Item 1. Business
General
Community Bank Shares of Indiana, Inc. (the “Company”) is a bank holding company headquartered in New Albany, Indiana. The Company’s wholly-owned banking subsidiaries are Your Community Bank (“YCB”) and The Scott County State Bank (“SCSB”)(YCB and SCSB are at times collectively referred to as the “Banks”). The Banks are state-chartered commercial banks headquartered in New Albany, Indiana and Scottsburg, Indiana, respectively, and are both regulated by the Indiana Department of Financial Institutions. YCB is also regulated by the Federal Deposit Insurance Corporation (“FDIC”) and (with respect to its Kentucky branches) the Kentucky Department of Financial Institutions while SCSB is also regulated by the Federal Reserve.
YCB has three wholly-owned subsidiaries to manage its investment portfolio. CBSI Holdings, Inc. and CBSI Investments, Inc. are Nevada corporations which jointly own CBSI Investment Portfolio Management, LLC, a Nevada limited liability corporation which holds and manages investment securities previously owned by the Bank.
YCB also has a Community Development Entity (CDE) subsidiary named CBSI Development Fund, Inc. The CDE enables YCB to participate in the federal New Markets Tax Credit (NMTC) Program. The NMTC Program is administered by the Community Development Financial Institutions Fund of the United States Department of the Treasury and is designed to promote investment in low-income communities by providing a tax credit over seven years for equity investments in CDE’s.
In June 2004 and June 2006, the Company completed placements of floating rate subordinated debentures through two trusts formed by the Company, Community Bank Shares (IN) Statutory Trust I and Trust II (“Trusts”). Because the Trusts are not consolidated with the Company, the Company’s financial statements reflect the subordinated debt issued by the Company to the Trusts.
The Company had total assets of $801.5 million, total deposits of $618.8 million, and stockholders' equity of $63.2 million as of December 31, 2010. The Company's principal executive office is located at 101 West Spring Street, New Albany, Indiana 47150, and the telephone number at that address is (812) 944-2224.
Business Strategy
The Company's current business strategy is to operate well-capitalized, profitable and independent community banks that have a significant presence in their primary market areas. The Company’s growth strategy is focused on expansion through organic growth within its market areas. The Company offers business and personal banking services through a full range of deposit products that include non-interest and interest-bearing checking accounts, ATM’s, debit cards, savings accounts, money market accounts, certificates of deposit and individual retirement accounts. The Company’s loan products include: secured and unsecured business loans of various terms to local businesses and professional organizations; consumer loans including home equity lines of credit, automobile and recreational vehicles, construction, and loans secured by deposit accounts; and residential real estate loans. In addition, the Company also offers non-deposit investment products such as stocks, bonds, mutual funds, and annuities to customers within its banking market areas through a strategic alliance with Wells Fargo Advisors.
Internal Growth. Management believes the optimum way to grow the Company is by attracting new loan and deposit customers within its existing markets through its extensive product offerings and attentive customer service. Management believes the Company’s customers seek a banking relationship with a service-oriented community banking institution and feels the Company’s banking centers have an atmosphere which facilitates personalized service and a broad range of product offerings to meet customers’ needs. However, the Company will consider acquisition opportunities that help advance its strategic objectives.
Branch Expansion. Management continues to consider opportunities for branch expansion and is focusing its current efforts within existing markets. Management considers a variety of criteria when evaluating potential branching opportunities. These include: the market location of the potential branch and demographics of the surrounding communities; the investment required and opportunity costs; staffing needs; and other criteria management deems of particular importance.
Lending Activities
Commercial Business Loans. The Company originates non-real estate related business loans to local businesses and professional organizations. This type of commercial loan has been offered at both variable rates and fixed rates and can be unsecured or secured by general business assets such as equipment, accounts receivable or inventory. Such loans generally have shorter terms and higher interest rates than commercial real estate loans. These commercial business loans involve a higher level of credit risk because of the type and nature of the collateral.
Commercial Real Estate Loans. The Company's commercial real estate loans are secured by improved property such as offices, small business facilities, apartment buildings, nursing homes, warehouses and other non-residential buildings, most of which are located in the Company's primary market area and some of which are to be used or occupied by the borrowers. Commercial real estate loans have been offered at adjustable interest rates and at fixed rates, typically with balloon provisions at the end of the term financing. The Company continues to offer commercial real estate loans, commercial real estate construction and development loans and land loans. Loans secured by commercial real estate generally involve a greater degree of risk than residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentrations of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multifamily and commercial real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired. The Company has sought to increase its origination of multi-family residential or commercial real estate loans over the last few years while attempting to decrease its exposure to development and land loans and has attempted to protect itself against the increased credit risk associated with these loans through its underwriting standards and ongoing monitoring processes.
Residential Real Estate Loans. The Company originates one-to-four family, owner-occupied, residential mortgage loans secured by property located in the Company's market area. While the Company currently sells a portion of its residential real estate loans into the secondary market, the Company does originate and retain a significant amount of these loans in its own portfolio. The majority of the Company's residential mortgage loans consist of loans secured by owner-occupied, single family residences. The Company currently offers residential mortgage loans for terms up to thirty years, with adjustable (“ARM”) or fixed interest rates. Origination of fixed-rate mortgage loans versus ARM loans is monitored continuously and is affected significantly by the level of market interest rates, customer preference, and loan products offered by the Company's competitors. Therefore, even if management's strategy is to emphasize ARM loans, market conditions may be such that there is greater demand for fixed-rate mortgage loans and/or fixed rate mortgage loans with balloon payment features.
The Company's fixed and adjustable rate residential mortgage loans are amortized on a monthly basis with principal and interest due each month. Residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms because borrowers may refinance or prepay loans at their option.
The primary purpose of offering ARM loans is to make the Company's loan portfolio more interest rate sensitive. ARM loans, however, can carry increased credit risk because during a period of rising interest rates the risk of default on ARM loans may increase due to increases in borrowers’ monthly payments.
After the initial fixed rate period, the Company's ARM loans generally adjust annually with interest rate adjustment limitations of two percentage points per year and six percentage points over the life of the loan. The Company also makes ARM loans with interest rates that adjust every one, three or five years. Under the Company's current practice, after the initial fixed rate period the interest rate on ARM loans adjusts to the applicable index plus a spread. The Company's policy is to qualify borrowers for one-year ARM loans based on the initial interest rate plus the maximum annual rate increase.
The Company has used different indices for its ARM loans such as the National Average Median Cost of Funds, the Sixth District Net Cost of Funds Monthly Index, the National Average Contract Rate for Previously Occupied Homes, the average three year Treasury Bill Rate, and the Eleventh District Cost of Funds. Consequently, the adjustments in the Company's portfolio of ARM loans tend not to reflect any one particular change in any specific interest rate index, but general interest rate trends overall.
Secondary market regulations limit the amount that a bank may lend based on the appraised value of real estate. Such regulations permit a maximum loan-to-value ratio of 95% percent for residential property and from 65-90% for all other real estate related loans.
The Company occasionally makes real estate loans with loan-to-value ratios in excess of 80%. For the loans sold into the secondary market, individual investor requirements pertaining to private mortgage insurance apply. For the mortgage real estate loans retained by the Company with loan-to-value ratios of 80-90%, the Company may require the first 20% of the loan to be covered by private mortgage insurance. For the mortgage real estate loans retained by the Company with loan-to-value ratios of 90-95%, the Company may require private mortgage insurance to cover the first 25-30% of the loan amount. The Company requires fire and casualty insurance, as well as title insurance or an opinion of counsel regarding good title, on all properties securing real estate loans made by the Company.
Construction Loans. The Company originates loans to finance the construction of owner-occupied residential property. The Company makes construction loans to private individuals for the purpose of constructing a personal residence or to local real estate builders and developers. Construction loans generally are made with either adjustable or fixed-rate terms, typically up to 12 months. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are structured to be converted to permanent loans at the end of the construction period or to be terminated upon receipt of permanent financing from another financial institution.
Consumer Loans. The principal types of consumer loans offered by the Company are home equity lines of credit, auto loans, home improvement loans, and loans secured by deposit accounts. Home equity lines of credit are predominately made at rates which adjust periodically and are indexed to the prime rate and generally have rate floors. Some consumer loans are offered on a fixed-rate basis depending upon the borrower's preference. The Company's home equity lines of credit are generally secured by the borrower's principal residence and a personal guarantee.
The underwriting standards employed by the Company for consumer loans include a determination of the applicant's credit history and an assessment of the prospective borrower’s ability to meet existing obligations and payments on the proposed loan. The stability of the applicant's monthly income may be determined by verification of gross monthly income from primary employment and from any verifiable secondary income. The underwriting process also includes a comparison of the value of the collateral in relation to the proposed loan amount.
Mortgage-Banking Operations. The Company originates qualified government guaranteed loans and conventional secondary market loans which are sold with the servicing released. This arrangement provides necessary liquidity to the Company while providing additional loan products to the Company’s customers.
Loan Solicitation and Processing. Loans are originated through a number of sources including loan sales staff, real estate broker referrals, existing customers, borrowers, builders, attorneys and walk-in customers. Processing procedures are affected by the type of loan requested and whether the loan will be funded by the Company or sold into the secondary market.
Mortgage loans that are sold into the secondary market are submitted, when possible, for Automated Underwriting, which allows for faster approval and an expedited closing. The Company’s responsibility on these loans is the fulfillment of the loan purchaser's requirements. These loans require credit reports, appraisals, and income verification before they are approved or disapproved. Private mortgage insurance is generally required on loans with a ratio of loan to appraised value of greater than eighty percent. Property insurance and flood certifications are required on all real estate loans.
Installment loan documentation varies by the type of collateral offered to secure the loan. In general, an application and credit report is required before a loan is submitted for underwriting. The underwriter determines the necessity of any additional documentation, such as income verification or appraisal of collateral. An authorized loan officer approves or declines the loan after review of all applicable loan documentation collected during the underwriting process.
Commercial loans are underwritten by the commercial loan officer who makes the initial contact with the customer applying for credit. The underwriting of these loans is reviewed after the fact by the Risk Management area for compliance with the Company's general underwriting standards. A loan exceeding the authority of the underwriting loan officer requires the approval of other officers of the Banks based upon individual lending authorities, the Directors’ Loan Committee, or the Board of Directors of the Banks, depending on the loan amount.
Loan Commitments. The Company issues loan origination commitments to qualified borrowers primarily for the construction and purchase of residential real estate and commercial real estate. Such commitments are made with specified terms and conditions for periods of thirty days for commercial real estate loans and sixty days for residential real estate loans.
Employees
As of December 31, 2010, the Company employed 205 employees, 191 full-time and 14 part-time. None of these employees are represented by a collective bargaining group. Neither the Company nor any subsidiary has ever experienced a work stoppage.
Competition and Market Area Served
The banking business is highly competitive, and as such the Company competes not only with other commercial banks, but also with savings and loan associations, trust companies and credit unions for deposits and loans, as well as stock brokerage firms, insurance companies, and other entities providing one or more of the services and products offered by the Company. In addition to competition, the Company's business and operating results are affected by the general economic conditions prevalent in its market.
The Company’s primary market areas consist of Floyd, Clark, and Scott counties in Southern Indiana and Jefferson and Nelson counties in Kentucky. These are four (excluding Scott County) of the thirteen counties comprising the Louisville, Kentucky Standard Metropolitan Statistical Area, which has a population in excess of 1.2 million. The aggregate population of Floyd, Clark, and Scott counties is approximately 204,000 while the populations of Jefferson and Nelson Counties are approximately 714,000 and 43,000, respectively. The Company's headquarters are located in New Albany, Indiana, a city of 37,000 located approximately three miles from the center of Louisville.
Nature of Company’s Business
The business of the Company is not seasonal. The Company’s business does not depend upon a single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the Company. No material portion of the Company’s business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of any governmental entity.
Regulation and Supervision
As a bank holding company, the Company is regulated under the Bank Holding Company Act of 1956, as amended (the "Act"). The Act limits the business of bank holding companies to banking, managing or controlling banks and other subsidiaries authorized under the Act, performing certain servicing activities for subsidiaries and engaging in such other activities as the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) may determine to be closely related to banking. The Company is registered with and is subject to regulation by the Federal Reserve Board. Among other things, applicable statutes and regulations require the Company to file an annual report and such additional information as the Federal Reserve Board may require pursuant to the Act and the regulations which implement the Act. The Federal Reserve Board also conducts examinations of the Company.
The Act provides that a bank holding company must obtain the prior approval of the Federal Reserve Board to acquire more than five percent of the voting stock or substantially all the assets of any bank or bank holding company. The Act also provides that, with certain exceptions, a bank holding company may not (i) engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries, or (ii) own or control more than five percent of the voting shares of any company that is not a bank, including any foreign company. A bank holding company is permitted, however, to acquire shares of any company, the activities of which the Federal Reserve Board has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company may also acquire shares of a company which furnishes or performs services for a bank holding company and acquire shares of the kinds and in the amounts eligible for investment by national banking associations. In addition, the Federal Reserve Act restricts the Bank’s extension of credit to the Company.
The Dodd-Frank Wall Street Reform and Consumer Protection Act financial reform legislation (“Dodd-Frank”), which became law on July 21, 2010, significantly revised and expanded the rulemaking, supervisory and enforcement authority of federal bank regulators. Dodd-Frank impacts many aspects of the financial industry and, in many cases, will impact larger and smaller financial institutions and community banks differently over time. Dodd-Frank includes, among other provisions, the following:
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the creation of a Financial Stability Oversight Counsel to identify emerging systemic risks and improve interagency cooperation;
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the establishment of strengthened capital and liquidity requirements for banks and bank holding companies, including minimum leverage and risk-based capital requirements no less than the strictest requirements in effect for depository institutions as of the date of enactment;
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the requirement by statute that bank holding companies serve as a source of financial strength for their depository institution subsidiaries;
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the termination of investments by the U.S. Treasury under TARP;
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the elimination and phase out of trust preferred securities from Tier 1 capital for institutions with more than $15 billion in assets;
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a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000 and an extension of federal deposit coverage until January 1, 2013 for the full net amount held by depositors in non-interest bearing transaction accounts;
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authorization for financial institutions to pay interest on business checking accounts;
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changes in the calculation of FDIC deposit insurance assessments, such that the assessment base will no longer be the institution’s deposit base, but instead, will be its average consolidated total assets less its average tangible equity;
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expanded restrictions on transactions with affiliates and insiders under Section 23A and 23B of the Federal Reserve Act and lending limits for derivative transactions, repurchase agreements and securities lending and borrowing transactions;
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provisions that affect corporate governance and executive compensation at most U.S. publicly traded companies, including: 1) stockholder advisory votes on executive compensation, 2) executive compensation “clawback” requirements for companies listed on national securities exchanges in the event of materially inaccurate statements of earnings, revenues, gains or other criteria, 3) enhanced independence requirements for compensation committee members, and 4) authority for the SEC to adopt proxy access rules which would permit stockholders of publicly traded companies to nominate candidates for election as director and have those nominees included in a company’s proxy statement; and
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the creation of a Consumer Financial Protection Bureau, which is authorized to promulgate consumer protection regulations relating to bank and non-bank financial products and examine and enforce these regulations on institutions with more than $10 billion in assets.
Many of the requirements of Dodd-Frank will be implemented over time and most will be subject to regulations to be implemented or which will not become fully effective for several years.
On November 12, 1999, Congress enacted the Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act permits bank holding companies to qualify as "financial holding companies" that may engage in a broad range of financial activities, including underwriting, dealing in and making a market in securities, insurance underwriting and agency activities and merchant banking. The Federal Reserve Board is authorized to expand the list of permissible financial activities. The Gramm-Leach-Bliley Act also authorizes banks to engage through financial subsidiaries in nearly all of the activities permitted for financial holding companies. The Company has not elected the status of financial holding company and at this time has no plans for these investments or broader financial activities.
As state-chartered commercial banks, the Company’s subsidiary banks are subject to examination, supervision and extensive regulation by the Federal Deposit Insurance Corporation (“FDIC”), the Indiana Department of Financial Institutions (“DFI”) and (with respect to YCB and its branch offices located in Kentucky) the Kentucky Department of Financial institutions (“KDFI). The Banks are members of and own stock in the Federal Home Loan Bank (“FHLB”) of Indianapolis and Cincinnati. The FHLB institutions located in Indianapolis and Cincinnati are two of the twelve regional banks in the FHLB system. The Banks are also subject to regulation by the Federal Reserve Board, which governs reserves to be maintained against deposits and regulates certain other matters. The extensive system of banking laws and regulations to which the Banks are subject is intended primarily for the protection of the Company’s customers and depositors, and not its shareholders.
The FDIC, Federal Reserve, and DFI/KOFI regularly examine the Banks and prepare reports for the consideration of the Banks’ Board of Directors on any deficiencies that they may find in the Banks’ operations. The relationship of the Banks with their depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in such matters as the form and content of the Banks’ mortgage documents and communication of loan and deposit rates to both existing and prospective customers.
The investment and lending authority of a state-chartered bank is prescribed by state and federal laws and regulations, and such banks are prohibited from engaging in any activities not permitted by such laws and regulations. These laws and regulations generally are applicable to all state chartered banks. The Banks may not lend to a single or related group of borrowers on an unsecured basis an amount in excess of the greater of $500,000 or fifteen percent of the Banks unimpaired capital and surplus on a disaggregated basis. An additional amount may be lent, equal to ten percent of unimpaired capital and surplus, if such loan is secured by readily marketable collateral, which is defined to include certain securities, but generally does not include real estate.
Federal Regulations
Sections 22(h) and (g) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer and to a greater than ten percent stockholder of a bank, and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the institution's loans to one borrower limit (15% of the Bank’s unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and also requires prior board of directors approval for certain loans. In addition, the aggregate amount of extensions of credit to all insiders cannot exceed the institution's unimpaired capital and surplus. At December 31, 2010 the Banks were in compliance with the above restrictions.
Safety and Soundness. The Federal Deposit Insurance Act (“FDIA”), as amended by the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) and the Riegle Community Development and Regulatory Improvement Act of 1994, requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to the internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest-rate-risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits and such other operational and managerial standards as the agencies may deem appropriate. The federal bank regulatory agencies adopted, effective August 9, 1995, a set of guidelines prescribing safety and soundness standards pursuant to FDICIA, as amended. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines.
The FDIC generally is authorized to take enforcement action against a financial institution that fails to meet its capital requirements; such action may include restrictions on operations and banking activities, the imposition of a capital directive, a cease and desist order, civil money penalties or harsher measures such as the appointment of a receiver or conservator or a forced merger into another institution. In addition, under current regulatory policy, an institution that fails to meet its capital requirements is prohibited from paying any dividends. Except under certain circumstances, further disclosure of final enforcement action by the FDIC is required.
Prompt Corrective Action. Under Section 38 of the FDIA, as amended by the FDICIA, each federal banking agency was required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies, including the FDIC, adopted substantially similar regulations to implement Section 38 of the FDIA, effective as of December 19, 1992. Under the regulations, an institution is deemed to be (i) "well-capitalized" if it has total risk-based capital of 10.0% or more, a Tier 1 risk-based capital ratio of 6.0% or more, a Tier 1 leverage capital ratio of 5.0% or more and is not subject to any order or final capital directive to meet and maintain a specific capital level for any capital measure, (ii) "adequately-capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more and a Tier 1 leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well-capitalized," (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio that is less than 4.0% or a Tier 1 leverage capital ratio that is less than 4.0% (3.0% under certain circumstances), (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a Tier II average capital ratio that is less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. Section 38 of the FDIA and the regulations promulgated thereunder also specify circumstances under which a federal banking agency may reclassify a well-capitalized institution as adequately-capitalized and may require an adequately-capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). At December 31, 2010, the Company and the Banks were deemed well-capitalized for purposes of the above regulations. As discussed above, Dodd-Frank may result in more stringent capital requirements in the future.
Federal Home Loan Bank System. The Banks are members of the FHLB of Indianapolis and Cincinnati. The FHLB of Indianapolis and Cincinnati are two of the 12 regional FHLB's that lend money to its members to finance housing and economic development. With the enactment of the Housing and Economic Recovery Act on July 30, 2008, the Federal Housing Finance Agency (“FHFA”) was created to oversee the secondary mortgage market. The Act empowered the FHFA with the powers to oversee and regulate Fannie Mae, Freddie Mac, and the FHLBs.
As members of the FHLB system, the Banks are required to purchase and maintain stock in the FHLB in an amount equal to the greater of one percent of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year, or 1/20 (or such greater fraction as established by the FHLB) of outstanding FHLB advances. At December 31, 2010, $6.4 million of FHLB stock was outstanding for the Banks, which were in compliance with this requirement. In past years, the Banks have received dividends on its FHLB stock.
Insurance of Accounts. The FDIC is an independent federal agency that insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures our customer deposits through the Deposit Insurance Fund (the “DIF”) up to prescribed limits for each depositor. Pursuant to Dodd-Frank, the maximum deposit insurance amount has been permanently increased to $250,000 and all non-interest-bearing transaction accounts are insured through December 31, 2012. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Due to the greatly increased number of bank failures and losses incurred by DIF, as well as the recent extraordinary programs in which the FDIC has been involved to support the banking industry generally, the FDIC’s DIF was substantially depleted and the FDIC has incurred substantially increased operating costs. In November, 2009, the FDIC adopted a requirement for institutions to prepay in 2009 their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011, and 2012. The Banks prepaid their assessments based on the calculations of the projected assessments at that time.
As required by Dodd-Frank, the FDIC adopted a new DIF restoration plan which became effective on January 1, 2011. Among other things, the plan: (1) raises the minimum designated reserve ratio, which the FDIC is required to set each year, to 1.35 percent (from the former minimum of 1.15 percent) and removes the upper limit on the designated reserve ratio (which was formerly capped at 1.5 percent) and consequently on the size of the fund; (2) requires that the fund reserve ratio reach 1.35 percent by 2020; (3) requires that, in setting assessments, the FDIC "offset the effect of (requiring that the reserve ratio reach 1.35 percent by September 30, 2020 rather than 1.15 percent by the end of 2016) on insured depository institutions with total consolidated assets of less than $10,000,000,000; (4) eliminates the requirement that the FDIC provide dividends from the fund when the reserve ratio is between 1.35 percent and 1.5 percent; and (5) continues the FDIC’s authority to declare dividends when the reserve ratio at the end of a calendar year is at least 1.5 percent, but grants the FDIC sole discretion in determining whether to suspend or limit the declaration or payment of dividends. The FDI Act continues to require that the FDIC’s Board of Directors consider the appropriate level for the designated reserve ratio annually and, if changing the designated reserve ratio, engage in notice-and-comment rulemaking before the beginning of the calendar year. The FDIC has set a long-term goal of getting its reserve ratio up to 2% of insured deposits by 2027.
On February 7, 2011, the FDIC approved a final rule, as mandated by Dodd-Frank, changing the deposit insurance assessment system from one that is based on total domestic deposits to one that is based on average consolidated total assets minus average tangible equity. In addition, the final rule creates a scorecard-based assessment system for larger banks (those with more than $10 billion in assets). Larger insured depository institutions will likely pay higher assessments to the DIF than under the old system. The FDIC suspended dividends indefinitely; however, in lieu of dividends, and pursuant to its authority to set risk-based assessments, the FDIC adopted progressively lower assessment rate schedules that will take effect when the reserve ratio exceeds 1.15 percent, 2 percent, and 2.5 percent. Additionally, the final rule includes a new adjustment for depository institution debt whereby an institution would pay an additional premium equal to 50 basis points on every dollar of long-term, unsecured debt held as an asset that was issued by another insured depository institution (excluding debt guaranteed under the TLGP). to the extent that all such debt exceeds 3 percent of the other insured depository institution’s Tier 1 capital. Except for future assessment rate schedules, the new rule is effective beginning April 1, 2011.
The Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain reserves against their transaction accounts and non-personal time deposits. Banks are authorized to borrow from the Federal Reserve Bank "discount window," but Federal Reserve Board regulations require banks to exhaust other reasonable alternative sources of funds, including FHLB advances, before borrowing from the Federal Reserve Bank.
Federal Taxation. For federal income tax purposes, the Company and its subsidiaries file a consolidated federal income tax return on a calendar year basis. Consolidated returns have the effect of eliminating intercompany distributions, including dividends, from the computation of consolidated taxable income for the taxable year in which the distributions occur.
The Company and its subsidiaries are subject to the rules of federal income taxation generally applicable to corporations under the Internal Revenue Code of 1986, as amended (the "Code").
Indiana Taxation. The Company is subject to an income tax imposed by the State of Indiana. The tax is imposed at the rate of 8.5 percent of the Company's adjusted gross income. In computing adjusted gross income, no deductions are allowed for municipal interest and U.S. Government interest. In 2000, the Indiana financial institution tax law was amended to treat resident financial institutions the same as nonresident financial institutions by providing for apportionment of Indiana income based on receipts in Indiana. This revision allowed for the exclusion of receipts from out of state sources and federal government and agency obligations.
Currently, income from YCB’s subsidiaries CBSI Holdings, Inc., CBSI Investments, Inc. and CBSI Investment Portfolio Management, LLC is not subject to the Indiana income tax.
Kentucky Taxation. The Company is subject to a franchise tax imposed by the Commonwealth of Kentucky on its operations in Kentucky. The tax is imposed at a rate of 1.1% on taxable net capital, which equals capital stock paid in, surplus, undivided profits and capital reserves, and accumulated other comprehensive income or loss, less an amount equal to the same percentage of the total as the book value of United States obligations and Kentucky obligations bears to the book value of the total assets of the financial institution. A financial institution whose business activity is taxable within and without Kentucky must apportion its net capital based on the three factor apportionment formula of receipts, property and payroll unless the Kentucky Revenue Cabinet has granted written permission to use another method.
Participation in the Capital Purchase Program. Throughout 2008, the United States Federal Government launched a series of financial initiatives aimed at stabilizing the economy. The United States Department of the Treasury (“Treasury”) launched one of its largest initiatives, the Capital Purchase Program (“CPP”), under the Emergency Economic Stabilization Act (“EESA”) in October 2008. The CPP is a voluntary program which offered qualifying banks and bank holding companies the opportunity to sell preferred securities and warrants to the Treasury. The same terms generally applied to all public company participants in the plan. By providing capital to financial institutions through the CPP, Treasury aimed to enhance market confidence in the entire banking system by stabilizing the financial markets, thereby increasing the capacity of these institutions to lend to U.S. businesses and consumers and to support the U.S. economy under the difficult financial market conditions. On May 29, 2009, we entered into a letter agreement with the Treasury under the CPP by which we sold to the Treasury our preferred securities and warrant. For a description of our CPP securities and their terms, see Note 13 to the Consolidated Financial Statements.
As a result of participating in the CPP, some of our officers are subject to restrictions upon executive compensation imposed by the Emergency Economic Stabilization Act of 2008, as amended, and the regulations issued thereunder by the Treasury. Additionally, we are subject to dividend restrictions; see the section “Capital” under Management’s Discussion and Analysis of Financial Condition and Results of Operations for a description of the dividend restrictions.
Management Discussion and Analysis “Capital” for a description of the dividend restrictions.
Available Information. The Company files annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission (“SEC”) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The public may read and copy any material the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549 and may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC on its website at www.sec.gov. The Company makes available through its website, www.yourcommunitybank.com, its annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K.
Item 1A.
Item 1A. Risk Factors
There are a number of factors, including those specified below, that may adversely affect our business, financial results or stock price. Additional risks that we currently do not know about or currently view as immaterial may also impair our business or adversely impact our financial results or stock price.
As used in this Item 1A of the Form 10-K, the terms “we”, “us” and “our” refer to Community Bank Shares of Indiana, Inc., an Indiana corporation and its subsidiaries (unless the context clearly implies otherwise).
Industry Risk Factors
Economic Conditions. Our earnings are affected by the general economic conditions in the United States, and to a lesser extent, general international economic conditions. Economic conditions in the United States and abroad deteriorated significantly in the latter part of 2008 which continued into 2009 and 2010. Business activity across a wide range of industries and regions in the United States was greatly reduced. Although economic conditions have improved, certain sectors, such as real estate, remain weak and unemployment remains high. Many businesses are still in serious difficulty due to reduced consumer spending and continued liquidity challenges in the credit markets. Many financial institutions and institutional investors have tightened the availability of credit to borrowers and other financial institutions, which, in turn, results in more loan defaults and decreased business activity. While we have seen some signs of improvement, we do not expect significant improvement in the economy in the near future.
Enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the promulgation of regulations thereunder could significantly increase our compliance and operating costs or otherwise have a material and adverse effect on the Company’s financial position, results of operations, or cash flows. Recent government efforts to strengthen the U.S. financial system have resulted in the imposition of additional regulatory requirements, including expansive financial services regulatory reform legislation. Dodd-Frank sets out sweeping regulatory changes. Changes imposed by Dodd-Frank include, among others: (i) new requirements on banking, derivative and investment activities, including modified capital requirements, the repeal of the prohibition on the payment of interest on business demand accounts, and debit card interchange fee requirements; (ii) corporate governance and executive compensation requirements; (iii) enhanced financial institution safety and soundness regulations, including increases in assessment fees and deposit insurance coverage; and (iv) the establishment of new regulatory bodies, such as the Bureau of Consumer Financial Protection. Many of the requirements of Dodd-Frank will be implemented over time and most will be subject to regulations to be implemented or which will not become fully effective for several years.
Current and future legal and regulatory requirements, restrictions and regulations, including those imposed under Dodd-Frank, may adversely impact our profitability and may have a material and adverse effect on our business, financial condition, and results of operations. These requirements, restrictions and regulations may require us to invest significant management attention and resources to evaluate and make any changes required by the legislation and accompanying rules and may make it more difficult for us to attract and retain qualified executive officers and employees. See previous discussion under “Regulation and Supervision” beginning on page 8 for more information on Dodd-Frank.
Changes in the laws, regulations and policies governing financial services companies could alter our business environment and adversely affect our operations. The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its fiscal and monetary policies determine in a large part our cost of funds for lending and investing and the return that can be earned on those loans and investments, both of which affect our net interest margin. Federal Reserve Board policies can also materially affect the value of financial instruments that we hold, such as debt securities.
We, along with our subsidiaries, are heavily regulated at the federal and state levels. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole. Congress and state legislatures and federal and state agencies continually review banking laws, regulations and policies for possible changes. Changes in statutes, regulations or policies could affect us in substantial and unpredictable ways, including limiting the types of financial services and products that we offer and/or increasing the ability of non-banks to offer competing financial services and products. We cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it or any regulations would have on our financial condition or results of operations.
The financial services industry is highly competitive, and competitive pressures could intensify and adversely affect our financial results. We operate in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. We compete with other commercial banks, savings and loan associations, mutual savings banks, finance companies, mortgage banking companies, credit unions and investment companies. In addition, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. Many of our competitors have fewer regulatory constraints and some have lower cost structures. Also, the potential need to adapt to industry changes in information technology systems, on which we and the financial services industry are highly dependent, could present operational issues and require capital spending.
Changes in consumer use of banks and changes in consumer spending and saving habits could adversely affect our financial results. Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This “disintermediation” could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect our operations, and we may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.
Risks associated with unpredictable economic and political conditions may be amplified as a result of our limited market area. Commercial banks and other financial institutions are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. Conditions such as inflation, value of the dollar, recession, unemployment, high interest rates, short money supply, scarce natural resources, international disorders, terrorism and other factors beyond our control may adversely affect profitability. In addition, almost all of our primary business area is located in Southern Indiana and Jefferson County, Kentucky. A significant downturn in this regional economy may result in, among other things, deterioration in our credit quality or a reduced demand for credit and may harm the financial stability of our customers. Due to the regional market area, these negative conditions may have a more noticeable effect on us than would be experienced by an institution with a larger, more diverse market area.
Changes in the domestic interest rate environment could reduce our net interest income. Interest rate volatility could significantly harm our business. Our results of operations are affected by the monetary and fiscal policies of the federal government and the regulatory policies of governmental authorities. A significant component of earnings is net interest income, which is the difference between the income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits. A change in market interest rates could adversely affect earnings if market interest rates change such that the interest we pay on deposits and borrowings increases faster than the interest we collect on loans and investments. Consequently, along with other financial institutions generally, we are sensitive to interest rate fluctuations.
Company Risk Factors
Our allowance for loan losses may not be adequate to cover actual losses. Like all financial institutions, we maintain an allowance for loan losses to provide for probable incurred losses due to loan defaults, non-performance, and other qualitative factors. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, loan portfolio performance, fair value of collateral securing the loans, current economic conditions and geographic concentrations within the portfolio. Our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect its financial results.
We may suffer losses in our loan portfolio despite our underwriting practices. Our results of operations are significantly affected by the ability of borrowers to repay their loans. Lending money is an essential part of the banking business. However, borrowers do not always repay their loans. The risk of non-payment is historically small, but if nonpayment levels are greater than anticipated, our earnings and overall financial condition, as well as the value of our common stock, could be adversely affected. No assurance can be given that our underwriting practices or monitoring procedures and policies will reduce certain lending risks. Loan losses can cause insolvency and failure of a financial institution and, in such an event, our stockholders could lose their entire investment. In addition, future provisions for loan losses could materially and adversely affect profitability. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.
We may incur losses in our investments portfolio. Our investment portfolio is comprised of state and municipal securities, residential mortgage-backed agencies issued by U.S. Government sponsored entities securities, trust preferred securities, and mutual funds. We must evaluate these securities for other-than-temporary impairment loss (“OTTI”) on a periodic basis. In 2009 and 2010, we recognized an OTTI charge on five of our six trust preferred securities holdings. Our remaining trust preferred securities, including those for which we recognized an OTTI charge, still exhibit signs of weakness which may necessitate an OTTI charge in the future should the financial condition of the underling issuers in the pools deteriorate further. Also, given the current economic environment we may need to record an OTTI charges in our other investments the future should the issuers of those securities experience financial difficulties. Any future OTTI charges could significantly impact our earnings.
Maintaining or increasing our market share may depend on lowering prices and market acceptance of new products and services. Our success depends, in part, on our ability to adapt our products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. Lower prices can reduce our net interest margin and revenues from our fee-based products and services. In addition, the widespread adoption of new technologies, including internet services, could require us to make substantial expenditures to modify or adapt our existing products and services. Also, these and other capital investments in our businesses may not produce expected growth in earnings anticipated at the time of the expenditure. We might not be successful in introducing new products and services, achieving market acceptance of its products and services, or developing and maintaining loyal customers.
Because the nature of the financial services business involves a high volume of transactions, we face significant operational risks. Operational risk is the risk of loss resulting from our operations, including, but not limited to, the risk of fraud by employees or persons outside of the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, we could suffer financial loss, face regulatory action and suffer damage to its reputation.
Acquisitions and the addition of branch facilities may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration difficulties. We regularly explore opportunities to establish branch facilities and acquire other banks or financial institutions. New or acquired branch facilities and other facilities may not be profitable. We may not be able to correctly identify profitable locations for new branches. The costs to start up new branch facilities or to acquire existing branches, and the additional costs to operate these facilities, may increase our noninterest expense and decrease earnings in the short term. It may be difficult to adequately and profitably manage growth through the establishment of these branches. In addition, we can provide no assurance that these branch sites will successfully attract enough deposits to offset the expenses of operating these branch sites. Any new or acquired branches will be subject to regulatory approval, and there can be no assurance that we will succeed in securing such approvals.
We cannot predict the number, size or timing of acquisitions. Difficulty in integrating an acquired business or company may cause us not to realize expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from the acquisition. The integration could result in higher than expected deposit attrition (run-off), loss of key employees, disruption of our business or the business of the acquired company, or otherwise adversely affect our ability to maintain relationships with customers and employees or achieve the anticipated benefits of the acquisition. Also, the negative effect of any divestitures required by regulatory authorities in acquisitions or business combinations may be greater than expected.
Our business could suffer if we fail to attract and retain skilled people. Our success depends, in large part, on our ability to attract and retain key people. Competition can be intense for the best people in most activities in which we engage. We may not be able to hire the best people or to keep them.
Significant legal actions could subject us to substantial uninsured liabilities. We are from time to time subject to claims related to our operations. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. To protect us from the cost of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage may not cover all claims against us or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our results of operations and financial condition.
We are exposed to risk of environmental liability when we take title to properties. In the course of our business, we may foreclose on and take title to real estate. As a result, we could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we become subject to significant environmental liabilities, our financial condition and results of operations could be adversely affected.
There is a limited trading market for our stock and you may not be able to resell your shares at or above the price you paid for them. The price of the common stock purchased may decrease significantly. Although our common stock is quoted on the Nasdaq Capital Market under the symbol "CBIN", trading activity in the stock historically has been sporadic. A public trading market having the desired characteristics of liquidity and order depends on the presence in the market of willing buyers and sellers at any given time. The presence of willing buyers and sellers depends on the individual decisions of investors and general economic conditions, all of which are beyond our control.
Our historical growth rates may not be sustainable. We may not be able to maintain and manage our growth, which may adversely affect our results of operations and financial condition and the value of our common stock. We cannot assure you that we will continue to be successful in increasing the volume of loans and deposits at acceptable risk levels and upon acceptable terms. Additionally, we may not continue to be successful in expanding our asset base to a targeted size and managing the costs and implementation risks associated with our growth strategy. We cannot assure you that further expansion will be profitable or that our historical rate of growth will continue to be sustained, either through internal growth or otherwise, or that capital will be maintained sufficient to support continued growth. Furthermore, if we grow too quickly and are not able to control costs and maintain asset quality, rapid growth also could adversely affect our financial performance. In 2009 and 2010, our assets decreased which is not consistent with our historical growth rates. We cannot guarantee we will be able return to our historical growth trends in the short term future due to tepid loan demand from qualified loan customers as a result of the current economic environment. Additionally, our ability to grow our assets may be restricted if our regulatory capital is not sufficient to support the growth while maintaining capital ratios that meet the Company’s policy guidelines and satisfy regulatory restrictions.
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition. Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us. Our ability to acquire deposits or borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole.
Our status as a holding company makes us dependent on dividends from our subsidiaries to meet our obligations. We are a bank holding company and conduct almost all of our operations through YCB and SCSB. We do not have any significant assets other than cash and the stock of YCB and SCSB. Accordingly, we depend on dividends from our subsidiaries to meet our obligations and obtain revenue. Our right to participate in any distribution of earnings or assets of our subsidiaries is subject to the prior claims of creditors of such subsidiaries. Under federal and state law, our bank subsidiaries are limited in the amount of dividends they may pay to us without prior regulatory approval. The Banks must maintain sufficient capital and liquidity and be in compliance with other general regulatory restrictions. Bank regulators have the authority to prohibit the subsidiary banks from paying dividends if the bank regulators determine the payment would be an unsafe and unsound banking practice. As of December 31, 2010, our subsidiaries had limited ability to pay us a dividend without prior regulatory approval.
The FDIC’s restoration plan and the related increased assessment rate could affect our earnings. As a result of a series of financial institution failures and other market developments, the deposit insurance fund, or DIF, of the FDIC has been significantly depleted and reduced the ratio of reserves to insured deposits. In response to the recent economic conditions and the enactment of the Dodd-Frank Act, the FDIC has increased the deposit insurance assessment rates and thus raised deposit premiums for insured depository institutions. If these increases are insufficient for the DIF to meet its funding requirements, further special assessments or increases in deposit insurance premiums may be required which we may be required to pay. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures or if the FDIC otherwise determines, we may be required to pay even higher FDIC premiums than the recently increased levels. Any future additional assessments, increases or required prepayments in FDIC insurance premiums may materially adversely affect our results of operations and could have a materially adverse effect on the value or market for our common stock.
Our ability to pay dividends is subject to certain limitations and restrictions, and there is no guarantee that we will be able to continue paying the same level of dividends in the future that we paid in 2010 or that we will be able to pay future dividends at all. Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of Your Community Bank and The Scott County Bank to pay dividends to us is limited by its obligations to maintain sufficient capital and liquidity and by other general restrictions on dividends that are applicable to these banks, including state regulatory requirements. The FDIC and other bank regulators have proposed guidelines and seek greater liquidity, and have been discussing increasing capital requirements. If these regulatory requirements are not met, our subsidiary banks will not be able to pay dividends to us, and we may be unable to pay dividends on our common stock.
In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Federal Reserve regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) in light of our earnings, capital adequacy and financial condition. In addition, as a matter of policy, the Federal Reserve has indicated that bank holding companies should not pay dividends on common stock (or make distributions on trust preferred securities) using funds from the Treasury’s Capital Purchase Program. As a general matter, the Federal Reserve indicates that the board of directors of a bank holding company (including a financial holding company) should eliminate, defer or significantly reduce the dividends if:
•
the company’s net income available to stockholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends;
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the prospective rate of earnings retention is inconsistent with the company’s capital needs and overall current and prospective financial condition; or
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the company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.
On May 29, 2009, we issued shares of perpetual senior preferred stock to the Treasury as part of the Capital Purchase Program. The terms of the senior preferred stock restrict the payment of dividends on shares of our common stock. Without the prior consent of Treasury, we are prohibited from increasing common stock dividends beyond the $0.175 quarterly dividend that we paid prior to closing Treasury’s investment for the first three years while Treasury holds the senior preferred stock. Further, we are prohibited from continuing to pay dividends on our common stock unless we have fully paid all required dividends on the senior preferred stock. Although we expect to be able to pay all required dividends on the senior preferred stock, there is no guarantee that we will be able to do so.
Changes in future rules applicable to Capital Purchase Program recipients could adversely affect our business, financial condition and results of operations. On May 29, 2009, we issued 19,468 of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A and a warrant to purchase 386,270 shares of our common stock, for an aggregate purchase price of $19,468,000 to the Treasury pursuant to the Capital Purchase Program. The rules and policies applicable to recipients of capital under the Capital Purchase Program continue to evolve and their scope, timing and effect cannot be predicted. Any redemption of the securities sold to the Treasury to avoid these restrictions would require prior Federal Reserve and Treasury approval. Based on guidelines recently issued by the Federal Reserve, institutions seeking to redeem Capital Purchase Program preferred stock must demonstrate an ability to access the long-term debt markets, successfully demonstrate access to public equity markets and meet a number of additional requirements and considerations before such institutions can redeem any securities sold to the Treasury.
If the Company is unable to redeem its Series A Preferred Stock after an initial five-year period, the cost of this capital will increase substantially. If the Company is unable to redeem its Series A Preferred Stock prior to February 15, 2014, the cost of this capital to us will increase from approximately $1.5 million annually (5.0% per annum of the Series A preferred stock liquidation value) to $2.7 million annually (9.0% per annum of the Series A preferred stock liquidation value). This increase in the annual dividend rate on the Series A preferred stock would have a material negative effect on the earnings the Company can retain for growth and to pay dividends on its common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
The Company has received no written communication from the staff of the SEC regarding its periodic or current reporting under the Exchange Act.
Item 2.
Item 2. Properties
The Company conducts its business through its corporate headquarters located in New Albany, Indiana. YCB operates a main office and eleven branch offices in Clark and Floyd Counties, Indiana, and five branch offices in Jefferson and Nelson Counties, Kentucky. SCSB operates a main office and three branch offices in Scott County, Indiana. The following table sets forth certain information concerning the main offices and each branch office at December 31, 2010. The Company’s aggregate net book value of premises and equipment was $13.7 million at December 31, 2010.
Item 3.
Item 3. Legal Proceedings
There are various claims and law suits in which the Company or its subsidiaries are periodically involved, such as claims to enforce liens, foreclosure or condemnation proceedings on properties in which the Banks hold mortgages or security interests, claims involving the making and servicing of real property loans and other issues incident to the Banks’ business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits. Further, we maintain liability insurance to cover some, but not all, of the potential liabilities normally incident to the ordinary course of our businesses as well as other insurance coverage customary in our business, with coverage limits as we deem prudent.
Part II
Item 5.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases of Equity Securities
Market Information
The Company’s common stock is traded on the Nasdaq Capital Market under the symbol “CBIN”. The quarterly range of low and high trade prices per share of the Company’s common stock for the periods indicated as reported on the Nasdaq Capital Market, as well as the per share dividend paid in each such quarter by the Company on its common stock is shown below.
Holders
As of March 23, 2011 there were 834 holders of the Company’s common stock.
Dividends
The Company intends to continue its historical practice of paying quarterly cash dividends although there is no assurance that such dividends will continue to be paid in the future. The payment of dividends in the future is dependent on future income, financial position, capital requirements, the discretion and judgment of the Board of Directors, and other considerations. In addition, the payment of dividends is subject to the regulatory restrictions described in Note 14 to the Company's consolidated financial statements.
Securities Authorized for Issuance under Equity Compensation Plans
The following table sets forth certain information regarding Company compensation plans under which equity securities of the Company are authorized for issuance.
(1) Of the shares reflected, 25,333 shares have been awarded under the Company’s Stock Award Plan for deferred stock units all of which will be paid in shares (see Note 11 of the Company’s consolidated financial statements for further information on the Company’s deferred stock units). The deferred stock units have been excluded from the weighted-average exercise price column.
(2) Of the shares reflected, 197,417 shares are available to be awarded under the Company’s Stock Award Plan and 267,525 shares are available to be awarded under the Company’s Performance Units Plan.
Performance Graph
The following performance graph and included data shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed soliciting material or subject to Regulation 14A of the Exchange Act or incorporated by reference in any filing under the Exchange Act or the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing.
The graph compares the performance of Community Bank Shares of Indiana, Inc. common stock to the Russell 2000 index and the SNL Bank $500 MM - $1 B Bank index for the Company’s last five fiscal years. The graph assumes the value of the investment in Company common stock and in each index was $100 at December 31, 2005 and that all dividends were reinvested.
Item 6.
Item 6. Selected Financial Data
The following table sets forth the Company’s selected historical consolidated financial information from 2006 through 2010. This information should be read in conjunction with the Consolidated Financial Statements and the related Notes. Factors affecting the comparability of certain indicated periods are discussed in "Management’s Discussion And Analysis Of Financial Condition And Results Of Operations." For analytical purposes, net interest margin is adjusted to a taxable equivalent adjustment basis to recognize the income tax savings on tax-exempt assets, such as state and municipal securities. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent (“FTE”) basis.
* Number is not meaningful
Item 7.
Item 7. Management’s Discussion And Analysis Of Financial Condition And Results of Operations
Overview
This section presents an analysis of the consolidated financial condition of the Company and its wholly-owned subsidiaries, the Banks, at December 31, 2010 and 2009, and the consolidated results of operations for each of the years in the three year period ended December 31, 2010. The information contained in this section should be read in conjunction with the consolidated financial statements, notes to consolidated financial statements and other financial data presented elsewhere in this annual report on Form 10-K.
The Company conducts its primary business through the Banks, which are community-oriented financial institutions offering a variety of financial services to its local communities. The Banks are engaged primarily in the business of attracting deposits from the general public and using such funds for the origination of: 1) commercial business and real estate loans and 2) secured consumer loans such as home equity lines of credit, automobile loans, and recreational vehicle loans. Additionally, the Banks originate and sell into the secondary market mortgage loans for the purchase of single-family homes in Floyd, Clark, and Scott counties, Indiana, and Jefferson and Nelson counties, Kentucky, including surrounding communities. The Banks invest excess liquidity balances in mortgage-backed, U.S. agency, state and municipal and corporate securities.
The operating results of the Company depend primarily upon the Banks’ net interest income, which is the difference between interest earned on interest-earning assets and interest incurred on interest-bearing liabilities. Interest-earning assets principally consist of loans, taxable and tax-exempt securities, and FHLB stock. Interest-bearing liabilities principally include deposits, retail repurchase agreements, federal funds purchased, advances from the FHLB Indianapolis, and subordinated debentures. The earnings of the Banks are also affected by 1) provision for loan losses, 2) non-interest income (including mortgage banking income, net gains on sales of securities, deposit account service charges and commission-based income on non-deposit investment products), 3) non-interest expenses (including compensation and benefits, occupancy, equipment, data processing expenses, marketing and advertising, legal and professional fees, FDIC insurance premiums, net foreclosed and repossessed asset expense, and other expenses, such as postage, printing, and telephone expenses), and 4) income tax expense.
Forward Looking Information
Statements contained within this report that are not statements of historical fact constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. When used in this discussion the words "anticipate," "project," "expect," "believe," and similar expressions are intended to identify forward-looking statements. The Company cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which may change over time. Actual results could differ materially from forward-looking statements.
In addition to factors disclosed by the Company elsewhere in this annual report on Form 10-K, the following factors, among others, could cause actual results to differ materially from such forward-looking statements: 1) adverse changes in economic conditions affecting the banking industry in general and, more specifically, the market areas in which the Company and its subsidiary Banks operate, 2) adverse changes in the legislative and regulatory environment affecting the Company and its subsidiary Banks, 3) increased competition from other financial and non-financial institutions, 4) the impact of technological advances on the banking industry, and 5) other risks detailed at times in the Company’s filings with the Securities and Exchange Commission (see Item 1A of this annual report on Form 10-K for more risk factors). The Company does not assume an obligation to update or revise any forward-looking statements subsequent to the date on which they are made.
Application of Critical Accounting Policies
The Company's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and follow general practices within the financial services industry. The most significant accounting policies followed by the Company are presented in Note 1 to the Consolidated Financial Statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, fair value of investment securities and deferred tax assets to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
Allowance for Loan Losses
The allowance for loan losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated fair value of collateral securing the loans, estimated losses on loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for loan losses, and a discussion of the factors driving changes in the amount of the allowance for loan losses is included under "Asset Quality" below.
Loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, amounts of allowances are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Company. Included in the review of individual loans are those that are impaired. The Company evaluates the collectability of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other loans not subject to allowance allocations. These historical loss rates may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, asset quality trends, risk management and loan administration, changes in internal lending policies and credit standards, and examination results from bank regulatory agencies and the Company's internal credit examiners.
The Company has not substantively changed any aspect to its overall approach in the determination of the allowance for loan losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance.
Based on the procedures discussed above, management is of the opinion that the allowance of $10.9 million was adequate to address probable incurred credit losses associated with the loan portfolio at December 31, 2010.
Fair Value of Trust Preferred Securities
The Company had six trust preferred securities in its investment portfolio as of December 31, 2010 with a combined book value of $4.1 million and a fair value of $1.4 million as of the same date. Beginning in 2008, the market for these types of securities effectively froze as market participants were unwilling to conduct transactions unless forced to do so. As a result, the fair value of these securities began deteriorating significantly in 2008 and remained depressed in 2009 and 2010. In 2009 and 2010, the Company recorded aggregate other-than-temporary impairment (“OTTI”) charges to earnings of $1.5 million related to five of the six securities in its portfolio due to continued weakening of the underlying issuers. Management evaluates these investments for OTTI by estimating the anticipated discounted cash flows from each security. The determination of the anticipated cash flows and the discount rate are both significant estimates requiring management’s judgment. Also, the estimated fair value of these securities is more difficult to determine due to the current market volatility and illiquidity. The valuation model to determine fair value utilizes discounted cash flow models with significant unobservable inputs. In management’s estimation, the valuation method provided a more relevant and accurate representation of the fair value of these securities as of December 31, 2010.
Carrying Value of Foreclosed and Repossessed Assets
Foreclosed and repossessed assets are acquired through or instead of loan foreclosure and are initially measured at fair value less estimated costs to sell. The Company obtains appraisals to determine the initial fair value and then makes any adjustments deemed necessary based on prevailing market conditions and length the asset remains in the Company’s inventory. Determining the carrying value requires significant management judgment as foreclosed and repossessed assets are typically acquired in distressed situations which may materially impact the valuation compared to similar assets in non-distressed sales transactions. Also, if foreclosed and repossessed assets are not sold in a timely manner, they can deteriorate in value significantly as there may be volatility in the market. At December 31, 2010, the Company had foreclosed and repossessed assets of $3.6 million which, in management’s estimation, were reported at the appropriate carrying value.
Deferred Tax Assets
The Company has a net deferred tax asset of approximately $4.3 million. The Company evaluates this asset on a quarterly basis. To the extent the Company believes it is more likely than not that it will not be utilized, the Company will establish a valuation allowance to reduce its carrying amount to the amount it expects to be realized. At December 31, 2010, a valuation allowance of $1.8 million has been established against the outstanding deferred tax asset due to incurred net operating losses for state income taxes. The net operating loss is partially due to YCB’s Nevada subsidiaries that hold and manage YCB’s investments and for the results of 2009 including elevated provision for loan losses. There is uncertainty the Company will be able to utilize this benefit, thus a valuation allowance has been established against the state net operating loss. Note 12 to the Consolidated Financial Statements describes the net deferred tax asset. The Company was profitable in 2010 and has a positive earnings outlook for 2011. The net loss for 2009 was primarily attributable to a goodwill and other intangible asset impairment of $16.2 million and an elevated provision for loan losses of $15.9 million which were not repeated in 2010 and are not expected to be repeated in 2011. As of December 31, 2010, the Company has $1.1 million of remaining other intangible assets subject to impairment and has an allowance for loan losses to total loans ratio of 2.11% which management believes is sufficient to cover probable incurred losses as of that date. The estimate of the realizable amount of this asset is a critical accounting policy.
Highlights
The Company had net income available to common shareholders of $5.9 million for the year ended December 31, 2010 from a net loss attributable to common shareholders of $(22.6) million for 2009. The improvement in earnings was primarily due to a reduction in provision for loan losses of $12.1 million and a reduction in non-interest expenses of $18.7 million, $16.2 million of which was attributable to a goodwill and other intangible asset impairment charge recorded in 2009 that was not repeated in 2010. Also, contributing to the improvement in earnings were increases in net interest income of $3.8 million and non-interest income of $1.1 million. Earnings per basic and diluted common shares increased to $1.80 and $1.77 for the year ended December 31, 2010 compared to basic and diluted loss per common share of $(6.93) in 2009. The Company’s book value per common share increased to $13.36 per share at December 31, 2010 from $12.49 at December 31, 2009.
The following table summarizes selected financial information regarding the Company's financial performance:
Table 1 - Summary
The Company’s total assets decreased to $801.5 million at December 31, 2010 from $819.2 million at December 31, 2009 primarily due to a decrease in net loans of $26.0 million and a decrease in cash and deposit in other financial institutions of $18.9 million, offset by an increase in securities available for sale of $31.5 million. Total deposits increased by $26.4 million to $618.8 million at December 31, 2010 while non-interest deposits increased by $4.8 million from 2009. Other borrowings and FHLB advances decreased by $27.6 million and $18.5 million, respectively, to $49.4 million and $50.0 million as of December 31, 2010. Total shareholders’ equity increased by $3.2 million to $63.2 million at December 31, 2010 as the Company achieved net income available to common shareholders of $5.9 million and declared and paid dividends on common shares of $1.3 million.
Results of Operations
Net Interest Income
The Company’s principal revenue source is net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities, and the interest expense on the liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is impacted by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.
Net interest income for the year ended December 31, 2010 increased to $27.7 million from $23.9 million for 2009 while the net interest margin on a taxable equivalent basis increased to 3.90% for 2010 from 3.19% in 2009. The increase in net interest income and net interest margin in 2010 was due to a decrease in the cost of interest bearing liabilities of 97 basis points while the yield on interest earnings assets decreased by 15 basis points. The Company’s cost of interest bearing liabilities decreased for most categories of interest bearing liabilities, primarily time deposits and FHLB advances, but increased slightly for other borrowings. Also contributing to the increase in net interest income for 2010 was an increase in average non-interest bearing deposits to $135.8 million from $110.1 million. The Company’s non-interest deposits at December 31, 2010 were $115.0 million, which was lower than the average for the year due to the loss of a significant customer account late in the fourth quarter of 2010. As a result, the average non-interest bearing deposits for 2011 will most likely be lower than 2010.
Average interest earning assets decreased to $739.8 million for the year ended December 31, 2010 from $775.9 million for 2009 while the average yield decreased to 5.01% in 2010 from 5.16% in 2009. Most of the decrease in average interest earning assets was due to a reduction in average loans to $524.0 million in 2010 from $588.0 million in 2009. The decrease was due to net loan repayments and charge-offs during 2010 as loan demand from qualified borrowers remained soft. The yield on loans increased for 2010 to 5.66% from 5.56% as the Company was able to reduce its loans on non-accrual from $22.7 million in 2009 to $15.3 million in 2010. Also factoring into the increase in loan yields was management’s efforts to add rate floors to existing and new credit relationships where the loan was indexed to a variable rate. The Company’s yield on loans remains under pressure as higher-yielding fixed rate loans mature or refinance into a historically low rate environment. In addition, the Company continues to face heavy competition from other financial institutions in its market for new customers which has also put downward pressure on loan yields. Due to the net repayments of loans coupled with soft loan demand and the increase in deposits, the Company’s on balance-sheet liquidity remained elevated during the year. As a result, the Company used incoming cash flows to reduce FHLB advances and withstand a decrease in other borrowings due to reduction in offering rates (see discussion in following paragraph) and increase its investment in securities available for sale. The average balance of taxable securities increased to $120.4 million with a yield of 3.31% for 2010 from $104.5 million and 4.42% in 2009. The decrease in yield was attributable to sales and maturities in the portfolio for gains during the year replaced with purchases of lower-yielding securities. The average balance of tax-exempt securities increased to $47.1 million with a fully taxable equivalent yield of 6.74% from $34.8 million and 6.64% in 2009. The increase in yield on a fully taxable equivalent basis was due to minimal maturities in the portfolio and purchases of securities with higher yields than the portfolio.
Average interest bearing liabilities decreased to $614.5 million in 2010 from $667.1 million in 2009 due mostly to a decrease in the average FHLB advances and average time deposits. During 2010, the Company repaid $18.5 million, net, of FHLB advances, $10.5 million of which were prepayments of putable advances. The Company incurred prepayment penalties of $335,000 on repayment of the putable advances. As a result of these repayments, the Company’s interest expense paid on FHLB advances decreased by $2.8 million during 2010 while the average cost decreased by 232 bps to 2.66%. Beginning in 2009 and finishing in the first quarter of 2010, the Company prepaid a total of $67.0 million of putable advances which had a weighted average cost of 6.03%. These advances had a significant impact on the Company’s net interest income in 2009 and 2008 and a limited effect on net interest income 2010. The weighted average cost of the putable advances was significantly higher than most all alternative funding sources. The cost of time deposits decreased to 1.76% in 2010 from 2.98% in 2009 which contributed further to the overall reduction in the cost of funds. In 2010, the Company was able to reprice maturing time deposits and lower its offering rates for new time deposit accounts due to its strong liquidity position.
In 2009, net interest income increased to $23.9 million from $23.5 million for 2008 while the net interest margin on a taxable equivalent basis increased to 3.19% for 2009 from 3.09% in 2008. The increase in net interest income and net interest margin in 2009 was due to a decrease in the cost of interest bearing liabilities of 85 basis points while the yield on interest earnings assets decreased by 71 basis points. The Company’s cost of interest bearing liabilities decreased for all categories of interest bearing liabilities, primarily time deposits and savings and others. Also contributing to the increase in net interest income for 2009 was an increase in average non-interest bearing deposits to $110.1 million from $97.7 million.
Average interest earning assets increased to $775.9 million for the year ended December 31, 2009 from $770.6 million for 2008 while the average yield decreased to 5.16% in 2009 from 5.87% in 2008. In 2009, the Company sold fixed rate 1-4 family mortgage loans with a book value of $14.5 million for a gain of $197,000 and had a net decrease in loans of $58.0 million due to charge-offs, collected payments and lower loan originations which contributed to a decline in the average balance of loans to $588.0 million for 2009 from $639.3 million. The yield on loans decreased to 5.56% for the year as the portfolio continued to be impacted by a historically low prime rate, of which a significant portion of the Company’s portfolio is indexed to, and an increase in non-accrual loans to $22.7 million at December 31, 2009. Also, the yield on average interest earning assets was impacted by a significant increase in the average balance of interest bearing deposits in other financial institutions to $40.3 million for 2009, yielding 0.33% from $12.1 million in 2008.
Average interest bearing liabilities decreased to $667.1 million in 2009 from $680.0 million in 2008 due mostly to a decrease in the average FHLB advances. At the beginning of 2009, $67.0 million of the Company’s $111.9 million FHLB advances outstanding were putable advances with a weighted average cost of 6.03% which significantly impacted the Company’s average cost of interest bearing liabilities and net interest margin. During 2009, the Company elected to prepay $56.5 million of the $67.0 million putable advances and $5.0 million of fixed rate advances, incurring prepayment penalties of $838,000 with the remaining $10.5 million of putable advances prepaid in the first quarter of 2010. As a result of these prepayments, the Company’s interest expense paid on FHLB advances decreased by $1.3 million during 2009 while the average cost decreased 26 basis points to 4.98%. Management estimates the prepayment penalties incurred (reported in non-interest expense) will be fully offset by an increase in net interest income over the term from the prepayment to the scheduled maturity. The cost of savings and other deposits and time deposits in 2009 decreased to 0.60% and 2.98%, respectively, from 1.30% and 3.94% in 2008 as the Company lowered its offering rates for deposits and repriced maturing time deposits.
Table 2 provides detailed information as to average balances, interest income/expense, and rates by major balance sheet category for 2008 through 2010.
Table 2 - Average Balance Sheets and Rates for Years Ended 2010, 2009 and 2008
For analytical purposes, net interest margin and net interest spread are adjusted to a taxable equivalent adjustment basis to recognize the income tax savings on tax-exempt assets, such as state and municipal securities. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent (“FTE”) basis.
(1) The amount of direct loan origination cost included in interest on loans was $591, $726, and $412 for the years ended December 31, 2010, 2009, and 2008, respectively.
(2) Includes loans held for sale and non-accruing loans in the average loan amounts outstanding.
Table 3 illustrates the extent to which changes in interest rates on a fully taxable equivalent basis and changes in the volume of interest-earning assets and interest-bearing liabilities affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent (“FTE”) basis.
Table 3 - Volume/Rate Variance Analysis
Non-interest Income
Non-interest income was $7.4 million for 2010, $6.3 million for 2009, and $6.1 million for 2008. For the year ended December 31, 2010, non-interest income increased by 17.2%, due to increases in net gain on sales of available for sale securities of $371,000, commission income of $77,000, interchange income of $68,000 and a reduction in other-than-temporary impairment losses of $740,000, offset by decreases in gain on sale of loans of $197,000. In 2009, non-interest income increased 3.9% as compared to 2008 due to increases in net gain on sales of available for sale securities of $1.0 million, mortgage banking income of $147,000 and gain on sale of loans of $197,000 and other income of $164,000, offset by an other-than-temporary impairment loss of $1.1 million and decreases in commission income of $141,000 and a change in the fair value and cash settlement of interest rate swaps of $180,000.
Table 4 provides a breakdown of the Company’s non-interest income during the past three years.
Table 4 - Analysis of Non-interest Income
Service charges on deposit accounts decreased slightly by $20,000 to $3.4 million for the year ended December 31, 2010. Of the $3.4 million of service charge income recognized in 2010, approximately $2.5 million was earned from non-sufficient funds and overdraft fees charged to customers. On July 1, 2010 regulatory changes required customers to opt in or affirmatively consent to overdraft services and provides them with an ongoing right to revoke consent. Also, we must provide customers who do not opt in with the same account terms, conditions and features, including price, as provided to customers who do opt in. As a result of the aforementioned regulatory change, non-sufficient funds and overdraft fees decreased by $165,000 from 2009 to 2010. The decrease in non-sufficient funds and overdraft fees in 2010 was partially offset by an increase in service fees on deposit accounts of approximately $100,000. The Company is continuing to investigate alternatives for replacing lost fee income due to recent regulatory changes. Service charges on deposit accounts increased slightly by $97,000 to $3.5 million in 2009 from $3.4 million in 2008. The increase was mostly attributable to fees earned on a new retail deposit product implemented in 2007 which accounted for approximately $45,000 of the increase from 2008. Of the $3.5 million of service charge income recognized in 2009, approximately $2.7 million is earned from non-sufficient funds and overdraft fees charged to customers.
Commission income from investment products offered to customers through our alliance with Wells Fargo Advisors increased $77,000 for the year ended December 31, 2010 to $130,000 from the year prior. In 2009, income decreased to $53,000 from $194,000 for the equivalent period in 2008. During 2009, the Company transitioned its relationship from Smith Barney to Wells Fargo, as a result, there was a period during 2009 for which the Company did not recognize commission income.
In 2010, the Company received net proceeds of $117.8 million on sales of available for sale securities for net gains of $1.8 million compared to proceeds of $76.5 million and net gains of $1.4 million in 2009. The proceeds from sales were reinvested in the security portfolio. Management continues to selectively sell securities when the proceeds can be reinvested in similar securities with equivalent yields, usually with longer maturities.
Mortgage banking income increased by $51,000 to $365,000 for the year ended December 31, 2010 compared to $314,000 in 2009. In 2010, the Company originated $20.2 million of loans for sale into the secondary market as compared to $21.2 million in 2009 as customers continued to take advantage of historically low interest rates and government incentive programs. In 2009, mortgage banking income increased by $147,000 to $314,000 compared to $167,000 in 2008. In 2009, the Company originated $21.2 million of loans for sale into the secondary market as compared to $13.6 million in 2008.
In 2009, the Company sold fixed rate 1-4 family residential loans previously held for an investment with a book value of $14.5 million for a gain of $197,000 to a third party investor. Management sold these long-term fixed rate loans to reduce the Company’s exposure to rising interest rates and increased liquidity. The Company did not sell loans held for investment in 2010 or 2008.
Earnings on company owned life insurance decreased slightly to $720,000 for the year ended December 31, 2010 from $745,000 for the equivalent period in 2009. The income decreased in 2010 due to a decrease in the crediting rate by the companies that issued the policies. The Company did not purchase or exchange any policies during 2010. During 2009, earnings on company owned life insurance increased slightly to $745,000 compared $734,000 in 2008 as the crediting rate remained relatively consistent with 2008. The Company did not purchase or exchange any policies during 2010 or 2009.
Interchange income increased to $907,000 in 2010 from $839,000 in 2009. The Company has focused on increasing interchange income through various initiatives including offering incentives to current and new customers. In addition, the Company has added new deposit accounts during 2010 which also factored into the increase in interchange income.
The Company recorded a net other-than-temporary impairment (“OTTI”) charge in earnings of $360,000 for the year ended December 31, 2010 compared to a charge of $1.1 million in 2009. In 2010 and 2009, the Company recorded OTTI charges on five of its six pooled trust preferred securities (“CDO”), which consisted of bank issuers (the one CDO for which the Company did not record an OTTI charge is comprised of insurance companies). Beginning in 2008 and continuing into 2009 and 2010 we noted a continuing decline in the fair value of our CDO portfolio due to market illiquidity and a lack of transactions involving these types of securities. Additionally, as the economic downturn continued in 2010, we noted further deterioration in the financial condition of the underlying issuers, particularly those pools with issuer banks. Also, we noted an increase in the number of issuers deferring and defaulting on the underlying notes in the CDO’s consistent with the increase in bank closures. Our analysis to determine OTTI is based on estimating the expected cash flows to be received from the underlying issuers and determining the present value of cash flows expected to us utilizing an appropriate discount rate (see footnote 2 to the Consolidated Financial Statements for further discussion). At December 31, 2010, the fair value of our CDO’s has yet to recover. Although an appropriate amount of OTTI has been recorded in 2009 and 2010, further deterioration in the issuers in the CDO’s could lead to future OTTI charges should they be significant.
Non-interest Expense
Non-interest expense decreased to $22.5 million for the year ended December 31, 2010 from $41.2 million in 2009. Most categories of non-interest expense declined from the previous year including: salaries and employee benefits, occupancy, equipment, marketing and advertising, legal and professional service fees, FDIC insurance premiums, goodwill and other intangible asset impairment, prepayment penalties on extinguishment of debt, foreclosed and repossessed assets, net, and other expense. Generally, the reductions were achieved through expense reduction initiatives implemented in the second and third quarters of 2009 which were continued into 2010. Non-interest expense increased to $41.2 million for the year ended December 31, 2009 from $22.6 million for 2008, due to a goodwill and other intangible asset impairment charge of $16.2 million, prepayment penalties on extinguishment of debt of $838,000 and increases in occupancy expense of $248,000, data processing of $567,000, legal and professional fees of $474,000, FDIC insurance premiums of $1.2 million, and foreclosed and repossessed asset expense $448,000, offset by decreases in salaries and employee benefits of $965,000, equipment expense of $116,000, and marketing and advertising of $206,000.
Table 5 provides a breakdown of the Company’s non-interest expense for the past three years.
Table 5 - Analysis of Non-interest Expense
Salaries and benefits decreased to $10.5 million for the twelve months ended December 31, 2010 compared to $11.2 million in 2009 while the number of full time equivalent employees (“FTE”) was 199 at the end of each year or $53,000 expense per FTE in 2010 versus $56,000 in 2009. The reduction in expense was primarily achieved due to reductions in staff in the middle of 2009 which lowered the Company’s base compensation from $9.6 million in 2009 to $8.7 million in 2010. Also contributing to the decrease in salaries and employee benefits was a reduction in the employer portion of insurance benefits of $124,000 from the aforementioned reduction in FTEs and new health insurance plan options offered to employees which had lower premiums and a decrease of $77,000 in expenditures for education and other employee benefits. These decreases were partially offset by an increase in stock award and bonus/incentive expense of $474,000 from 2009 to 2010. Due to the Company’s performance in 2009, all stock and bonuses with performance conditions tied to earnings were not met, therefore, expense was not recognized in 2009 related to these plans. In 2010, the Company achieved at least the minimum threshold for most of the plans and recorded the appropriate expense as determined by the Company’s compensation committee and performance conditions. In 2009, salaries and benefits decreased to $11.2 million compared to $12.1 million for the equivalent period in 2008. The primary cause for the decrease was the reduction in the Company’s full time equivalent employees to 199 at December 31, 2009 from 238 at December 31, 2008 which reduced expense for wages by $503,000 as well as related payroll taxes by $62,000. Additionally, the Company had reduction for incentive compensation of $116,000 and other stock based compensation of $257,000. The reduction in incentive compensation and stock based compensation was directly attributable to the Company’s earnings performance in 2009. In 2009, incentive compensation was suspended during the third quarter as a result of the net loss available to common shareholders for the second quarter while the minimum earnings thresholds were not met for certain stock based compensation grants with 2009 fiscal year performance criteria.
Occupancy expense decreased by $364,000 to $2.1 million in 2010 from $2.4 million in 2009 due to reductions in property taxes, utilities, and depreciation expense. During 2010, the Company closed one of its branch locations in the Jefferson County Kentucky market which lowered utilities and other related costs of operating the branch. In addition, the Company completed depreciating certain leasehold improvements during 2010 which resulted in a significant decrease in expense. Occupancy expense increased to $2.4 million for the twelve months ended December 31, 2009 from $2.2 million in 2008 due primarily to increases in property taxes on the Company’s owned branch locations of $180,000 and utility expenses of $50,000. The increase in property taxes was related to the adjustment of the taxable value of the Company’s Floyd and Clark County, Indiana branches by the local taxing authorities.
Equipment expense was $1.2 million for the year ended December 31, 2010, a reduction of $204,000 from $1.4 million in 2009 due to reductions in depreciation expense of $99,000 and maintenance and repairs expenditures of $57,000. As previously noted, the Company implemented several cost reduction initiatives during 2009, one of which was a limitation on purchases of equipment and software. Because equipment and software have short depreciable lives, typically between 3 to 7 years, lower capital expenditures have an immediate impact on the Company’s depreciation expense. Management will continue to carefully review the return on investment for capital expenditures in 2011 and beyond to insure that efficient use of purchases is achieved. Equipment expense decreased $116,000 to $1.4 million for 2009 from $1.5 million in 2008. The decrease was the result of the Company’s efforts to reduce non-interest expense including expenditures on furniture and fixtures below the Company’s capitalization limit.
Data processing expense in 2010 remained consistent with 2009 at $2.5 million as reductions in expenditures in communication lines and hardware maintenance were offset by an increase in expense for the Company’s third party core data processor. The increase in core data processor expense was due to the outsourcing of proof operations during 2010 which management estimates will be offset by reductions in hardware maintenance and personnel costs. In 2009, data processing expense increased to $2.5 million from $1.9 million for 2008. The increase was primarily due to expenses related to the conversion of SCSB’s third party core data processor during 2009 including termination expenses for exiting existing associated contracts.
Marketing and advertising expense decreased to $241,000 for 2010 from $362,000 in 2009. The reduction was achieved by decreases in the expenditures for newspaper advertising and promotional items. Marketing and advertising expense decreased to $362,000 for the twelve months ended December 31, 2009 from $568,000 for the equivalent period in 2008. The decrease was due to efforts to reduce expense in 2009 and also from marketing expenditures in 2008 that were not repeated in 2009.
Legal and professional service fees decreased to $1.4 million for the twelve months ended December 31, 2010 as compared to $1.6 million for the equivalent period in 2009. The decrease in was attributable to reductions in legal fees incurred to resolve past due loans of $96,000 and other legal fees of $150,000. The Company continues to have elevated levels of non-performing assets which will necessitate higher legal fees then we have historically incurred to collect and dispose of any foreclosed assets. Legal and professional fees increased by $474,000 to $1.6 million for 2009 from $1.2 million in 2008. The increase is directly attributable to legal fees associated with collection and repossession efforts associated with the Company’s loan portfolio. During 2009, the Company experienced a significant increase in its non-performing loans which necessitated an increase in expenditures on legal fees. In addition, the Company has several large credit relationships that have been in collection proceedings and negotiations for an extensive period of time which has led to enhanced fees as well.
FDIC insurance premiums were $1.4 million in 2010, a decrease of $315,000 from $1.7 million in 2009 due primarily to a special assessment by the FDIC in 2009 of $370,000 which was not repeated in 2010. FDIC insurance premiums increased to $1.7 million for the twelve months ended December 31, 2009, or $1.2 million, from $480,000 for the same period in 2008. Beginning in 2008 and continuing into 2009 and 2010, the number of bank failures has placed continued stress on the FDIC and its funds reserved to cover depositors of failed institutions (up to the insured limit). As a result, the FDIC undertook several initiatives during 2009 in an effort to replenish its funds including the implementation of the aforementioned special assessment which was payable on June 30, 2009 and requiring the prepayment of 3 years of assessments on December 30, 2009. The prepaid assessment was based on YCB’s and SCSB’s current annual assessment rate in effect on September 30, 2009 for the 2010 prepayment and increased by 3 basis points for 2011 and 2012. The assessment was multiplied by the deposits reported in each bank’s call reports at September 30, 2009 and increased quarterly by a 5% annual growth rate. As of December 31, 2010 and 2009, the Company’s prepaid FDIC assessment was $3.7 million and $4.9 million, respectively.
The Company recorded a goodwill and other intangible asset impairment charge of $16.2 million for the year ended December 31, 2009 which was not repeated in 2010. The Company had historically tested its goodwill and other intangible assets for impairment in the fourth quarter of each year, however, beginning in 2008 and extending into 2009, the Company’s stock price traded at a market price less than its per share common book value necessitating more frequent evaluations. In 2009, the Company’s first quarter net income was less than historical amounts due to increasing delinquencies and deterioration in the loan portfolio while the Company recorded a significant provision in the second quarter as the loan portfolio continued to demonstrate weakness and several large relationships were downgraded. As a result, the Company performed an impairment analysis as of June 30, 2009 which indicated its goodwill was impaired. To evaluate goodwill, the Company engaged third party valuation consultants to assist with valuing the Company and its other intangible assets. The results of these analyses indicated that all of the Company’s recorded goodwill was impaired, or $15.3 million, while an impairment charge of $819,000 was required for other intangible assets (see footnote 5 of the Consolidated Financial Statements for further information). After the impairment charges, the Company had $1.1 million and $1.4 million of other intangible assets on its balance sheet as of December 31, 2010 and 2009, respectively, that were subject to impairment evaluation in the future.
During the twelve months ended December 31, 2010 and 2009 the Company incurred $335,000 and $838,000 in prepayment penalties on extinguishment of debt for the prepayment of $10.5 million and $56.5 million of FHLB advances, respectively. In total, the Company prepaid $67.0 million in putable advances that carried a weighted average cost of 6.03% which was significantly higher compared to the Company’s other cost of funds. Management determined the penalties incurred for prepaying the advances would be more than offset by a reduction in interest expense over the remaining scheduled maturities for each advance. The prepaid advances were not replaced with other borrowings, therefore, the penalties were entirely expensed in 2010 and 2009.
Foreclosed and repossessed assets expense, net was $548,000 for the twelve months ended December 31, 2010 from $665,000 in 2009 due primarily to realized net gains on sales of $12,000 in 2010 as compared to net losses of $(107,000) in 2009. Management was successful in reducing the balance of foreclosed and repossessed assets to $3.6 million as of December 31, 2010 from $5.2 million at end of 2009, however, due to current level of non-performing assets, it is likely the Company will continue to maintain a higher than historical average balance in 2011. In 2009, foreclosed and repossessed assets expense, net increased to $665,000 from $217,000 for the equivalent period in 2008. The increase was attributable to the deterioration of the Company’s loan portfolio and the subsequent foreclosure, maintenance, and disposition of the collateral. In 2009, the Company transferred $6.8 million of loans to foreclosed and repossessed assets while realizing net proceeds from those sales of $2.4 million resulting in net losses from dispositions of $107,000. In addition, the foreclosed and repossessed asset expense was significantly impacted by payments for delinquent property taxes on foreclosed real estate.
Income Tax Expense (Benefit)
Income tax expense was $1.8 million for the twelve months in 2010 compared to an income tax benefit of $(4.9) million for the equivalent period in 2009. The change was the result of the large increase in the Company’s pre-tax earnings from 2009. Going forward, the Company’s income tax provision will be impacted by the expiration of $180,000 tax credits at the end of 2010 from participation in the New Markets Tax Credit program. Management has invested in a low income housing development project that will result in tax credits, the timing of which will be dependent upon completion and disposition of the developed properties in an effort to offset the loss. The credits from this new project will not fully offset those lost from the New Markets Tax Credit program. Income tax benefit was $(4.9) million for the year ended December 31, 2009 from $(691,000) for the same period in 2008. The increase in the income tax benefit over the period was attributable to Company’s net loss recognized before income taxes in 2009 of $(26.8) million as compared to net income before taxes of $130,000 in 2008. The Company did not recognize a tax benefit in 2009 for the $16.2 million goodwill and other intangible asset impairment charge as it was not a deductible item for tax purposes.
Financial Condition
Loan Portfolio
The Company’s loan portfolio decreased to $513.1 million as of December 31, 2010 from $543.4 million at December 31, 2009. All categories of loans, with the exception of Commercial loans, declined from the previous year with the largest decrease occurring in the Company’s commercial real estate portfolio. The decreases were due to loan charge-offs during the year of $8.7 million and as well as soft loan demand which resulted in net loan repayments during the year of $21.7 million. The Company’s loan portfolio mix changed slightly from 2009 as commercial loans increased to 20.1% of the total portfolio at the end of 2010 from 17.3% in 2009 while commercial real estate loans decreased to 33.5% in 2010 from 35.6% in 2009. All other categories remained relatively unchanged from the previous year.
Commercial loans, which consist of loans to business customers secured by business assets such as accounts receivable, inventory, and equipment, increased to $103.3 million as of December 31, 2010 from $94.2 million at December 31, 2009. Management has focused on increasing the diversity of the Company’s loan portfolio by reducing the percentage of loans to business customers secured by real estate. The results of these efforts were reflected in the growth in the commercial portfolio over 2010. Also contributing to the increase was the relatively low charge-offs as compared to other portfolio segments which totaled $843,000 in 2010 of the total of $8.7 million. Commercial loans have certain inherent risks which require loan officers to carefully monitor the borrower’s financial condition and receive periodic updates on the aging and balance of accounts receivable and inventory, if secured by these types of assets. Should the Company be forced to pursue foreclosure, there can often be significant erosion in the value of the collateral securing these types of loans. The value of equipment securing commercial borrowings generally tends to depreciate in value rapidly and/or may be industry specific with a limited market for resale. Accounts receivable are most likely have significant past due issues if the borrower is having financial difficulty and also may be worth a fraction of the balance while inventory may be stale.
Construction loans decreased from $51.6 million at December 31, 2009 to $48.9 million as of December 31, 2010. The decline in construction loans was attributable to charge-offs totaling $4.1 million for 2010 as compared to $5.7 million in 2009. Construction loans consist of both individual and business borrowings for the development and construction of 1-4 family residences and subdivisions. Beginning in 2008, the Company has experienced a high rate of delinquency and charge-offs in this portfolio, mostly to developers of multiple properties, as the market for new homes in our market area slowed. The repayment of commercial construction loans is dependent on the resale to third parties in a timely fashion. Should there be a significant delay in selling the finished properties or a downturn in the market, the developer may not receive cash sufficient to service their borrowings. In addition, if the Company forecloses on a partially or fully developed property, there can be significant erosion in value as the improvements may have deteriorated resulting in losses to the Company. Management has continued to work with our construction borrowers who are having difficulty to minimize our loss exposure and prevent foreclosure including restructuring where appropriate.
Commercial real estate loans decreased by $21.6 million to $171.9 million at December 31, 2010 from $193.6 million as of December 31, 2009. Most of the decline in commercial real estate loans was due to low new loan demand in addition to charge-offs in 2010 totaling $1.9 million. Given the sluggish economic conditions, loan demand for new commercial real estate loans has been minimal with most new loans during the year coming from refinancing of existing debt with other financial institutions. Also, we have had strong competition from other financial institutions in our market for new commercial real estate loans to qualified customers and, in some cases, we have declined to match offering rates that we believed were not commensurate with the associated risk.
Residential real estate loans were $177.4 million as of December 31, 2010 as compared to $189.4 million at December 31, 2009, a decrease of $12.0 million. Residential loans included borrowings secured by first and second liens on 1-4 family residential properties, including home equity lines of credit. The decrease in the portfolio was mostly due to soft loan demand as home sales in the Company’s market have been depressed resulting in fewer new loan originations.
At the end of 2010, the Company was servicing $8.0 million in mortgage loans for other investors compared to $10.4 million in 2009. Loans serviced for others consist of loans the Company has sold to the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation with servicing rights retained by the Company.
The Company’s lending activities remain primarily concentrated within its existing markets, and are principally comprised of loans secured by single-family residential housing developments, owner occupied manufacturing and retail facilities, general business assets, and single-family residential real estate. The Company emphasizes the acquisition of deposit relationships from new and existing commercial business and real estate loan clients.
Table 6 provides a breakdown of the Company’s loans by type during the past five years.
Table 6 - Loans by Type
Table 7 illustrates the Company’s fixed rate maturities and repricing frequency for the loan portfolio.
Table 7 - Selected Loan Distribution
Allowance and Provision for Loan Losses
Federal regulations require insured institutions to classify their assets on a regular basis. The regulations provide for three categories of classified loans: substandard, doubtful and loss. The regulations also contain a special mention and a specific allowance category. Special mention is defined as loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management’s close attention. Assets classified as substandard or doubtful require the institution to establish general allowances for loan losses. If an asset or portion thereof is classified as loss, the insured institution must either establish specified allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge off such amount.
The Company maintains the allowance for loan losses at a level that is sufficient to absorb probable credit losses incurred in its loan portfolio. The allowance is determined based on the application of loss estimates to graded loans by categories. Management determines the level of the allowance for loan losses based on its evaluation of the collectability of the loan portfolio, including the composition of the portfolio, historical loan loss experience, specific impaired loans, and general economic conditions. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated future cash flows. The allowance for loan losses is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs of specific loans, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited directly to the provision for loan losses. As of December 31, 2010, the Company’s allowance for loan losses totaled $10.9 million, a decrease of $4.4 million from December 31, 2009 which lowered the allowance for loan losses to total loans ratio to 2.11% from 2.80% for the same periods, respectively. The Company’s net charge-offs totaled $8.2 million in 2010, down from $10.2 million for the 2009 fiscal year as all loan categories continued to experience higher than historical losses. Beginning in late 2007 the Company has experienced an elevated level of non-performing loans coupled with a significant decline in the collateral values securing certain types of loans in its portfolio, specifically construction real estate. The Company’s loan portfolio has had increases in past due loans, impaired loans, and classified loans beginning in 2007 through 2009 before improving slightly in 2010 which has led to an increase in charge-offs for those credits management has determined to be uncollectible. Management has allocated amounts for probable incurred losses in the Company’s loan portfolio based on the best estimate available as of December 31, 2010.
Provisions for loan losses are charged against earnings to bring the total allowance for loan losses to a level considered adequate by management based on historical experience, the volume and type of lending conducted by the Company, the status of past due principal and interest payments, general economic conditions, and inherent credit risk related to the collectability of the Company’s loan portfolio. The provision for loan losses decreased to $3.8 million for the twelve months ended December 31, 2010 from $15.9 million for the same period in 2009, or $(12.1) million and (75.9)%. The provision for loan losses in 2010 was attributable to the continued elevated level of non-performing and classified loans. During 2010, the volume of new identified problem credits slowed as compared to 2009 which resulted in a reduction in the Company’s total non-performing loans to $25.4 million at December 31, 2010 from $31.2 million at December 31, 2009. While the volume of new problem credits has slowed, the impact of new identified credits continues to be at a level that required a significant provision for loan losses during the year. The Company’s local economy continues to be weak and which has started to impact some of the stronger borrowers who have been able to service their debt previously. Also, loans that have previously been classified have either become more severely past due and have accordingly been downgraded during the year which has resulted in more provision for loan losses as well. As of December 31, 2010, the Company had a total of $14.8 million in loans classified as doubtful and $24.2 million classified as substandard. Of the total balance of substandard and doubtful loans, $15.8 million were construction loans. Beginning in 2008, the Company has had significant collection issues in its construction portfolio which has led to aggregate charge-offs of $10.6 million of the total $22.9 million total charge-ffs for the three year period ended December 31, 2010 despite representing only approximately 10% of the Company entire loan portfolio over the same period. In addition, $25.3 million of the $48.9 million construction loans outstanding as of December 31, 2010, were classified with an allocated allowance for loan losses of $1.9 million as of the same date. In an effort to properly identify and resolve problem credits in the construction portfolio, management has undertaken several initiatives including loan reviews of unclassified construction credits and weekly meetings with loan officers. While management believes all construction loans have been properly classified as of December 31, 2010 with the appropriate allocation of allowance for loan losses, there can be no assurance that provision for loan losses in the future will decrease for this portfolio segment.
Statements made in this section regarding the adequacy of the allowance for loan losses are forward-looking statements that may or may not be accurate due to the impossibility of predicting future events. Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may differ from actual results.
Table 8 provides the Company’s loan charge-off and recovery activity during the past five years.
Table 8 - Summary of Loan Loss Experience
The following table depicts management’s allocation of the allowance for loan losses by loan type during the last five years. Allowance funding and allocation is based on management’s assessment of economic conditions, past loss experience, loan volume, past-due history and other factors. Since these factors and management's assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that may be charged off. Loan losses are charged against the allowance when management deems a loan uncollectible.
Table 9 - Management's Allocation of the Allowance for Loan Losses
Asset Quality
Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest. When loans are placed on non-accrual status, all unpaid accrued interest is reversed. These loans remain on non-accrual status until the loan becomes current or the loan is deemed uncollectible and is charged off. The Company defines impaired loans to be those loans that management has determined it is probable, based on current information and events, the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans individually classified as impaired decreased to $26.2 million at December 31, 2010 from $32.0 million at December 31, 2009. Impaired loans at December 31, 2010 and 2009 included $10.4 million and $8.6 million, respectively, of troubled debt restructurings (“TDR’s”).
Total non-performing loans decreased from $31.2 million at December 31, 2009 to $25.4 million at December 31, 2010 with total non-performing assets decreasing to $29.0 million from $36.4 million as of the same dates, respectively. Non-performing assets also include foreclosed real estate and other repossessed assets that have been acquired through foreclosure or acceptance of a deed in lieu of foreclosure. Foreclosed real estate and repossessed assets are carried at fair value less estimated selling costs, and are actively marketed for sale. Also included in non-performing assets at December 31, 2010 were $10.4 million of TDR’s, which included one large commercial real estate credit totaling $8.1 million. The structure of the loans for this credit relationship are such that management does not anticipate it will be able to remove it from TDR status until the loans are repaid or the relationship is refinanced at a market rate commensurate with the risk inherent in the credit which is not anticipated to occur in the immediate future. The customer is currently performing under the modified terms of the loan agreement. For further information on non-performing loans and their impact on the Company’s earnings, see discussion above under “Allowance and Provision for Loan Losses”.
Table 10 provides the Company’s non-performing loan experience during the past five years.
Table 10 - Non-Performing Assets
(1) Impaired loans on non-accrual status are included in loans. See Note 3 to the Consolidated Financial Statements for additional discussion on impaired loans.
Investment Securities
Table 11 sets forth the breakdown of the Company’s securities portfolio for the past five years.
Table 11 - Securities Portfolio
Table 12 sets forth the breakdown of the Company’s investment securities available for sale by type and maturity as of December 31, 2010. For analytical purposes, the weighted average yield on state and municipal securities is adjusted to a taxable equivalent adjustment basis to recognize the income tax savings on tax-exempt securities. A tax rate of 34% was used in adjusting interest on tax-exempt securities to a fully taxable equivalent (“FTE”) basis.
Table 12 - Investment Securities Available for Sale
Securities available for sale increased from $172.7 million at December 31, 2009 to $204.2 million at December 31, 2010. The increase in available for sale securities was due primarily to purchases of $173.4 million, offset by maturities, prepayments, and calls of $21.9 million and sales of $117.8 million during 2009. The current strategy for the securities portfolio is to maintain an intermediate average life that remains relatively stable in a changing interest rate environment, thus minimizing exposure to sustained increases in interest rates. The investment portfolio primarily consists of mortgage-backed securities, securities issued by the United States government and its agencies, securities issued by states and municipalities, and trust preferred securities. Mortgage-backed securities consist primarily of obligations insured or guaranteed by Federal Home Loan Mortgage Corporation, Federal National Mortgage Association, or Government National Mortgage Association.
A significant portion of the Company’s unrealized losses at December 31, 2010 were related to six trust preferred securities comprised of debt of banks and insurance companies. The decrease in the fair value of these securities is due primarily to the lack of transactions and the credit risk for these types of securities as market participants are currently unwilling to conduct transactions unless forced to do so. Also, the Company recorded an other-than-temporary impairment charge through earnings on three of the six securities in 2010. See footnote 2 to the Company’s consolidated financial statements for further discussion of the fair value of these securities and management’s evaluation of other-than-temporary impairment.
Deposits
The Company attracts deposits from the market areas it serves by offering a wide range of deposit accounts with a variety of rate structures and terms. The Company uses interest rate risk simulations to assist management in monitoring the Company’s deposit pricing, and periodically may offer special rates on certificates of deposits and money market accounts to maintain sufficient liquidity levels. The Company relies primarily on its retail and commercial sales staff and current customer relationships to attract and retain deposits. Market interest rates and competitive pressures can significantly affect the Company’s ability to attract and retain deposits. The Company’s strategic plan includes continuing to grow non-interest bearing accounts which contribute to higher levels of non-interest income and net interest margin.
Total deposits increased by $26.4 million to $618.8 million at December 31, 2010 due to increases in both interest bearing deposits of $21.6 million and non-interest bearing deposits of $4.8 million. The increase in total and interest bearing deposits was mostly attributable to an increase in of $29.8 million in money market deposits offset by a decline in certificates of deposits and individual retirement accounts of $13.3 million. In 2010, management continued its focus on repricing maturing certificates of deposits and the current offering rates for other interest bearing deposit accounts given the current rate environment. Because the Company continued to have soft loan demand and excess liquidity, management was able to reprice deposits rates at or below rates offered in its markets. Despite the reduction in rates, the Company saw an increase in its money market accounts which carry the highest transaction account offering rates. The Company’s non-interest bearing deposits increased in 2010 due to an emphasis on growing these types of accounts such as allocating a significant portion of incentive based compensation for business service and retail employees on growth of non-interest deposits.
Table 13 provides a profile of the Company’s deposits during the past five years.
Table 13 - Deposits
Table 14 - Average Deposits
Other Borrowings
The Company’s other borrowings consist of repurchase agreements, lines of credit with other financial institutions, federal funds purchased, which represent overnight liabilities to non-affiliated financial institutions, and a structured repurchase agreement. While repurchase agreements are effectively deposit equivalents, these arrangements consist of securities that are sold to commercial customers under agreements to repurchase. Other borrowings decreased to $49.4 million at December 31, 2010 from $77.0 million at December 31, 2009 primarily due to a decrease in the Company’s repurchase agreements of $25.8 million as a result of reductions in offering rates for these types of accounts.
Federal Home Loan Bank Advances
FHLB advances decreased to $50.0 million at December 31, 2010 from $68.5 million at December 31, 2009 due to the prepayment of the remaining $10.5 million of putable advances in the first quarter of 2010. At the beginning of 2009, the Company had a total of $67.0 million of these advances which carried a weighted average rate of 6.03%. Because the Company elected to prepay through the exercise of the put option by the FHLB, penalties of $335,000 and $838,000 were incurred in 2010 and 2009. Management elected to prepay the putable advances in 2009 and early 2010 due to the impact these advances had on the Company’s net interest margin. Prior to prepaying each advance, management determined that the penalty incurred would be fully offset by increases in net interest income through the remaining scheduled maturity of each advance. The Company does not anticipate that it will enter into putable advances for the foreseeable future, but instead may use fixed or variable rate advances to fund balance sheet growth as needed.
Liquidity
Liquidity levels are adjusted in order to meet funding needs for deposit outflows, repayment of borrowings, and loan commitments and to meet asset/liability objectives. The Bank’s primary sources of funds are deposits; repayment of loans and mortgage-backed securities; Federal Home Loan Bank advances; maturities of investment securities and other short-term investments; and income from operations. While scheduled loan and mortgage-backed security repayments are a relatively predictable source of funds, deposit flows and loan and mortgage-backed security prepayments are greatly influenced by general interest rates, economic conditions and competition. Liquidity management is both a daily and long term function of business management. If the Banks require funds beyond those generated internally, then as of December 31, 2010 the Banks had $77.7 million in additional capacity under its borrowing agreements with the FHLB based on the Banks’ current FHLB stock holdings and approximately $33.0 million in federal funds purchased with other financial institutions. Also, the holding company had $700,000 of additional borrowing capacity under a line of credit agreement with another financial institution. The holding company has other sources of liquidity outside of the line of credit, primarily dividends from its subsidiaries, YCB and SCSB which are limited by banking regulations. Currently, YCB can declare and pay dividends of $2.5 million while SCSB cannot declare dividends without prior regulatory approval due to a significant net loss in 2009. The holding company had $2.5 million in a correspondent account as of December 31, 2010. The Company anticipates it will have sufficient funds available to meet current loan commitments and other credit commitments.
Capital
Total capital of the Company increased to $63.2 million at December 31, 2010 from $60.0 million as of December 31, 2009, an increase of $3.2 million or 5.4%. The increase in capital was primarily due to net income available to common shareholders of $5.9 million offset by dividends on common shares of $1.3 million and dividends on preferred shares of $1.1 million. In 2009, the Company issued 19,468 shares of its Fixed Rate Cumulative Perpetual Preferred Stock to the U.S. Treasury as part of the Capital Purchase Program (“CPP”) for aggregate proceeds of $19.5 million which offset the decreases previously described (see footnote 13 to the Company’s Consolidated Financial Statements for further information). The terms of the agreement with the Treasury prohibit us from increasing our dividend on common stock above $0.175 quarterly without prior consent of the Treasury. Also, we are prohibited from continuing to pay dividends on our common stock unless we have fully paid all required dividends on the senior preferred stock.
Up until May 29, 2009, the Company had actively been repurchasing shares of its common stock since May 21, 1999. A net total of 566,312 shares at an aggregate cost of $9.8 million have been repurchased since that time under both the current and prior repurchase plans. The Company's Board of Directors authorized a share repurchase plan in June 2007 under which a maximum of $5.0 million of the Company's common stock could be purchased. Through December 31, 2010, a total of $1.6 million had been expended to purchase 85,098 shares under this plan. The CPP currently restricts the Company from repurchasing its common stock.
Regulatory agencies measure capital adequacy within a framework that makes capital requirements, in part, dependent on the risk inherent in the balance sheets of individual financial institutions. The Company and the Banks continue to exceed the regulatory requirements for Tier I, Tier I leverage and total risk-based capital ratios (see Note 14 to the Consolidated Financial Statements).
Off Balance Sheet Arrangements
The Company uses off balance sheet financial instruments, such as commitments to make loans, credit lines and letters of credit to meet customer financing needs. These agreements provide credit or support the credit of others and usually have expiration dates but may expire without being used. In addition to credit risk, the Company also has liquidity risk associated with these commitments as funding for these obligations could be required immediately. The contractual amount of these financial instruments with off balance sheet risk was as follows at December 31, 2010:
Aggregate Contractual Obligations
Time deposits represent certificates of deposit held by the Company.
FHLB advances represent the amounts that are due the FHLB and consist of $50.0 million in fixed rate advances.
Subordinated debentures represent the scheduled maturities of subordinated debentures issued to trusts formed by the Company in connection with the issuance of trust preferred securities.
Line of credit represents borrowings on the Company’s revolving line of credit with another bank.
Note payable represents amounts due for the participation in construction of a low income housing development project and are payable on demand.
Defined benefit plan represent expected benefit payments to be paid to participants.
Lease commitments represent the total minimum lease payments under noncancelable operating leases, before considering renewal options that generally are present.
Item 7A.
Item 7A. Quantitative And Qualitative Disclosures About Market Risk
Asset/liability management is the process of balance sheet control designed to ensure safety and soundness and to maintain liquidity and regulatory capital standards while maintaining acceptable net interest income. Interest rate risk is the exposure to adverse changes in net interest income as a result of market fluctuations in interest rates. Management continually monitors interest rate and liquidity risk so that it can implement appropriate funding, investment, and other balance sheet strategies. Management considers market interest rate risk to be one of the Company’s most significant ongoing business risk considerations.
The Company currently contracts with an independent third party consulting firm to measure its interest rate risk position. The consulting firm utilizes an earnings simulation model to analyze net interest income sensitivity. Current balance sheet amounts, current yields and costs, corresponding maturity and repricing amounts and rates, other relevant information, and certain assumptions made by management are combined with gradual movements in interest rates of 200 basis points up and 200 basis points down within the model to estimate their combined effects on net interest income over a one-year horizon. In 2008, the Federal Open Market Committee lowered its target for the federal funds rate to 0-25 bps. A majority of our loans are indexed to prime, therefore, the Company has excluded an evaluation of the effect on net interest income assuming a decrease in interest rates as further reductions in the prime rate are extremely unlikely. Interest rate movements are spread equally over the forecast period of one year. The Company feels that using gradual interest rate movements within the model is more representative of future rate changes than instantaneous interest rate shocks. The Company does not project growth in amounts for any balance sheet category when constructing the model because of the belief that projected growth can mask current interest rate risk imbalances over the projected horizon. The Company believes that the changes made to its interest rate risk measurement process have improved the accuracy of results of the process. Consequently, the Company believes that it has better information on which to base asset and liability allocation decisions going forward.
Assumptions based on the historical behavior of the Company’s deposit rates and balances in relation to changes in interest rates are incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. The Company continually monitors and updates the assumptions as new information becomes available. Actual results will differ from the model's simulated results due to timing, magnitude and frequency of interest rate changes, and actual variations from the managerial assumptions utilized under the model, as well as changes in market conditions and the application and timing of various management strategies.
The base scenario represents projected net interest income over a one year forecast horizon exclusive of interest rate changes to the simulation model. Given a gradual 200 basis point increase in the projected yield curve used in the simulation model (“Up 200 Scenario”), it is estimated that as of December 31, 2010 the Company’s net interest income would decrease by an estimated 1.31%, or $398,000, over the one year forecast horizon. As of December 31, 2009, in the Up 200 Scenario the Company estimated that net interest income would decrease 6.28%, or $1.9 million, over a one year forecast horizon ending December 31, 2010
The projected results are within the Company’s asset/liability management policy limits, which states that the negative impact to net interest income should not exceed 7% in a 200 basis point decrease or increase in the projected yield curve over a one year forecast horizon. The forecast results are heavily dependent on the assumptions regarding changes in deposit rates; the Company can minimize the reduction in net interest income in a period of rising interest rates to the extent that it can curtail raising deposit rates during this period. The Company continues to explore transactions and strategies to both increase its net interest income and minimize its interest rate risk.
The interest sensitivity profile of the Company at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities as well as their relative repricing schedules. Such profile is also influenced by market interest rates, deposit growth, loan growth, and other factors.
The following tables, which are representative only and are not precise measurements of the effect of changing interest rates on the Company’s net interest income in the future, illustrate the Company’s estimated one year net interest income sensitivity profile based on the above referenced asset/liability model as of December 31, 2010 and 2009, respectively:
Interest Rate Sensitivity For 2010
Interest Rate Sensitivity For 2009
COMMUNITY BANK SHARES OF INDIANA, INC.
New Albany, Indiana
FINANCIAL STATEMENTS
December 31, 2010, 2009, and 2008
CONTENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Community Bank Shares of Indiana, Inc.
New Albany, Indiana
We have audited the accompanying consolidated balance sheets of Community Bank Shares of Indiana, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. 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 audit procedures 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 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 financial position of Community Bank Shares of Indiana, Inc. as of December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2010 in conformity with U.S. generally accepted accounting principles.
Crowe Horwath LLP
Louisville, Kentucky
March 29, 2011
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED BALANCE SHEETS
December 31
(In thousands, except share amounts)
See accompanying notes.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31
(In thousands, except per share amounts)
See accompanying notes.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31
(In thousands, except per share amounts)
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31
(In thousands except per share data)
See accompanying notes.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31
(In thousands except per share data)
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31
(In thousands)
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31
(In thousands)
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Principles of Consolidation: The consolidated financial statements include Community Bank Shares of Indiana, Inc. and its wholly owned subsidiaries, Your Community Bank (YCB) and The Scott County State Bank (SCSB), collectively referred to as “the Company”. YCB utilizes three wholly-owned subsidiaries to manage its investment portfolio. CBSI Holdings, Inc. and CBSI Investments, Inc. are Nevada corporations which jointly own CBSI Investment Portfolio Management, LLC, a Nevada limited liability corporation which holds and manages the Bank’s investment securities. YCB established a new Community Development Entity (CDE) subsidiary in July 2002 named CBSI Development Fund, Inc. The CDE enables YCB to participate in the federal New Markets Tax Credit (NMTC) Program. The NMTC Program is administered by the Community Development Financial Institutions Fund of the United States Treasury and is designed to promote investment in low-income communities by providing a tax credit over seven years for equity investments in CDE’s. During June 2004 and June 2006, the Company completed placements of floating rate subordinated debentures through Community Bank Shares (IN) Statutory Trust I and Trust II (Trusts), trusts formed by the Company. Because the Trusts are not consolidated with the Company, the financial statements reflect the subordinated debt issued by the Company to the Trusts. Intercompany balances and transactions are eliminated in consolidation.
The Company provides financial services through its offices in Floyd, Clark and Scott counties in Indiana, and Jefferson and Nelson counties in Kentucky. Its primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are residential mortgage, commercial, and installment loans. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. There are no significant concentrations of loans to any one industry or customer. However, the customers’ ability to repay their loans is dependent on the real estate and general economic conditions in the area.
Use of Estimates: To prepare financial statements in conformity with U.S. generally accepted accounting principles management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, fair value and impairment of securities, carrying value of foreclosed and repossessed assets, and deferred tax assets are particularly subject to change.
Cash Flows: Cash and cash equivalents include cash and non-interest bearing deposits with other financial institutions with maturities less than 90 days. Net cash flows are reported for interest-bearing deposits in other financial institutions, loans, deposits, and other borrowings.
Interest-bearing Deposits in Other Financial Institutions: Interest-bearing deposits in other financial institutions mature within one year, are carried at cost.
Securities: Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.
Mortgage Banking Activities: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value. To deliver closed loans to the secondary market and to control its interest rate risk prior to sale, the Company enters into agreements to sell loans. The aggregate fair value of mortgage loans held for sale considers the price of the sales contracts. Loan commitments related to the origination of mortgage loans held for sale and the corresponding sales contracts are considered derivative instruments. The Company’s commitments are for fixed rate mortgage loans, generally lasting 60 days and are at market rates when initiated. The Company had commitments to originate $952,000 and $427,000 in loans and an equal amount of corresponding sales contracts at December 31, 2010 and 2009. The impact of accounting for these instruments as derivatives was not material and substantially all of the gain on sale generated from mortgage banking activities continues to be recorded when closed loans are delivered into the sales contracts.
The Company sells loans on a servicing released basis. The Company sold loans previous to 2006 on a servicing retained basis. Servicing assets were recorded on loans sold with servicing retained and were capitalized in other assets and expensed into non-interest income against service fee income in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the assets, using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Any impairment of a grouping is reported as a valuation allowance, to the extent that fair value is less than the capitalized amount for a grouping.
Servicing fee income, which is reported on the income statement as mortgage banking income, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal. The amortization of mortgage servicing rights is netted against mortgage servicing fee income. Servicing fees, net of amortization, totaled $10,000, $21,000 and $39,000 for the years ended December 31, 2010, 2009 and 2008. The Company recorded an impairment charge of $0, $0, and $69,000 for the years ended December 31, 2010, 2009 and 2008. Late fees and ancillary fees related to loan servicing are not material.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and an allowance for loan losses.
Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments. Interest income on commercial, mortgage and consumer loans is discontinued at the time the loan is 90 days delinquent. Consumer loans are typically charged-off no later than 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not received for loans placed on non-accrual is reversed against interest income. Interest received on such 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 a valuation allowance for probable incurred credit losses. 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. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as special mention, substandard, or doubtful.
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
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 and reasons for the delay, the borrower’s prior payment record, and the amount of shortfall in relation to the principal and interest owed.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Smaller balance homogeneous loans, such as consumer and residential real estate, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosure. Troubled debt restructurings are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent 3 years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following portfolio segments have been identified: Commercial, Construction, Commercial Real Estate, Residential Real Estate, and Consumer.
Commercial loans consist of borrowings for commercial purposes to individuals, corporations, partnerships, sole proprietorships, and other business enterprises. Commercial loans are generally secured by business assets such as equipment, accounts receivable, inventory, or any other asset excluding real estate and generally made to finance capital expenditures or operations. The Company’s risk exposure is related to deterioration in the value of collateral securing the loan should foreclosure become necessary. Generally, business assets used or produced in operations do not maintain their value upon foreclosure which may require the Company to write-down the value significantly to sell.
Construction loans primarily consist of borrowings to purchase and develop raw land into 1-4 family residential properties. Construction loans are extended to individuals as well as corporations for the construction of an individual or multiple properties and are secured by raw land and the subsequent improvements. Repayment of the loans to real estate developers is dependent upon the sale of properties to third parties in a timely fashion upon completion. Should there be delays in construction or a downturn in the market for those properties, there may be significant erosion in value which may be absorbed by the Company. In recent fiscal years, the most significant portion of the Company’s loan charge-offs have been on 1-4 family development properties. Consequently, the Company has allocated the highest percentage of allowance for loan losses as a percentage of loans to construction loans compared to the other identified loan portfolio segments.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
-
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Commercial real estate consists of borrowings secured by owner-occupied and non-owner-occupied commercial real estate. Repayment of these loans is dependent upon rental income or the subsequent sale of the property for loans secured by non-owner-occupied commercial real estate and by cash flows from business operations for owner-occupied commercial real estate. Loans for which the source of repayment is rental income are primarily impacted by local economic conditions which dictate occupancy rates and the amount of rent charged. Commercial real estate loans that are dependent on cash flows from operations can also be adversely affected by current market conditions for their product or service.
Residential real estate loans consist of loans to individuals for the purchase of primary residences and open and closed-end home equity loans with repayment primarily through wage or other income sources of the individual borrower. The Company’s loss exposure to these loans is dependent on local market conditions for residential properties as loan amounts are determined, in part, by the fair value of the property at origination.
Consumer loans are comprised of loans to individuals both unsecured and secured by automobiles. These loans typically have maturities of 5 years or less with repayment dependent on individual wages and income. The risk of loss on consumer loans is elevated as the collateral securing these loans, if any, rapidly depreciate in value or may be worthless and/or difficult to locate if repossession is necessary. Losses in this portfolio are generally relatively low, however, due to the small individual loan size and the balance outstanding as a percentage of the Company’s entire portfolio.
Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 7 to 40 years. Furniture, fixtures, and equipment are depreciated using the straight-line method with useful lives ranging from 2 to 10 years. Leasehold improvements are amortized over the shorter of their economic lives or the term of the lease with lives ranging from 5 to 15 years.
Federal Home Loan Bank (FHLB) and Federal Reserve Stock: FHLB and Federal Reserve stock are required investments for institutions that are members of the Federal Reserve and FHLB systems. The required investment in the common stock is based on a predetermined formula. Federal Reserve and FHLB stock are carried at cost, classified as restricted securities, and are periodically evaluated for impairment. Because the stocks are viewed as long term investments, impairment is based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Company Owned Life Insurance: The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Other Intangible Assets: Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank acquisitions are amortized on an accelerated method over their estimated useful lives, which the Company has determined to be 10 years.
Foreclosed and Repossessed Assets: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Repurchase Agreements: Repurchase agreement liabilities, included in other borrowings, represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance.
Equity: Treasury stock is carried at cost.
Retirement Plans: Pension expense is the net of service and interest cost, return on plan assets, and amortization of gains and losses not immediately recognized. Profit sharing and 401k plan expense is the amount of matching contributions. Deferred compensation expense allocated the benefits over years of service.
Stock-Based Compensation: Compensation cost is recognized for stock options, restricted stock awards, and deferred stock units issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock and deferred stock unit awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A 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 recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded.
The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer-financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Earnings (Loss) Per Common Share: Basic earnings (loss) per common share is net income (loss) available (attributable) to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options and stock warrants. Earnings and dividends per share are restated for stock splits and dividends through the date of issuance of the financial statements.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income, recognized as separate components of equity, includes changes in the following items: unrealized gains and losses on securities available for sale and changes in the funded status of the pension plan.
Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the consolidated financial statements.
Restrictions on Cash: Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements.
Dividend Restriction: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank subsidiaries to the holding company or by the holding company to shareholders, as more fully described in a separate note.
Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Operating Segments: While the chief decision-makers monitor the revenue streams of the various products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Adoption of New Accounting Standards:
ASC Topic 860, “Transfers and Servicing.” New authoritative accounting guidance under ASC Topic 860, “Transfers and Servicing,” 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. The new authoritative accounting guidance eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. The new authoritative accounting guidance 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 Company adopted the provisions of the new authoritative accounting guidance under ASC Topic 860 on January 1, 2010. Adoption of the new guidance did not have a significant impact on the Company’s financial statements.
Reclassifications: Some items in the prior years’ financial statements were reclassified to conform to the current presentation.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 2 - SECURITIES
The following table summarizes the amortized cost and fair value of the available-for-sale securities portfolio at December 31, 2010 and 2009 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:
Sales of available for sale securities were as follows:
The tax provision applicable to these net realized gains amounted to $595,000, $469,000 and $124,000, respectively.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 2 - SECURITIES (Continued)
The amortized cost and fair value of the contractual maturities of available for sale securities at year-end 2010 were as follows. Mortgage-backed agency securities and mutual funds which do not have a single maturity date are shown separately.
Securities pledged at year-end 2010 and 2009 had a carrying amount of $62.0 million and $72.2 million to secure public deposits, repurchase agreements and Federal Home Loan Bank advances.
At year end 2010 and 2009, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders’ equity.
Securities with unrealized losses at year end 2010 and 2009, aggregated by investment category and length of time that individual securities have been in a continuous loss position are as follows (in thousands):
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 2 - SECURITIES (Continued)
The investment securities portfolio is evaluated for OTTI by segregating the portfolio into two general segments and applying the appropriate OTTI model. Investment securities are generally evaluated for OTTI under FASB ASC 320-10. However, certain purchased beneficial interests, including collateralized debt obligations that had credit ratings at the time of purchase of below AA are evaluated using the model outlined in FASB ASC 325-40.
In determining OTTI under the FASB ASC 320-10 model, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
The second segment of the portfolio uses the OTTI guidance provided by FASB ASC 325-40 that is specific to purchased beneficial interests that, on the purchase date, were rated below AA. Under the FASB ASC 325-40 model, the Company compares the present value of the remaining cash flows as estimated at the preceding evaluation date to the current expected remaining cash flows. An OTTI is deemed to have occurred if there has been an adverse change in the remaining expected cash flows.
As of December 31, 2010, the Company’s security portfolio consisted of 224 securities, 42 of which were in an unrealized loss position. The majority of unrealized losses are related to the Company’s state and municipal, residential mortgage-backed securities issued by U.S. Government sponsored entities, and collateralized debt obligations, as discussed below:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 2 - SECURITIES (Continued)
State and Municipal
At December 31, 2010 the Company had approximately $8.7 million of state and municipal securities out of a portfolio of $56.5 million with an unrealized loss of $234,000. Of the 134 state and municipal securities in the Company’s portfolio, 124 had an investment grade rating as of December 31, 2010 while 10 were not rated. The decline in value in these securities is attributable to interest rate and liquidity, and not credit quality. All of the state and municipal securities in the Company’s portfolio, with the exception of 1 security, have a fair value as a percentage of amortized cost greater than 90%. The other security had a fair value as a percentage of amortized cost of 87% and was rated AA+ by S&P. The Company does not have the intent to sell its state and municipal securities and it is unlikely that we will be required to sell the securities before the anticipated recovery. The Company does not consider these securities to be other-than-temporarily impaired at December 31, 2010.
Mortgage-backed Securities
At December 31, 2010, all of the mortgage-backed securities held by the Company were issued by U.S. government-sponsored entities, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2010.
Collateralized Debt Obligations
The Company’s unrealized losses on collateralized debt obligations relate to its investment in six pooled trust preferred securities.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 2 - SECURITIES (Continued)
Our analysis of these six investments falls within the scope of FASB ASC 325-40 and includes $4.1 million amortized cost of pooled trust preferred securities (CDOs). See the table below for a detail of the CDOs (in thousands):
The issuers in five of the six securities are banks and bank holding companies while one is comprised of insurance companies. The Company uses the OTTI evaluation model to evaluate the present value of expected cash flows. The OTTI model considers the structure and term of the CDO and the financial condition of the underlying issuers. Specifically, the model details interest rates, principal balances of note classes and underlying issuers, the timing and amount of interest and principal payments of the underlying issuers, and the allocation of the payments to the note classes. The current estimate of expected cash flows is based on the most recent trustee reports and any other relevant market information including announcements of interest payment deferrals or defaults of underlying trust preferred securities. Assumptions used in the model include expected future default rates and prepayments. To develop our assumptions we reviewed the underlying issuers and determined the specific default rate by reviewing the financial condition of each issuer and whether they were currently in deferral or default. We considered all defaults to be immediate. We considered all relevant data in developing our assumptions, however, we specifically reviewed each issuer’s profitability, credit ratings, if available, credit ratios, and credit quality metrics for the loan portfolios (if a bank). For those issuers we identified at risk of default, we estimated the amount of loss, net of any anticipated recoveries, which ranged from 100% for those issuers already in default at the evaluation date to 5.00%. After four years we assume a 0.40% annual default rate until scheduled maturity of the underlying note. Additionally, we assumed that all bank and bank holding company issuers with total assets of greater than $15 billion would prepay their obligations before the phase-out period begins for inclusion in Tier 1 capital on January 1, 2013 in accordance with the Dodd-Frank Act. Upon completion of the analysis, our model indicated other-than-temporary impairment on two of these securities in the first quarter of 2010 and one in the third quarter. These three securities remained classified as available for sale at December 31, 2010, and together, the six securities subject to FASB ASC 325-40 accounted for the $2.7 million of unrealized loss in the collateralized debt obligations category at December 31, 2010.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 2 - SECURITIES (Continued)
The table below presents a rollforward of the credit losses recognized in earnings for the years ended December 31, 2010 and 2009:
NOTE 3 - LOANS
Loans at year-end were as follows:
During 2010 and 2009, substantially all of the Company’s residential and commercial real estate loans were pledged as collateral to the Federal Home Loan Bank to secure advances.
Activity in the allowance for loan losses was as follows:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 3 - LOANS (Continued)
The following table presents the balance in the allowance for loan losses and the recorded investment in loans, which includes the unpaid principal balance, net of partial charge-offs (accrued interest has been excluded due to its insignificance), by portfolio segment and based on impairment method as of December 31, 2010 (in thousands):
The Company’s impaired loans totaled $26.2 million and $32.0 million with allocated allowance for loan losses of $2.2 million and $3.5 million as of December 31, 2010 and 2009. There were no impaired loans at December 31, 2010 and 2009 which did not have allocated allowance for loan losses.
Further information about impaired loans is presented below:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 3 - LOANS (Continued)
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2010:
The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2010:
The Company had non-accrual loans of $22.7 million and no loans past due over 90 days still on accrual as of December 31, 2009.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 3 - LOANS (Continued)
The following table presents the aging of the recorded investment in past due loans as of December 31, 2010 by class of loans:
Troubled Debt Restructurings:
Troubled debt restructurings totaled $10.4 million and $8.6 million at December 31, 2010 and 2009. The Company has allocated $911,000 and $323,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2010 and 2009. The Company did not have any commitments to lend additional amounts to customers with outstanding loans that are classified as troubled debt restructurings as of December 31, 2010 and 2009.
Credit Quality Indicators:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. On a monthly basis, the Company reviews its loans that are risk rated Watch, Special Mention, Substandard, or Doubtful to determine they are properly classified. In addition, the Company reviews loans rated as a “pass” that have exhibited signs that may require a classification change. The Company uses the following definitions for risk ratings:
Watch. Loans classified as watch are not considered “rated” or “classified” for regulatory purposes, but are considered criticized assets which exhibit modest deterioration in financial performance or external threats.
Special Mention. Loans classified as special mention exhibit potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan, or in the Company’s credit position at some future date. Economic or market conditions exist which may affect the borrower more severely than other companies in its industry.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 3 - LOANS (Continued)
Substandard. Loans classified as substandard are characterized by having well defined financial weakness. Substandard loans are usually evidenced by chronic or emerging past due performance and serious deficiencies in the primary source of repayment.
Doubtful. Loans classified as doubtful have a well-defined and documented financial weaknesses. They have all the weaknesses of a substandard loan with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. Generally, loans classified as doubtful are on non-accrual.
Loans not meeting the criteria above that are listed as pass are included in groups of homogeneous loans. As of December 31, 2010, based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
Related Party Loans: Loans to principal officers, directors, and their affiliates were as follows.
Off-balance-sheet commitments (including commitments to make loans, unused lines of credit, and letters of credit) to principal officers, directors, and their affiliates as of December 31, 2010 and 2009 were $13.2 million and $11.9 million.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 3 - LOANS (Continued)
Mortgage Banking Activities: Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage loans serviced for others were approximately $8.0 million and $10.4 million at year-end 2010 and 2009. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in non-interest bearing deposits, were approximately $94,000 and $89,000 at year-end 2010 and 2009. Servicing assets related to these loans, included in other assets, were $43,000 and $57,000 at year-end 2010 and 2009. Amortization expense was $14,000, $12,000 and $8,000 at year-end 2010, 2009, and 2008. The company recorded impairment charges of $0, $0, and $69,000 in 2010, 2009, and 2008. The fair value for mortgage servicing rights were $43,000 and $63,000 at year-end 2010 and 2009. Fair value at year-end 2010 and 2009 was determined using a discount rate of 12.0%, prepayment speeds ranging from 15.00% to 25.00%, depending on the stratification of the specific right, and a default rate of 0.00 due to the short remaining amortization period and historical performance history.
The weighted average amortization period is 3.0 years. Estimated amortization expense for each of the next three years is approximately $14,000 per year.
NOTE 4- PREMISES AND EQUIPMENT
Year-end premises and equipment were as follows.
Depreciation expense was $1.3 million, $1.4 million, and $1.5 million for 2010, 2009, and 2008.
Branch location rent expense was $640,000, $679,000 and $672,000 for 2010, 2009, and 2008, respectively. Rent commitments under noncancelable operating leases (in thousands) were as follows, before considering renewal options that generally are present.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 5 - GOODWILL AND INTANGIBLE ASSETS
Goodwill
The change in balance for goodwill during the year is as follows (in thousands):
Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of our single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. We determined the fair value of our reporting unit and compared it to its carrying amount. If the carrying amount of a reporting unit exceeds its fair value, we are required to perform a second step to the impairment test.
The Company evaluates goodwill for impairment annually in the fourth quarter unless events or changes in circumstances indicate potential impairment has occurred between formal assessments. An impairment analysis as of June 30, 2009 was performed because the Company’s stock had traded at a market price less than its per share common book value since 2008, decreased earnings from historical performance in 2008 and the first quarter 2009, and a large provision for loan losses in the second quarter of 2009 related to deterioration in the Company’s loan portfolio. The Company’s stock is lightly traded, therefore, a third party valuation consultant was engaged to assist management in determining the fair value of the Company and whether goodwill was impaired. The fair value was determined by comparing the output of several different valuation methodologies including:
·
Market comparison - The market comparison methodology utilizes data from recent acquisitions in the Company’s geographical market area, including those transactions with companies that have similar characteristics to the Company including return on average assets.
·
Asset value method - The asset value methodology considers the liquidation value of assets based on information available.
·
Earnings value method - The earnings value method is based on the premise that common
stock value is equivalent to that price at which its future dividends and residual earnings will produce a particular yield. A short-term value was estimated based on a 5 year earnings projections and cash flows while a long-term value was also determined based on a 20 year earnings projection and cash flows.
·
Acquisition analysis - The acquisition analysis considers what a potential acquirer would pay for the Company to achieve a desirable rate of return contemplating both a 10% and 20% reduction in non-interest expense.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 5 - GOODWILL AND INTANGIBLE ASSETS (Continued)
The fair value assessment indicated that the Step 2 analysis was necessary. Step 2 of the goodwill impairment test is performed to measure the impairment loss. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. After performing Step 2 it was determined that the implied value of goodwill was less than the carrying costs, resulting in an impairment charge of $15.3 million in the second quarter of 2009. The impairment charge had no impact on the Company’s liquidity, cash flows, or regulatory capital ratios.
Acquired Intangible Assets
Acquired amortized intangible assets were as follows at year end (in thousands):
Aggregate amortization expense was $246,000, $321,000 and $407,000 for 2010, 2009 and 2008.
Estimated amortization expense for each of the next five years (in thousands):
In conjunction with the analysis of goodwill in 2009, the Company engaged a third party valuation consultant to determine the value of its other intangible assets which included the core deposit intangible and loan customer intangible acquired in the 2006 acquisition of the Scott County State Bank. Based on the results of analysis, the Company recognized an impairment charge of $819,000 related to its core deposit intangible asset. The impairment charge had no impact on the Company’s liquidity, cash flows, or regulatory capital ratios.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 6 - DEPOSITS
Time deposits of $100,000 or more were $92.8 million and $99.4 million at year-end 2010 and 2009.
Scheduled maturities of time deposits for the next five years (in thousands) were as follows:
Deposits from principal officers, directors and their affiliates at year-end 2010 and 2009 were approximately $33.0 million and $24.8 million.
NOTE 7 - OTHER BORROWINGS
Other borrowings consist of retail repurchase agreements representing overnight borrowings from deposit customers, federal funds purchased representing overnight borrowings from other financial institutions, lines of credit with other financial institutions, a structured repurchase agreement, and a note payable. The debt securities sold under the repurchase agreements were under the control of the subsidiary banks during 2010 and 2009.
The Company has available a revolving line of credit with a bank for $4.5 million. The line of credit expires on June 30, 2011 and bears interest at 3 month LIBOR plus 4.00% (4.30% at December 31, 2010). Payments of $350,000 in principal plus all accrued and unpaid interest are due quarterly. The line of credit is collateralized by 500 shares of Your Community Bank common stock and 73,000 of The Scott County State Bank common stock. The outstanding balance on the line of credit was $3.8 million and $6.3 million at December 31, 2010 and 2009.
One of the Company’s subsidiary banks is a limited partner in an investment partnership which constructs low income housing. The Company currently has a 14.8% ownership interest, although that is expected to be reduced to 5% - 7% once all partnership units have been sold. In exchange for an investment of $1.0 million, the Company issued a note payable for $1.0 million to the partnership. The note payable had a balance of $730,000 and $0 at December 31, 2010 and 2009. Payments are due on demand in the amount requested from the partnership. The note does not bear interest unless payments are not paid within 15 days of the request. In accordance with accounting guidance, the Company did not consolidate the investment in the partnership into its financial statements because it owns less than 50% of the partnership and does not control the operations.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 7 - OTHER BORROWINGS (Continued)
Information concerning 2010, 2009, and 2008 other borrowings is summarized as follows.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 8 - FEDERAL HOME LOAN BANK ADVANCES
At year-end, advances from the Federal Home Loan Bank (FHLB) were as follows.
The advances were collateralized by $273.7 million and $310.2 million of first mortgage and commercial real estate loans under a blanket lien arrangement and certain available for sale securities at year-end 2010 and 2009. Based on this collateral and the Company’s holdings of FHLB stock, the Company is eligible to borrow an additional $77.7 million at year-end 2010.
The contractual maturities of advances outstanding as of December 31, 2010 are as follows:
There is a substantial penalty if the Company prepays the advances before the contractual maturities. The Company recognized penalties on prepayment of FHLB advances of $335,000, $838,000, and $0 for the years ended December 31, 2010, 2009, and 2008.
NOTE 9 - SUBORDINATED DEBENTURES
On June 15, 2006, a trust formed by the Company, Community Bank Shares (IN) Statutory Trust II (Trust II), issued $10.0 million of floating rate trust preferred securities as part of a pooled offering of such securities. On June 17, 2004, a trust formed by the Company, Community Bank Shares (IN) Statutory Trust I (Trust I), issued $7.0 million of floating rate trust preferred securities as part of a pooled offering of such securities. The Company issued subordinated debentures to Trusts I and II in exchange for the proceeds of each offering; the debentures and related debt issuance costs represent the sole assets of Trusts I and II. The Company is not considered the primary beneficiary of the Trusts (variable interest entity), therefore the trusts are not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the trust preferred securities are payable quarterly in arrears at the annual rate (adjusted quarterly) of three-month LIBOR plus 1.70% (2.00% as of the last adjustment) for Trust II and three-month LIBOR plus 2.65% (2.95% as of the last adjustment) for Trust I and are included in interest expense.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 9 - SUBORDINATED DEBENTURES (Continued)
The maturity dates of the subordinated debentures are June 15, 2036 for Trust II and June 17, 2034 for Trust I. The subordinated debentures may be redeemed by the Company, in whole or in part, at any distribution payment date on or after the distribution payment date in June 2011 for Trust II and June 2009 for Trust I, at the redemption price. The subordinated debentures have variable rates, adjusted quarterly, which are identical to the trust preferred securities. In addition, the subordinated debentures are redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust debenture. The Company has the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. Should interest payments be deferred, the Company is restricted from paying dividends until all deferred payments have been made.
Subordinated debentures are considered as Tier I capital for the Company under current regulatory guidelines.
NOTE 10 - BENEFIT PLANS
Defined Benefit Plans: The Company sponsors a defined benefit pension plan. The benefits are based on years of service and the employees’ highest average of total compensation for five consecutive years of employment. In 1997, the plan was amended such that there can be no new participants or increases in benefits to the participants.
A reconciliation of the projected benefit obligation and the value of plan assets follow.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 10 - BENEFIT PLANS (Continued)
Amounts recognized in accumulated other comprehensive loss consisted of a net actuarial loss of $509,000 and $497,000 at year-end 2010 and 2009. The accumulated benefit obligation was $1.1 million and $1.0 million at year-end 2010 and 2009. The funded status of the plan was a liability as of the years ended 2010 and 2009 and is reported in other liabilities in the Company’s consolidated financial statements.
Components of Net Periodic Benefit Cost and Other Amounts Recognized in Other Comprehensive Loss
The estimated net loss for the defined benefit pension plan that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost over the next fiscal year is $13,000.
Assumptions
Plan Assets: The Company’s target allocation for 2011, pension plan asset allocation at year-end 2010 and 2009, and expected long-term rate of return by asset category are as follows:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 10 - BENEFIT PLANS (Continued)
The investment policy of the pension plan prohibits investments in: fixed income securities not denominated in U.S. Dollars or Eurodollars, venture capital, guaranteed insurance contracts, commodities, precious metals or gems, derivatives, short-selling and other hedging strategies, or any other non-traditional asset.
The expected long-term return is based on a periodic review and modeling of the plan’s asset allocation and liability structure over a long-term horizon. Expectations of returns on each asset class are the most important of the assumptions used in the review and modeling and are based on reviews of historical data. The expected long-term rate of return on assets was selected from within the reasonable range of rates determined by (a) historical real returns, net of inflation, for the asset classes covered by the investment policy, and (b) projections of inflation over the long-term period during which benefit are payable to plan participants.
Fair Value of Plan Assets:
Fair value is the exchange price that would be received for an asset in the principal or most advantageous market for the asset in an orderly transaction between market participants on the measurement date. 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 Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:
Equity Mutual Funds: The fair values for equity mutual funds are determined by quoted market prices (Level 1). The Company does not modify or apply assumptions to the quoted market prices.
Money Market Mutual Funds: The fair values for money market mutual funds are determined by quoted market prices (Level 1). The Company does not modify or apply assumptions to the quoted market prices.
The fair value of the plan assets by asset category is as follows:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 10 - BENEFIT PLANS (Continued)
There were no transfers between Level 1 and Level 2 during 2010.
Estimated Future Payments: The following benefit payments, which reflect expected future service, are expected (in thousands):
The Company expects to contribute approximately $95,000 to its pension plan in 2011.
Your Community Bank is a participant in the Financial Institutions Retirement Fund, a multi-employer defined benefit pension plan covering two of its employees. Employees are fully vested at the completion of five years of participation in the plan. No contributions were required during the three-year period ended December 31, 2010. There have been no new enrollments since 1998.
Deferred Compensation Arrangements: The Company has entered into deferred compensation arrangements with certain directors and officers. The liability for such arrangements is fully accrued during the service period, with benefits paid monthly upon retirement until death, or date specified by the agreement. The liability was $255,000 and $271,000 at December 31, 2010 and 2009, respectively, and was included in other liabilities in the Company’s consolidated financial statements. Expense related to these arrangements for 2010, 2009 and 2008 was $12,000, $17,000 and $(11,000).
Defined Contribution Plans: The 401(k) benefit plan matches employee contributions equal to 100% of the first 3% plus 50% of the next 2% of the compensation contributed. Expense for 2010, 2009 and 2008 was $257,000, $271,000 and $274,000.
NOTE 11 - STOCK-BASED COMPENSATION PLANS
The Company has three share based compensation plans as described below. Total compensation cost that has been charged against income for those plans was $174,000, $68,000, and $325,000 for 2010, 2009, and 2008. The total income tax benefit was $36,000, $9,000, and $68,000.
Stock Options: The Company’s stock option plan provides for the granting of both incentive and nonqualified stock options and other share based awards, including restricted stock and deferred stock units, for up to 400,000 shares of common stock at exercise prices not less than the fair market value of the common stock on the date of grant and expiration dates of up to ten years. Terms of the options are determined by the Board of Directors at the date of grant and generally vest over periods of three to four years. Non-employee directors are eligible to receive only nonqualified stock options. As of December 31, 2010, the plan allows for additional option and share-based award grants of up to 197,417 shares.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 11 - STOCK-BASED COMPENSATION PLANS (Continued)
The fair value of each option award is estimated on the date of grant using the Black-Scholes model. Expected volatilities are based on historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
The Company did not grant options during 2010, 2009, or 2008.
A summary of the activity in the stock option plan for 2010 follows:
Information related to the stock option plan during each year follows (in thousands, except for weighted fair value of options granted):
As of December 31, 2010, all outstanding stock options had vested and there was no remaining compensation cost to be recognized.
Performance Units Awards: The Company may grant performance unit awards to employees for up to 275,000 shares of common stock. The level of performance shares eventually distributed is contingent upon the achievement of specific performance criteria within a specified award period set at the grant date. The Company estimates the progress toward achieving these objectives when estimating the number of awards expected to vest and correspondingly, periodic compensation expense.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 11 - STOCK-BASED COMPENSATION PLANS (Continued)
The compensation cost attributable to these restricted performance units awards is based on both the fair market value of the shares at the grant date and the Company’s stock price at the end of a reporting cycle. Thirty-five percent of the total award will be paid in cash and is therefore classified as a liability, with total compensation cost changing as the Company’s stock price changes. The remaining sixty-five percent is classified as an equity award; total compensation cost is based on the fair market value of sixty-five percent of the total award on the date of grant. The compensation expense is recognized over the specified performance period.
As of December 31, 2010, there were no outstanding units granted under the Plan. The total fair value of units vested during the years ended December 31, 2010, 2009 and 2008 was $0, $135,000 and $335,000. There were no modifications or cash paid to settle performance unit awards during the three year period ending December 31, 2010.
Restricted Share Awards: Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at issue date. The fair value of the stock was determined using the market value of the Company’s stock on the grant date. The restricted shares fully vest on the third anniversary of the grant date.
A summary of changes in the Company’s nonvested shares for the year follows:
As of December 31, 2010, there was $8,000 of total unrecognized compensation cost related to nonvested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of 0.1 years. There were no shares that vested during the years ended December 31, 2010, 2009 and 2008. There were no modifications or cash paid to settle restricted share awards during the three year period ended December 31, 2010.
Deferred Stock Unit Awards: Deferred stock units totaling 45,000 units were awarded to our employees during 2009 and were allocated and divided equally between three performance periods. The 2009, 2010 and 2011 fiscal years were established as the performance periods by the Board of Directors’ Compensation Committee. The level of deferred stock shares eventually distributed is contingent upon the achievement of the specific performance criteria set at the grant date. The grant date for purposes of this award is the date the Compensation Committee establishes the specific performance criteria for the corresponding period. The Company estimates the progress toward achieving these objectives when estimating the number of awards expected to vest and correspondingly, periodic compensation expense which is recognized over the vesting period which begins on the grant date and ends on December 31, 2011. The compensation cost attributable to these deferred stock unit awards is based on the fair market value at the date of grant.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 11 - STOCK-BASED COMPENSATION PLANS (Continued)
A summary of changes in the Company’s nonvested units for the year follows:
As of December 31, 2010, there was $51,000 of total unrecognized compensation cost related to nonvested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of 1.0 years. There were no units that vested during the years ended December 31, 2010, 2009 and 2008. There were no modifications or cash paid to settle deferred stock unit awards during the three year period ended December 31, 2010.
NOTE 12 - INCOME TAXES
Income tax expense (benefit) was as follows.
Effective tax rates differ from federal statutory rates applied to financial statement income due to the following.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 12 - INCOME TAXES (Continued)
Year-end deferred tax assets and liabilities were due to the following.
The Company incurred net operating losses for state income taxes during years 2002 through 2010 which will be carried forward and applied to future state taxable income. Due to the uncertainty of the Company’s ability to use this benefit, a valuation allowance has been recorded. The cumulative state net operating loss is $16.2 million and can be carried forward for 15 years with expiration beginning in 2017.
The Company has general business credit carryforwards of $540,000 and AMT credit carryforwards of $589,000. The general business credits will begin to expire in 2028 and the AMT credit carryforwards have no expiration period.
Retained earnings of Your Community Bank includes approximately $3.7 million for which no deferred income tax liability has been recognized. This amount represents an allocation of income to bad debt deductions as of December 31, 1987 for tax purposes only. Reduction of amounts so allocated for purposes other than tax bad debt losses including redemption of bank stock or excess dividends, or loss of “bank” status would create income for tax purposes only, which would be subject to the then-current corporate income tax rate. The unrecorded deferred income tax liability on the above amount for Your Community Bank at December 31, 2010 was approximately $1.3 million.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 12- INCOME TAXES (Continued)
As of December 31, 2007, the Company’s 2004 and 2005 federal tax returns were being audited by the Internal Revenue Service. In the first quarter of 2008, the Company received notification the Internal Revenue Service had completed their audits and had determined adjustments were not required for tax positions taken in those returns. Accordingly, the Company reduced its reserve for unrecognized tax benefits in 2008 by $55,000. The Company has no unrecognized tax benefits as of December 31, 2010 and 2009 and there is no expected change for unrecognized tax benefits over the next twelve months.
The Company did not record any amounts of interest and penalties in the income statement for the years ended December 31, 2010 and 2009 and did not have an amount accrued for interest and penalties at December 31, 2010 and 2009.
The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the states of Indiana and Kentucky. The Company is no longer subject to examination by taxing authorities for years before 2007.
NOTE 13 - PREFERRED STOCK AND WARRANTS
On May 29, 2009, as part of the U.S. Treasury’s Troubled Asset Relief Program (“TARP”) Capital Purchase Program (“CPP”) of the Emergency Stabilization Act of 2008, the Company issued and sold (i) 19,468 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value, having a liquidation preference of $1,000 per share and (ii) a warrant to purchase 386,270 shares of the Company’s common stock, par value $0.10 per share, for an aggregate purchase price of $19.5 million. This capital is considered Tier I capital and ranks senior to common stock.
The preferred stock will accrue cumulative dividends at a rate of 5% per anum on the liquidation value of $1,000 per share for the first five years, and 9% per annum thereafter. The dividends will only be paid when declared by the Company’s Board of Directors. The preferred stock is generally non-voting and has no maturity date. The preferred stock may be redeemed by the Company after August 15, 2012. Prior to August 15, 2012, the preferred stock may be redeemed by the Company only with proceeds from the sale of qualifying equity securities and would require the approval of the Federal Reserve Board. The warrant has a term of ten years and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $7.56 per share.
In conjunction with the issuance of the preferred stock and stock warrant, the proceeds, net of direct issuance costs, were allocated to each based on their relative fair values. Accordingly, the value of the stock warrant was determined to be $445,000, which was allocated from the net proceeds and recorded in additional paid in capital on our consolidated balance sheet. This non-cash amount is considered a discount on the preferred stock and is accreted against retained earnings over a five year period using the level yield method and is reflected in our consolidated statement of operations as preferred stock accretion. Notwithstanding the terms of the Articles of Amendment for the preferred stock, under Section 111 of the Emergency Economic Stabilization Act of 2008, as amended (the “EESA”), the U.S. Treasury, subject to consultation with the Federal Reserve Board, must permit the Company to repurchase the preferred stock owned by the U.S. Treasury at any time regardless of the source of funds used for the redemption. This is confirmed by the U.S. Treasury in a letter agreement with the Company. The warrant is included in our diluted average common shares outstanding (subject to anti-dilution).
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 13 - PREFERRED STOCK AND WARRANTS (Continued)
Pursuant to the terms of the Purchase Agreement, the ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its Common Stock will be subject to restrictions, including a restriction against increasing dividends from the last quarterly cash dividend per share ($0.175) declared on the Common Stock prior to May 29, 2009. The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted. These restrictions will terminate on the earlier of (a) the third anniversary of the date of issuance of the Preferred Stock and (b) the date on which the Preferred Stock has been redeemed in whole or the U.S. Treasury has transferred all of the Preferred Stock to third parties, except that, after the third anniversary of the date of issuance of the Preferred Stock, if the Preferred Stock remains outstanding at such time, the Company may not increase its common dividends per share without obtaining consent of the U.S. Treasury.
The Purchase Agreement also subjects the Company to certain of the executive compensation limitations included in the Emergency Economic Stabilization Act of 2008 (the “EESA”). In this connection, as a condition to the closing of the transaction, the Company’s Senior Executive Officers (as defined in the Purchase Agreement) (the “Senior Executive Officers”), (i) voluntarily waived any claim against the U.S. Treasury or the Company for any changes to such officer’s compensation or benefits that are required to comply with the regulation issued by the U.S. Treasury under the TARP Capital Purchase Program and acknowledged that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements as they relate to the period the U.S. Treasury owns the Preferred Stock of the Company; and (ii) entered into a letter with the Company amending the Benefit Plans with respect to such Senior Executive Officers as may be necessary, during the period that the Treasury owns the Preferred Stock of the Company, as necessary to comply with Section 111(b) of the EESA.
NOTE 14 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON DIVIDENDS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. As of December 31, 2010, the most recent regulatory notifications categorized YCB and SCSB as well capitalized under the regulatory framework for prompt corrective action. There are no considerations or events since December 31, 2010 that management believes have changed the institution’s classification as well capitalized.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 14 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON DIVIDENDS (Continued)
Actual and required capital amounts and ratios are presented below at year-end.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 14 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON DIVIDENDS (Continued)
Dividend Restrictions: The Company’s principal source of funds for dividend payments is dividends received from the Banks. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s retained net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above. In 2011, YCB could declare dividends of $2.5 million plus 2011 earnings without prior regulatory approval while SCSB cannot declare dividends without prior approval due to net losses incurred in 2009. In addition, the Company has limitations on dividends it can pay to common shareholders as more fully described in Note 13 - Preferred Stock and Warrants.
NOTE 15 - OFF-BALANCE-SHEET ACTIVITIES
Some financial instruments, such as commitments to make loans for the Company’s portfolio, credit lines and letters of credit, are issued to meet customer-financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.
The contractual amount of financial instruments with off-balance-sheet risk was as follows at year-end.
Commitments to make loans are generally made for periods of 30 days or less and are at market rates. The fixed rate loan commitments have interest rates ranging from 3.75% to 14.00% and maturities ranging from 1 year to 30 years.
NOTE 16 - FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 16 - FAIR VALUE (Continued)
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate the fair value:
Securities: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). In instances where broker quotes are used, these quotes are obtained from market makers or broker-dealers recognized to be market participants. These valuation methods are classified as Level 2 in the fair value hierarchy.
Collateralized debt obligations which are collateralized by financial institutions and insurance companies were historically priced using Level 2 inputs. The decline in the level of observable inputs and market activity in this class of investments by the measurement date has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely. The once active market has become comparatively inactive. As such, these investments are now priced using Level 3 inputs. Prior to 2010, the fair values of our collateralized debt obligations were determined by using pricing information provided by our bond accounting service as determined by Moody’s analysts. Beginning in 2010, the fair values were determined by us utilizing an estimate of the expected cash flows based on our review of the underlying issuers’ financial condition and the anticipated deferral of payments and defaults of issuers. We provide our estimate of default for each issuer, which ranges from 100% loss to 0.40% loss at December 31, 2010, to the capital market traders of our bond accountant who provide the cash flows we will receive based upon our assumptions. To determine the discounted projected cash flows for our collateralized debt obligations, we utilize discount rates ranging from 8.93% to 27.49% (19.54% weighted average weight) depending on the security. The discount rates were determined utilizing a risk free rate of three month LIBOR plus 300 bps (3.30% at December 31, 2010), plus a premium for market illiquidity, and a credit component based on the quality of the collateral and the deal structure. Management believes this method results in a more accurate estimate of the fair value of our collateralized debt obligations.
Impaired Loans: Impaired loans are evaluated at the time the loan is identified as impaired and are recorded at the lower of the carrying amount of the loan or the fair value of the underlying collateral less costs to sell. The fair value of real estate is primarily determined based on appraisals by qualified licensed appraisers. The appraisals are discounted to reflect management’s estimate of the fair value of the collateral given the current circumstances and condition of the collateral. Impaired loans are evaluated quarterly for additional impairment. Fair value of impaired loans is classified as Level 3 in the fair value hierarchy.
Foreclosed and Repossessed Assets: Foreclosed and repossessed assets are initially recorded at fair value less estimated costs to sell when acquired. The fair value of foreclosed and repossessed assets is primarily determined based on appraisals by qualified licensed appraisers. The appraisals are discounted to reflect management’s estimate of the fair value of the collateral given the current circumstances of the collateral and reduced by management’s estimate of costs to dispose of the asset. Fair value of foreclosed and repossessed assets is classified as Level 3 in the fair value hierarchy.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 16 - FAIR VALUE (Continued)
Assets measured at fair value on a recurring basis are summarized below:
There were no transfers between Level 1 and Level 2 during 2010.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 16 - FAIR VALUE (Continued)
The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended December 31:
The table below summarizes changes in unrealized gains and losses recorded in earnings for the year ended December 31 for level 3 assets that are still held at December 31:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 16 - FAIR VALUE (Continued)
Assets measured at fair value on a nonrecurring basis are summarized below:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 16 - FAIR VALUE (Continued)
The Company measures for impairment using the fair value of the collateral less costs to sell for collateral-dependent loans. The Company’s impaired loans totaled $26.2 million as of December 31, 2010, which included collateral-dependent loans with a carrying value of $16.0 million. As of December 31, 2010, the Company’s collateral dependent loans had a valuation allowance of $1.9 million, resulting in an additional provision for loan losses of $2.5 million during the twelve months ended December 31, 2010. The Company’s impaired loans totaled $32.0 million as of December 31, 2009, which included collateral-dependent loans with a carrying value of $21.0 million. As of December 31, 2009, the Company’s collateral dependent loans had a valuation allowance of $3.1 million, resulting in an additional provision for loan losses of $5.2 million during the twelve months ended December 31, 2009.
The Company evaluates goodwill for impairment on an annual basis, or more frequently if certain conditions are present. During the year ended December 31, 2009, the Company recorded an impairment charge of $15.3 million, which reduced goodwill to its fair value of $0. See Note 5 for further information on goodwill impairment.
The Company evaluates acquired intangible assets on an annual basis, or more frequently if certain conditions are present. During the year ended December 31, 2009, the Company recorded an impairment charge of $819,000 which reduced the acquired intangible assets to its fair value of $1.4 million. See Note 5 for further information on acquired intangible assets impairment.
The Company evaluates the fair value of foreclosed assets at the time they are transferred from loans and on a quarterly basis thereafter. During the years ended December 31, 2010 and 2009, the Company recognized charges of $30,000 and $97,000 to write down foreclosed assets to their fair value.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 16 - FAIR VALUE (Continued)
Fair value of Financial Instruments
Carrying amount and estimated fair values of financial instruments, not previously presented, were as follows at year-end.
The methods and assumptions used to estimate fair value are described as follows:
The estimated fair value equals the carrying amount for cash and due from banks, interest-bearing deposits in other financial institutions, accrued interest receivable and payable, demand deposits, other borrowings, and variable rate loans or deposits that reprice frequently and fully. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life. Loans are reported net of the allowance for loan losses. Fair value of loans held for sale is based on market quotes. It is not practical to determine the fair value of FHLB and Federal Reserve stock due to restrictions placed on transferability. Fair value of FHLB advances and subordinated debentures are based on current rates for similar financing. The fair value of off-balance-sheet items is based on current fees or costs that would be charged to enter into or terminate such arrangements and is not material.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 17- PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION
Condensed financial information for Community Bank Shares of Indiana, Inc. is as follows:
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF OPERATIONS
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 17 - PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 18 - EARNINGS PER SHARE
The factors used in the earnings per share computation follows.
Stock options of 193,000, 224,000, and 241,000 common shares were excluded from 2010, 2009, and 2008 diluted earnings per share because they were anti-dilutive.
Performance units of 0, 0, and 22,500 were excluded from 2010, 2009, and 2008 diluted earnings per share because all the conditions required for issuance at those dates had not been met.
Deferred stock units of 25,000, 13,000, and 0 were excluded from 2010, 2009, and 2008 diluted earnings per share because all the conditions required for issuance at those dates had not been met.
Warrants for 0 and 386,000 of common shares were excluded from 2010 and 2009 diluted earnings per share because they were anti-dilutive.
Restricted share awards of 17,000, 17,000, and 0 common shares were excluded from 2010, 2009, and 2008 diluted earnings per share because all the condition required for issuance at those dates had not been met.
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 19 - OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) components and related taxes were as follows.
The following is a summary of the accumulated other comprehensive income (loss) balances, net of tax:
COMMUNITY BANK SHARES OF INDIANA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
NOTE 20 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Net loss for the second quarter of 2009 was negatively impacted by a goodwill and other intangible asset impairment charge of $16.2 million which was not repeated in other quarters in 2009. Also, the Company recorded a provision for loan losses of $14.3 million in the second quarter of 2009.
Part II
Item 9. Changes In And Disagreements With Accountants On Accounting And Financial Disclosures
There have been no changes in or disagreements with the Company’s principal independent accountant during the Company’s two most recent fiscal years.
Item 9A. Controls And Procedures
Company management, including the Chief Executive Officer (serving as the principal executive officer) and Chief Financial Officer (serving as the principal financial officer), have conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Securities Exchange Act of 1934 Rule 13a-15. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. There has been no change in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected or is reasonably likely to materially affect the Company’s internal control over financial reporting.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Community Bank Shares of Indiana’s (the Company’s) management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:

Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the Company’s assets;

Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Our management, including our principal executive officer and principal financial officer, assessed the effectiveness of our internal control over financial reporting as of the end of the fiscal year covered by this annual report on Form 10-K. In making this assessment, our management used the criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our management’s assessment, management concluded that, as of December 31, 2010, our Company’s internal control over financial reporting is effective based on the COSO criteria.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
/s/ James D. Rickard
/s/ Paul A. Chrisco
James D. Rickard
Paul A. Chrisco
President and Chief Executive Officer
Executive Vice President and
Chief Financial Officer
Item 9B. Other Information
There was no information to be disclosed by the Company on a Form 8-K during the fourth quarter of 2010 but not reported.
Part III
Item 10. Directors, Executive Officers And Corporate Governance
The information regarding Company directors required by this item is incorporated herein by reference to information under the headings “CORPORATE GOVERNANCE AND BOARD MATTERS” and “PROPOSAL NO. 2 - ELECTION OF DIRECTORS” in our definitive proxy statement, to be filed with the SEC, relating to our 2011 annual meeting of shareholders (“2011 Proxy Statement”) to be held on May 17, 2011. Information regarding the members of the Audit Committee, the Company’s code of business conduct and ethics, the identification of the Audit Committee Financial Expert and stockholder nominations of directors is also incorporated by reference to the information under the aforesaid headings. The information regarding our executive officers required by this item is incorporated by reference to the information under the heading “Executive Officers Who Are Not Directors” and the other headings listed above in the 2011 Proxy Statement.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company’s directors and executive officers and person who own more than 10% of the Company’s common stock to file reports of ownership and changes in ownership with the SEC. Based solely upon a review of the Forms 3, 4 and 5 filed during 2010, and written representations from certain reporting persons that no Forms 5 were required, the Company reasonably believes that all required reports were timely filed.
Item 11. Executive Compensation
Information concerning executive compensation is incorporated herein by reference to the information under the heading “EXECUTIVE COMPENSATION” in the 2011 Proxy Statement.
Item 12. Security Ownership Of Certain Beneficial Owners And Management And Related Stockholder Matters
See Part II, Item 5, for information securities authorized for issuance under the Company’s equity compensation plans. Information concerning security ownership of management is incorporated herein by reference to the information under the heading “STOCK OWNERSHIP BY DIRECTORS AND EXECUTIVE OFFICERS” in the 2011 Proxy Statement.
Item 13. Certain Relationships And Related Transactions, And Director Independence
Information concerning relationships and related transactions, and director independence is incorporated herein by reference to the information under the headings "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION”, “CORPORATE GOVERNANCE AND BOARD MATTERS” and “CERATIN RELATIONSHIPS AND RELATED PERSON TRANSACTIONS” in the 2011 Proxy Statement.
Item 14. Principal Accountant Fees And Services
Information concerning principal accountant fees and services is incorporated herein by reference to the information under the headings “REPORT OF THE AUDIT COMMITTEE,” INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM and “RATIFICATION OF APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM” in the 2011 Proxy Statement.
Part IV
Item 15. Exhibits And Financial Statement Schedules
(a)(1) Financial Statements
The following financial statements are included in Item 8