Item 1. Business
Historical Development of Business
This report, in Item 1, Item 7 and elsewhere, includes forward-looking statements within the meaning of Sections 27A of the Securities Act of 1933, as amended, and 21E of the Securities Exchange Act of 1934, as amended, that involve inherent risks and uncertainties. These forward-looking statements concern the financial condition, results of operations, plans, objectives, future performance and business of ConnectOne Bancorp, Inc. and its subsidiaries, including statements preceded by, followed by or that include words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain,” “pattern” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions may increase significantly; (2) changes in the interest rate environment may reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions may vary substantially from period to period; (4) general economic conditions may be less favorable than expected; (5) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) legislative or regulatory changes or actions may adversely affect the businesses in which ConnectOne Bancorp, Inc. is engaged; (7) changes and trends in the securities markets may adversely impact ConnectOne Bancorp, Inc.; (8) a delayed or incomplete resolution of regulatory issues could adversely impact our planning; (9) difficulties in integrating any businesses that we may acquire, which may increase our expenses and delay the achievement of any benefits that we may expect from such acquisitions; (10) the impact of reputation risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity could be significant; and (11) the outcome of any future regulatory and legal investigations and proceedings may not be anticipated. Further information on other factors that could affect the financial results of ConnectOne Bancorp, Inc. are included in Item 1A
Item 1A. Risk Factors
An investment in our common stock involves risks. Stockholders should carefully consider the risks described below, together with all other information contained in this Annual Report on Form 10-K, before making any purchase or sale decisions regarding our common stock. If any of the following risks actually occur, our business, financial condition or operating results may be harmed. In that case, the trading price of our common stock may decline, and stockholders may lose part or all of their investment in our common stock.
Risks Applicable to Our Business:
Our growth-oriented business strategy could be adversely affected if we are not able to attract and retain skilled employees or if we lose the services of our senior management team.
We may not be able to successfully manage our business as a result of the strain on our management and operations that may result from growth. Our ability to manage growth will depend upon our ability to continue to attract, hire and retain skilled employees. The loss of members of our senior management team, including those officers named in the summary compensation table of our proxy statement, could have a material adverse effect on our results or operations and ability to execute our strategic goals. Our success will also depend on the ability of our officers and key employees to continue to implement and improve our operational and other systems, to manage multiple, concurrent customer relationships and to hire, train and manage our employees.
We may need to raise additional capital to execute our growth oriented business strategy.
In order to continue our growth, we will be required to maintain our regulatory capital ratios at levels higher than the minimum ratios set by our regulators. In light of current economic conditions, our regulators have been seeking higher capital bases for insured depository institutions experiencing strong growth. In addition, the implementation of the Basel III regulatory capital requirements may require us to increase our regulatory capital ratios and raise additional capital. We can offer you no assurances that we will be able to raise capital in the future, or that the terms of any such capital will be beneficial to our existing security holders. In the event we are unable to raise capital in the future, we may not be able to continue our growth strategy
We have a significant concentration in commercial real estate loans.
Our loan portfolio is made up largely of commercial real estate loans. These types of loans generally expose a lender to a higher degree of credit risk of non-payment and loss than do residential mortgage loans because of several factors, including dependence on the successful operation of a business or a project for repayment, and loan terms with a balloon payment rather than full amortization over the loan term. In addition, commercial real estate loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one-to four-family residential mortgage loans. Underwriting and portfolio management activities cannot completely eliminate all risks related to these loans. Any significant failure to pay on time by our customers or a significant default by our customers would materially and adversely affect us.
At December 31, 2015, we had $2.0 billion of commercial real estate loans, which represented 63.4% of our total loan portfolio and 492.3% of risk-based capital. Our commercial real estate loans include loans secured by multifamily, owner occupied and nonowner occupied properties for commercial uses.
Loans secured by owner-occupied real estate are reliant on the operating businesses to provide cash flow to meet debt service obligations, and as a result they are more susceptible to the general impact on the economic environment affecting those operating companies as well as the real estate.
Although the economy in our market area generally, and the real estate market in particular, is improving, we can give you no assurance that it will continue to grow or that the rate of growth will accelerate. We can give you no assurance that it will continue to grow or that the rate of growth will accelerate to historical levels. Many factors, including continuing European economic difficulties could reduce or halt growth in our local economy and real estate market. Accordingly, it may be more difficult for commercial real estate borrowers to repay their loans in a timely manner in the current economic climate, as commercial real estate borrowers’ ability to repay their loans frequently depends on the successful development of their properties. The deterioration of one or a few of our commercial real estate loans could cause a material increase in our level of nonperforming loans, which would result in a loss of revenue from these loans and could result in an increase in the provision for loan and lease losses and/or an increase in charge-offs, all of which could have a material adverse impact on our net income. We also may incur losses on commercial real estate loans due to declines in occupancy rates and rental rates, which may decrease property values and may decrease the likelihood that a borrower may find permanent financing alternatives. Given the continued weaknesses in the commercial real estate market in general, there may be loans where the value of our collateral has been negatively impacted. Any weakening of the commercial real estate market may increase the likelihood of default of these loans, which could negatively impact our loan portfolio’s performance and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, we could incur material losses. Any of these events could increase our costs, require management time and attention, and materially and adversely affect us.
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Federal banking agencies have issued guidance regarding high concentrations of commercial real estate loans within bank loan portfolios. The guidance requires financial institutions that exceed certain levels of commercial real estate lending compared with their total capital to maintain heightened risk management practices that address the following key elements: board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and maintenance of increased capital levels as needed to support the level of commercial real estate lending. If there is any deterioration in our commercial real estate portfolio or if our regulators conclude that we have not implemented appropriate risk management practices, it could adversely affect our business, and could result in the requirement to maintain increased capital levels. Such capital may not be available at that time, and may result in our regulators requiring us to reduce our concentration in commercial real estate loans.
If we are limited in our ability to originate loans secured by commercial real estate we may face greater risk in our loan portfolio
If, because of our concentration of commercial real estate loans, or for any other reasons, we are limited in our ability to originate loans secured by commercial real estate, we may incur greater risk in our loan portfolio. For example, we may seek to originate commercial and industrial loans, including both secured and unsecured commercial and industrial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses and personal guarantees. Secured commercial and industrial loans are generally collateralized by accounts receivable, inventory, equipment or other assets owned by the borrower and typically include a personal guaranty of the business owner. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed. Therefore, we may be exposed to greater risk of loss on these credits.
The nature and growth rate of our commercial loan portfolio may expose us to increased lending risks.
Given the significant growth in our loan portfolio, many of our commercial real estate loans are unseasoned, meaning that they were originated relatively recently. As of December 31, 2015, we had $2.0 billion in commercial real estate loans outstanding. Approximately 63.9% of the loans, or $1.3 billion, had been originated in the past three years. Our limited experience with these loans does not provide us with a significant payment history pattern with which to judge future collectability. As a result, it may be difficult to predict the future performance of our loan portfolio. These loans may have delinquency or charge-off levels above our expectations, which could negatively affect our performance.
Our portfolio of loans secured by New York City taxi medallions could expose us to both credit risk and significant volatility in our reported results of operations in future periods due to changes in the value of these medallions.
We maintain a significant ($103.2 million at December 31, 2015) portfolio of loans secured by New York City taxi medallions. The taxi industry in New York City is facing significant competition and pressure from technology based ride share companies such as Uber and Lyft. This has resulted in volatility in the pricing of medallions, and has impacted the earnings of many medallion holders, including our borrowers. These trends in the New York City taxi industry could expose us to greater credit risk and the risk of loss if our borrowers are unable to comply with the terms of their loans.
In addition, a significant portion ($78.5 million) of our portfolio of loans secured by New York City taxi medallions has been deemed impaired, and classified as troubled debt restructurings (“TDRs”) and the level of specific allocations we may need to recognize with regard to these loans and any additional take medallion loans that may become impaired in future periods will be largely dependent upon the valuation we assign to these medallions. Because reported sales prices of these medallions recently have been very volatile, as the industry is under competitive stress, and do not necessarily represent orderly sales, we may also need to take into consideration factors beyond the market price of the medallions in determining our valuation, such as cash flow and industry prospects. In any case, our valuation may be volatile from period to period, and could result in our recognizing significant additional provisions if our valuation declines, while an increase in our valuation could result in a recapture, or reversal, of any such additional provisions. As a result, our results of operations could be materially adversely affected by declines in our valuation of New York City taxi medallions, even if our loans continue to perform as agreed, and we could experience significant volatility in our reported earnings if the reported prices for these medallions continue to be unsettled.
We have concluded that we have material weaknesses in our internal control over financial reporting.
As disclosed elsewhere in this Annual Report, we identified material weaknesses in our internal control over financial reporting related to controls over the identification and measurement of troubled debt restructurings in our taxi medallion portfolio, which, due to loan size and structure, is underwritten using market and industry data, and did not contain individual loan information required to accurately assess whether or not a modification should be deemed a troubled debt restructuring (“TDR”) and the measurement of impairment for such TDRs. Upon completion of the review, it was determined that $75.4 million in carrying value of taxi medallion loans, which were originally deemed to not be TDRs, should have been deemed TDRs when they were modified in April 2015. All of the modified loans are fully performing in accordance with their modified terms, and there have been no missed payments regarding any of the modified loans.
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When such oversights occur, we evaluate the impact on our disclosure controls and procedures, including our internal controls over financial reporting. Because our controls did not timely identify the modified loans as TDRs, we have concluded that we have a material weakness in our internal control over financial reporting with regard to the identification of TDRs in our taxi medallion portfolio. Management has taken steps to improve its controls with respect to identifying and measuring impairment of TDRs when loans are modified by reviewing and enhancing the financial documentation on an individual loan basis, calculating impairment based on objectively verifiable evidence and by strengthening management oversight. However, we can give you no assurances that we may not discover additional issues which make us conclude that we have other material weaknesses in our internal control over financial reporting or that our disclosure controls and procedures are not effective in the future, or that future material weaknesses in our internal controls over financial reporting or failures in our disclosure controls and procedures may not have a material adverse effect on our results of operations or financial condition.
The small to medium-sized businesses that the Bank lends to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to the Bank that could materially harm our operating results.
The Bank targets its business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These small to medium-sized businesses frequently have smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair the borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns and other events that negatively impact our market areas could cause the Bank to incur substantial credit losses that could negatively affect our results of operations and financial condition.
We are a community bank and our ability to maintain our reputation is critical to the success of our business and the failure to do so may materially adversely affect our performance.
We are a community bank, and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected, by the actions of our employees or otherwise, our business and, therefore, our operating results may be materially adversely affected.
Historically low interest rates may adversely affect our net interest income and profitability.
During the last seven years it has been the policy of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) to maintain interest rates at historically low levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, yields on securities we have purchased, and to a lesser extent, market rates on the loans we have originated, have been at levels lower than were available prior to 2008. Consequently, the average yield on our interest-earning assets has decreased during the recent low interest rate environment. As a general matter, our interest-bearing liabilities re-price or mature more quickly than our interest-earning assets, which have contributed to increases in net interest income (the difference between interest income earned on assets and interest expense paid on liabilities) in the short term. However, our ability to lower our interest expense is limited at these interest rate levels, while the average yield on our interest-earning assets may continue to decrease. Accordingly, our net interest income may decrease, which may have an adverse effect on our profitability. For information with respect to changes in interest rates, see “Risk Factors-Changes in interest rates may adversely affect or our earnings and financial condition.”
Anti-takeover provisions in our corporate documents and in New Jersey corporate law may make it difficult and expensive to remove current management.
Anti-takeover provisions in our corporate documents and in New Jersey law may render the removal of our existing board of directors and management more difficult. Consequently, it may be difficult and expensive for our stockholders to remove current management, even if current management is not performing adequately.
Competition from other financial institutions in originating loans and attracting deposits may adversely affect our profitability.
We face substantial competition in originating loans. This competition comes principally from other banks, savings institutions, mortgage banking companies, credit unions and other lenders. Many of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of loans that we originate and the interest rates we may charge on these loans.
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In attracting deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many of our competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations.
These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations, which may increase our cost of funds.
We also compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, insurance companies and governmental organizations, which may offer more favorable terms. Some of our non-bank competitors are not subject to the same extensive regulations that govern our operations. As a result, such non-bank competitors may have advantages over us in providing certain products and services. This competition may reduce or limit our margins on banking services, reduce our market share and adversely affect our earnings and financial condition.
External factors, many of which we cannot control, may result in liquidity concerns for us.
Liquidity risk is the potential that the Bank may be unable to meet its obligations as they come due, capitalize on growth opportunities as they arise, or pay regular dividends because of an inability to liquidate assets or obtain adequate funding in a timely basis, at a reasonable cost and within acceptable risk tolerances.
Liquidity is required to fund various obligations, including credit commitments to borrowers, mortgage and other loan originations, withdrawals by depositors, repayment of borrowings, operating expenses, capital expenditures and dividend payments to shareholders.
Liquidity is derived primarily from deposit growth and retention; principal and interest payments on loans; principal and interest payments on investment securities; sale, maturity and prepayment of investment securities; net cash provided from operations, and access to other funding sources. In addition, in recent periods we have substantially increased our use of alternate deposit origination channels, such as brokered deposits, including reciprocal deposit services, and internet listing services.
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 market factors or an adverse regulatory action against us. In addition, our ability to use alternate deposit originations channels could be substantially impaired if we fail to remain “well capitalized”. Our ability to 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. The liquidity issues have been particularly acute for regional and community banks, as many of the larger financial institutions have significantly curtailed their lending to regional and community banks to reduce their exposure to the risks of other banks. In addition, many of the larger correspondent lenders have reduced or even eliminated federal funds lines for their correspondent customers. Furthermore, regional and community banks generally have less access to the capital markets than do the national and super-regional banks because of their smaller size and limited analyst coverage. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, or fulfill obligations such as meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, results of operations and financial condition.
Declines in the value of our investment securities portfolio may adversely impact our results.
As of December 31, 2015, we had approximately $419.8 million in investment securities, consisting of available-for-sale and held-to-maturity. We may be required to record impairment charges on our investment securities if they suffer a decline in value that is considered other-than-temporary. Numerous factors, including lack of liquidity for re-sales of certain investment securities, absence of reliable pricing information on investment securities, adverse changes in business climate, adverse actions by regulators, or unanticipated changes in the competitive environment could have a negative effect on our investment portfolio in future periods. If an impairment charge is significant enough, it could affect the ability of the Bank to upstream dividends to the Company, which could have a material adverse effect on our liquidity and our ability to pay dividends to shareholders and could also negatively impact our regulatory capital ratios.
The Bank’s ability to pay dividends is subject to regulatory limitations, which, to the extent that the Company requires such dividends in the future, may affect the Company’s ability to honor its obligations and pay dividends.
As a bank holding company, the Company is a separate legal entity from the Bank and its subsidiaries and does not have significant operations. We currently depend on the Bank’s cash and liquidity to pay our operating expenses and to fund dividends to shareholders. We cannot assure you that in the future the Bank will have the capacity to pay the necessary dividends and that we will not require dividends from the Bank to satisfy our obligations. Various statutes and regulations limit the availability of dividends from the Bank. It is possible, depending upon our and the Bank’s financial condition and other factors, that bank regulators could assert that payment of dividends or other payments by the Bank are an unsafe or unsound practice. In the event that the Bank is unable to pay dividends, we may not be able to service our obligations, as they become due, or pay dividends on our capital stock. Consequently, the inability to receive dividends from the Bank could adversely affect our financial condition, results of operations, cash flows and prospects.
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In addition, as described under “Capital Adequacy Guidelines,” beginning in 2016, banks and bank holding companies will be required to maintain a capital conservation buffer on top of minimum risk-weighted asset ratios. When fully phased in on January 1, 2019, the capital conservation buffer will be 2.5%. Banking institutions which do not maintain capital in excess of the capital conservation buffer will face constraints on the payment of dividends, equity repurchases and compensation based on the amount of the shortfall. Accordingly, if the Bank fails to maintain the applicable minimum capital ratios and the capital conservation buffer, distributions to the Company may be prohibited or limited.
We may incur impairment to goodwill.
We review our goodwill at least annually. Significant negative industry or economic trends, reduced estimates of future cash flows or disruptions to our business, could indicate that goodwill might be impaired. Our valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and to rely on projections of future operating performance. We operate in a competitive environment and projections of future operating results and cash flows may vary significantly from actual results. Additionally, if our analysis results in an impairment to our goodwill, we would be required to record a non-cash charge to earnings in our financial statements during the period in which such impairment is determined to exist. Any such charge could have a material adverse effect on our results of operations.
If we pursue acquisitions, we may heighten the risks to our operations and financial condition.
To the extent that we undertake acquisitions, we may experience the effects of higher operating expenses relative to operating income from the new operations, which may have a material adverse effect on our levels of reported net income, return on average equity and return on average assets. Other effects of engaging in such growth strategies may include potential diversion of our management’s time and attention and general disruption to our business. To the extent that we grow through acquisitions, we cannot assure you that we will be able to adequately and profitably manage this growth. Acquiring other banks and businesses involve similar risks to those commonly associated with branching, but may also involve additional risks, including:
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potential exposure to unknown or contingent liabilities of banks and businesses we acquire;
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exposure to potential asset quality issues of the acquired bank or related business;
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difficulty and expense of integrating the operations and personnel of banks and businesses we acquire; and
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the possible loss of key employees and customers of the banks and businesses we acquire.
Attractive acquisition opportunities may not be available to us in the future.
We expect that other banking and financial service companies, many of which have significantly greater resources than us, will compete with us in acquiring other financial institutions if we pursue such acquisitions. This competition could increase prices for potential acquisitions that we believe are attractive. Also, acquisitions are subject to various regulatory approvals. If we fail to receive the appropriate regulatory approvals, we will not be able to consummate an acquisition that we believe is in our best interests. Among other things, our regulators will consider our capital, liquidity, profitability, regulatory compliance and levels of goodwill when considering acquisition and expansion proposals. Any acquisition could be dilutive to our earnings and shareholders’ equity per share of our common stock.
Hurricanes or other adverse weather events could negatively affect our local economies or disrupt our operations, which would have an adverse effect on our business or results of operations.
Hurricanes and other weather events can disrupt our operations, result in damage to our properties and negatively affect the local economies in which we operate. In addition, these weather events may result in a decline in value or destruction of properties securing our loans and an increase in delinquencies, foreclosures and loan losses.
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Risks Applicable to the Banking Industry Generally:
The financial services industry is undergoing a period of great volatility and disruption.
Beginning in mid-2007, there has been significant turmoil and volatility in global financial markets. Recent market uncertainty regarding the financial sector has increased. In addition to the impact on the economy generally, changes in interest rates, in the shape of the yield curve, or in valuations in the debt or equity markets or disruptions in the liquidity or other functioning of financial markets, all of which have been seen recently, could directly impact us in one or more of the following ways:
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Net interest income, the difference between interest earned on our interest earning assets and interest paid on interest bearing liabilities, represents a significant portion of our earnings. Both increases and decreases in the interest rate environment may reduce our profits. We expect that we will continue to realize income from the spread between the interest we earn on loans, securities and other interest-earning assets, and the interest we pay on deposits, borrowings and other interest-bearing liabilities. The net interest spread is affected by the differences between the maturity and repricing characteristics of our interest-earning assets and interest-bearing liabilities. Our interest-earning assets may not reprice as slowly or rapidly as our interest-bearing liabilities.
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The market value of our securities portfolio may decline and result in other than temporary impairment charges. The value of securities in our portfolio is affected by factors that impact the U.S. securities market in general as well as specific financial sector factors and entities. Recent uncertainty in the market regarding the financial sector has negatively impacted the value of securities within our portfolio. Further declines in these sectors may result in future other than temporary impairment charges.
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Asset quality may deteriorate as borrowers become unable to repay their loans.
Our allowance for loan and lease losses may not be adequate to cover actual losses.
Like all financial institutions, we maintain an allowance for loan and lease losses to provide for loan defaults and nonperformance. The process for determining the amount of the allowance is critical to our financial results and condition. It requires difficult, subjective and complex judgments about the future, including the impact of national and regional economic conditions on the ability of our borrowers to repay their loans. If our judgment proves to be incorrect, our allowance for loan and lease losses may not be sufficient to cover losses inherent in our loan portfolio. Further, state and federal regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan and lease losses and may require an increase in our allowance for loan and lease losses.
Although we believe that our allowance for loan and lease losses is adequate to cover known and probable incurred losses included in the portfolio, we cannot assure you that we will not further increase the allowance for loan and lease losses or that our regulators will not require us to increase this allowance. Either of these occurrences could adversely affect our earnings.
Changes in interest rates may adversely affect our earnings and financial condition.
Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds. The level of net interest income is primarily a function of the average balance of our interest-earning assets, the average balance of our interest-bearing liabilities, and the spread between the yield on such assets and the cost of such liabilities. These factors are influenced by both the pricing and mix of our interest-earning assets and our interest-bearing liabilities which, in turn, are impacted by such external factors as the local economy, competition for loans and deposits, the monetary policy of the Federal Open Market Committee of the Federal Reserve Board of Governors (the “FOMC”), and market interest rates.
A sustained increase in market interest rates could adversely affect our earnings if our cost of funds increases more rapidly than our yield on our earning assets, and compresses our net interest margin. In addition, the economic value of portfolio equity would decline if interest rates increase. For example, we estimate that as of December 31, 2015, a 200 basis point increase in interest rates would have resulted in our economic value of portfolio equity declining by approximately $45.1 million or 9.6%. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Sensitivity Analysis.”
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, deflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.
We also attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.
The banking business is subject to significant government regulations.
We are subject to extensive governmental supervision, regulation and control. These laws and regulations are subject to change, and may require substantial modifications to our operations or may cause us to incur substantial additional compliance costs. In addition, future legislation and government policy could adversely affect the commercial banking industry and our operations. Such governing laws can be anticipated to continue to be the subject of future modification. Our management cannot predict what effect any such future modifications will have on our operations. In addition, the primary focus of Federal and state banking regulation is the protection of depositors and not the shareholders of the regulated institutions.
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For example, the Dodd-Frank Act may result in substantial new compliance costs. The Dodd-Frank Act was signed into law on July 21, 2010. Generally, the Dodd-Frank Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the law, many of which will not become effective until various Federal regulatory agencies have promulgated rules implementing the statutory provisions. Uncertainty remains as to the ultimate impact of the Dodd-Frank Act, which could have a material adverse impact either on the financial services industry as a whole, or on our business, results of operations and financial condition.
The following aspects of the financial reform and consumer protection act are related to the operations of the Bank:
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A new independent consumer financial protection bureau was established within the Federal Reserve, empowered to exercise broad regulatory, supervisory and enforcement authority with respect to both new and existing consumer financial protection laws. However, smaller financial institutions, like the Bank, are subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws.
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The act also imposes new obligations on originators of residential mortgage loans, such as the Bank. Among other things, originators must make a reasonable and good faith determination based on documented information that a borrower has a reasonable ability to repay a particular mortgage loan over the long term. If the originator cannot meet this standard, the loan may be unenforceable in foreclosure proceedings. The act contains an exception from this ability to repay rule for “qualified mortgages”, which are deemed to satisfy the rule, but does not define the term, and left authority to the Consumer Financial Protection Bureau (“CFPB”) to adopt a definition. A rule issued by the CFPB in January 2013, and effective January 10, 2014, sets forth specific underwriting criteria for a loan to qualify as a Qualified Mortgage Loan. The criteria generally exclude loans that are interest-only, have excessive upfront points or fees, have negative amortization features or balloon payments, or have terms in excess of 30 years. The underwriting criteria also impose a maximum debt to income ratio of 43%. If a loan meets these criteria and is not a “higher priced loan” as defined in FRB regulations, the CFPB rule establishes a safe harbor preventing a consumer from asserting as a defense to foreclosure the failure of the originator to establish the consumer’s ability to repay. However, this defense will be available to a consumer for all other residential mortgage loans. Although the majority of residential mortgages historically originated by the Bank would qualify as Qualified Mortgage Loans, the Bank has also made, and may continue to make in the future, residential mortgage loans that will not qualify as Qualified Mortgage Loans. These loans may expose the Bank to greater losses, loan repurchase obligations, or litigation related expenses and delays in taking title to collateral real estate, if these loans do not perform and borrowers challenge whether the Bank satisfied the ability to repay rule on originating the loan.
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Tier 1 capital treatment for “hybrid” capital items like trust preferred securities is eliminated subject to various grandfathering and transition rules.
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The prohibition on payment of interest on demand deposits was repealed, effective July 21, 2011.
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Deposit insurance is permanently increased to $250,000.
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The deposit insurance assessment base calculation now equals the depository institution’s total assets minus the sum of its average tangible equity during the assessment period.
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The minimum reserve ratio of the Deposit Insurance Fund increased to 1.35 percent of estimated annual insured deposits or assessment base; however, the FDIC is directed to “offset the effect” of the increased reserve ratio for insured depository institutions with total consolidated assets of less than $10 billion.
In addition, in order to implement Basel III and certain additional capital changes required by the Dodd-Frank Act, on July 9, 2013, the Federal banking agencies, including the FDIC, the Federal Reserve and the Office of the Comptroller of the Currency, approved, as an interim final rule, the regulatory capital requirements for U.S. insured depository institutions and their holding companies. This regulation requires financial institutions to maintain higher capital levels and more equity capital.
These provisions, as well as any other aspects of current or proposed regulatory or legislative changes to laws applicable to the financial industry, may impact the profitability of our business activities and may change certain of our business practices, including the ability to offer new products, obtain financing, attract deposits, make loans, and achieve satisfactory interest spreads, and could expose us to additional costs, including increased compliance costs. These changes also may require us to invest significant management attention and resources to make any necessary changes to operations in order to comply, and could therefore also materially and adversely affect our business, financial condition and results of operations.
Our management is actively reviewing the provisions of the Dodd-Frank Act, many of which are to be phased-in over the next several months and years, and assessing the probable impact on our operations. However, the ultimate effect of these changes on the financial services industry in general, and us in particular, is uncertain at this time.
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The laws that regulate our operations are designed for the protection of depositors and the public, not our shareholders.
The federal and state laws and regulations applicable to our operations give regulatory authorities extensive discretion in connection with their supervisory and enforcement responsibilities, and generally have been promulgated to protect depositors and the Deposit Insurance Fund and not for the purpose of protecting shareholders. These laws and regulations can materially affect our future business. Laws and regulations now affecting us may be changed at any time, and the interpretation of such laws and regulations by bank regulatory authorities is also subject to change.
We can give no assurance that future changes in laws and regulations or changes in their interpretation will not adversely affect our business. Legislative and regulatory changes may increase our cost of doing business or otherwise adversely affect us and create competitive advantages for non-bank competitors.
The potential impact of changes in monetary policy and interest rates may negatively affect our operations.
Our operating results may be significantly affected (favorably or unfavorably) by market rates of interest that, in turn, are affected by prevailing economic conditions, by the fiscal and monetary policies of the United States government and by the policies of various regulatory agencies. Our earnings will depend significantly upon our interest rate spread (i.e., the difference between the interest rate earned on our loans and investments and the interest raid paid on our deposits and borrowings). Like many financial institutions, we may be subject to the risk of fluctuations in interest rates, which, if significant, may have a material adverse effect on our operations.
We cannot predict how changes in technology will impact our business; increased use of technology may expose us to service interruptions or breaches in security.
The financial services market, including banking services, is increasingly affected by advances in technology, including developments in:
●
Telecommunications;
●
Data processing;
●
Automation;
●
Internet-based banking, including personal computers, mobile phones and tablets;
●
Debit cards and so-called “smart cards”; and
●
Remote deposit capture.
Our ability to compete successfully in the future will depend, to a certain extent, on whether we can anticipate and respond to technological changes. We offer electronic banking services for our consumer and business customers via our website, www.cnob.com, including Internet banking and electronic bill payment, as well as mobile banking by phone. We also offer check cards, ATM cards, credit cards, and automatic and ACH transfers. The successful operation and further development of these and other new technologies will likely require additional capital investments in the future. In addition, increased use of electronic banking creates opportunities for interruptions in service or security breaches, which could expose us to claims by customers or other third parties. We cannot assure you that we will have sufficient resources or access to the necessary proprietary technology to remain competitive in the future, or that we will be able to maintain a secure electronic environment.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
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Item 2.
Item 2. Properties
The Bank operates seven banking offices in Bergen County, NJ, consisting of one office each in Englewood Cliffs, Englewood, Cresskill, Fort Lee, Hackensack, Ridgewood and Saddle River; nine banking offices in Union County, NJ, consisting of five offices in Union Township, and one office each in Springfield Township, Berkeley Heights, Vauxhall and Summit; three banking offices in Morris County, NJ, consisting of one office each in Boonton, Madison and Morristown; one office in Newark in Essex County, NJ; one office in West New York in Hudson County, NJ; one office in Princeton in Mercer County, NJ, and one office in Holmdel in Monmouth County, NJ. The Bank is also opened a branch office in the borough of Manhattan in New York City. The Bank’s principal office is located at 301 Sylvan Avenue, Englewood Cliffs, NJ. The principal office is a three-story leased building constructed in 2008.
The following table sets forth certain information regarding the Bank’s leased locations.
The Bank operates a Drive In/Walk Up located at 2022 Stowe Street, Union, NJ.
Item 3.
Item 3. Legal Proceedings
There are no significant pending legal proceedings involving the Company other than those arising out of routine operations. None of these matters would have a material adverse effect on the Company or its results of operations if decided adversely to the Company.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
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PART II
Item 5.
Item 5. Market for the Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities
Security Market Information
The common stock of the Company is traded on the NASDAQ Global Select Market under the symbol “CNOB”. As of December 31, 2015, the Company had 514 stockholders of record, excluding beneficial owners for whom CEDE & Company or others act as nominees. On December 31, 2015, the closing sale price was $18.69.
The following table sets forth the high and low closing sales price, and the dividends declared, on a share of the Company’s common stock for the years ended December 31, 2015 and 2014.
Share Repurchase Program
Historically, repurchases have been made from time to time as, in the opinion of management, market conditions warranted, in the open market or in privately negotiated transactions. Shares repurchased were used for stock dividends and other issuances. No repurchases were made of the Company’s common stock during 2015 or 2014.
Dividends
Federal laws and regulations contain restrictions on the ability of the Parent Corporation and the Bank to pay dividends. For information regarding restrictions on dividends, see Part I, Item 1, “Business” and Part II, Item 8, “Financial Statements and Supplementary Data”, Note 20 of the Notes to Consolidated Financial Statements.”
Stockholders Return Comparison
Set forth on the following page is a line graph presentation comparing the cumulative stockholder return on the Parent Corporation’s common stock, on a dividend reinvested basis, against the cumulative total returns of the NASDAQ and the KBW Bank Index for the period from December 31, 2010 through December 31, 2015.
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COMPARABLE FIVE-YEAR CUMULATIVE TOTAL RETURN
AMONG CONNECTONE BANCORP, INC,
S&P COMPOSITE AND SNL MID-ATLANTIC BANK INDEX
Assumes $100 invested on January 1, 2011
Assumes dividends reinvested
Year ended December 31,
COMPARISON OF CUMULATIVE TOTAL RETURN OF ONE OR MORE
COMPANIES, PEER GROUPS, INDUSTRY INDEXES AND/OR BROAD MARKETS
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Item 6.
Item 6. Selected Financial Data
The following tables set forth selected consolidated financial data as of the dates and for the periods presented. The selected consolidated statement of financial condition data as of December 31, 2015 and 2014 and the selected consolidated summary of income data for the years ended December 31, 2015, 2014 and 2013 have been derived from our audited consolidated financial statements and related notes that we have included elsewhere in this Annual Report. The selected consolidated statement of financial condition data as of December 31, 2013, 2012 and 2011 and the selected consolidated summary of income data for the years ended December 31, 2012 and 2011 have been derived from audited consolidated financial statements that are not presented in this Annual Report.
The selected historical consolidated financial data as of any date and for any period are not necessarily indicative of the results that may be achieved as of any future date or for any future period. You should read the following selected statistical and financial data in conjunction with the more detailed information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes that we have presented elsewhere in this Annual Report.
On July 1, 2014, the Merger was completed. See Note 3 - Business Combinations of the Notes to the Consolidated Financial Statements.
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SUMMARY OF SELECTED STATISTICAL INFORMATION AND FINANCIAL DATA
____________________
(1) These measures are not measures recognized under generally accepted accounting principles in the United States (“GAAP”), and are therefore considered to be non-GAAP financial measures. See -“Non-GAAP Financial Measures” for a reconciliation of these measurers to their most comparable GAAP measures.
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____________________
(1) These measures are not measures recognized under generally accepted accounting principles in the United States (“GAAP”), and are therefore considered to be non-GAAP financial measures. See -“Non-GAAP Financial Measures” for a reconciliation of these measurers to their most comparable GAAP measures.
(2) Nonperforming assets are defined as nonaccrual loans plus other real estate owned.
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Notes to Selected Financial Data
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Item 7.
Item 7. Management’s Discussion and Analysis (“MD&A”) of Financial Condition and Results of Operations
The purpose of this analysis is to provide the reader with information relevant to understanding and assessing the Company’s results of operations for each of the past three years and financial condition for each of the past two years. In order to fully appreciate this analysis, the reader is encouraged to review the consolidated financial statements and accompanying notes thereto appearing under Item 8 of this report, and statistical data presented in this document.
Cautionary Statement Concerning Forward-Looking Statements
See Item 1 of this Annual Report on Form 10-K for information regarding forward-looking statements.
Critical Accounting Policies and Estimates
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to our audited consolidated financial statements contains a summary of our significant accounting policies. Management believes our policy with respect to the methodology for the determination of the allowance for loan and lease losses involves a higher degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact results of operations. This critical policy and its application are periodically reviewed with the Audit Committee and our Board of Directors.
Business Combinations
The Company accounts for business combinations under the purchase method of accounting. The application of this method of accounting requires the use of significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed in order to properly allocate purchase price consideration between assets that are amortized, accreted or depreciated from those that are recorded as goodwill. Our estimates of the fair values of assets acquired and liabilities assumed are based upon assumptions that we believe to be reasonable, and whenever necessary, include assistance from independent third-party appraisal and valuation firms.
Allowance for Loan and Lease Losses and Related Provision
The allowance for loan and lease losses represents management’s estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan and lease 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 losses on pools of homogeneous 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 Company’s Consolidated Statements of Condition.
The evaluation of the adequacy of the allowance for loan and lease losses includes, among other factors, an analysis of historical loss rates by loan category applied to current loan totals. However, actual loan losses may be higher or lower than historical trends, which vary. Actual losses on specified problem loans, which also are provided for in the evaluation, may vary from estimated loss percentages, which are established based upon a limited number of potential loss classifications.
The allowance for loan and lease losses is established through a provision for loan and lease losses charged to expense. Management believes that the current allowance for loan and lease losses will be adequate to absorb loan and lease losses on existing loans and leases that may become uncollectible based on the evaluation of known and inherent risks in the originated loan portfolio. The evaluation takes into consideration such factors as changes in the nature and size of the portfolio, overall portfolio quality, and specific problem loans and current economic conditions which may affect our borrowers’ ability to pay. The evaluation also details historical losses by loan category and the resulting loan loss rates which are projected for current loan total amounts. Loss estimates for specified problem loans are also detailed. Various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan and lease losses. Such agencies may require us to make additional provisions for loan losses based upon information available to them at the time of their examination. All of the factors considered in the analysis of the adequacy of the allowance for loan and lease losses may be subject to change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required that could materially adversely impact earnings in future periods. Additional information can be found in Note 1 of the Notes to Consolidated Financial Statements.
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Income Taxes
The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns.
Fluctuations in the actual outcome of these future tax consequences could impact the Company’s consolidated financial condition or results of operations. Notes 1 (under the caption “Use of Estimates”) and 12 of the Notes to Consolidated Financial Statements include additional discussion on the accounting for income taxes.
Goodwill
The Company has adopted the provisions of FASB ASC 350-10-05, which requires that goodwill be reported separate from other intangible assets in the Consolidated Statements of Condition and not be amortized but tested for impairment annually or more frequently if indicators arise for impairment. No impairment charge was deemed necessary for the years ended December 31, 2015, 2014 and 2013.
Fair Value of Investment Securities
The Company relies upon the guidance in FASB ASC 820-10-65 when determining fair value for the Company’s pooled trust preferred securities and private issue corporate bond. See Note 22 of the Notes to Consolidated Financial Statements, Fair Value Measurements and Fair Value of Financial Instruments, for further discussion.
Overview and Strategy
We serve as a holding company for the Bank, which is our primary asset and only operating subsidiary. We follow a business plan that emphasizes the delivery of customized banking services in our market area to customers who desire a high level of personalized service and responsiveness. The Bank conducts a traditional banking business, making commercial loans, consumer loans and residential and commercial real estate loans. In addition, the Bank offers various non-deposit products through non-proprietary relationships with third party vendors. The Bank relies upon deposits as the primary funding source for its assets. The Bank offers traditional deposit products.
Many of our customer relationships start with referrals from existing customers. We then seek to cross sell our products to customers to grow the customer relationship. For example, we will frequently offer an interest rate concession on credit products for customers that maintain a non-interest bearing deposit account at the Bank. This strategy has lowered our funding costs and helped slow the growth of our interest expense even as we have substantially increased our total deposits. It has also helped fuel our significant loan growth. We believe that the Bank’s significant growth and increasing profitability demonstrate the need for and success of our brand of banking.
Our results of operations depend primarily on our net interest income, which is the difference between the interest earned on our interest-earning assets and the interest paid on funds borrowed to support those assets, primarily deposits. Net interest margin is the difference between the weighted average rate received on interest-earning assets and the weighted average rate paid to fund those interest-earning assets, which is also affected by the average level of interest-earning assets as compared with that of interest-bearing liabilities. Net income is also affected by the amount of non-interest income and non-interest expenses.
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General
The following discussion and analysis presents the more significant factors affecting the Company’s financial condition as of December 31, 2015 and 2014 and results of operations for each of the years in the three-year period ended December 31, 2015. The Merger was effective July 1, 2014, which significantly impacts comparisons to earlier periods. The MD&A should be read in conjunction with the consolidated financial statements, notes to consolidated financial statements and other information contained in this report. On July 1, 2014, the combined company changed its name to ConnectOne.
Operating Results Overview
Net income for the year ended December 31, 2015 was $41.3 million, an increase of $22.7 million, or 123.4%, compared to net income of $18.6 million for 2014. Net income available to common shareholders for the year ended December 31, 2015 was $41.2 million, an increase of $22.7 million, or 123.3%, compared to net income available to common shareholders of $18.5 million for 2014. Diluted earnings per share were $1.36 for 2015, a 73.1% increase from $0.79 for 2014.
The increase in net income from 2014 to 2015 was attributable to the following:
●
Increased net interest income of $37.8 million primarily due to the impact of the Merger and organic growth,
●
Increased provision for loan and lease losses of $7.9 million primarily due to an increase in organic loan growth during 2015, higher levels of specific reserves including $4.5 million related to the taxi medallion portfolio and $1.3 million related to the Union Center’s former operations center that was repositioned as a lease financing receivable and the maturity and extension of acquired portfolio loans,
●
Increased noninterest income of $3.7 million primarily resulting from an insurance recovery ($2.2 million) and an increase in net gains on sale of investment securities ($1.1 million),
●
Noninterest expense remained relatively flat due to an increase in salaries and employee benefits ($8.9 million), occupancy and equipment ($2.3 million), and professional and consulting ($1.3 million), offset by impact of the Merger (including direct merger charges of $12.4 million in 2014), and
●
Increased income tax expense of $11.1 million resulting from higher pretax income in 2015 offset by nondeductible merger-related expenses incurred in 2014.
Net income for the year ended December 31, 2014 was $18.6 million, a decrease of $1.4 million, or 6.8%, compared to net income of $19.9 million for 2013. Net income available to common shareholders for the year ended December 31, 2014 was $18.5 million, a decrease of $1.3 million, or 6.7%, compared to net income available to common shareholders of $19.8 million for 2013. Diluted earnings per share were $0.79 for 2014, a 34.7% decrease from $1.21 for 2013.
The decrease in net income from 2013 to 2014 was attributable to the following:
●
Increased net interest income of $33.2 million primarily due to the impact of the Merger and including net favorable purchase accounting adjustments of $5.3 million,
●
A higher loan loss provision of $4.3 million largely due to an increase in organic loan growth during 2014, the maturity and extension of acquired portfolio loans during the second half of 2014 and an increase in net loan charge-offs,
●
A $29.5 million increase in non-interest expense principally due to the impact of the Merger (including direct merger charges of $12.4 million), a $4.6 million loss on the extinguishment of debt and a $2.4 million charge on a fraudulent wire transfer, and
●
Increased income tax expense of $1.4 million resulting from nondeductible merger-related expenses incurred in 2014.
Net Interest Income
Fully taxable equivalent net interest income for 2015 totaled $119.7 million, an increase of $37.9 million, or 46.4%, from 2014. The increase in net interest income was due to an increase in average interest-earning assets, which grew by 47.3% to $3.4 billion principally as a result of the Merger, which was effective on July 1, 2014. Partially offsetting the increase in interest earning assets was a 2 basis-point contraction in the net interest margin. During 2015, the Bank’s funding costs were higher due to an increase in longer-term funding, including time deposits and subordinated debt. Average total loans increased by 64.6% to $2.8 billion in 2015 from $1.7 billion in 2014.
Fully taxable equivalent net interest income for 2014 totaled $81.8 million, an increase of $33.1 million, or 67.9%, from 2013. The increase in net interest income was due to an increase in average interest-earning assets, which grew by 54.9% to $2.3 billion principally as a result of the Merger, as well as a 27 basis-point widening of the net interest margin to 3.57% due to net accretion of purchase accounting fair value adjustments recognized on acquired loans, securities, time deposits and borrowings and a reduction in the average rate paid on borrowings resulting from a $70 million debt extinguishment and subsequent refinancing accomplished at the end of the third quarter of 2014. Average total loans increased by 86.7% to $1.7 billion in 2014 from $908.8 million in 2013.
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Average Balance Sheets
The following table sets forth certain information relating to our average assets and liabilities for the years ended December 31, 2015, 2014 and 2013 and reflect the average yield on assets and average cost of liabilities for the periods indicated. Such yields are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown.
___________________
(1) Average balances for available-for-sale securities are based on amortized cost.
(2) Interest income is presented on a tax equivalent basis using 35% Federal tax rate.
(3) Includes loan fee income.
(4) Loans receivable include nonaccrual loans.
(5) Represents difference between the average yield on interest earnings assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.
(6) Represents net interest income on a fully taxable equivalent basis divided by average total interest-earning assets.
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Rate/Volume Analysis
The following table presents, by category, the major factors that contributed to the changes in net interest income. Changes due to both volume and rate have been allocated in proportion to the relationship of the dollar amount change in each.
Provision for Loan and Lease Losses
In determining the provision for loan and lease losses, management considers national and local economic trends and conditions; trends in the portfolio including orientation to specific loan types or industries; experience, ability and depth of lending management in relation to the complexity of the portfolio; effects of changes in lending policies, trends in volume and terms of loans; levels and trends in delinquencies, impaired loans and net charge-offs and the results of independent third party loan and lease review.
For the year ended December 31, 2015, the provision for loan and lease losses was $12.6 million, an increase of $7.9 million, compared to the provision for loan and lease losses of $4.7 million for the same period in 2014. The increase resulted from an increase in organic loan growth during 2015, higher levels of specific reserves including $4.5 million related to the taxi medallion portfolio and $1.3 million related to the Union Center’s former operations center that was repositioned as a lease financing receivable and the maturity and extension of acquired portfolio loans.
For the year ended December 31, 2014, the provision for loan and lease losses was $4.7 million, an increase of $4.3 million, compared to the provision for loan and lease losses of $0.4 million for the same period in 2013. This increase resulted from organic loan growth during 2014, the maturity and extension of acquired portfolio loans during the second half of 2014 and an increase in net loan charge-offs.
Noninterest Income
Noninterest income for the full-year 2015 increased by $3.7 million, or 49.0% to $11.2 million from $7.5 million in 2014. The increase was primarily the result of a 2015 insurance recovery of $2.2 million and higher net investment securities gains, increasing by $1.1 million to $3.9 million for the year ended December 31, 2015 from $2.8 million for the year ended December 31, 2014, partially offset by a slight decline in deposit, loan and other income of $0.1 million to $2.7 million and a decline in annuities and insurance commissions of $0.2 million to $0.2 million for the year ended December 31, 2015.
Noninterest income for the full-year 2014 increased by $0.6 million, or 9.4% to $7.5 million from $6.9 million in 2013. The increase was primarily the result of higher net investment securities gains, increasing by $1.1 million to $2.8 million for the year ended December 31, 2014 from $1.7 million for the year ended December 31, 2013, partially offset by a slight decline in deposit, loan and other income of $0.2 million to $2.8 million and a decline in annuities and insurance commissions of $0.1 million to $0.4 million for the year ended December 31, 2014.
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The decline in fee income was the result of the Company de-emphasizing service charges, focusing instead on customer growth and retention. This strategy was particularly important during the Merger conversion process as the implementation of certain fees and other charges were intentionally delayed or waived.
Noninterest Expense
Noninterest expenses for the full-year 2015 decreased by $0.3 million, or 0.6% to $54.5 million from $54.8 million in 2014. The decrease was a result of merger-related charges of $12.4 million in 2014, offset by increases attributable to the Merger (2015 reflected a full-year of combined company expenses whereas 2014 reflected only the second half) as well as an increased level of business and staff resulting from organic growth. Salary and employee benefits increased by $8.9 million, occupancy and equipment expenses increased by $2.3 million and professional and consulting fees increased by $1.3 million.
Noninterest expenses for the full-year 2014 increased by $29.5 million, or 116.8% to $54.8 million from $25.3 million in 2013. The increase was primarily due to the impact of the Merger, including merger-related charges of $12.4 million. In addition, at the end of the third quarter of 2014, the Company repurchased $70.0 million of putable Federal Home Loan Bank advances which resulted in a loss on debt extinguishment of $4.6 million.
Income Taxes
Income tax expense was $19.9 million for the full-year 2015 compared to $8.8 million for the full-year 2014 and $7.5 million for the full-year 2013. The effective tax rates were 32.5% for 2015 and 32.3% for 2014 and 27.3% for 2013. The effective tax rate in 2015 from 2014 remained relatively flat, while the effective tax rate increased in 2014 from 2013 due to nondeductible merger-related expenses incurred in 2014 as well as an increase in income subject to state taxes.
For a more detailed description of income taxes see Note 12 of the Notes to Consolidated Financial Statements.
Financial Condition Overview
At December 31, 2015, the Company’s total assets were $4.0 billion, an increase of $568 million from December 31, 2014. Loans receivable were $3.1 billion, an increase of $560 million from December 31, 2014. Deposits were $2.5 billion, an increase of $315 million from December 31, 2014.
At December 31, 2014, the statement of financial condition reflected the Merger. The Company’s total assets were $3.4 billion, an increase of $1.8 billion from December 31, 2013. Loans receivable were $2.5 billion, an increase of $1.6 billion from December 31, 2013. Deposits were $2.5 billion, an increase of $1.1 billion from December 31, 2013.
Loan Portfolio
The Bank’s lending activities are generally oriented to small-to-medium sized businesses, high net worth individuals, professional practices and consumer and retail customers living and working in the Bank’s market area of Bergen, Union, Morris, Essex, Hudson, Mercer and Monmouth counties, New Jersey. The Bank has not made loans to borrowers outside of the United States. The Bank believes that its strategy of high-quality customer service, competitive rate structures and selective marketing have enabled it to gain market share.
Commercial loans are loans made for business purposes and are primarily secured by collateral such as cash balances with the Bank, marketable securities held by or under the control of the Bank, business assets including accounts receivable, taxi medallions, inventory and equipment and liens on commercial and residential real estate. Commercial construction loans are loans to finance the construction of commercial or residential properties secured by first liens on such properties. Commercial real estate loans include loans secured by first liens on completed commercial properties, including multi-family properties, to purchase or refinance such properties. Residential mortgages include loans secured by first liens on residential real estate, and are generally made to existing customers of the Bank to purchase or refinance primary and secondary residences. Home equity loans and lines of credit include loans secured by first or second liens on residential real estate for primary or secondary residences. Consumer loans are made to individuals who qualify for auto loans, cash reserve, credit cards and installment loans.
During 2015 and 2014, loan portfolio growth was positively impacted in several ways including (i) an increase in demand for small business lines of credit, and business term loans as economic conditions have stabilized and begun to improve, (ii) industry consolidation and lending restrictions involving larger competitors allowing the Bank to gain market share, (iii) an increase in refinancing strategies employed by borrowers during the current low rate environment, and (iv) the Bank’s success in attracting highly experienced commercial loan officers with substantial local market knowledge.
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Gross loans at December 31, 2015 totaled $3.1 billion, an increase of $562 million, or 22.1%, over gross loans at December 31, 2014 of $2.5 billion. The increase in gross loans was attributed to organic loan growth. The largest component of our loan portfolio at December 31, 2015 and December 31, 2014 was commercial real estate loans. Our commercial real estate loans at December 31, 2015 totaled $2.0 billion, an increase of $332 million, or 20.3%, over commercial real estate loans at December 31, 2014 of $1.6 billion. Our commercial loans totaled $570.1 million at December 31, 2015, an increase of $70.3 million, or 14.1%, over commercial loans at December 31, 2014 of $499.8 million. Our commercial construction loans at December 31, 2015 totaled $328.8 million, an increase of $161.5 million, or 96.5%, over commercial construction loans at December 31, 2014 of $167.4 million. Our residential real estate loans totaled $233.7 million at December 31, 2015, a decrease of $1.3 million, or 0.5%, over residential real estate loans at December 31, 2014 of $235.0 million. Our consumer loans at December 31, 2015 totaled $2.5 million, a decrease of $0.4 million, 14.8%, over consumer loans of $2.9 million at December 31, 2014. The growth in our loan portfolio reflects the success of our business strategy, in particular emphasizing high-quality customer service strategy, which has led to continued customer referrals.
The following table sets forth the classification of our loans by loan portfolio class as of December 31, 2015, 2014, 2013, 2012 and 2011.
The following table sets forth the classification of our gross loans by loan portfolio class and by fixed and adjustable rate loans as of December 31, 2015 and 2014 in term of contractual maturity.
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Asset Quality
General. One of our key objectives is to maintain a high level of asset quality. When a borrower fails to make a scheduled payment, we attempt to cure the deficiency by making personal contact with the borrower. Initial contacts typically are made 15 days after the date the payment is due, and late notices are sent approximately 15 days after the date the payment is due. In most cases, deficiencies are promptly resolved. If the delinquency continues, late charges are assessed and additional efforts are made to collect the deficiency. All loans which are delinquent 30 days or more are reported to the board of directors of the Bank on a monthly basis.
On loans where the collection of principal or interest payments is doubtful, the accrual of interest income ceases (“nonaccrual” loans). Except for loans that are well secured and in the process of collection, it is our policy to discontinue accruing additional interest and reverse any interest accrued on any loan that is 90 days or more past due. On occasion, this action may be taken earlier if the financial condition of the borrower raises significant concern with regard to his/her ability to service the debt in accordance with the terms of the loan agreement. Interest income is not accrued on these loans until the borrower’s financial condition and payment record demonstrate an ability to service the debt.
Real estate acquired as a result of foreclosure is classified as OREO until sold. OREO is recorded at the lower of cost or fair value less estimated selling costs. Costs associated with acquiring and improving a foreclosed property are usually capitalized to the extent that the carrying value does not exceed fair value less estimated selling costs. Holding costs are charged to expense. Gains and losses on the sale of OREO are charged to operations, as incurred.
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. As part of the evaluation of impaired loans, the Company individually reviews for impairment all non-homogeneous loans internally classified as substandard or below. Generally, smaller impaired non-homogeneous loans and impaired homogeneous loans are collectively evaluated for impairment.
In limited situations we will modify or restructure a borrower’s existing loan terms and conditions. A restructured loan is considered a troubled debt restructuring (“TDR”) when, for economic or legal reasons related to a borrower’s financial difficulties, we grant a concession to the borrower in modifying or renewing a loan that the institution would not otherwise consider.
Asset Classification. Federal regulations and our policies require that we utilize an internal asset classification system as a means of reporting problem and potential problem assets. We have incorporated an internal asset classification system, substantially consistent with Federal banking regulations, as a part of our credit monitoring system. Federal banking regulations set forth a classification scheme for problem and potential problem assets as “substandard,” “doubtful” or “loss” assets. An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the insured institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated “special mention.”
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When an insured institution classifies one or more assets, or portions thereof, as “substandard” or “doubtful,” it is required that a general valuation allowance for loan and lease losses must be established for loan losses in an amount deemed prudent by management. General valuation allowances represent loss allowances which have been established to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies one or more assets, or portions thereof, as “loss,” it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge off such amount.
A bank’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by Federal bank regulators which can order the establishment of additional general or specific loss allowances. The Federal banking agencies have adopted an interagency policy statement on the allowance for loan and lease losses. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines. Generally, the policy statement recommends that institutions have effective systems and controls to identify, monitor and address asset quality problems; that management analyze all significant factors that affect the collectability of the portfolio in a reasonable manner; and that management establish acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. Our management believes that, based on information currently available, our allowance for loan and lease losses is maintained at a level which covers all known and probable incurred losses in the portfolio at each reporting date. However, actual losses are dependent upon future events and, as such; further additions to the level of allowances for loan losses may become necessary.
The table below sets forth information on our classified assets designated special mention at the dates indicated.
During the year ended December 31, 2015, “substandard” loans, which include lower credit quality loans which possess higher risk characteristics than special mention assets, increased from $42.3 million, or 1.7% of total loans, at December 31, 2014 to $130.5 million, or 4.2% of total loans, at December 31, 2015. The increase in “substandard” loans was due to downgrades of specific credits in both the commercial and commercial real estate segments of the loan portfolio, including $80.3 million of taxi medallion loans.
Nonperforming Loans, Troubled Debt Restructurings, Past Due Loans and OREO
Nonperforming loans include nonaccrual loans and accruing loans which are contractually past due 90 days or more. Nonaccrual loans represent loans on which interest accruals have been suspended. It is the Company’s general policy to consider the charge-off of loans, or a portion thereof, when they become contractually past due ninety days or more as to interest or principal payments or when other internal or external factors indicate that collection of principal or interest is doubtful. Troubled debt restructurings represent loans on which a concession was granted to a borrower, such as a reduction in interest rate to a rate lower than the current market rate for new debt with similar risks, and which are currently performing in accordance with the modified terms. The Company previously reported performing troubled debt restructured loans as a component of nonperforming assets. For additional information regarding loans, see Note 5 of the Notes to the Consolidated Financial Statements.
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The following table sets forth, as of the dates indicated, the amount of the Company’s nonaccrual loans, other real estate owned (“OREO”), performing troubled debt restructurings (“TDRs”) and loan past due 90 days and still accruing:
The increase in performing TDRs was mainly attributable to 48 loans secured by NYC taxi medallions totaling $78.5 million as of December 31, 2015 that were modified in troubled debt restructurings during the second and fourth quarter of 2015. The modifications consisted of a deferral of principal amortization from approximately 25-30 year amortization to interest-only. There was no extension of the loans’ contractual maturity dates and the loans’ interest rates were increased from approximately 3%-3.25% to 3.75%. There was no forgiveness of principal and the average remaining maturity of the loans was approximately 23 months at the time of modification. These loans were accruing prior to modification and remained in accrual status post-modification.
A specific reserve of $4.5 million in specific allocations associated with taxi medallion lending was recorded during the year ended December 31, 2015. The reserve was based on the fair value of the collateral, and excludes any consideration for the personal guarantees of borrowers, which provides an additional source of repayment but cannot be relied upon. The valuation per corporate medallion used for the calculation at December 31, 2015 was $800,000. A specific allocation was required at December 31, 2015 primarily due to a decline in the value of taxi medallions.
As of December 31, 2015, taxi medallion loans totaled $103.2 million, of which $99.9 million was current and $3.3 million was past due 30-60 days. The average loan-to-value ratio, assuming current estimated values, was approximately 90%.
Allowance for Loan and Lease Losses and Related Provision
The allowance for loan and lease losses is a reserve established through charges to earnings in the form of a provision for loan and lease losses. We maintain an allowance for loan and lease losses at a level considered adequate to provide for all known and probable incurred losses in the portfolio. The level of the allowance is based on management’s evaluation of estimated losses in the portfolio, after consideration of risk characteristics of the loans and prevailing and anticipated economic conditions. Loan charge-offs (i.e., loans judged to be uncollectible) are charged against the reserve and any subsequent recovery is credited. Our officers analyze risks within the loan portfolio on a continuous basis and through an external independent loan review function, and the results of the loan review function are also reviewed by our Audit Committee. A risk system, consisting of multiple grading categories for each portfolio class, is utilized as an analytical tool to assess risk and appropriate reserves. In addition to the risk system, management further evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors which management feels deserve recognition in establishing an appropriate reserve. These estimates are reviewed at least quarterly and, as adjustments become necessary, they are recognized in the periods in which they become known. Although management strives to maintain an allowance it deems adequate, future economic changes, deterioration of borrowers’ creditworthiness, and the impact of examinations by regulatory agencies all could cause changes to our allowance for loan and lease losses.
At December 31, 2015, the allowance for loan and lease losses was $26.6 million, an increase of $12.4 million or 87.7%, from $14.2 million for the year ended December 31, 2014. Net charge-offs totaled $0.2 million during 2015 and $0.9 million for 2014. The allowance for loan and lease losses as a percentage of loans receivable was 0.86% at December 31, 2015 and 0.56% at December 31, 2014. The increase in this percentage was attributable to organic loan growth and the maturity and extension of acquired portfolio loans. In purchase accounting, any allowance for loan and lease losses on an acquired loan portfolio is reversed and a credit risk discount is applied directly to the acquired loan balances.
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Five-Year Statistical Allowance for Loan and Lease Losses
The following table reflects the relationship of loan volume, the provision and allowance for loan and lease losses and net charge-offs for the past five years.
For additional information regarding loans, see Note 5 of the Notes to the Consolidated Financial Statements.
Implicit in the lending function is the fact that loan losses will be experienced and that the risk of loss will vary with the type of loan being made, the creditworthiness of the borrower and prevailing economic conditions. The allowance for loan and lease losses has been allocated in the table below according to the estimated amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the following categories of loans at December 31, for each of the past five years.
The table below shows, for three types of loans, the amounts of the allowance allocable to such loans and the percentage of such loans to total loans, along with the amount of the unallocated allowance.
Investments
For the year ended December 31, 2015, the average volume of investment securities decreased by $25.3 million to approximately $482.7 million or 14.3% of average earning assets, from $508.0 million on average, or 22.2% of average earning assets, in 2014. The decrease in investment securities resulted from a focus on funding new loan originations. At December 31, 2015, the total investment portfolio amounted to $419.8 million, a decrease of $94.4 million from December 31, 2014. At December 31, 2015, the principal components of the investment portfolio are U.S. Treasury and Government Agency Obligations, Federal Agency Obligations including mortgage-backed securities, Obligations of U.S. states and political subdivision, corporate bonds and notes, and other debt and equity securities.
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During the year ended December 31, 2015, volume related factors decreased investment revenue by $1.1 million. The tax-equivalent yield on investments increased by 23 basis points to 3.57% from a yield of 3.34% during the year ended December 31, 2014. This caused the Company to prudently decrease the size of its investment portfolio in an effort to deploy excess cash into loans.
There were no holdings of any pooled trust preferred securities at December 31, 2015 and 2014. The Company owned one pooled trust preferred security in 2013, which consisted of securities issued by financial institutions and insurance companies. The Company held the mezzanine tranche of these securities. Senior tranches generally are protected from defaults by over-collateralization and cash flow default protection provided by subordinated tranches, with senior tranches having the greatest protection and mezzanine tranches subordinated to the senior tranches. During 2013, a Pooled TRUP, ALESCO VII, incurred its eighteenth interruption of cash flow payments to date. Management reviewed the expected cash flow analysis and credit support to determine if it was probable to that all principal and interest would be repaid, and recorded an other-than-temporary impairment charge of $628,000 for the twelve months ended December 31, 2013. The new cost basis for this security had been written down to $260,000. This security was sold effective December 31, 2013 at the new cost basis.
At December 31, 2015 and 2014 the Company did not own any private label mortgage backed securities which required evaluation for impairment. The Company owned one variable rate private label collateralized mortgage obligation (CMO) in 2013, which was evaluated for impairment, which was subsequently sold. The Company recorded $24,000 in principal losses in 2013.
Securities available-for-sale are a part of the Company’s interest rate risk management strategy and may be sold in response to changes in interest rates, changes in prepayment risk, liquidity management and other factors. The Company continues to reposition the investment portfolio as part of an overall corporate-wide strategy to produce reasonable and consistent margins where feasible, while attempting to limit risks inherent in the Company’s balance sheet.
At December 31, 2015, the net unrealized gain carried as a component of accumulated other comprehensive income and included in stockholders’ equity, net of tax, amounted to $0.6 million as compared with a net unrealized gain of $4.9 million at December 31, 2014, resulting from changes in market conditions and interest rates at December 31, 2015. No alternative valuation approaches were used for any holdings at December 31, 2015 or December 31, 2014. For additional information regarding the Company’s investment portfolio, see Note 4, Note 17 and Note 22 of the Notes to the Consolidated Financial Statements.
During 2015, securities sold from the Company’s available-for-sale portfolio amounted to $65.3 million, as compared with $81.8 million in 2014 and $122.2 million in 2013. The gross realized gains on securities sold, called or matured amounted to approximately $3.9 million in 2015, as compared to $2.8 million in 2014 and $2.5 million in 2013, while there were no gross realized losses in 2015, and there were losses of $19 thousand in 2014 and $88 thousand in 2013. There were no impairment charges in 2015 and in 2014 as compared to $740 thousand in 2013, which included impairment charges of $652 thousand. During 2013, the Company recorded an other-than-temporary charge of $628,000 on the Pooled TRUP, ALESCO VII, and $24,000 in principal losses on the same variable rate private label CMO.
The table below illustrates the maturity distribution and weighted average yield on a tax-equivalent basis for investment securities at December 31, 2015, on a contractual maturity basis.
For information regarding the carrying value of the investment portfolio, see Note 4, Note 17 and Note 22 of the Notes to the Consolidated Financial Statements.
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The securities listed in the table above are either rated investment grade by Moody’s and/or Standard and Poor’s or have shadow credit ratings from a credit agency supporting an investment grade and conform to the Company’s investment policy guidelines. There were no municipal securities, or corporate securities, of any single issuer exceeding 10 percent of stockholders’ equity at December 31, 2015.
Equity securities and other securities do not have a contractual maturity and are included in the “Due after ten years” maturity in the table above.
The following table sets forth the carrying value of the Company’s investment securities, as of December 31 for each of the last three years.
For other information regarding the Company’s investment securities portfolio, see Note 4 and Note 22 of the Notes to the Consolidated Financial Statements.
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Interest Rate Sensitivity Analysis
The principal objective of our asset and liability management function is to evaluate the interest-rate risk included in certain balance sheet accounts; determine the level of risk appropriate given our business focus, operating environment, and capital and liquidity requirements; establish prudent asset concentration guidelines; and manage the risk consistent with Board approved guidelines. We seek to reduce the vulnerability of our operations to changes in interest rates, and actions in this regard are taken under the guidance of the Bank’s Asset Liability Committee (the “ALCO”). The ALCO generally reviews our liquidity, cash flow needs, maturities of investments, deposits and borrowings, and current market conditions and interest rates.
We currently utilize net interest income simulation and economic value of equity (“EVE”) models to measure the potential impact to the Bank of future changes in interest rates. As of December 31, 2015 and December 31, 2014 the results of the models were within guidelines prescribed by our Board of Directors. If model results were to fall outside prescribed ranges, action, including additional monitoring and reporting to the Board, would be required by the ALCO and Bank’s management.
The net interest income simulation model attempts to measure the change in net interest income over the next one-year period, and over the next three-year period on a cumulative basis, assuming certain changes in the general level of interest rates.
Based on our model, which was run as of December 31, 2015, we estimated that over the next one-year period a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 5.65%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 3.62%. As of December 31, 2014, we estimated that over the next one-year period, a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 0.29%, while a 100 basis-point instantaneous decrease in the general level of interest rates would decrease our net interest income by 3.41%.
Based on our model, which was run as of December 31, 2015, we estimated that over the next three years, on a cumulative basis, a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 6.66%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 5.59%. As of December 31, 2014, we estimated that over the next three years, on a cumulative basis, a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 2.76%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 6.54%.
An EVE analysis is also used to dynamically model the present value of asset and liability cash flows with instantaneous rate shocks of up 200 basis points and down 100 basis points. The economic value of equity is likely to be different as interest rates change. Our EVE as of December 31, 2015, would decline by 9.65% with an instantaneous rate shock of up 200 basis points, and increase by 8.20% with an instantaneous rate shock of down 100 basis points. Our EVE as of December 31, 2014, would decline by 15.02% with an instantaneous rate shock of up 200 basis points, and increase by 13.65% with an instantaneous rate shock of down 100 basis points.
Estimates of Fair Value
The estimation of fair value is significant to certain assets of the Company, including available-for-sale investment securities. These are all recorded at either fair value or the lower of cost or fair value. Fair values are volatile and may be influenced by a number of factors. Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, expected cash flows, credit quality, discount rates, or market interest rates. Fair values for most available for sale investment securities are based on quoted market prices. If quoted market prices are not available, fair values are based on judgments regarding future expected loss experience, current economic condition risk characteristics of various financial instruments, and other factors. See Note 22 of the Notes to Consolidated Financial Statements for additional discussion.
These estimates are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
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Impact of Inflation and Changing Prices
The financial statements and notes thereto presented elsewhere herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the operations; unlike most industrial companies, nearly all of the Company’s assets and liabilities are monetary. As a result, interest rates have a greater impact on performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Liquidity
Liquidity is a measure of a bank’s ability to fund loans, withdrawals or maturities of deposits, and other cash outflows in a cost-effective manner. Our principal sources of funds are deposits, scheduled amortization and prepayments of loan principal, maturities of investment securities, and funds provided by operations. While scheduled loan payments and maturing investments are relatively predictable sources of funds, deposit flow and loan prepayments are greatly influenced by general interest rates, economic conditions and competition.
At December 31, 2015, the amount of liquid assets remained at a level management deemed adequate to ensure that, on a short and long-term basis, contractual liabilities, depositors’ withdrawal requirements, and other operational and client credit needs could be satisfied. As of December 31, 2015, liquid assets (cash and due from banks, interest-bearing deposits with banks and unencumbered investment securities) were $466.5 million, which represented 12.2% of total assets and 17.5% of total deposits and borrowings, compared to $416.4 million at December 31, 2014, which represented 12.1% of total assets and 14.0% of total deposits and borrowings on such date.
The Bank is a member of the Federal Home Loan Bank of New York and, based on available qualified collateral as of December 31, 2015, had the ability to borrow $1.2 billion. In addition, at December 31, 2015, the Bank had in place borrowing capacity of $25 million through correspondent banks. The Bank also has a credit facility established with the Federal Reserve Bank of New York for direct discount window borrowings with capacity based on pledged collateral of $78 million. At December 31, 2015, the Bank had aggregate available and unused credit of $635 million, which represents the aforementioned facilities totaling $1.3 billion net of $656 million in outstanding borrowings. At December 31, 2015, outstanding commitments for the Bank to extend credit were $626 million.
Cash and cash equivalents totaled $200.9 million on December 31, 2015, increasing by $74.0 million from $126.8 million at December 31, 2014. Operating activities provided $52.3 million in net cash. Investing activities used $509.9 million in net cash, primarily reflecting an increase in loans, which was offset in part by cash flow from the securities portfolio. Financing activities provided $531.7 million in net cash, primarily reflecting a net increase of $233.1 million in deposits, $50.0 million of new subordinated debt, and a net increase of $176.0 in borrowings (consisting of $848.9 million in new borrowings offset by notional repayments of $672.9 million). Borrowing activity was significantly higher during the year ended December 31, 2015 when compared to the same period of 2014 due to the Merger and continued growth in our lending operations.
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Deposits
Deposits are our primary source of funds. Average total deposits increased $673.3 million, or 35.5% to $2.6 billion in 2015 from 2014, $594.3 million, or 45.6%, to $1.9 billion in 2014 from $1.3 billion in 2013. Growth in both periods was, due to the impact of the Merger and a growth in core deposits, primarily in money market accounts deposits. Transaction and nontransaction (time) deposits have grown as the customer’s base has expanded.
The following table sets forth the average amount of various types of deposits for each of the periods indicated.
The following table sets forth the distribution of total deposit accounts, by account types for each of the periods indicated.
The following table summarizes the maturity distribution of time deposits in denomination of $250,000 or more:
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Borrowings
Borrowings consist of long and short term advances from the Federal Home Loan Bank and securities sold under agreements to repurchase. Federal Home Loan Bank advances are secured, under the terms of a blanket collateral agreement, by commercial mortgage loans. As of December 31, 2015, the Company had $671.6 million in notes outstanding at a weighted average interest rate of 1.37%. As of December 31, 2014, the Company had $495.6 million in notes outstanding at a weighted average interest rate of 1.48%.
Contractual Obligations and Other Commitments
The following table summarizes contractual obligations at December 31, 2015 and the effect such obligations are expected to have on liquidity and cash flows in future periods.
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Capital
The maintenance of a solid capital foundation continues to be a primary goal for the Company. Accordingly, capital plans and dividend policies are monitored on an ongoing basis. The most important objective of the capital planning process is to balance effectively the retention of capital to support future growth and the goal of providing stockholders with an attractive long-term return on their investment.
The Company’s Tier 1 leverage capital (defined as tangible stockholders’ equity for common stock and Trust Preferred Capital Securities) at December 31, 2015 amounted to $339.5 million or 9.1% of average total assets. At December 31, 2014, the Company’s Tier 1 leverage capital amounted to $301.6 million or 9.4% of average total assets. Tier 1 capital excludes the effect of FASB ASC 320-10-05, which amounted to $0.7 million of net unrealized losses, after tax, on securities available-for-sale at December 31, 2015 (and would be reported as a component of accumulated other comprehensive income which is included in stockholders’ equity), and is reduced by goodwill and intangible assets, which amounted to $147.5 million as of December 31, 2015. For information on goodwill and intangible assets, see Note 1 to the Consolidated Financial Statements.
United States bank regulators have issued guidelines establishing minimum capital standards related to the level of assets and off balance-sheet exposures adjusted for credit risk. Specifically, these guidelines categorize assets and off balance-sheet items into four risk-weightings and require banking institutions to maintain a minimum ratio of capital to risk-weighted assets. At December 31, 2015, the Company’s CET 1, Tier 1 and total risk-based capital ratios were 9.1%, 9.6% and 11.8%, respectively. For information on risk-based capital and regulatory guidelines for the Parent Corporation and its bank subsidiary, see Note 16 to the Consolidated Financial Statements.
The foregoing capital ratios are based in part on specific quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the bank regulators regarding capital components, risk weightings, and other factors.
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Subordinated Debentures
During December 2003, Center Bancorp Statutory Trust II, a statutory business trust and wholly-owned subsidiary of the Parent Corporation issued $5.0 million of MMCapS capital securities to investors due on January 23, 2034. The trust loaned the proceeds of this offering to the Company and received in exchange $5.2 million of the Parent Corporation’s subordinated debentures. The subordinated debentures are redeemable in whole or part. The floating interest rate on the subordinated debentures is three-month LIBOR plus 2.85% and reprices quarterly. The rate at December 31, 2015 was 3.17%.
During June 2015, the Parent Corporation issued $50 million in aggregate principal amount of fixed-to-floating rate subordinated notes (the “Notes”) to certain institutional accredited investors. The net proceeds from the sale of the Notes are expected to be used to redeem, by March 31, 2016, $11.3 million outstanding of its Senior Noncumulative Perpetual Preferred Stock issued in 2011 to the U.S. Treasury under the Small Business Lending Fund Program, and for general corporate purposes, which included the Parent Corporation contributing $35 million of the net proceeds to the Bank in the form of common equity. The Notes are non-callable for five years, have a stated maturity of July 1, 2025, and bear interest at a fixed rate of 5.75% per year, from and including June 30, 2015 to, but excluding July 1, 2020. From and including July 1, 2020 to the maturity date or early redemption date, the interest rate will reset quarterly to a level equal to the then current three-month LIBOR rate plus 393 basis points.
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Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Interest Sensitivity
Market Risk
Interest rate risk management is our primary market risk. See "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation- Interest Rate Sensitivity Analysis" herein for a discussion of our management of our interest rate risk.
8. Financial Statements and Supplementary Data
All Financial Statements:
The following financial statements are filed as part of this report under Item 8
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
Upon effectiveness of the Merger, BDO USA, LLP the Company’s certifying accountant since July 8, 2013, including during the 2013 fiscal year, was replaced by Crowe Horwath LLP, and the certifying accountant for Legacy ConnectOne. The change was in connection with the Merger, and was approved by the Board of Directors immediately following completion of the Merger. BDO USA, LLP’s report on the financial statements does not contain an adverse opinion or a disclaimer of opinion, and was not qualified or modified as to uncertainty, audit scope, or accounting principles. During the Company’s two most recent fiscal years (and all subsequent interim periods) there were no disagreements with BDO USA, LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreement(s), if not resolved to the satisfaction of BDO USA, LLP, would have caused it to make reference to the subject matter of the disagreement(s) in connection with its report.
Also upon completion of the Merger, the Audit Committee of the Company’s Board of Directors engaged Crowe Horwath LLP as the Company’s independent registered public accounting firm. Crowe Horwath LLP was Legacy ConnectOne’s independent registered public accounting firm prior to completion of the Merger. Prior to engaging Crowe Horwath LLP, the Company did not consult with Crowe Horwath LLP regarding the application of accounting principles to a specific completed or contemplated transaction or regarding the type of audit opinions that might be rendered by Crowe Horwath LLP on the Company’s financial statements, and Crowe Horwath LLP did not provide any written or oral advice that was an important factor considered by the Company in reaching a decision as to any such accounting, auditing or financial reporting issue. In addition, the Company did not consult Crowe Horwath LLP with respect to any subject of a disagreement with BDO USA, LLP or with respect to any reportable event.
Item 9A.
Item 9A. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its reports filed or submitted pursuant to the Securities Exchange Act of 1934, as amended (“Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that information required to be disclosed by the Company in its Exchange Act reports is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Under the supervision and with the participation of its management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e) and 15d-15(e) as of December 31, 2015. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that because of the weaknesses discussed below, the Company’s disclosure controls and procedures were not effective as of such date.
(b) Management’s Report on Internal Control over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) of the Exchange Act. The Company’s internal control system is a process designed to provide reasonable assurance to the Company’s management, Board of Directors and shareholders regarding the reliability of financial reporting and the preparation and fair presentation of financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances 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 are being made only in accordance with authorizations of management and the 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 our financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
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As part of the Company’s program to comply with Section 404 of the Sarbanes-Oxley Act of 2002, our management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015 (the “Assessment”). In making this Assessment, management used the control criteria framework of the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission published in its report entitled Internal Control - Integrated Framework (2013). Management’s Assessment included an evaluation of the design of the Company’s internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting. Management reviewed the results of its Assessment with the Audit Committee.
Based on this Assessment, management determined that, as of December 31, 2015, the Company’s internal control over financial reporting was not effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
In the course of business, and from time to time, the Company modifies loans at the request of borrowers. Modifications that involve borrowers experiencing financial difficulties and that result in concessions regarding loan terms including reduced interest rates, deferral of principal and extension of maturities can be deemed troubled debt restructurings. We recently identified material weaknesses in our controls over the identification and measurement of troubled debt restructurings in our taxi medallion portfolio, which, due to loan size and structure, is underwritten using market and industry data, and did not contain individual loan information required to accurately assess whether or not a modification should be deemed a TDR and the measurement of impairment for such TDRs. Upon completion of the review, it was determined that $75.4 million carrying value of taxi medallion loans, which were originally deemed to not be TDRs, should have been deemed TDRs when they were modified in April 2015.
Crowe Horwath LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements included in this Annual Report on Form 10-K, has issued an audit report on the Company’s internal control over financial reporting as of December 31, 2015. The report, which expresses an adverse opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015, is included in this item under the heading “Report of Independent Registered Public Accounting Firm.”
(c) Changes in Internal Controls Over Financial Reporting
When the material weaknesses were identified, we enhanced our internal controls concerning identification of all TDRs by (i) strengthening our policies and procedures, including requirements that we obtain and analyze current information on each individual borrower and (ii) enhancing oversight, monitoring and approval authorities, before agreeing to any modification of a borrower’s loan. We also enhanced our internal controls concerning measurement of TDR impairment with regard to taxi medallion loans by employing the services of a third-party valuation firm specializing in the industry and implementing a control to evaluate the results of the third-party. Despite these control enhancements, we cannot assert as of December 31, 2015 that our material weaknesses have been fully remediated, due to insufficient time to fully test these controls.
Other than as discussed above, there have been no changes in the Company’s internal controls over financial reporting that occurred during the Company’s last fiscal quarter to which this report relates that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We have audited ConnectOne Bancorp, Inc.’s internal control over financial reporting as of December 31, 2015, based on criteria established in the 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). ConnectOne Bancorp, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses have been identified and included in Management's Report on Internal Control Over Financial Reporting. Internal controls over the identification and measurement of troubled debt restructurings in the taxi medallion portfolio are not effective. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2015 consolidated financial statements, and this report does not affect our report dated March 4, 2016 on those consolidated financial statements.
In our opinion, because of the effects of the material weaknesses described above, ConnectOne Bancorp, Inc.’s has not maintained effective internal control over financial reporting as of December 31, 2015, based on criteria established in the 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of ConnectOne Bancorp, Inc. as of December 31, 2015 and 2014, and the related statements of income, comprehensive income, changes in stockholders' equity, and cash flows for the years then ended and our report dated March 4, 2016 expressed an unqualified opinion on those consolidated financial statements.
/s/ Crowe Horwath LLP
Crowe Horwath LLP
Livingston, New Jersey
March 4, 2016
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Item 9B.
Item 9B. Other Information
None.
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PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information required by this part is included in the definitive Proxy Statement for the Company’s 2016 Annual Meeting under the captions “ELECTION OF DIRECTORS” and “SECTION 16(A) BENEFICIAL OWNERSHIP REPORTS COMPLIANCE,” each of which is incorporated herein by reference. It is expected that such Proxy Statement will be filed with the Securities and Exchange Commission no later than April 30, 2016.
Item 11.
Item 11. Executive Compensation
Information concerning executive compensation is included in the definitive Proxy Statement for the Company’s 2015 Annual Meeting under the captions “EXECUTIVE COMPENSATION” and “DIRECTOR COMPENSATION”, which is incorporated by reference herein. It is expected that such Proxy Statement will be filed with the Securities and Exchange Commission no later than April 30, 2016.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning security ownership of certain beneficial owners and management is included in the definitive Proxy statement for the Company’s 2016 Annual Meeting under the caption “SECURITY OWNERSHIP OF MANAGEMENT”, which is incorporated herein by reference. It is expected that such Proxy statement will be filed with the Securities and Exchange Commission no later than April 30, 2016.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information concerning certain relationships and related transactions is included in the definitive Proxy Statement for the Company’s 2016 Annual Meeting under the caption “INTEREST OF MANAGEMENT AND OTHERS IN CERTAIN TRANSACTIONS”, which is incorporated herein by reference. It is expected that such Proxy statement will be filed with the Securities and Exchange Commission no later than April 30, 2016.
Item 14.
Item 14. Principal Accounting Fees and Services
The information concerning principal accountant fees and services as well as related pre-approval policies under the caption “RATIFICATION OF INDEPENDENT AUDITORS” in the Proxy Statement for the Company’s 2016 Annual Meeting of Shareholders is incorporated by reference herein. It is expected that such Proxy Statement will be filed with the Securities and Exchange Commission no later than April 30, 2016.
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PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)
(1) Financial Statements and Schedules:
The following Financial Statements and Supplementary Data are filed as part of this annual report:
(b)
Exhibits (numbered in accordance with Item 601 of Regulation S-K) filed herewith or incorporated by reference as part of this annual report.
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All financial statement schedules are omitted because they are either inapplicable or not required, or because the required information is included in the Consolidated Financial Statements or notes thereto.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, ConnectOne Bancorp, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant, in the capacities described below on March 4, 2016, have signed this report below.
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