reference from our definitive Proxy Statement (the “Proxy Statement”), specifically the section captioned “Proposal I - Election of Directors.”
ITEM 11.
ITEM 11. Executive Compensation
Information concerning executive compensation is incorporated herein by reference from our Proxy Statement, specifically the section captioned “Proposal I - Election of Directors.”
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning security ownership of certain owners and management is incorporated herein by reference from our Proxy Statement, specifically the sections captioned “Voting Securities and Principal Holders Thereof” and “Proposal I - Election of Directors.”
We do not have any equity compensation program other than our employee stock ownership plan.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions and Director Independence
Information concerning relationships and transactions is incorporated herein by reference from our Proxy Statement, specifically the section captioned “Transactions with Certain Related Persons.” Information concerning director independence is incorporated herein by reference from our Proxy Statement, specifically the section captioned “Proposal I - Election of Directors.”
ITEM 14.
ITEM 14. Principal Accountant Fees and Services
Information concerning principal accountant fees and services is incorporated herein by reference from our Proxy Statement, specifically the section captioned “Proposal II-Ratification of Appointment of Independent Registered Public Accountants.”
PART IV
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
(a)(1)
Financial Statements
The documents filed as a part of this Form 10-K are:
(a)(2)
Financial Statement Schedules
All financial statement schedules have been omitted as the required information is inapplicable or has been included in the Notes to Consolidated Financial Statements.
* Incorporated by reference to the Registration Statement on Form S-1 (file no. 333-161931), initially filed September 15, 2009.
Signatures
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Harvard Illinois Bancorp, Inc.
Date: March 25, 2011
By:
/s/ Duffield J. Seyller III
Duffield J. Seyller III, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange 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.
EXHIBIT INDEX
* Incorporated by reference to the Registration Statement on Form S-1 (file no. 333-161931), initially filed September 15, 2009.
Harvard Illinois Bancorp, Inc.
Report of Independent Registered Public Accounting Firm
and Consolidated Financial Statements
December 31, 2010 and 2009
Harvard Illinois Bancorp, Inc.
December 31, 2010 and 2009
Contents
Report of Independent Registered Public Accounting Firm
Audit Committee and Board of Directors
Harvard Illinois Bancorp, Inc.
Harvard, Illinois
We have audited the accompanying consolidated balance sheets of Harvard Illinois Bancorp, Inc. (Company) as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for the years then ended. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these consolidated 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. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing auditing procedure that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Harvard Illinois Bancorp, Inc. as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
/sig/ BKD, LLP
Decatur, Illinois
March 29, 2011
Harvard Illinois Bancorp, Inc.
Consolidated Balance Sheets
December 31, 2010 and 2009
(in thousands)
Assets
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Consolidated Balance Sheets
December 31, 2010 and 2009
(in thousands)
Liabilities and Stockholders’ Equity
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Consolidated Statements of Income
Years Ended December 31, 2010 and 2009
(in thousands, except share data)
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Consolidated Statements of Income
Years Ended December 31, 2010 and 2009
(in thousands, except share data)
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Consolidated Statements of Stockholders’ Equity
Years Ended December 31, 2010 and 2009
(in thousands)
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Consolidated Statements of Cash Flows
Years Ended December 31, 2010 and 2009
(in thousands)
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Consolidated Statements of Cash Flows
Years Ended December 31, 2010 and 2009
(in thousands)
See Notes to Consolidated Financial Statements
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 1: Nature of Operations and Summary of Significant Accounting Policies
Nature of Operations
The 2009 consolidated financial statements include the accounts of Harvard Savings, MHC (Company) and its wholly-owned subsidiaries, Harvard Savings Bank (Bank) and Harvard Illinois Financial Corporation. All significant intercompany accounts and transactions have been eliminated in consolidation.
On April 8, 2010, Harvard Savings, MHC completed its conversion and reorganization from a two-tier mutual holding company to a stock holding company. In accordance with the plan of conversion adopted by the Board of Directors of Harvard Savings, MHC on July 23, 2009, Harvard Savings, MHC (the mutual holding company) and Harvard Illinois Financial Corporation (the mid-tier stock holding company) ceased to exist as separate legal entities and a stock holding company, Harvard Illinois Bancorp, Inc. issued and sold shares of common stock to eligible depositors of Harvard Savings Bank and to former borrowers of Morris Building & Loan, s.b. in a subscription offering, and to the general public in a community offering. A total of 784,689 shares, par value of $0.01 per shares, were sold in the conversion at $10 per share, raising $7.8 million of gross proceeds. The Company established an employee stock ownership plan that purchased 8% of the total shares, or a total of 62,775 shares in the offering, for a total of $628. The $1.0 million of conversion expenses were offset against the gross proceeds. Of the conversion expenses $548 were included in other assets at December 31, 2009. Harvard Illinois Bancorp, Inc.’s common stock began trading on the over-the-counter market under the symbol “HARI” on April 9, 2010. The 2010 consolidated financial statements include the accounts of Harvard Illinois Bancorp, Inc. and its wholly-owned subsidiary, Harvard Savings Bank.
Harvard Illinois Bancorp, Inc. (Company) owns 100% of the outstanding shares of common stock of Harvard Savings Bank (Bank). The Company is primarily engaged in providing a full range of banking and mortgage services to individual and corporate customers in McHenry, Grundy, and to a lesser extent Boone counties, Illinois and Walworth County in Wisconsin. The Company also provides other services, including certain brokerage services. The Company and Bank are subject to competition from other financial institutions. The Company and Bank also are subject to the regulation of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Harvard Savings Bank. All significant intercompany accounts and transactions have been eliminated in consolidation.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Operating Segment
The Company provides community banking services, including such products and services as loans, certificates of deposits, savings accounts, mortgage originations and brokerage services. These activities are reported as a single operating segment.
The Company does not derive revenues from, or have assets located in, foreign countries, nor does it derive revenues from any single customer that represents 10% or more of the Company’s total revenues.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, loan servicing rights, valuation of deferred taxes, other-than-temporary impairment (OTTI) and fair values of securities, and Federal Home Loan Bank stock impairment.
Cash Equivalents
The Company considers all liquid investments with original maturities of three months or less to be cash equivalents. At December 31, 2010 and 2009, cash equivalents consisted primarily of interest-bearing demand deposits and securities purchased under agreements to resell.
The financial institutions holding the Company’s cash accounts are participating in the FDIC’s Transaction Account Guarantee Program. Under that program, through December 31, 2010, all noninterest-bearing transaction accounts are fully guaranteed by the FDIC for the entire amount in the account. Pursuant to legislation enacted in 2010, the FDIC will fully insure all noninterest-bearing transaction accounts beginning December 31, 2010 through December 31, 2012, at all FDIC-insured institutions.
Effective July 21, 2010, the FDIC’s insurance limits were permanently increased to $250,000. At December 31, 2010 and 2009, none of the Company’s interest-bearing cash accounts exceeded federally insured limits.
Interest-bearing Deposits With Other Financial Institutions
Interest-bearing deposits with other financial institutions have original maturities of more than three months to five years and are carried at cost.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Securities
Certain debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Securities not classified as held to maturity are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using a method that approximates the interest method over the terms of the securities. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
For debt securities with fair value below carrying value when the Company does not intend to sell a debt security, and it is more likely than not, the Company will not have to sell the security before recovery of its cost basis, it recognizes the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. For held-to-maturity debt securities, the amount of an other-than-temporary impairment recorded in other comprehensive income for the noncredit portion of a previous other-than-temporary impairment is amortized prospectively over the remaining life of the security on the basis of the timing of future estimated cash flows of the security.
For equity securities, when the Company has decided to sell an impaired available-for-sale security and the entity does not expect the fair value of the security to fully recover before the expected time of sale, the security is deemed other-than-temporarily impaired in the period in which the decision to sell is made. The Company recognizes an impairment loss when the impairment is deemed other than temporary even if a decision to sell has not been made.
Loans Held for Sale
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or fair value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to noninterest income. Gains and losses on loan sales are recorded in noninterest income.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoffs are reported at their outstanding principal balances adjusted for unearned income, charge-offs, the allowance for loan losses, any unamortized deferred fees or costs on originated loans, and unamortized premiums or discounts on purchased loans.
For loans amortized at cost, interest income is accrued based on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, as well as premiums and discounts, are deferred and amortized as a level yield adjustment over the respective term of the loan.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The accrual of interest on loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not collected for loans that are placed on nonaccrual or charged off are reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of allocated and general components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical charge-off experience and expected loss given default derived from the Company’s internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Groups of loans with similar risk characteristics are collectively evaluated for impairment based on the group’s historical loss experience adjusted for changes in trends, conditions and other relevant factors that affect repayment of the loans. Accordingly, the Company does not separately identify individual consumer loans for impairment measurements, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.
Premises and Equipment
Depreciable assets are stated at cost less accumulated depreciation. Depreciation is charged to expense using the straight-line method over the estimated useful lives of the assets.
The estimated useful lives for each major depreciable classification of premises and equipment are as follows:
Buildings and improvements
5-50 years
Equipment
3-10 years
Federal Home Loan Bank Stock
Federal Home Loan Bank stock is a required investment for institutions that are members of the Federal Home Loan Bank system. The required investment in the common stock is based on a predetermined formula.
The Company owned $6,549 or 65,489 shares of Federal Home Loan Bank stock as of December 31, 2010 and 2009. The Federal Home Loan Bank of Chicago (FHLB) is operating under a Cease and Desist Order from their regulator, the Federal Housing Finance Board. The order prohibits capital stock repurchases until a time to be determined by the Federal Housing Finance Board. The FHLB will continue to provide liquidity and funding through advances. With regard to dividends, the FHLB will continue to assess their dividend capacity each quarter and make appropriate request for approval. The FHLB did not pay a dividend during 2010 or 2009; however early in 2011 the FHLB announced they have declared an annualized rate of 10 basis points per share (approximately $2) to be paid on February 14, 2011. Management performed an analysis as of December 31, 2010 and deemed the cost investment in FHLB stock was ultimately recoverable.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Foreclosed Assets Held for Sale
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net income or expense from foreclosed assets.
Bank-owned Life Insurance
Bank-owned life insurance policies are reflected on the consolidated balance sheets at the estimated cash surrender value. Changes in the cash surrender value are reflected in noninterest income in the consolidated statements of income.
Fee Income
Loan origination fees, net of direct origination costs, are recognized as income using the level-yield method over the term of the loans. Brokerage commissions represents fees earned on brokerage activities and are recognized when earned.
Mortgage Servicing Rights
Mortgage servicing assets are recognized separately when rights are acquired through purchase or through sale of financial assets. Under the servicing assets and liabilities accounting guidance (ASC 860-50), servicing rights resulting from the sale or securitization of loans originated by the Company are initially measured at fair value at the date of transfer. The Company subsequently measures each class of servicing asset using either the fair value or the amortization method. The Company has elected to initially and subsequently measure the mortgage servicing rights for consumer mortgage loans using the fair value method. Under the fair value method, the servicing rights are carried in the balance sheet at fair value and the changes in fair value are reported in earnings in the period in which the changes occur.
Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. These variables change from quarter to quarter as market conditions and projected interest rates change, and may have an adverse impact on the value of the mortgage servicing right and may result in a reduction to noninterest income.
Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned in loan servicing fees in non-interest income.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Income Taxes
The Company accounts for income taxes in accordance with income tax accounting guidance (ASC 740, Income Taxes). The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.
Uncertain tax positions are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances and information available at the reporting date and is subject to management’s judgment.
The Company recognizes interest and penalties on income taxes as a component of income tax expense.
The Company files consolidated income tax returns with its subsidiary.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Earnings Per Share
Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during each year.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income, net of applicable income taxes. Other comprehensive income includes unrealized appreciation (depreciation) on available-for-sale securities.
Transfers between Fair Value Hierarchy Levels
Transfers in and out of Level 1 (quoted market prices), Level 2 (other significant observable inputs) and Level 3 (significant unobservable inputs) are recognized on the period ending date.
Reclassifications
Certain reclassifications have been made to the 2009 financial statements to conform to the 2010 financial statement presentation. These reclassifications had no effect on net income or equity.
Recent and Future Accounting Requirements
Accounting Standards Update (ASU) No. 2009-16, “Transfers and Servicing (Topic 860)-Accounting for Transfers of Financial Assets.” ASU 2009-16 amends prior accounting guidance to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. ASU 2009-16 eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. ASU 2009-16 also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The provisions of ASU 2009-16 became effective on January 1, 2010 and did not have a significant impact on the Company’s financial statements.
ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820)-Improving Disclosures About Fair Value Measurements.” ASU 2010-06 requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) companies should provide disclosures about the
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy will be required for the Company beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for the Company on January 1, 2010. See Note 16 - Disclosures About Fair Value of Assets and Liabilities.
ASU No. 2010-20, “Receivables (Topic 310)-Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” ASU 2010-20 requires entities to provide disclosures designed to facilitate financial statement users’ evaluation of (i) the nature of credit risk inherent in the entity’s portfolio of financing receivables, (ii) how that risk is analyzed and assessed in arriving at the allowance for credit losses and (iii) the changes and reasons for those changes in the allowance for credit losses. Disclosures must be disaggregated by portfolio segment, the level at which an entity develops and documents a systematic method for determining its allowance for credit losses, and class of financing receivable, which is generally a disaggregation of portfolio segment. The required disclosures include, among other things, a rollforward of the allowance for credit losses as well as information about modified, impaired, non-accrual and past due loans and credit quality indicators. ASU 2010-20 became effective for the Company’s financial statements as of December 31, 2010, as it relates to disclosures required as of the end of a reporting period. Disclosures that relate to activity during a reporting period will be required for the Company’s financial statements that include periods beginning on or after January 1, 2011. ASU 2011-01, “Receivables (Topic 310)-Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20,” temporarily deferred the effective date for disclosures related to troubled debt restructurings to coincide with the effective date of a proposed accounting standards update related to troubled debt restructurings, which is currently expected to be effective for periods ending after June 15, 2011. See Note 4 - Loans and Allowance for Loan Losses.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 2: Securities
The amortized cost and approximate fair values, together with gross unrealized gains and losses, of securities are as follows:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
With the exception of obligations of U.S. Treasury and other U.S. government agencies and corporations, the Company held no securities at December 31, 2010 with a book value that exceeded 10% of total equity.
Available for sale equity securities consist of shares in the Shay Asset Management mutual funds, shares of FHLMC and FNMA common stock, and shares in other financial institutions.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The Company recorded an other-than-temporary impairment on the FNMA and FHLMC common stock included in equity securities of $12 and $5 in 2010 and 2009, respectively. As of December 31, 2010 and 2009, the Company held investments in FNMA and FHLMC common stock with an amortized cost of $12 and $24, respectively. The investments in FNMA and FHLMC common stock are valued using available market prices. Management performed an analysis and deemed the remaining investment in FNMA and FHLMC common stock was not other than temporarily impaired as of December 31, 2010.
The Company also recorded an other than temporary impairment on the Shay Asset Management mutual funds included in equity securities in the amount of $11 and $35 for 2010 and 2009, respectively. As of December 31, 2010 and 2009, the Company held investments in the mutual funds with an amortized cost of $424 and $418, respectively. The investments in mutual funds are valued using available market prices. Management performed an analysis and deemed the remaining investment in the mutual funds was not other than temporarily impaired as of December 31, 2010.
The Company recorded an other-than-temporary impairment on other equity securities of $4 and $19 for 2010 and 2009, respectively. As of December 31, 2010 and 2009, the Company held investments in other equity securities with an amortized cost of $19 and $23, respectively.
Other than temporary impairment recorded for 2010 and 2009 totaled $27 and $59, respectively as previously described.
The amortized cost and fair value of available-for-sale securities and held-to-maturity securities at December 31, 2010, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
The carrying value of securities pledged as collateral, to secure public deposits and for other purposes, was $2,623 at December 31, 2010 and $2,729 at December 31, 2009.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Gross gains of $0 and $0 and gross losses of $1 and $7 resulting from sales of available-for-sale securities were realized for 2010 and 2009, respectively. The tax benefit applicable to these net realized losses amounted to $0 and $2, respectively.
Certain investments in debt and marketable equity securities are reported in the financial statements at an amount less than their historical cost. Total fair value of these investments at December 31, 2010 and 2009, was $3,562 and $177, respectively, which is approximately 46% and 2% of the Company’s available-for-sale and held-to-maturity investment portfolio. These declines primarily resulted from recent increases in market interest rates and failure of certain investments to maintain consistent credit quality ratings. Management believes the declines in fair value for these securities are temporary.
The following table shows the Company’s investments’ gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2010 and 2009:
There were no unrealized losses on the held to maturity securities for December 31, 2010 or 2009. As of December 31, 2010 and 2009, the amount of gross unrealized losses on securities is not material.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 3: Securities Purchased Under Agreements to Resell
The Company enters into purchases of securities under agreements to resell. The amounts advanced under these agreements were $13,896 and $11,800 at December 31, 2010 and 2009, respectively, and represent short-term cash investment alternatives. These agreements are over-collateralized by 103% with collateral consisting of securities guaranteed by the “full faith and credit” of the United States government, typically SBA securities. During the period, the securities were delivered by appropriate entry into the third-party custodian’s account designated by the Company under a written custodial agreement that explicitly recognizes the Company’s interest in the securities. At December 31, 2010 and 2009, these agreements mature by notice by the Company or 30 days by the custodian.
The Company’s policy requires that all securities purchased under agreements to resell be fully collateralized.
At December 31, 2010 and 2009, agreements to resell securities purchased were outstanding with the following entities:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 4: Loans and Allowance for Loan Losses
Categories of loans include:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following tables present the balance in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of December 31, 2010 and 2009:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following tables present the credit risk profile of the Company’s loan portfolio based on rating category and payment activity as of December 31, 2010 and 2009:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following tables present the Company’s loan portfolio aging analysis as of December 31, 2010 and 2009:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
At December 31, 2010 and 2009, the Company held $13,735 and $778 in agricultural production loans and $3,622 and $459, respectively in agricultural real estate loans in the Company’s geographic lending area. Generally, those loans are collateralized by assets of the borrower. The loans are expected to be repaid from cash flows or from proceeds of sale of related assets of the borrower. Declines in prices for corn, beans, livestock and farm land could significantly affect the repayment ability for many agricultural loan customers.
At December 31, 2010 and 2009, the Company held $26,702 and $20,133 in commercial real estate loans and $1,588 and $5,323 in loans collateralized by construction and development real estate primarily in the Company’s geographic lending area. Due to national, state and local economic conditions, values for commercial and development real estate have declined significantly, and the market for these properties is depressed.
A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable the Company will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following tables present impaired loans for the years ended December 31, 2010 and 2009:
The average investment in impaired loans for December 31, 2010 and 2009 was $3,515 and $3,430, respectively. The interest income recognized on impaired loans for December 31, 2010 and 2009 was $169 and $200, respectively.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Included in certain loan categories in the impaired loans are troubled debt restructurings that were classified as impaired. At December 31, 2010, the Company had $686 of commercial real estate loans that were modified in troubled debt restructurings and impaired that were considered nonperforming. The Company had troubled debt restructurings that were performing in accordance with their modified terms of $666 of residential land development loans at December 31, 2010.
The following table presents the Company’s nonaccrual loans at December 31, 2010 and 2009. This table excludes purchased impaired loans and performing troubled debt restructurings.
Note 5: Premises and Equipment
Major classifications of premises and equipment, stated at cost, are as follows:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 6: Loan Servicing
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage loans serviced for others was $65,236 and $59,215 at December 31, 2010 and 2009, respectively. The Company has a credit enhancement obligation to individual loan losses, to the limit of $927 at December 31, 2010 and 2009, respectively. Management has determined that the allowance for loan losses is adequate to cover possible future losses from its credit enhancement obligation.
The following summarizes the activity in mortgage servicing rights measured using the fair value method for the years ended December 31, 2010 and 2009:
Comparable market values and a valuation model that calculates the present value of future cash flows were used to estimate fair value. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, custodial earnings rate, default rates and losses and prepayment speeds.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 7: Interest-bearing Deposits
Interest-bearing deposits in denominations of $100 or more were $41,248 and $34,230 on December 31, 2010 and 2009, respectively.
The following table represents deposit interest expense by deposit type:
At December 31, 2010, the scheduled maturities of certificates of deposit are as follows:
Note 8: Federal Home Loan Bank Advances
The Federal Home Loan Bank (“FHLB”) advances and lines of credit consisted of the following components:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The Federal Home Loan Bank advances and line of credit are secured by mortgage loans totaling $55,395 and $49,179 at December 31, 2010 and 2009, respectively. Advances at December 31, 2010 at interest rates from 1.55% to 5.35%, are subject to restrictions or penalties in the event of prepayment.
Annual maturities of the advances at December 31, 2010, are:
Note 9: Income Taxes
The Company and its subsidiary file income tax returns in the U.S. federal and state of Illinois jurisdictions. With a few exceptions, the Company is no longer subject to U.S. federal and Illinois income tax examinations by tax authorities for years before 2007. During the years ended December 31, 2010 and 2009, the Company did not recognize expense for interest or penalties.
The benefit for income taxes includes these components:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
A reconciliation of income tax expense (benefit) at the statutory rate to the Company’s actual income tax benefit is shown below:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The tax effects of temporary differences related to deferred taxes shown on the balance sheets were:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
At December 31, 2010 and 2009, the Company’s deferred tax asset relating to realized losses and losses on other-than-temporary impairment of equity securities resulted in capital losses. Management has established a valuation allowance for the portion of the deferred tax asset as realization of the asset does not meet the “more likely than not” criteria. The carryback period on these losses is three years and the carryforward period is five years from the date of sale.
At December 31, 2010 and 2009, the Company had federal net operating loss carryforwards totaling approximately $1,114 and $1,417, respectively, which expire in varying amounts between 2024 and 2029.
At December 31, 2010 and 2009, the Company had Illinois net operating loss carryforwards totaling approximately $3,390 and $3,811, respectively, which will expire in varying amounts between 2015 and 2021. Management has not recorded a deferred tax asset for the state net operating loss carryforwards.
Retained earnings at December 31, 2010 and 2009, include approximately $2,216 for which no deferred federal income tax liability has been recognized. This amount represents an allocation of income to bad debt deductions for tax purposes only. Reduction of amounts so allocated for purposes other than tax bad debt losses or adjustments arising from carryback of net operating losses would create income for tax purposes only, which would be subject to the then-current corporate income tax rate. The deferred income tax liability on the preceding amount that would have been recorded if the allocations were expected to reverse into taxable income in the foreseeable future was approximately $753 at December 31, 2010 and 2009.
Note 10: Other Comprehensive Income (Loss)
Other comprehensive income (loss) components and related taxes were as follows:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The components of accumulated other comprehensive income (loss), included in stockholders’ equity, are as follows:
Note 11: Regulatory Matters
The 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 Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s 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 the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital to average assets (as defined). Management believes, as of December 31, 2010 and 2009, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 2010, the most recent notification from regulators categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Then Bank’s actual capital amounts and ratios are also presented in this table:
The following is a reconciliation of the Bank equity amount included in the consolidated balance sheets to the amounts reflected above for regulatory capital purposes:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 12: Restriction on Dividends
Without prior approval, the Bank is restricted by Illinois law and regulations of the Illinois Department of Financial and Professional Regulation, State of Illinois, and the Federal Deposit Insurance Corporation as to the maximum amount of dividends it can pay to the Company to the balance of the undivided profits account, adjusted for defined bad debts. As a practical matter, the Bank restricts dividends to a lesser amount because of the need to maintain an adequate capital structure.
Note 13: Related Party Transactions
At December 31, 2010 and 2009, the Company had loans outstanding to executive officers, directors and their affiliates (related parties). Changes in loans to executive officers and directors are summarized as follows:
Deposits from related parties held by the Company at December 31, 2010 and 2009 totaled $1,880 and $3,301, respectively.
The Company also has an employee loan program which is described more fully in Note 14.
In management’s opinion, such loans and other extensions of credit and deposits were made in the ordinary course of business and were made on substantially the same terms (including interest rates and collateral) as those prevailing at the time for comparable transactions with other persons. Further, in management’s opinion, these loans did not involve more than normal risk of collectibility or present other unfavorable features.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 14: Employee Benefit Plans
The Company participates in a multi-employer defined benefit retirement plan covering all employees under 65 years of age. Although employees will receive defined benefits under the multi-employer plan, the multi-employer plan does not provide for the accrual of defined pension benefits for the future services of the present employees. The Company’s expense for this plan was $148 and $138 for the years ended December 31, 2010 and 2009, respectively. The contribution is based on a fixed rate; however, the Employee Retirement Security Act (ERISA) imposes certain contingent liabilities on contributors to multi-employer plans such as this. In the event of plan termination and under certain other conditions, a contributor to a multi-employer pension plan may be liable to the government-established Pension Benefit Guarantee Corporation (PBGC) for the pension benefits guaranteed by ERISA in accordance with formulas established by the PBGC. At December 31, 2010 and 2009, the Company was unable to determine its share of liability, if any, in the event of such conditions on plan termination. Effective January 1, 2008, the Board approved to close the plan to new employees. In 2010, the Company elected to freeze its defined benefit retirement plan. Effective July 1, 2010, all benefit accruals under the Plan ceased.
The Company has a retirement savings 401(k) profit sharing plan covering substantially all employees. The Company matches 50% of the employee’s contribution on the first 6% of the employee’s compensation. Employer contributions charged to expense for 2010 and 2009 were $37 and $38, respectively.
The Company has a liability of $1,102 and $1,101 as of December 31, 2010 and 2009, respectively, for deferred compensation agreements with certain directors of the Company. The agreements provide for 120 monthly payments upon retirement of the directors. The charge to expense for the agreements was $117 for 2010 and $110 for 2009. Such charges reflect the deferred director fees plus the interest accrued at the rate of 5.94 - 8.50% on the contributions to the deferred compensation accounts.
The Company has a supplemental employee retirement plan with certain active officers of the Company. The plan provides for benefits to be paid upon retirement of the officers. The charge to the expense for the plan was $175 and $251 in 2010 and 2009, respectively. Such charges reflect the straight-line accrual over the period until full eligibility of the present value of benefits due each participant on the full eligibility date, using a 5.94% to 8.50% discount factor. The liability for the plan was $1,069 and $995 at December 31, 2010 and 2009, respectively.
The Company has adopted a lending policy which provides eligible employees, officers, and directors of the Company the opportunity to obtain one mortgage loan (primary residence only) at an interest rate below what is offered to customers in the normal course of business. The interest rate is based upon 1% below the Fannie Mae rate on the date of entering the program or the date the loan is scheduled to re-price. Employees who have been employed full-time for 3 months or have accumulated 1000 hours of employment are eligible to participate in the plan. The outstanding balance of such loans totaled approximately $2,096 and $2,332 at December 31, 2010 and 2009, respectively. Approximately $857 and $854, respectively, were loans to executive officers and directors. Effective April 2008, directors were no longer eligible to obtain new loans through this program.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Employee Stock Ownership Plan
In connection with the conversion to stock form, the Bank established an ESOP for the exclusive benefit of eligible employees (all salaried employees who have completed at least 1,000 hours of service in a twelve-month period and have attained the age of 18). The ESOP borrowed funds from the Company in an amount sufficient to purchase 62,775 shares (approximately 8% of the Common Stock issued in the stock offering). The loan is secured by the shares purchased and will be repaid by the ESOP with funds from contributions made by the Bank and dividends received by the ESOP, with funds from any contributions on ESOP assets. Contributions will be applied to repay interest on the loan first, then the remainder will be applied to principal. The loan is expected to be repaid over a period of up to 15 years. Shares purchased with the loan proceeds are held in a suspense account for allocation among participants as the loan is repaid. Contributions to the ESOP and shares released from the suspense account are allocated among participants in proportion to their compensation, relative to total compensation of all active participants. Participants will vest 100% in their accrued benefits under the employee stock ownership plan after three vesting years, with no prorated vesting prior to reaching three vesting years. Vesting is accelerated upon retirement, death or disability of the participant or a change in control of the Bank. Forfeitures will be reallocated to remaining plan participants. Benefits may be payable upon retirement, death, disability, separation from service, or termination of the ESOP. Since the Bank’s annual contributions are discretionary, benefits payable under the ESOP cannot be estimated.
Participants receive the shares at the end of employment. Because the Company’s stock is not traded on an established market, as of December 31, 2010, it is required to provide the participants in the Plan with a put option to repurchase their shares. This repurchase obligation is reflected in the Company’s financial statements in other liabilities and reduces shareholders’ equity by the estimated fair value of the earned shares.
The Company is accounting for its ESOP in accordance with ASC Topic 718, Employers Accounting for Employee Stock Ownership Plans. Accordingly, the debt of the ESOP is eliminated in consolidation and the shares pledged as collateral are reported as unearned ESOP shares in the consolidated balance sheet. Contributions to the ESOP shall be sufficient to pay principal and interest currently due under the loan agreement. As shares are committed to be released from collateral, the Company reports compensation expense equal to the average market price of the shares for the respective period, and the shares become outstanding for earnings per shares computations. Dividends, if any, on unallocated ESOP shares are recorded as a reduction of debt and accrued interest. ESOP compensation expense for the years ended December 31, 2010 and 2009 was $28 and $0, respectively.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
A summary of the ESOP shares at December 31, 2010 and 2009 is as follows:
The Company is obligated at the option of each beneficiary to repurchase shares of the ESOP upon the beneficiary’s termination or after retirement. At December 31, 2010, the fair value of the 4,185 allocated shares held by the ESOP is $26. The fair value of all shares subject to the repurchase obligation is $26.
Note 15: Earnings Per Share
Basic earnings per common share for 2010 is presented for the period beginning April 8, 2010, the date of conversion, to December 31, 2010. Income per share data is not presented for 2009, since there were no outstanding shares of common stock until the conversion on April 8, 2010. The factors used in the earnings per common share computation follow:
There were no potential dilutive common shares for the period presented. There were no common shares outstanding prior to April 8, 2010.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 16: Disclosures About Fair Value of Assets and Liabilities
ASC Topic 820, Fair Value Measurements (FAS 157) defines fair value as 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. Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1
Quoted prices in active markets for identical assets or liabilities
Level 2
Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities
Level 3
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities
Following is a description of the valuation methodologies and inputs used for assets and liabilities measured at fair value on a recurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.
Available-for-sale Securities
Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include equity securities in FNMA and FHLMC common stock as well as shares in publicly traded financial institutions. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include U.S. Government and federal agency, mortgage-backed securities (GSE - residential), municipal securities, and mutual funds. Municipal securities are generally priced using a matrix pricing model. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. These securities include municipal securities with no observable market inputs.
Mortgage Servicing Rights
Mortgage servicing rights do not trade in an active, open market with readily observable prices. Accordingly, fair value is estimated using discounted cash flow models. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following table presents the fair value measurements of assets and liabilities recognized in the accompanying balance sheets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall at December 31, 2010 and 2009:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the accompanying balance sheet using significant unobservable (Level 3) inputs:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Following is a description of the valuation methodologies and inputs used for assets measured at fair value on a nonrecurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.
Impaired Loans (Collateral Dependent)
Loans for which it is probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amounts of impairment include estimating fair value include using the fair value of the collateral for collateral dependent loans.
If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value.
Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.
The following table presents the fair value measurement of assets measured at fair value on a nonrecurring basis and the level within the fair value hierarchy in which the fair value measurements fall at December 31, 2010 and 2009:
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following methods were used to estimate the fair value of all other financial instruments recognized in the accompanying consolidated balance sheets at amounts other than fair value.
Cash and Cash Equivalents, Interest-Bearing Deposits with Other Institutions, Federal Home Loan Bank Stock, Accrued Interest Receivable, Accrued Interest Payable and Advances from Borrowers for Taxes and Insurance
The carrying amount approximates fair value.
Held-to-maturity Securities
Fair value is based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans
The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans with similar characteristics were aggregated for purposes of the calculations.
Deposits
Deposits include demand deposits, savings accounts, NOW accounts and certain money market deposits. The carrying amount approximates fair value. The fair value of fixed-maturity time deposits is estimated using a discounted cash flow calculation that applies the rates currently offered for deposits of similar remaining maturities.
Federal Home Loan Bank Advances
Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt.
Commitments to Originate Loans, Letters of Credit and Lines of Credit
The fair value of commitments to originate loans is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of letters of credit and lines of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties at the reporting date.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The following table presents estimated fair values of the Company’s financial instruments December 31, 2010 and 2009.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 17: Significant Estimates and Concentrations
Accounting principles generally accepted in the United States of America require disclosure of certain significant estimates and current vulnerabilities due to certain concentrations. Estimates related to the allowance for loan losses are reflected in the footnote regarding loans. Current vulnerabilities due to certain concentrations of credit risk are discussed in the footnote on commitments and credit risk. Other significant estimates and concentrations not discussed in those footnotes include:
Investments
The Company invests in various investment securities. Investment securities are exposed to various risks such as interest rate, market and credit risks. Due to the level of risk associated with certain investment securities, it is at least reasonably possible that changes in the values of investment securities will occur in the near term and that such change could materially affect the amounts reported in the accompanying consolidated balance sheet.
Deferred Income Taxes
The Company has maintained net deferred tax assets for deductible temporary differences. The Company evaluated the recoverability of the deferred tax asset and established a valuation allowance of $496,000 for certain capital loss carryforwards that are not expected to be fully recognized. Management believes that it is more likely than not that the remainder of the deferred tax assets will be fully realized. The Company has determined that no further valuation allowance is required for any other deferred tax assets as of December 31, 2010, although there is no guarantee that those assets will be recognizable in future periods.
Current Economic Conditions
The current protracted economic decline continues to present financial institutions with circumstances and challenges, which in some cases have resulted in large and unanticipated declines in the fair values of investments and other assets, constraints on liquidity and capital and significant credit quality problems, including severe volatility in the valuation of real estate and other collateral supporting loans.
At December 31, 2010 and 2009, the Company held $13,735 and $778 in agricultural production loans and $3,622 and $459, respectively in agricultural real estate loans in the Company’s geographic lending area. Generally, those loans are collateralized by assets of the borrower. The loans are expected to be repaid from cash flows or from proceeds of sale of related assets of the borrower. Declines in prices for corn, beans, livestock and farm land could significantly affect the repayment ability for many agricultural loan customers.
At December 31, 2010 and 2009, the Company held $26,702 and $20,133 in commercial real estate loans and $1,588 and $5,323 in loans collateralized by commercial and development real estate in the Company’s geographic lending area. Due to national, state and local economic conditions, values for commercial and development real estate have declined significantly, and the market for these properties is depressed.
The accompanying financial statements have been prepared using values and information currently available to the Company.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Given the volatility of current economic conditions, the values of assets and liabilities recorded in the financial statements could change rapidly, resulting in material future adjustments in asset values, the allowance for loan losses and capital that could negatively impact the Company’s ability to meet regulatory capital requirements and maintain sufficient liquidity.
Note 18: Commitments and Credit Risk
The Company generates commercial, mortgage and consumer loans and receives deposits from customers located primarily in McHenry, Grundy, and to a lesser extent Boone counties, Illinois and Walworth County in Wisconsin. The Company’s loans are generally secured by specific items of collateral including real property, consumer assets and business assets. Although the Company has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon economic conditions in the Company’s markets.
Commitments to Originate Loans
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the counterparty. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, commercial real estate and residential real estate.
At December 31, 2010 and 2009, the Company had outstanding commitments to originate loans aggregating approximately $6,247 and $6,005, respectively. The commitments extended over varying periods of time with the majority being disbursed within a one-year period. Loan commitments at fixed rates of interest amounted to $1,754 and $5,695 at December 31, 2010 and 2009, respectively, with the remainder at floating market rates. The range of fixed rates was 3.75% to 6.50% as of December 31, 2010 and 3.63% to 7.90% as of December 31, 2009.
Standby Letters of Credit
Standby letters of credit are irrevocable conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Financial standby letters of credit are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Performance standby letters of credit are issued to guarantee performance of certain customers under non-financial contractual obligations. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to customers. Should the Company be obligated to perform under the standby letters of credit, the Company may seek recourse from the customer for reimbursement of amounts paid.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
The Company had total outstanding standby letters of credit amounting to $125 and $388 at December 31, 2010 and 2009, respectively. The term of the standby letters of credit outstanding at December 31, 2009 expire in 2010. At December 31, 2010 and 2009, the Company’s deferred revenue under standby letters of credit agreements was nominal.
Lines of Credit
Lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Lines of credit generally have fixed expiration dates. Since a portion of the line may expire without being drawn upon, the total unused lines do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, commercial real estate and residential real estate. Management uses the same credit policies in granting lines of credit as it does for on-balance-sheet instruments.
At December 31, 2010, the Company had granted unused lines of credit to borrowers aggregating approximately $4,534 and $6,728 from commercial lines and open-end consumer lines, respectively. At December 31, 2009, the Company had granted unused lines of credit to borrowers aggregating approximately $1,442 and $8,271 for commercial lines and open-end consumer lines, respectively.
Other Credit Risk
The Company had a concentration of funds on deposit with the Federal Home Loan Bank totaling $3,184 and $2,594 at December 31, 2010 and 2009, respectively.
The Company had a concentration of funds in securities purchased under agreements to resell with Coastal Securities totaling $6,096 and $6,450 at December 31, 2010 and 2009, respectively. The remainder of the agreements totaling $7,800 and $5,350 as of December 31, 2010 and 2009, respectively, were with HEC Opportunity Fund LLC and BCM High Income Fund, LP.
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 19: Condensed Financial Information (Parent Company Only)
Presented below is condensed financial information as to financial position, results of operations and cash flows of the Company:
Condensed Balance Sheets
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Condensed Statements of Income
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Condensed Statements of Cash Flows
Harvard Illinois Bancorp, Inc.
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
(in thousands)
Note 20: Regulatory Matters
Effective September 2, 2010, the Board of Directors of the Company entered into a memorandum of understanding (the “MOU”) with the Office of Thrift Supervision (the “OTS”). The MOU, which is an informal enforcement action, requires the Company to take a number of actions, including among other things:
1. review the business plan of its subsidiary, Harvard Savings Bank, and provide the OTS with a written compliance report identifying any instances of Bank’s material non-compliance with its business plan and establishing a target date for correcting any such non-compliance or indicating that a new business plan will be submitted;
2. submit a capital plan (the “Capital Plan”) which shall include, among other things, a minimum tangible capital ratio commensurate with the Company’s consolidated risk profile, capital preservation strategies to achieve and maintain the Board-established minimum tangible equity capital ratio, operating strategies to achieve net income levels that will result in adequate cash flow throughout the term of the Capital Plan, and quarterly pro forma consolidated and unconsolidated financial statements for the period covered by the Capital Plan;
3. submit any material modifications to the Capital Plan to the OTS for its non-objection;
4. update the Capital Plan on an annual basis;
5. prepare and submit quarterly reports comparing projected operating results contained in the Capital Plan to actual results;
6. implement a risk management program which shall, among other things, appoint one or more individuals responsible for implementing and maintaining the program, clearly define the duties of the appointed individual(s), and identify the means and methods to be used to identify and monitor significant risks and trends impacting the Company’s consolidated risk and compliance profile;
7. to not declare or pay any dividends or purchase, repurchase, or redeem, or commit to purchase, repurchase, or redeem any Company stock without the prior written non-objection of the OTS; and
8. to not incur any additional debt at the holding company without the prior written non-objection of the OTS.
The Company has taken the relevant actions to comply with the terms of the agreement and believes it will be able to maintain compliance, although compliance will be determined by the OTS and not by the Company. The requirements of the MOU will remain in effect until the OTS decides to terminate, suspend or modify it.