ITEM 1. BUSINESS
General
Baylake Corp., a Wisconsin corporation organized in 1976, ("Baylake" or the "Company"), is a registered bank holding company under the Federal Bank Holding Company Act of 1956, as amended. Baylake's primary activities consist of holding indirectly the stock of Baylake Bank ("Bank"), and providing a wide range of banking and related business activities, through the Bank and its other subsidiaries. Baylake has elected to become a "financial holding company" under the Gramm-Leach Bliley Act of 1999 ("GLB Act").
Baylake Bank
The Bank is a Wisconsin state bank originally chartered in 1876. The Bank conducts its community banking business through 26 full-service financial centers located throughout Northeast Wisconsin, in Brown, Door, Green Lake, Kewaunee, Manitowoc, Outagamie, Waupaca, and Waushara Counties. The Bank has eight financial centers in Door County, which is known for its seasonal and tourism related services. The Bank has six financial centers in Brown County, which includes the city of Green Bay and has a broader range of service, manufacturing and retail job segments in its market. The balance of the Bank's financial centers are located in the other previously mentioned counties. Other principal industries in Bank's market area include light industry and manufacturing, agriculture, food related products, and to a lesser degree, lumber and furniture.
The Bank is an independent community bank offering a full range of financial services primarily to small businesses and individuals located in its market area. To complement the Bank's traditional banking products, such as demand deposit accounts, various savings account plans, certificates of deposit and real estate, consumer, commercial/industrial and agricultural loans, the Bank offers its customers a variety of services. These services include transfer agency, personal and corporate trust, insurance agency, brokerage, financial planning, cash management and electronic banking services.
Subsidiaries
In addition to its banking operations, the Bank owns four non-bank subsidiaries: Baylake Investments, Inc., located in Las Vegas, Nevada, which holds and manages an investment and loan portfolio; Bank of Sturgeon Bay Building Corporation, which owns the Bank's main office building in Sturgeon Bay, Wisconsin and nearby conference center facilities and underlying real property; Cornerstone Financial, Inc., which manages the conference center facilities; and Baylake Insurance Agency, Inc., which offers various types of insurance products to the general public as an independent
agent. The Bank also owns a minority interest (49.8% of the outstanding common stock) in United Financial Services, Inc. ("UFS"), a data processing services company, located in Grafton, Wisconsin, that provides data processing services to approximately 23 banks (including the Bank) and ATM processing services to 50 banks. In February 2003, the Bank sold an additional subsidiary, Arborview LLC ("Arborview") which was formed for purposes of the operation of a community based residential facility, acquired in lieu of foreclosure as a result of loan problems.
At December 31, 2003, the Company had total assets of $975.2 million. For additional financial information, see the Consolidated Financial Statements and Notes beginning at Item 8 of this Form 10-K.
Corporate Governance Matters
Baylake maintains a website at www.baylake.com. The Company makes available through that website, free of charge, copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, as soon as reasonably practical after Baylake electronically files those materials with, or furnishes them to, the Securities and Exchange Commission ("SEC"). The Company's SEC reports can be accessed through the Baylake Corp link of our website. The SEC also maintains a website at www.sec.gov that contains reports, proxy statements and other information regarding SEC registrants.
Acquisitions
Effective November 21, 2003, Baylake acquired a branch facility from M&I Marshall & Ilsley Bank, Milwaukee, Wisconsin ("M&I") located in Kewaunee, WI. Approximately $9.5 million in deposits and $ 1.0 million in loans were acquired as a result of the transaction. Costs to complete the purchase, including premium on purchase, were $361,000 and were capitalized as a core deposit intangible asset to be written off over seven years.
Lending
The Company offers short-term and long-term loans on a secured and unsecured basis for business and personal purposes. It makes real estate, commercial/industrial, agricultural and consumer loans, in accordance with the basic lending policies established by its board of directors. The Company focuses lending activities on individuals and small businesses in its market area. Lending has, historically, been exclusively within the State of Wisconsin. The Company does not conduct any substantial business with foreign obligors. The markets served by the Company include a wide variety of industries, including a limited concentration in tourism related industries, directly and indirectly. Concentration in the restaurant and lodging business totaled $108.7 million in loans at the end of 2003. Although competitive and economic pressures exist in this segment, business remains strong in the markets served by the Company. However, any general weakness in the economy of Northeastern Wisconsin (as a result, for example, of a decline in its manufacturing and tourism industries or otherwise) could have a material adverse effect on the business and operations of Baylake.
The Company's total outstanding loans as of December 31, 2003 amounted to approximately $696.0 million, consisting of 84.8% residential, commercial, agricultural and construction real estate loans, 12.0% commercial and industrial loans, 2.1% installment and 1.1% agricultural loans.
Investments
The Company maintains a portfolio of other investments, primarily consisting of U.S. Treasury securities, U.S. Government Agency securities, mortgage-backed securities, and obligations of states and their political subdivisions. The Company attempts to balance its portfolio to manage interest rate risks, maximize tax advantages and meet its liquidity needs while endeavoring to maximize investment income.
Deposits
The Company offers a broad range of depository products, including non-interest bearing demand deposits,
interest-bearing demand deposits, various savings and money market accounts and certificates of deposit. Deposits at the Company are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC") up to statutory limits. At December 31, 2003, the Company's total deposits amounted to $783.3 million, including interest bearing deposits of $676.7 million and non-interest bearing deposits of $106.6 million.
Other Customer Services and Products
Other services and products offered by the Company include transfer agency, safe deposit box services, personal and corporate trust services, conference center facilities, insurance agency and brokerage services, cash management, financial planning and electronic banking services, including eBanc, an Internet banking product for its customers.
Seasonality
The tourism industry serviced in the market areas served, particularly the Door County market, remains important with respect to the commercial and retail lines doing business with the Company. The tourist business of the Door County is seasonal, with the season beginning in early spring and continuing until late fall. The seasonal nature of the tourist business imposes increased demands for loans shortly before and during the tourist season and causes reduced deposits shortly before and during the early part of the tourist season, although the financial needs of those involved in the delivery of tourist related services is a year around concern.
The Company's expansion into other market areas has reduced the concentration level of tourism-related business, but these types of businesses still remain an important element of the core business served by the Company.
Competition
The financial services industry is highly competitive. The Company competes with other financial institutions and businesses in both attracting and retaining deposits and making loans in all of its principal markets. The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. Competition for deposit products comes primarily from other commercial banks, savings banks, credit unions and non-bank competitors, including insurance companies, money market and mutual funds, and other investment alternatives. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services. Competition for loans comes primarily from other commercial banks, savings banks, mortgage banking firms, credit unions, finance companies, leasing companies, and other financial intermediaries. The Company also faces direct competition from members of bank holding company systems that have greater assets and resources than those of the Company.
Regulation and Supervision
The banking industry is highly regulated by both federal and state regulatory authorities. Regulation includes, among other things, capital and reserve requirements, dividend limitations, limitations on products and services offered, geographical limits, consumer credit regulations, community reinvestment requirements and restrictions on transactions with affiliated parties. The system of supervision and regulation applicable to Baylake and the Bank establishes a comprehensive framework for our respective operations and is intended primarily for the protection of the FDIC's deposit funds, the depositors of the Bank and the public, rather than shareholders of the Bank or Baylake. Any change in government regulation may have a material adverse effect on the business of Baylake and the Bank.
Baylake Corp. As a financial holding company, Baylake is subject to regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended, or BHCA. Under the BHCA, Baylake is subject to examination by the Federal Reserve Board and is required to file reports of its operations and such additional information as the Federal Reserve Board may require. Baylake is also subject to supervision and examination by the Wisconsin Department of Financial Institutions under Wisconsin law. Under Federal Reserve Board policy, Baylake is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where Baylake might not do so absent such policy.
Any loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
With certain limited exceptions, the BHCA prohibits bank holding companies from acquiring direct or indirect ownership or control of voting shares or assets of any company other than a bank, unless the company involved is engaged solely in one or more activities which the Federal Reserve Board has determined to be financial in nature, and the extent to which state laws will apply to managing or controlling activities of banks as to be incidental to these operations.
The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies. If capital falls below minimum guidelines, a bank holding company may, among other things, be denied approval to acquire or establish banks or non-bank businesses.
Baylake Bank. As a Federal Reserve Board member Wisconsin bank, the Bank is subject to supervision and regulation by the Wisconsin Department of Financial Institutions (the "WDFI"), the Board of Governors of the Federal Reserve System and the FDIC. Federal law and regulations establish supervisory standards applicable to the lending activities of the Bank, including internal controls, credit underwriting, loan documentation and loan-to-value ratios for loans secured by real property.
The Bank is subject to federal and state statutory and regulatory restrictions on any extension of credit to Baylake or its subsidiaries, on investments in the stock or other securities of Baylake or its subsidiaries, on the payment of dividends to Baylake, and on the acceptance of the stock or other securities of Baylake or its subsidiaries as collateral for loans to any person. Limitations and reporting requirements are also placed on extension of credit by the Bank to its directors and officers, to directors and officers of us and our subsidiaries, to principal shareholders of us, and to "related interests" of such directors, officers and principal shareholders. In addition, such legislation and regulations may affect the terms upon which any person becoming a director or officer of us or one of our subsidiaries or a principal shareholder of us may obtain credit from banks with which we maintain a correspondent relationship.
The FDIC and the Federal Reserve Board have published guidelines establishing operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines establish standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. In general, the guidelines prescribe the goals to be achieved in each area, and each institution will be responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution's primary federal bank regulator may require the institution to submit a plan for achieving and maintaining compliance. The preamble to the guidelines states that the agencies expect to require a compliance plan from an institution whose failure to meet one or more of the standards is of such severity that it could threaten the safe and sound operation of the institution. Failure to submit an acceptable compliance plan, or failure to adhere to a compliance plan that has been accepted by the appropriate regulator, would constitute grounds for further enforcement action.
The Bank's business includes making a variety of types of loans to individuals. In making these loans, the Bank is subject to state usury and regulatory laws and to various federal statutes, such as the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Real Estate Settlement Procedures Act and the Home Mortgage Disclosure Act, and the regulations promulgated thereunder, which prohibit discrimination, specify disclosures to be made to borrowers regarding credit and settlement costs and regulate the mortgage loan servicing activities of the Bank, including the maintenance and operation of escrow accounts and the transfer of mortgage loan servicing. The Riegle Act imposed new escrow requirements on depository and non-depository mortgage lenders and services under the National Flood Insurance Program. In receiving deposits, the Bank is subject to extensive regulation under state and federal law and regulations, including the Truth in Savings Act, the Expedited Funds Availability Act, the Bank Secrecy Act, the Electronic Funds Transfer Act, and the Federal Deposit Insurance Act. Violation of these laws could result in the imposition of significant damages and fines upon the Bank, its directors and officers.
Under the Community Reinvestment Act, or CRA, and the implementing regulations, the Bank has a continuing and affirmative obligation to help meet the credit needs of its local community including low and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. The CRA requires the board of directors of financial institutions, such as the Bank, to adopt a CRA statement for each assessment area that, among other things, describes its efforts to help meet community credit needs and the specific types of credit that the institution is willing to extend. The Bank's service area is designated and comprised of the eight counties within the geographic area of Central and Northeast, Wisconsin. The Bank's board of directors is required to review the appropriateness of this delineation at least annually.
Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future. This regulation substantially affects the business and financial results of all financial institutions and holding companies, including Baylake and its subsidiaries. As an example, Baylake is subject to the capital and leverage guidelines of the Board of Governors of the Federal Reserve System ("FRB"), which requires that Baylake's capital to asset ratio meet certain minimum standards. For a discussion of the Federal Reserve Board's guidelines and the Company's applicable ratios, see the section entitled "Capital Resources" under Item 7: "Management's Discussion and Analysis of Financial Condition and Results of Operation."
The Federal Reserve adopted a new regulation, Regulation W, effective April 1, 2003, that comprehensively implements sections 23A and 23B. The regulation unifies and updates staff interpretations issued over the years, incorporates several new interpretative proposals (such as to clarify when transactions with an unrelated third party will be attributed to an affiliate), and addresses new issues arising as a result of the expanded scope of nonbanking activities engaged in by banks and bank holding companies in recent years and authorized for financial holding companies under the GLB Act.
Under the GLB Act, all financial institutions, including the Company and the Bank, are required to adopt privacy policies, restrict the sharing of nonpublic customer data with nonaffiliated parties at the customer's request, and establish procedures and practices to protect customer data from unauthorized access. The Company has developed such policies and procedures for itself and the Bank, and believes it is in compliance with all privacy provisions of the GLB Act.
On December 4, 2003, the Fair and Accurate Credit Transactions Act of 2003 ("FACT") was signed into law. The Act includes many provisions concerning national credit reporting standards, and permits consumers, including the customers of the Company and the Bank, to opt out of information sharing among affiliated companies for marketing purposes. The Act also requires financial institutions, including banks, to opt out of information sharing among affiliated companies for marketing purposes. FACT also requires financial institutions, including banks, to notify their customers if they report negative information about them to credit bureaus or if the credit that is granted to them is on less favorable terms than are generally available. Banks must also comply with guidelines to be established by their federal banking regulators to help detect identity theft.
Under Title III of the USA PATRIOT Act ("PATRIOT"), also known as the International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001, all financial institutions, including the Company and Bank, are required to take certain measures to identify customers, prevent money laundering, monitor certain customer transactions and report suspicious activity to U.S. law enforcement agencies, and scrutinize or prohibit altogether certain transactions of special concern. Financial institutions are also required to respond to requests for information from federal banking regulatory agencies and law enforcement agencies concerning their customers and their transactions. Information sharing among financial institutions concerning terrorist or money laundering activities is encouraged by an exemption provided from the privacy provisions of GLB Act and other laws. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act, which applies to Bank, or the BHC Act, which applies to Company. The Company has in place a Bank Secrecy Act compliance program, and it engages in very few transactions of any kind with foreign financial institutions or foreign persons.
The Sarbanes-Oxley Act of 2002 ("SOA"), addresses, among other issues, director and officer responsibilities for proper corporate governance of publicly traded companies, including the establishment of audit committees, certification of
financial statements, auditor independence and accounting standards, executive compensation, insider loans, whistleblower protection, and enhanced and timely disclosure of corporate information. In general, SOA is intended to allow stockholders to monitor more effectively the performance of publicly traded companies and their management. The Securities and Exchange Commission has enacted rules to implement various provisions of SOA. The federal banking regulators have adopted generally similar requirements concerning the certification of financial statements.
In addition to general requirements that banks retain specified levels of capital and otherwise conduct their business in a safe and sound manner, Wisconsin law requires that dividends of Wisconsin banks declared and paid without approval of the WDFI be paid out of current earnings or, no more than once within the immediate preceding two years, out of undivided profits in the event that there have been insufficient net profits. Any other dividends require the prior written consent of the WDFI. The Bank is in compliance with all applicable capital requirements and may pay dividends to Baylake.
Current federal law provides that adequately managed bank holding companies from any state may acquire banks and bank holding companies located in any other state, subject to certain conditions. Wisconsin law generally permits establishment of full service bank branch offices statewide.
Employees
At December 31, 2003, Baylake and its subsidiaries had 302 full-time equivalent employees. Baylake considers the relationship with its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
Baylake does not directly own any real property of any kind. However, the Bank owns twenty-three branches and leases the Company's main office building in Sturgeon Bay, Wisconsin from its subsidiary, the Bank of Sturgeon Bay Building Corporation. The Bank leases its remaining two offices from third parties.
The main office building located in Sturgeon Bay serves as headquarters for Baylake as well as the main banking office of the Bank. The main office also accommodates the expanded business of the Bank, primarily an insurance agency (Baylake Insurance Agency) and financial services. The twenty-six branches owned or leased by the Bank are in good condition and considered adequate for present and near term requirements. In addition, the Bank owns other real property that, when considered in the aggregate, is not material to its financial position.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Baylake and its subsidiaries may be involved from time to time in various routine legal proceedings incidental to its business. Neither Baylake nor any of its subsidiaries is currently engaged in any legal proceedings that are expected to have a material adverse effect on the results of operations or financial position of Baylake.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of fiscal year 2003.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS
Historically, trading in shares of the Company's Common Stock has been limited. Since mid-1993, Baylake Common Stock has been listed on the OTC Bulletin Board (Trading symbol: bylk.ob), an electronic interdealer quotation system providing real-time quotations on eligible securities. Trading in Baylake Common Stock has been conducted principally by certain brokerage and investment firms with offices in Door County, Wisconsin that have provided price quotations, and have assisted individual holders of Baylake Common Stock who wish to purchase or sell shares. In addition, prices for Baylake Common Stock are reported regularly in The Milwaukee Journal Sentinel based on information provided by a local brokerage firm.
The following table summarizes high and low bid prices and cash dividends paid for the Baylake Common Stock for the periods indicated. Bid prices are as reported from the OTC Bulletin Board. The reported high and low prices represent interdealer bid prices, without retail mark-up, mark-downs or commission, and may not necessarily represent actual transactions.
Baylake had approximately 1,838 shareholders of record at December 31, 2003. The number of shareholders does not reflect persons or entities that hold their stock in nominee or "street" name through various brokerage firms.
Dividends on Baylake Common Stock have historically been paid in cash on a quarterly basis in March, June, September and January, and Baylake expects to continue this practice for the immediate future. The holders of Baylake Common Stock are entitled to receive such dividends when and as declared by Baylake's Board of Directors. In determining the payment of cash dividends, the Board of Directors of Baylake considers the earnings, capital and debt servicing requirements, financial ratio guidelines issued by the FRB and other banking regulators, financial conditions of Baylake and the Bank, and other relevant factors.
The ability of Baylake to pay dividends is dependent upon receipt by Baylake of dividends from the Bank, which is subject to regulatory restrictions. Such restrictions, which govern state chartered banks, generally limit the payment of dividends on bank stock to the Bank's undivided profits after all payments of all necessary expenses, provided that the Bank's surplus equals or exceeds its capital, as discussed further in Item 7. "Management Discussion and Analysis of Financial Condition and Results of Operation-Capital Resources". In addition, under the terms of Baylake's 10.00% Junior Subordinated Debentures due 2031, Baylake would be precluded from paying dividends on the Common Stock if it was in default under the Debentures, if it exercised its right to defer payments of interest on the Debentures, or if certain related defaults occurred.
Baylake maintains a dividend reinvestment plan enabling participating shareholders to elect to purchase shares of Baylake Common Stock in lieu of receiving cash dividends. Such shares may be newly issued securities or acquired in the market and will be purchased on behalf of participating shareholders at their then fair market value.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
BAYLAKE CORP. FIVE YEAR SELECTED FINANCIAL DATA
(1) Earnings and dividends per share are based on the weighted average number of shares outstanding for the period.
(2) Includes securities classified as held-to-maturity and available for sale.
(3) Consists of Federal Home Loan Bank advances, federal funds purchased and collateralized borrowings.
(4) Consists of Federal Home Loan Bank term notes and Company borrowings from unaffiliated correspondent bank.
(5) Net interest margin represents net interest income as a percentage of average interest-earning assets, and net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.
(6) Net overhead ratio represents the difference between noninterest expense and noninterest income, divided by average assets.
(7) Non-performing loans consist of non-accrual loans, guaranteed loans 90 days or more past due but still accruing interest and restructured loans.
(8) The capital ratios are presented on a consolidated basis. For information on Baylake and the Bank's regulatory capital requirements, see Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
The following sets forth management's discussion and analysis of the consolidated financial condition and results of operations of the Baylake Corp. ("Baylake" or the "Company"), which may not be otherwise apparent from the consolidated financial statements included in this report at Item 8. This discussion and analysis should be read in conjunction with those financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this report for a more complete understanding of the following discussion and analysis.
Critical Accounting Policies
In the course of the Company's normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in the consolidated financial statements of the Company. Some of these policies are more critical than others.
Allowance for Loan Losses: Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy because of the uncertainty and subjectivity inherent in estimating the levels of allowance needed to cover probable credit losses within the loan portfolio and the material effect that these estimates can have on the Company's results of operations. While management's evaluation of the allowance for loan losses as of December 31, 2003 considers the allowance to be adequate, under adversely different conditions or assumptions, the Company would need to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Company's non-performing loans and potential problem loans, as well as the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Though management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluation were significantly lowered, the Company's allowance for loan losses policy would also require making additional provisions for loan losses.
Management reviews the adequacy of the Allowance for Loan Losses ("allowance" or "ALL") on a quarterly basis to determine whether, in management's estimate, the allowance is adequate to provide for possible losses inherent in the loan portfolio as of the balance sheet date. Management's evaluation of the adequacy of the ALL is based primarily on management's periodic assessment and grading of the loan portfolio as described below. Additional factors considered by management include the consideration of past loan loss experience, trends in past due and non-performing loans, risk characteristics of the various classifications of loans, current economic conditions, the fair value of underlying collateral, and other regulatory or legal issues that could affect credit losses.
Loans are initially graded when originated. They are re-graded as they are renewed, when there is a loan to the same borrower, when identified facts demonstrate heightened risk of nonpayment, or if they become delinquent. The loan review, or, grading process attempts to identify and measure problem and watch list loans. Problem loans are those loans that management determines have a higher than average risk for default, with workout and/or legal action probable within one year. These loans are reported at least quarterly to the directors' loan committee and reviewed at the officers' loan committee for action to be taken. Watch list loans are those loans considered as having weakness detected in either character, capacity to repay or balance sheet concerns and prompt management to take corrective action at the earliest opportunity. Problem and watch list loans generally exhibit one or more of the following characteristics:
1. Adverse financial trends and condition
2. Decline in the entire industry
3. Managerial problems
4. Customer's failure to provide financial information or other collateral documentation
5. Repeated delinquency, overdrafts or renewals
Every significant problem credit is reviewed by the loan review process and assessments are performed quarterly to confirm the risk rating, proper accounting and the adequacy of loan loss reserve assigned. In addition to this
quarterly management review, all problem loans are monitored and evaluated on a monthly basis by a designated review committee. Depending on the change in condition, loans may be reassessed concerning allocation of risk, probable disposition, and potential loss, including changes to the ALL.
After reviewing the gradings in the loan portfolio, management will allocate or assign a portion of the ALL to categories of loans and individual loans to cover management's estimate of probable loss. Allocation is related to the grade of the loan and includes a component resulting from the application of the measurement criteria of Statements of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114") and No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures" ("SFAS 118"). Allocations also are made for unrated loans, such as credit card loans, based on historical loss experience adjusted for portfolio activity. The indirect risk in the form of off-balance sheet unfunded commitments are also taken into consideration. These allocated reserves are further supplemented by unallocated reserves based on management's estimate regarding risk of error, local economic conditions and any other relevant factors. Management then compares the amounts allocated for probable losses to the current allowance. To the extent that the current allowance is insufficient to cover management's best estimate of probable losses, management records additional provision for credit loss. If the allowance is greater than required at that point in time, provision expense is adjusted accordingly.
Mortgage servicing rights: Another valuation that requires management's judgment relates to mortgage servicing rights. Essentially, mortgage servicing rights are established on residential mortgage loans and guaranteed commercial loans that the Company originate and sell. A portion of the loan's book basis is allocated to mortgage servicing rights which are retained when a loan is sold, based upon its relative fair value. The fair value of mortgage servicing rights is the present value of estimated future net cash flows from the servicing relationship using current market assumptions for prepayments, servicing costs and other factors. As the loans are repaid and net servicing revenue is earned, mortgage servicing rights are amortized against servicing revenue. Net servicing rights are expected to exceed this amortization expense. However, if the actual prepayment experience exceeds what was originally anticipated, net servicing revenues may be less than expected and mortgage servicing rights may be impaired. This impairment would be recorded as a charge to earnings in the period in which it became impaired.
Core deposit intangibles: Judgment is used in the valuation of other intangible assets such as core deposit base intangibles. Core deposit base intangibles assets of $361,000 have been recorded for core deposits (defined as checking, money market, savings and time deposits) that have been acquired as a result of the Kewaunee branch acquisition from M&I Bank. The core deposit base intangible assets have been recorded using the assumption that they provide a more favorable source of funding than more expensive wholesale borrowings. An intangible asset has been recorded for the present value of the difference between the expected interest expense to be incurred on these deposits and interest expense that would be expected if these deposits were replaced by wholesale borrowings, over the expected lives of the core deposits. The Company currently estimates that the underlying core deposits have lives of seven years. If future analysis shows these deposits to have a shorter life, then the Company will write down the asset by expensing the amount that is impaired.
Goodwill: The Company has goodwill assets on the books as a result of two prior acquisitions. Goodwill is tested annually for impairment. Those tests inherently involve management's judgment as to factors such as an estimation of the fair value of a reporting unit; screening for potential impairment and measuring the amount of the impairment. There was no impairment of goodwill in 2003 or 2002. In the event of goodwill impairment, that amount would be charged to earnings in the period in which the impairment is determined.
Overview
Baylake is a full-service financial services company, providing a wide variety of loan, deposit and other banking products and services to its business, individual or retail, and municipal customers, as well as a full range of trust, investment and cash management services. The Company is the bank holding company of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member bank of the Federal Reserve and Federal Home Loan Bank.
From an industry and national perspective, the Company's profitability, like most financial institutions, is dependent to a large extent upon net interest income. Results of operations are also affected by the provision for loan losses, operating expenses such as salaries and employee benefits, occupancy and other operating expenses, including
income taxes, and to a lesser extent, non-interest income such as trust revenues, loan servicing fees and service charge income derived from deposit accounts. Economic conditions, competition and the monetary and fiscal policies of the Federal government in general, significantly affect financial institutions, including the Company. During 2003, the Federal government's focus was marked by steady low interest rates intended to stabilize the current economy and provide stimulation for future economic growth. Lending activities are also influenced by regional and local economic factors. Some specific factors may include the demand for and supply of housing, competition among lenders, interest rate conditions and prevailing market rates on competing investments, customer preferences and levels of personal income and savings in the Company's market area.
In the last several years, the Company has initiated strategic changes to its bank operations intended to enhance the Bank's utilization of resources, and the effectiveness of customer services within its primary market area. Bank has developed an internal customer relationship management system ("CRM") to manage and to more effectively market to its internal customer base.
Since the latter part of 2001, the Company has dedicated resources to its goal of improving asset quality. Improvements have been achieved relative to collections or recoveries from the disposition of collateral, especially related to the Company's level of non-performing commercial loans. Credit risk has improved in the commercial loan portfolio as a result of improved underwriting and more extensive collection efforts through the addition of legal and collection staff.
Results of Operations
Earnings Summary
The following is a brief summary of some of the factors which have affected our earnings in 2003. See the balance of this section for a more thorough discussion.
The Company reported net income of $8.0 million compared to $8.7 million and $7.5 million for 2002 and 2001, respectively. Basic and diluted earnings per share were $1.06 and $1.04, respectively, for 2003 compared to $1.17 and $1.15 for 2002 and $1.01 and $0.99 for 2001. Return on average assets for the year ended December 31, 2003 was 0.87% and 1.00% and 0.93% for 2002 and 2001, respectively. The return on average equity was 11.86% for 2003 and 13.82% and 13.37% for 2002 and 2001, respectively. Cash dividends declared in 2003 increased 8.2% to $0.53 per share compared with $0.49 in 2002. This compares to an increase of 8.9% in dividends declared in 2002 as compared to 2001.
Net income for 2001 reflects amortization expense of $486,000 of goodwill related to the acquisition in 1996 of Four Seasons and in 1998 of Evergreen. This expense reduced after-tax net income in 2001 by $486,000 or earnings per share by $0.07. Goodwill is no longer amortized, but, instead, is tested annually for impairment. If impairment were to be found, the net effect would be a reduction in net income in the year that impairment was measured.
The Company earned net interest income of $29.0 million and $29.4 million in 2003 and 2002, respectively. The continuing national trend of historically low interest rates produced a decrease in net interest income of 1.3% in 2003 from 2002 despite the increase in average balances. The changes in the loan and security portfolios, discussed later, generally reflect downward trends in rates associated with lower risk assets in addition to the current market rates.
The provision for loan losses in 2003 and 2002 were $5.7 million. The provisions reflected the increases in net loan charge-offs, the high level of non-performing loans, risk levels inherent in the loan portfolio and the changing mix of the overall loan portfolio.
Non-interest income during 2003 decreased $322,000 or 2.9% when compared to 2002. The primary factors decreasing non-interest income were a reduction in fees for other services to customers, a decrease in securities gains and a decrease in other income. These decreases were offset by an increase in fiduciary fees, an increase in loan servicing fee income and increased gains on sales of loans. Death benefits recognized in 2002 and gross revenues from bank subsidiaries realized in 2002 accounted for much of the difference in other income for 2003 relative to 2002.
Non-interest expense increased $641,000 during 2003, or 2.7% over 2002 levels. Factors contributing to the increase were increased personnel and benefits expenses and increased expenses related to the operation of other real estate owned. Increases in these expenses were offset by a significant decrease in expenses related to our former Arborview subsidiary, which was sold in February 2003.
The major components of net income and changes in these components are summarized in Table 1 for years ended December 31, 2003, 2002 and 2001 and are discussed in more detail on the following pages.
TABLE 1: NET INCOME COMPONENTS
Net Interest Income
Net interest income is impacted by the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities (interest rate spread) and the relative amounts of interest-earning assets and interest-bearing liabilities. The interest income and interest expense of financial institutions are significantly affected by general economic conditions, competition, policies of regulatory authorities and other factors.
Net interest income (on a tax equivalent basis) is the Company's principal source of revenue accounting for 73.9% of total income in 2003, as compared to 73.7% in 2002 and 81.3% in 2001. The reductions in 2003 and 2002 relative to 2001 reflect a lower rate environment effectively compressing net interest margin in addition to an increase in non-performing assets resulting in additional non-accrual interest for the period. Net interest income represents the difference between interest earned on loans, investments and other interest earning assets offset by the interest expense attributable to funding sources, principally deposits and borrowings. Interest rate fluctuations together with changes in the volume and types of earning assets and interest-bearing liabilities combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of interest income earned. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable.
Net interest income in the consolidated statements of income (which excludes the taxable equivalent adjustment on tax exempt assets) was $29.0 million in 2003, compared to $29.4 million in 2002 and $27.0 million in 2001. The taxable equivalent adjustments (the adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that income been subject to taxation, using a 34% tax rate) of $1.2 million for 2003 and $1.4 million for 2002 and 2001, resulted in fully taxable equivalent ("FTE") net interest income of $30.2 million, $30.8 million and $28.3 million, respectively. The decline in 2003 net interest income of $600,000 was in spite of an increase in the volume of net average earning assets of $17.7 million. A lower rate environment has impacted the
repricing of assets, primarily loans, to a greater degree than the liability side of the balance sheet, resulting in a decreased net interest margin. Average-earning assets increased 5.6% offset by an increase of 3.7% in average interest-bearing liabilities. The benefit from an increase in earning assets, non-interest bearing deposits and a decrease in the cost on interest paying liabilities were offset, in part, by an increase in interest-bearing liabilities and a decrease in the yield on interest earning assets. As a result, interest income decreased 8.1% while interest expense for 2003 decreased 16.8%.
Interest rate spread and net interest margin are terms utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets ("EAs") and the rate paid on interest-bearing liabilities ("IBLs") that fund those assets. The net interest margin is expressed as tax-equivalent net interest income as a percentage of average EAs. The net interest margin exceeds the interest rate spread because of the use of non-interest bearing sources of funds (net free funds), principally composed of demand deposits and stockholders' equity, to fund a portion of EAs. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt loans and securities is computed on an FTE basis. As a result, the level of funds available without interest cost is an important factor affecting the ability to increase net interest margin.
Table 2 provides average balances of EAs and IBLs, the associated income and expense, and the corresponding interest rates earned and paid, as well as net interest income, interest rate spread, and net interest margin on an FTE basis for the three years ended December 31, 2003. Tables 3 through 4 present additional information for the discussion of FTE net interest income, interest rate spread, and net interest margin.
As indicated in Tables 2 and 3, increases in volume and changes in the mix of both EAs and IBLs added $2.3 million to FTE net interest income, while changes in the rates resulted in a $2.8 million decrease, for a net decrease of $544,000.
Average loans outstanding grew to $678.0 million in 2003 from $635.4 million in 2002, an increase of 6.7%. The increase in loan volume was a significant contributing factor to net interest income. Average loans outstanding increased to $635.4 million in 2002 from $588.0 million in 2001, an increase of 8.1%. The mix of average loans to average total assets increased to 74.0% in 2003 from 72.8% in 2002 and from 72.7% in 2001. The relationship of a higher volume of loans as a percentage of the asset mix has provided a source of higher yielding assets, which has contributed to net interest income.
The year 2003 saw a decrease of the interest rate spread for the Company in spite of a lower interest rate environment. The interest rate spread decreased 26 basis points in 2003 to 3.35% from 3.61% in 2002, as the average yield on earning assets decreased 86 basis points while the average rate paid on interest-bearing liabilities decreased 60 basis points over the same period. In contrast, interest rate spread increased 27 basis points in 2002 compared to 2001 results. The decrease in the Company's earning assets yield reflects a lower rate environment impacting rates on the variable priced loans and re-pricing fixed rate loans (for competitive reasons) for the year 2003. Decreased investment interest income, which resulted from an increased investment portfolio, offset by lower yields on the investment portfolio, have contributed to some of the decrease in the yields on interest earning assets. A lower rate environment also affected the funding side of the balance sheet. Yields on interest-paying liabilities decreased 60 basis points. Decreased interest costs resulted from a lower rate environment offset to a lesser extent by increased competition for retail deposits and increased balances in time deposit accounts. Yields on interest bearing deposits decreased 60 basis points to 2.21% in 2003 from 2.81% in 2002.
The lower rate environment also had an effect in reducing yields on the wholesale funding side of the balance sheet. Yields on short-term borrowings decreased 65 basis points in 2003 compared to 2002, while yields on other borrowings decreased 73 basis points to 3.12% in 2003 from 3.85% in 2002.
The net interest margin for 2003 was 3.60% compared to 3.87% in 2002. The decrease in net interest margin was in part related to a general decline in the interest rate environment offset slightly by an increase in the free funds ratio and a decrease in non-accrual loans. The steady decrease in general interest rates, including the Company's commercial loan Prime Rate, which commenced during 2001, provided the general low interest rate environment that continued to drive the yield on commercial and other variable type loans lower into the year 2003. Increased competition, especially as it relates to the commercial loan portfolio, negatively affected net interest margin. The
free funds ratio, or the level of non-interest bearing funds that support earning assets, improved to 19.5% from 18.5% in 2002.
The net interest margin for 2002 was 3.87% compared to 3.79% in 2001 as re-pricing opportunities occurred more readily on the funding side of the balance sheet relative to the asset side of the balance sheet. The increase in 2002 during a declining interest rate environment occurred as the result of an increase in the interest rate spread and an increase in the free funds ratio offset by an increase in non-accrual loans.
The ratio of average earning assets to average total assets measures management's ability to employ overall assets for the production of interest income. This ratio was 91.6% in 2003 compared with 91.1% in 2002 and 92.5% in 2001. The ratio increased in 2003 as a result of a decrease in non-accrual loans.
Competition in the financial services industry will also affect net interest margin. Spreads will be a focus of management's attention, as the Company constantly seeks to attract lower cost core deposits, service the needs of customers, and provide attractively priced products. Competition for high quality assets will also affect asset yields and result in less interest income.
Changes in the levels of market interest rates also affect net income, but are less directly under the control of the Company. Although a lower rate environment has been experienced, management believes that a gradual increase in interest rates will not adversely affect the earning capacity of the Company. Past experience has shown that, although the Company remains in a short-term positive interest rate sensitivity gap, deposits tend not to be re-priced as quickly as loans in a rising rate scenario and are re-priced more frequently in a falling interest rate environment. More discussion on this subject is referenced in the section titled "Interest Rate Risk" below.
TABLE 2: AVERAGE BALANCES AND INTEREST RATES (INTEREST AND RATES ON A TAX-EQUIVALENT BASIS)
(1) The yield on tax exempt loans and securities is computed on a tax-equivalent basis using a tax rate of 34% for all periods presented.
(2) Nonaccrual loans and loans held for sale have been included in the average balances.
(3) Interest income includes net loan fees.
TABLE 3: RATE/VOLUME ANALYSIS (1)
(1) The change in interest due to both rate and volume has been allocated proportional to the relationship to the dollar amounts of the change in each.
(2) The yield on tax-exempt loans and securities is computed on an FTE basis using a tax rate of 34% for all periods presented.
TABLE 4: SELECTED AVERAGE BALANCES
TABLE 5: DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY
Provision for Loan Losses
The provision for loan losses ("PFLL") is the periodic cost determined, not less than quarterly, of providing an allowance for anticipated future loan losses. In any accounting period, the PFLL is based on the methodology used and management's evaluation of the loan portfolio, especially non-performing and other potential problem loans, taking into consideration many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's evaluation of loan quality, general economic factors and collateral values.
The Company's loan review department performs a risk rating analysis as an integral part of the review of each loan portfolio. For the commercial and commercial real estate portfolios, the risk rating analysis includes a grading system following a standard risk-rating matrix. Based upon this matrix, the Company determines a risk rating assignment an appropriate measure to each loan examined. As a result, the Company has provided $5.7 million in PFLL for 2003.
The PFLL in 2003 at $5.7 million compares to a PFLL of $5.7 million for 2002 and $2.9 million for 2001. Net charge-offs in 2003 were $4.9 million compared with net charge-offs of $2.3 million in 2002 and $1.9 million in 2001. Net charge-offs as a percentage of average loans is a key measure of asset quality. Net charge-offs to average loans were 0.72% in 2003 compared with 0.36% in 2002 and 0.32% in 2001. The increase in net charge-offs relates principally to a $2.6 million commercial loan charge-off in the fourth quarter of 2003 that had been previously disclosed. Management believes that the current provision conforms with the Company's loan loss reserve policy and is adequate in view of the present condition of the Company's loan portfolio. However, a decline in the quality of our loan portfolio, as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the allowance. If there are significant charge-offs against the allowance, or we otherwise determine that the allowance is inadequate, we will need to make higher provisions in the future. See "Risk Management and the Allowance for Loan Losses" below for more information related to non-performing loans.
Non-Interest Income
Total non-interest income for 2003, excluding securities transactions, was $10.7 million, a $322,000 decrease from 2002, or 2.9%. In 2002, total non-interest income was $4.5 million more than 2001, a 69.1% increase. Trust service fees, fees from loan servicing, gains from sales of loans and service charges continue to be the primary components of non-interest income as evidenced in Table 6.
TABLE 6: NONINTEREST INCOME
Trust fees increased $40,000 to $677,000 in 2003 compared to 2002, primarily as a result of increased trust business assets under investment. This compared to a decrease of $27,000 in 2002 compared to 2001, primarily as a result of a lower market values on various trust accounts for which fees are assessed.
Loan servicing fees increased $191,000 to $1.5 million in 2003. This followed an increase of $14,000 to $1.3 million in 2002. With mortgage market rates remaining at attractive levels throughout 2003, strong home purchase and refinance activity improved 2003 results. Mortgages serviced for secondary market placements (primarily Federal Home Loan Mortgage Corporation "FHLMC") were $117.8 million and $74.6 million at December 31, 2003 and 2002, respectively.
The strong mortgage market also provided improvement with respect to increases in mortgage servicing rights income and gains from sales of loans. Mortgage servicing rights improved $231,000 in 2003 resulting in income of $539,000 compared to $308,000 in 2002.
Gains from the sale of mortgage loans totaled $1.7 million in 2003 compared to $1.2 million in 2002. In addition, gains from the sale of commercial loans totaled $176,000 in 2003 compared to $183,000 in 2002. An increase in mortgage loan business sold during 2003 amounted to $135.9 million of loans sold compared to $104.8 million of mortgage loans sold in 2002. Total loans sold during 2003 were $140.0 million compared to $108.6 million in 2002.
The general level and direction of interest rates directly influence the volume and profitability of the mortgage loan business. Refinancing activity in mortgage loans began to decline in the fourth quarter of 2003. Therefore there can be no assurance as to the future amounts of income that will be received in the origination of fees and gains on sales of residential mortgage loans and, given current trends, decreases are likely.
The Company capitalizes the estimated market value of Mortgage Servicing Rights ("MSR") into income upon the origination and sale of each mortgage loan. The Company amortizes MSR in proportion to the servicing income it receives over the estimated life of the underlying mortgages, considering prepayment expectations and refinancing patterns. In addition, the Company amortizes, in full, any remaining MSR balance that is specifically associated with a serviced loan that is refinanced or paid-off.
Service charges on deposit accounts, representing 26.7% of total non-interest income in 2003, totaled $2.9 million in both 2003 and 2002, despite an 8.1% increase in the average balance of deposits for 2003 compared to 2002. The majority of the deposit pricing changes had been made in early 2002 therefore minimizing the impact on improvement in 2003. The results of 2002 provided an increase of $1.0 million, or 55.4%, over 2001 results accounting for the improvement in fee income generated for other services provided to customers.
Financial services income decreased $48,000, or 8.3%, to $527,000 in 2003 as compared to 2002 as a result of reduced sales staff on average during the year.
As a result of a purchase of $4 million and $13 million in business owned life insurance ("BOLI") made during 2003 and 2002, respectively, income made during 2003 and 2002 amounted to $685,000 and $332,000, respectively. The purchase of $13 million was made in mid-year 2002, therefore, the average investment held in BOLI was significantly less in 2002.
Death benefits were recognized in excess of cash surrender value in the amount of $754,000 in 2002. Life insurance is held on various directors as a funding vehicle for several deferred compensation agreements the Company has with them.
Securities gains for the year ended December 31, 2002 totaled $509,000. There were no securities gains or losses taken in 2003.
Included in the 2003 results was $67,000 of revenues generated by the Arborview LLC ("Arborview") operations compared to $705,000 in revenues generated in 2002. Arborview was a subsidiary formed to manage a community based residential facility acquired in January 2002 as a result of a deed in lieu of foreclosure; it was sold in February 2003. A gain on sale of Arborview fixed assets totaling $538,000 occurred as a result of the sale in 2003.
Other income decreased $164,000 to $752,000 in 2003 from $916,000 in 2002. Gains of $107,000 related to the sale of bank land not deemed necessary for development was recorded in 2002. Included in other income was income of $106,000 on previously amended tax returns received during the year 2003 compared to $133,000 in 2002. Undistributed income from United Financial Services, Inc., the Bank's data servicing subsidiary decreased $50,000 as a result of decreased earnings to $333,000, from the data processing subsidiary.
Non-Interest Expense
Non-interest expense in 2003 increased to $24.0 million, a $641,000, or 2.7% increase compared to 2002 results, primarily as a result of increased personnel, equipment, data processing, and other operating expense. The acquisition of the Kewaunee branch did not have a material effect on operating results in 2003, nor does management expect it to have such an effect in the future. This followed a $2.4 million or 11.5% increase in 2002 as compared to 2001. Primary categories impacting the change between 2003 and 2002 are noted in Table 7 below.
TABLE 7: NONINTEREST EXPENSE
The above non-interest expenses include expenses related to the Arborview subsidiary, the assets of which were sold in 2003. To help identify those expenses, which will not continue due to our sale of the Arborview assets, a breakdown of the Arborview expenses included above is set forth in the following table 8:
TABLE 8: ARBORVIEW EXPENSES
Salaries and employee benefits expense is the largest component of non-interest expense and totaled $14.2 million in 2003, an increase of $440,000, or 3.2%, as compared to 2002 results. The increase in 2003 primarily resulted from staffing increases, increased benefit costs, and normal salary increases offset by a decrease in bonus expense. Salary costs increased $324,000, or 3.2%, for 2003 compared to 2002 results as a result of increased staffing and normal salary increases. The increase in salary expense was partially offset by a decrease in Arborview related personnel
expenses of $420,000. The number of full-time equivalent employees increased to 302 in 2003 from 293 in 2002, an increase of 3.1%. Employee levels in 2002 increased to 293 from 286 in 2001, an increase of 5.1%.
Benefit costs, principally for health insurance and pension costs, represent the remaining increase in personnel-related costs. These costs increased $429,000, or 23.5%. The current trend for increased health insurance and pension costs is expected to continue into 2004. Salary and employee benefits expense in 2002 totaled $13.7 million, an increase of $1.8 million, or 15.3%, as compared to 2001 results. The 2002 increase resulted primarily from staffing increases, bonus expense, increased benefit costs, and normal salary increases. Management will continue its efforts to control salaries and employee benefits expense, although increases in these expenses are likely to continue to occur in future years.
Bonus expense in 2003 was $240,000 compared to $588,000 in 2002. The decrease occurred as a result of bonus expense arising from the Company's Pay-for-Performance Program in 2003. This program is designed to reward various divisions upon achievement of certain goals related to improvement in income and on return on equity. The Company did not achieve its return on equity goals and, accordingly, bonus expense was reduced.
The Company's 401(k) profit sharing plan, including a money purchase plan initiated in 1999, covering all employees who qualify as to age and length of service increased to $835,000, an increase of $25,000 over 2002 levels. Expenses in the same category in 2002 were up $97,000 over 2001 levels as a result of additional employees who qualified to participate in the plan.
Net occupancy expense for 2003 showed a decrease of $76,000 as compared to 2002 for a total of $2.1 million. A reduction in depreciation expense and real estate tax expense accounted for the balance of the decrease in 2003. This increase followed an increase of $329,000 in 2002 as a result of additional depreciation expense, increased real estate tax expense, and increased other occupancy costs.
Equipment expense for 2003 increased slightly, $16,000 compared to 2002. This followed an increase of $21,000 in 2002. The increase in 2003 resulted from contract expense related to ongoing maintenance on various equipment owned by the Bank.
Data processing expense in 2003 increased $45,000 due to an increase in the volume of transaction activity processed and technology enhancements. This followed an increase of $49,000 in 2002 compared to 2001. Management estimates that data processing expense should show minimal increases in the next several years with adjustments related only to any volume increases incurred by the Company.
Business development and advertising expense increased $109,000 compared to 2002. More emphasis was placed on business referral and development calls on new business and for customer retention programs in 2003 accounting for the balance of the increase. This compared to an increase of $34,000 in 2002 compared to 2001.
Supplies expense shows a decrease of $112,000, or 18.3%, in 2003 as compared to 2002. This decrease occurred primarily as a result of expenses related to the Arborview operation. This compared to an increase of $129,000, or 26.8%, in 2002 as compared to 2001, primarily related to Arborview.
Payments to regulatory agencies decreased $1,000 to $115,000 for 2003. This followed an increase of $6,000 in 2002 compared to 2001. The Bank's risk classification has remained at 1A, rating assigned to well-capitalized institutions. For additional information regarding the Company's capital adequacy, see "Capital Resources" below.
Legal and professional expense for 2003 increased $20,000, to $250,000 or an 8.7% increase. The increase was impacted by the levels of problematic loans and will have a similar impact in 2004. This compares to 2002 expenses of $230,000 compared to $256,000 in 2001.
Other real estate expenses are netted against income received in the determination of net other real estate owned expense (income). As a result, the Company has shown varied results. Other real estate owned showed net expense of $378,000 in 2003. Gains of $46,000 from four commercial property sales and $42,000 from seven residential property sales were realized in 2003. These were offset by losses of $23,000 from the sale of three commercial properties and two residential properties. Various operating expenses, net of income, of other real estate totaling
$443,000 occurred in 2003. Other real estate owned expenses resulted in net expense of $203,000 in 2002. Gains of $101,000 from four commercial property sales and $12,000 from three residential property sales were realized in 2002. These were offset by losses of $71,000 from the sale of five commercial properties and two residential properties. Various operating expenses, net of income, of other real estate totaling $245,000 occurred in 2002.
During 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangibles," which requires that goodwill no longer be amortized but, instead, tested annually for impairment. There was no impairment of goodwill in 2003 or 2002. The impairment of goodwill, if any, would be charged to earnings in the period in which the impairment is determined. Prior to 2002, goodwill was being amortized on a straight-line basis over 15 years. Amortization expense was $486,000 for 2001.
Other operating expenses in 2003 decreased $123,000 or 4.4%. Loan and collection expenses decreased $44,000 for 2003 compared to 2002. Included in other losses were losses taken on the disposal of fixed assets amounting to $3,000 and $107,000 for 2003 and 2002, respectively. Other operating expenses in 2002 increased $548,000 or 24.3% compared to 2001, primarily the result of an increase of $176,000 related to loan and collection expense, other losses taken upon disposition of equipment totaling $107,000 and an increase of $108,000 related to other outside service expense, such as payroll service expense and consulting fees.
The overhead ratio, which is computed by subtracting non-interest income from non-interest expense and dividing by average total assets was 1.46% for 2003 compared to 1.42% for 2002 and 1.79% for 2001.
Income Taxes
Income tax expense for the Company was $2.1 million in 2003, $2.6 million in 2002, and $2.1 million in 2001. The lower tax expense in 2003 reflected the Company's decrease in before tax earnings in addition to a decrease in tax-exempt interest income.
The Company's effective tax rate, income tax expense divided by income before taxes, was 20.6% in 2003 compared with 22.8% in 2002 and 21.7% in 2001. Of the 20.6% effective tax rate for 2003, the federal effective tax rate was 19.0% while the Wisconsin State effective tax rate was 1.6%.
Future income taxes may be affected by recent developments in the state of Wisconsin. Like many financial institutions that are located in Wisconsin, a subsidiary of the Bank located in the state of Nevada holds and manages various investment securities. Due to that fact that these subsidiaries are out of state, income from their operations has not been subject to Wisconsin state taxation. Although the Wisconsin Department of Revenue issued favorable tax rulings regarding Nevada subsidiaries of Wisconsin financial institutions, the Department representatives have recently stated that the Department intends to revoke those rulings, even though there has been no intervening change in the law. The Department has stated that those revocations would be effective immediately. The Department has also implemented a program for the audit of Wisconsin financial institutions who have formed and contributed assets to subsidiaries located in Nevada, and presumably will seek to impose Wisconsin state income taxes on income from those operations, at least on a going forward basis.
Although there will likely be challenges to the Department's actions and interpretations, the Bank's net income would be reduced if the Department would succeed in those actions. The Bank could also incur costs in the future to address any action taken against it by the Department.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance has been recognized to offset the related deferred tax assets due to the uncertainty of realizing tax benefits of a portion of loan loss and mortgage servicing differences.
Income taxes are provided for the tax effects of transactions reported in the financial statements and consists of taxes currently due plus deferred taxes related primarily to differences between the basis of the allowance for loan losses, deferred loan origination fees, deferred compensation, mortgage loan servicing, market value adjustments of securities, and depreciation for financial and income tax reporting in accordance with SFAS 109. The deferred tax
assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.
Balance Sheet Analysis
Acquisitions
Effective November 21, 2003, the Bank acquired a branch facility from M&I Marshall & Ilsley Bank, Milwaukee, WI ("M&I") located in Kewaunee, WI. Approximately $9.5 million in deposits and $1.0 million in loans were acquired as a result of the transaction. The purchase transaction did not have a material impact on the composition of the balance sheet.
Loans
Total loans outstanding grew to $696.0 million at December 31, 2003, a 4.8% increase from the end of 2002. This follows a 9.7% increase at December 31, 2002 over 2001 year-end.
Table 9 reflects composition (mix) of the loan portfolio at December 31:
TABLE 9: LOAN COMPOSITION
The commercial, financial, and agricultural loan classification primarily consists of commercial loans to small businesses. Loans of this type are in a broad range of industries and include service, retail, wholesale, and manufacturing concerns. Agricultural loans are made principally to farmers engaged in dairy, cherry and apple production. Borrowers are primarily concentrated in Door, Brown, Outagamie, Waupaca, Waushara and Kewaunee Counties, Wisconsin. With the current level of rates at historic lows and with financial institutions throughout the market area competitively pricing the loans, growth slowed in 2003. The origination of commercial and commercial real estate loans was primarily from the Company's market area in Brown County. Growth in tourism related business in Door County slowed in 2003 compared to growth experienced in prior years, the result of a slowdown in the local economy. The credit risk related to commercial loans made is largely influenced by general economic conditions, especially those applicable to the Northeast Wisconsin market area, and the resulting impact on a borrower's operations. These types of loans are generally higher in risk than residential real estate loans.
Commercial loans and commercial real estate loans (including construction loans) totaled $556.2 million at year end 2003 and comprised 79.9% of the loan portfolio compared with 77.7% of the portfolio at the end of 2002. Loans in these classifications grew $39.9 million or 7.7% during 2003. Loans of this type are in a broad range of industries. The credit risk related to these types of loans is greatly influenced by general economic conditions, especially those applicable to the Northeast Wisconsin market area, and the resulting impact on a borrower's operations.
Real estate loans (including construction loans) secured by non-residential real estate properties involve borrower characteristics similar to those for commercial loans. Because of their similarities, they are combined with commercial loans for purposes of analysis and discussion.
Management uses an active credit risk management process for commercial loans to ensure that sound and consistent credit decisions are made. Management attempts to control credit risk by adhering to detailed underwriting procedures, performing comprehensive loan administration, and undertaking periodic review of borrowers' outstanding loans and commitments. Borrower relationships are formally reviewed periodically during the life of the loan. Further analyses by customer, industry, and location are performed to monitor trends, financial performance and concentrations.
The Company's loan portfolio is diversified by types of borrowers and industry groups within the market areas that it serves. Significant loan concentrations are considered to exist for a financial entity when such amounts are loans to a multiple of borrowers engaged in similar activities that cause them to be similarly impacted by economic or other conditions. The Company has identified certain industry groups within its market area, including lodging, restaurants, retail shops, small manufacturing, real estate rental properties and real estate development. At December 31, 2003, there existed no industry group concentration in the Company's loans that exceeded 10% of total loans, although tourism related businesses remain a significant part of the business and loans in other sectors are affected by the tourism driven economy of Door County. At year end 2003, lodging represented $56.9 million in loans, the restaurant lines of business totaled $51.8 million in loans and the real estate rental properties accounted for $55.6 million in loans and are located in various areas of the Bank's market area.
Although management does not believe significant industry group loan concentrations exist in the Company's loan portfolio, it is aware that its market area is heavily reliant on seasonal tourism. As a result, a decrease in tourism could adversely affect one or more industry groups in the Company's loan portfolio, which could have a corresponding adverse effect on the Company's earnings. Additionally, a decline in tourism has an indirect effect in that other types of business (grocery and convenience stores, for example) rely on the tourism to provide cash flow to their operations. Loans to individuals who are employed by tourism related business could also be affected in the event of a downturn in the market.
Although growth was somewhat flat for tourism business in the Door County market, business activity still appears to remain adequate to service debt of the customers and for customers in general to make improvements to their operations. To date, these types of loans have had very little downgrade in loss potential relative to credit risk.
At the end of 2003, residential real estate mortgage loans totaled $125.7 million and comprised 18.1% of the loan portfolio. These loans decreased $7.7 million or 5.7% during 2003. The continued decline in interest rates during 2003 to their current low levels caused consumer preference to remain with fixed-rate residential loans and the ability of the Company to sell them into the secondary market. Loans were originated or refinanced at lower fixed rates as consumers looked to lock in to the attractive financing rates. Refinancing activity has slowed considerably in the fourth quarter of 2003 compared to 2002 and the first half of 2003. The Company expects the trend to continue into 2004, and given current trends, growth in mortgage loans would decline. Residential real estate loans consist of conventional home mortgages, adjustable indexed interest rate mortgage loans, home equity loans, and secondary home mortgages. Loans are primarily for properties within the market areas served by the Company. Residential real estate loans generally contain a limit for the maximum loan to collateral value of 75% to 80% of fair market value. Private mortgage insurance may be required when the loan to value exceeds these limits. Residential real estate loans are written normally with a one or three year adjustment rate feature.
The Company offers adjustable indexed interest rate mortgage loans based upon market demands. At year-end 2003, those loans totaled $23.8 million dollars, a decrease of $7.4 million dollars as consumers opted to lock in fixed rate mortgage debt. Adjustable indexed interest rate mortgage loans contain an interest rate adjustment provision tied to the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of one year, plus an additional mark-up of 2.75% (the "index") which varies with the mortgage loan product. Interest rates on indexed mortgage loans are adjusted, up or down, on predetermined dates fixed by contract, in relation to and based on the index or market interest rates as of a predetermined time prior to the adjustment date.
Adjustable indexed interest rate mortgage loans have an initial period, ranging from one or three years, during which the interest rate is fixed, with adjustments permitted thereafter, subject to annual and lifetime interest rate caps which vary with the product. Annual limits on interest rate changes are 2% while aggregate lifetime interest rate increases over the term of the loan are currently at 6% above the original mortgage loan interest rate. The Company also participates in a secondary fixed rate mortgage program under the Federal Home Loan Mortgage Corporation ("FHLMC") guidelines. These loans are sold in the secondary market and the Company retains servicing rights. At December 31, 2003, these loans totaled $116.5 million compared to $72.7 million at December 31, 2002.
The Company offers fixed rate mortgages through participation in secondary fixed rate mortgage programs under FHLMC and private investors. These loans are sold in the secondary market with servicing rights sold retained by buyer. In 2003, the Company sold $135.9 million in mortgage loans through the secondary programs compared to $104.8 million in 2002.
Installment loans to individuals totaled $14.5 million, or 2.1%, of the total loan portfolio at December 31, 2003 compared to $14.9 million, or 2.2%, at end of 2002. Installment loans include short-term installment loans, direct and indirect automobile loans, recreational vehicle loans, credit card loans, and other personal loans. Individual borrowers may be required to provide collateral or a satisfactory endorsement or guaranty from another party, depending upon the specific type of loan and the creditworthiness of the borrower. Loans are made to individual borrowers located in the market areas served by the Company. Credit risks for loans of this type are generally influenced by general economic conditions (especially in the market areas served), the characteristics of individual borrowers and the nature of the loan collateral. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers as well as taking the appropriate collateral and guaranty positions on such loans.
TABLE 10: LOAN MATURITY AND INTEREST RATE SENSITIVITY
Critical factors in the overall management of credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, adequate allowance for loan losses, and conservative non-accrual and charge-off policies.
Risk Management and the Allowance for Loan Losses
The loan portfolio is the Company's primary asset subject to credit risk. To reflect this credit risk, the Company sets aside an allowance or reserve for possible credit losses through periodic charges to earnings. These charges are shown in the Company's consolidated income statement as provision for loan losses. See "Provision for Loan Losses" above. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and an ongoing review of payment performance. Asset quality administration, including early identification of problem loans and timely resolution of problems, further enhances management of credit risk and minimization of loan losses. All specifically identifiable and quantifiable losses are immediately charged off against the allowance.
As Table 11 indicates, the ALL at December 31, 2003 was $12.2 million compared with $11.4 million at the end of 2002. Loans increased 4.8% in 2003, while the allowance as a percent of total loans increased as a result of a loan loss provision (offset by net charge-offs) increased to 1.75% from 1.72% at year-end 2002. The December 31, 2003 ratio of ALL to outstanding loans was 1.75% compared with 1.72% at December 31, 2002. Based on management's analysis of the loan portfolio risk at December 31, 2003, a provision expense of $5.7 million was recorded for the year ended December 31, 2003, a decrease of $50,000 compared to the same period in 2002. Factors evaluated were primarily based upon calculations made as a result of various loss risk percentages applied to various problem and watch type credits. The trend indicated a slight increase in risk relative to the loan portfolio at year-end 2003 compared to year-end 2002. Net loan charge-offs of $4.9 million occurred in 2003, and the ratio of net charge-offs to average loans for the period ended December 31, 2003 was 0.72% compared to 0.36% at December 31, 2002. Commercial loan charge-offs represented 69.8% of the total net charge-offs for the year 2003, primarily the result of a previously discussed $2.6 million loan charge-off taken in the fourth quarter of 2003. Real estate-mortgage charge-offs represented 25.0% of the total net charge-offs for the year 2003. Commercial mortgage loan charge-offs
accounted for $542,000 of the mortgage total and residential mortgage loan charge-offs totaled $683,000. Loans charged-off are subject to periodic review and specific efforts are taken to achieve maximum recovery of principal and accrued interest.
TABLE 11. LOAN LOSS EXPERIENCE
Consistent with generally accepted accounting principles ("GAAP") and with the methodologies used in estimating the unidentified losses in the loan portfolio, the ALL consists of several components.
First, the allowance includes a component resulting from the applicaton of the measurement criteria of SFAS 114 and SFAS 118. The amount of this component is included in the various categories presented in the following table.
The second component is statistically based and is intended to provide for losses that have occurred in large groups of smaller balance loans, the credit quality of which is impracticable to re-grade at end of each period. These loans would include residential real estate, consumer loans and loans to small businesses generally of $100,000 and less. The loss factors are based primarily on the Company's historical loss experience tracked over a three-year period and accordingly will change over time. Due to the fact that historical loss experience varies for the different categories of loans, the loss factors applied to each category also differ.
Finally, the "unallocated" component of the ALL is intended to absorb losses that may not be provided for by the other components. There are several reasons that the other components discussed above might not be sufficient to absorb the losses present in portfolios, and the unallocated portion of the ALL is used to provide for the losses that have occurred because of these reasons.
The first reason stems from the fact that there are limitations inherent to any credit risk grading process. Even for experienced loan reviewers, grading loans and estimating probable losses involves a significant degree of judgement regarding the present situation with respect to individual loans and the portfolio as a whole. The overall number of loans in the portfolio also makes it impracticable to re-grade every loan each quarter. Therefore, the possibility exists that some currently performing loans will not be as strong as their last grading estimate and an insufficient portion of the allowance will have been allocated to them. In addition, it's possible that grading and loan review may be done without all relevant facts. Troubled borrowers may inadvertently or deliberately omit important information from correspondence with lending officers regarding their financial condition and the diminished strength of repayment sources.
The second is that loss estimation factors are based on historical loss totals. As such, the factors may not give sufficient weight to such considerations as the current general economic and business conditions that affect the Company's borrowers and specific industry conditions that affect borrowers in that industry. For example, with respect to loans to borrowers who are influenced by trends in the local tourist industry, management considers the effects of weather conditions, market saturation, and the competition for borrowers from other tourist destinations and attractions. In addition, the Company evaluates the tourism related business types it serves to determine the impact of economic forces as it relates to other similar lines of business in making a determination of applying reserves across related industry segments.
Third, the loss estimation factors do not give consideration to the seasoning of the loan portfolio. Seasoning is relevant because losses are less likely to occur in loans that have been performing satisfactorily for several years than in loans that are more recent.
Finally, the loss estimation factors do not give consideration to the interest rate environment. For example, borrowers with variable rate loans may be less able to manage their debt service if interest rates rise.
For these reasons, management regards it as both a more practical and a more prudent practice to maintain the total allowance at an amount larger than the sum of the amounts allocated as described above.
Table 12 shows the amount of the ALL allocated for the time periods indicated to each loan type as described. It also shows the percentage of balances for each loan type to total loans. Management continues to target and maintain the ALL equal to the allocation methodology plus an unallocated portion, as determined by economic conditions on the Company's borrowers. In general, it would be expected that those types of loans which have historically more loss associated with them will have a proportionally larger amount of the allowance allocated to them than do loans that have less risk.
Consideration for making such allocations is consistent with the factors discussed above, and all of the factors are subject to change; thus, the allocation is not necessarily indicative of the loan categories in which future loan losses will occur. It would also be expected that the amount allocated for any particular type of loan will increase or decrease proportionately to both the changes in the loan balances and to increases or decreases in the estimated loss in loans of that type. In other words, changes in the risk profile of the various parts of the loan portfolio should be reflected in the allowance allocated.
TABLE 12: ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
While there exists probable asset quality problems in the loan portfolio, management believes sufficient reserves have been provided in the ALL to absorb probable losses in the loan portfolio at December 31, 2003. Ongoing efforts are being made to collect these loans, and the Company involves the legal process when it believes it necessary to minimize the risk of further deterioration of these loans for full collection.
While management uses available information to recognize losses on loans, future adjustments to the ALL may be necessary based on changes in economic conditions and the impact of such change on the Company's borrowers. As an integral part of their examination process, various regulatory agencies also review the ALL. Such agencies may require that changes in the ALL be recognized when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination.
Non-Performing Loans, Potential Problem Loans and Other Real Estate
Management encourages early identification of non-accrual and problem loans in order to minimize the risk of loss. This is accomplished by monitoring and reviewing credit policies and procedures on a regular basis.
Non-performing loans remain a leading indicator of future loan loss potential. Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days or more past due but still accruing, and restructured loans. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact on the collection of principal or interest on loans, it is the practice of management to place such loans on non-accrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than recorded as interest income.
Restructuring loans involve the granting of some concession to the borrower involving a loan modification, such as payment schedule or interest rate changes.
TABLE 13: NONPERFORMING LOANS AND OTHER REAL ESTATE OWNED
Non-performing loans at December 31, 2003 were $16.2 million compared to $22.1 million at December 31, 2002. Impacting the decrease in non-performing loans in 2003 was a loan charge-off of $2.6 million in restructured loans and a shifting, as a result of foreclosure, of approximately $1.4 million in loans to other real estate owned during 2003 in addition to a net decrease in non-performing loans totaling $1.9 million in 2003. Non-accrual loans represented $11.1 million of the total of non-performing loans. Real estate non-accrual loans account for $9.2 million of the total, of which $2.9 million was residential real estate and $5.7 million was commercial real estate, while commercial and industrial non-accruals account for $1.8 million. Management believes collateral is sufficient to offset losses in the event additional legal action would be warranted to collect these non-accrual loans. Restructured loans were $5.1 million at December 31, 2003 compared with $9.8 million at year-end 2002. The improvement in restructured loans resulted from the charge-off of $2.6 million in loans which were considered restructured loans at year-end 2002 and net loan principal pay downs on various other restructured loans totaling $2.1 million during the 2003. Of the restructured loans at December 31, 2003, approximately $4.3 million consisted of two commercial credits and conditional loans as to which the bank has granted various concessions as a result of the borrowers' past cash flow problems. These credits were current at December 31, 2003. Although management believes that collateral for these loans is generally sufficient if there were to be a default, management has allocated a loan loss provision of $640,000. This allocation relates to a commercial credit of $1.6 million, which is the net amount remaining after the charge-off of $2.6 million referred to above in 2003. As a result of the cash flow problems of the debtor, management is continuing to specially monitor this loan on a monthly basis and is working with the borrower to minimize any additional loss exposure. If the loan becomes not current or other factors change, this loan is subject to becoming a non-performing loan and/or further charge-off. As a result the ratio of non-performing loans to total loans at the end of 2003 was 2.3% compared to 3.3% at end of year 2002. The Company's ALL was 75.0% of total non-performing loans at December 31, 2003 compared to 51.7% at end of year 2002.
The following table shows, for those loans accounted for on a non-accrual basis for the years ended as indicated, the gross interest that would have been recorded if the loans had been current in accordance with their original terms and the amount of interest income that was included in interest income for the period.
TABLE 14: FOREGONE LOAN INTEREST
Potential problem loans are currently performing loans that management believes may incur difficulties in complying with loan repayment terms. Management's decision to place loans in this category does not necessarily mean that the Company expects to take losses on such loans, but that management needs to be more vigilant in its efforts to oversee the loans and recognize that a higher degree of risk is associated with these potential problem loans. At December 31, 2003, potential problem loans amounted to a total of $5.7 million compared to a total of $5.2 million at end of 2002. Of the problem loans a total of $5.4 million stem from one commercial borrower which is currently experiencing cash flow concerns. Various commercial real estate loans totaling $300,000 make up the balance of the total potential problem loans. Noting the exceptions above, potential problem loans are not concentrated in a particular industry but rather cover a diverse range of businesses. Except as noted above, management does not presently expect significant losses from credits in the potential problem loan category.
Other real estate owned, which represents property that the Company acquired through foreclosure or in satisfaction of debt, consisted of nineteen properties
totaling $2.3 million at end of year 2003. This compared to nine properties totaling $896,000 million at end of year 2002. Management actively seeks to ensure that properties held are administered to minimize any risk of loss.
The net cost of operation of other real estate for 2003, 2002, and 2001 consists of the following and are shown in Table 15:
TABLE 15: OTHER REAL ESTATE OPERATION SUMMARY
In the first quarter of 2002, a commercial real estate loan totaling $2.2 million was deeded over to the Bank, and a subsidiary, Arborview, formed for purposes of operating a community based residential facility. The assets of the subsidiary were sold in the first quarter of 2003.
Investment Portfolio
The investment portfolio is intended to provide the Company with adequate liquidity, flexibility in asset/liability management and, lastly, its earning potential.
TABLE 16: INVESTMENT SECURITIES PORTFOLIO
Investment securities are classified as held to maturity or available for sale. The Company determined at year end 2003 that all of its taxable securities, including U.S. Treasury, U.S. Agency securities and municipal bond securities purchased in 2003 were to be classified as available for sale. In addition, the Company determined that its non-taxable local municipals were classified as available for sale. In the case of the Company's non-taxable securities and municipal bond investments purchased prior to 1996, they were determined to be held to maturity. This determination was made because the Company wanted to retain the municipal bond issues due to their higher after-tax yields, and local non-taxable issues due to their lessened marketability. Held to maturity securities are those securities the Company has both the intent and ability to hold until maturity. Under this classification, securities are stated at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income. Gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method. At December 31, 2003, securities held to maturity had an aggregate market value of approximately $19.3 million compared with amortized cost of $19.0 million.
Investment securities classified as available for sale are those securities which the Company has determined might be sold to manage interest rates or in response to changes in interest rates or other economic factors. While the Company has no current intention of selling those securities, they may not be held to maturity. Investment securities available for sale at December 31, 2003 and 2002 are carried at market value. Adjustments up or down to market value at December 31, 2003 and 2002 are recorded as a separate component of equity, net of tax with one exception. In the event of a market value loss with regards to investments held in the investment subsidiary, the market value loss is recorded without a tax benefit since the loss would be treated as a capital loss. Premium amortization and discount accretion are recognized as adjustments to interest income. Realized gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold using the specific identification method. At December 31, 2003, securities available for sale had a market and carrying value of $176.8 million.
TABLE 17: INVESTMENT SECURITIES PORTFOLIO MATURITY DISTRIBUTION (dollars in thousands)
At December 31, 2002 and 2001, the Company's investment portfolio did not contain, other than U.S. treasury and federal agencies, securities of any single issuer that were payable from and secured by the same source of revenue of taxing authority where the aggregate book value of such securities exceed 10% of stockholders' equity.
Investment securities averaged $170.9 million in 2003 compared with $173.8 million in 2002. The average balance of securities decreased partly as a result of funds from maturing investments used to satisfy funding requirements for loan demand in the early part of 2003. In 2003, taxable securities comprised approximately 68.6% of the total average investments compared to 66.8% in 2002. Tax-exempt securities on average for 2003 accounted for 31.4% of the total average investments compared to 33.2% in 2002.
Deposits
Deposits are the Company's largest source of funds. At December 31, 2003, deposits were $783.3 million, an increase of $43.0 million or 5.8% from $740.3 million recorded at December 31, 2002. Brokered deposits decreased $800,000 to $97.8 million at year-end 2003 from $98.6 million at year end 2002. Average total deposits for 2003 were $748.0 million, an increase of 8.1% over 2002. Included in these results was an increase in average brokered deposits to $98.2 million in 2003 from $87.1 million in 2002. The increase in brokered time deposits occurred principally in the first half of 2003, and reflects the Company's use of such instruments to provide incremental funding to meet cash flow needs. The acquisition of brokered time deposits was accomplished generally at funding rates encountered by the Company in its own market area. Although the use of brokered deposits has increased in the last two years, Management views these as a stable source of funds. If liquidity concerns arose, the Company has alternative sources of funds such as lines with correspondent banks and borrowing arrangements with FHLB should the need present itself. Average deposits increased 12.7% in 2002 compared to 2001 results. Typically, overall deposits for the first six months tend to decline slightly as a result of the seasonality of the Company's customer base as customers draw down deposits during the early first half of the year in anticipation of the summer tourist season.
TABLE 18: AVERAGE DEPOSITS DISTRIBUTION
As shown in Table 18, non-interest bearing demand deposits in 2003 averaged $88.6 million, up 16.6% from $76.0 million recorded in 2002. This $12.6 million increase is attributable to improvement in the seasonal increases in these funds throughout the year along with an emphasis of attracting new customer relationships and selling more services to existing customers. At December 31, 2003, non-interest-bearing demand deposits were $106.6 million compared with $89.8 million at year-end 2002.
Interest bearing deposits generally consist of interest-bearing checking, savings deposits, money market accounts, individual retirement accounts ("IRAs") and certificates of deposit ("CDs"). In 2003, interest-bearing deposits averaged $659.3 million, an increase of 7.0%. Within the category of interest bearing deposits, savings deposits, including money market accounts, decreased $4.7 million or 2.4% as a result of customer preference to lock in higher short term rates through the purchase of short term time deposits . During the same period, time deposits, including CDs and IRAs (other than brokered time and time over $100,000) increased in average deposits $16.0 million or 8.3%, primarily the result of a shift in customer preferences. Average time deposits over $100,000 decreased by $945,000 or 1.1%. Time deposits greater than $100,000 and brokered time deposits were priced within the framework of the Company's rate structure and did not materially increase the average rates on deposit liabilities. Increased competition for consumer deposits and customer awareness of interest rates continues to limit the Company's core deposit growth in these types of deposits.
Emphasis will be placed on generating additional core deposits in 2004 through competitive pricing of deposit products and through the branch delivery systems that have already been established. The Company will also attempt to attract and retain core deposit accounts through new product offerings and customer service. The Company also may increase brokered CD's during the year 2004 as an additional source of funds to provide for loan growth in the event that core deposit growth goals would not be accomplished. Under that scenario, the Company will continue to look at other wholesale sources of funds, if the brokered CD market became illiquid or more costly in terms of rate.
Short-Term Borrowings and Other Borrowings
Short-term borrowings consist of federal funds purchased, securities under agreements to repurchase, and advances from FHLB. As indicated in Table 19, average 2003 short-term borrowings were $11.3 million compared to $21.0 million during 2003. The decrease of $9.7 million occurred as a result of growth in core deposits and an increase in non-core funding sources such as brokered time deposits, time deposits greater than $100,000 and increased term loans with FHLB offset to a lesser extent by increased loan demand, increased investment balances and decreased term loans with FHLB. Average short-term borrowings decreased $714,000 to $21.0 million in 2002 from $21.8 million in 2001 due to other forms of funding sources used during the year.
At year-end 2003, short-term borrowings increased to $23.4 million from $10.1 million a year earlier. The increase resulted from increased loans and investments at year-end compared to growth in deposits.
TABLE 19: SHORT-TERM BORROWINGS
Other borrowings consist of term loans with FHLB. Average other borrowings in 2003 were $65.3 million compared to $72.5 million. The decrease of $7.3 million or 10.0% occurred as a result of the availability of other funding sources used during 2003.
Federal funds are purchased from money center banks and correspondent banks at prevailing overnight interest rates. Securities are sold to bank customers under repurchase agreements at prevailing market rates. Borrowings with the FHLB are secured by one to four family residential mortgages and eligible investment securities allowing the Company to use it for additional funding purposes. FHLB advances are included as short-term borrowings. All other FHLB loans, including callable notes with call features greater than one year, are included in the other borrowings category.
Long-Term Debt
Long-term debt of $53,000 consists of a land contract requiring annual payments of $53,000 plus interest calculated at prime plus one quarter of one percent. The land contract was for the purchase of one of the properties in the Green Bay region for a branch location. The final payment on the land contract was made in January 2004.
In connection with the issuance of Trust Preferred Securities in 2001 (see "Capital Resources"), the Company issued long-term subordinated debentures to Baylake Capital Trust I, a Delaware Business Trust subsidiary of the Company. The aggregate principal amount of the debentures due 2031 to the trust subsidiary is $16,597,940. For additional details, please make reference to the Consolidated Financial Statements and Note 11 in the accompanying footnotes.
Off-Balance Sheet Obligations
As of December 31, 2003 the Company has the following commitments, which do not appear on its balance sheet:
Further discussion of these commitments is included in Note 13, "Financial Instruments with Off-Balance Sheet Risk" of the notes to consolidated financial statements.
Contractual Obligations
As of December 31, 2003, the Company is contractually obligated under long-term agreements as follows:
Further discussion of these contractual obligations is included in Note 20, " Commitments and Contingencies" of the notes to consolidated financial statements.
Liquidity
Liquidity management refers to the ability of the Company to ensure that cash is available in a timely manner to meet loan demand and depositors' needs, and to service other liabilities as they become due, without undue cost or risk, and without causing a disruption to normal operating activities. The Company and the Bank have different liquidity considerations.
The Company's primary sources of funds are dividends from the Bank; investment income, and net proceeds from borrowings and the offerings of junior subordinated obligations, in addition to the issuance of its common stock securities. The Company manages its liquidity position in order to provide funds necessary to pay dividends to its shareholders. Dividends received from Bank totaled $4.2 million in 2003 and will continue to be the Company's main source of liquidity. The dividends from the Bank were sufficient to pay cash dividends to the Company's shareholders of $3.9 million in 2003.
The Bank meets its cash flow needs by having funding sources available to it to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity at the Bank is derived from deposit growth, maturing loans, the maturity of the investment portfolio, access to other funding sources, marketability of certain of their assets; the ability to use its loan and investment portfolios as collateral for secured borrowings and strong capital positions.
Maturing investments have been a primary source of liquidity at the Bank. Sales of investments totaling $68.1 million were made in 2003. $115.5 million in investments were purchased in 2003. This resulted in net cash of $47.4 million used in investing activities for 2003. At December 31, 2003, the carrying or book value of investment securities maturing within one year amounted to $12.0 million or 6.1% of the total investment securities portfolio. This compares to a 33.2% level for investment securities with one year or less maturities as of December 31, 2002. Within the investing activities of the statement of cash flows, sales and maturities of investment securities during 2003 totaled $68.1 million. At the end of 2003, the investment portfolio contained $138.8 million of U.S. Treasury and federal agency backed securities representing 70.9% of the total investment portfolio. These securities tend to be highly marketable and had a market value above amortized cost at end of year 2003 amounting to $932,000.
Deposit growth is another source of liquidity for the Bank. As a financing activity reflected in 2003 Consolidated Statements of Cash Flows, deposits provided $43.0 million in cash inflow during 2003. The Company's overall average deposit base grew $55.9 million or 8.1% during 2003. Deposit growth is the most stable source of liquidity for the Bank, although brokered deposits are inherently less stable than locally generated core deposits. Affecting
liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause the Bank to develop alternative sources of funds which may not be as liquid and potentially a more costly alternative.
Federal funds sold averaged $1.7 million in 2003 compared to $1.1 million in 2002. The slight increase was the result of above average deposit growth, including non-core funding sources, offset to a lesser degree with above average growth in loans and a reduction in other borrowings. Funds provided from the maturity of these assets typically are used as funding sources for seasonal loan growth, which typically have higher yields. Short-term and liquid by nature, federal funds sold generally provide a yield lower than other earning assets. The Bank has a strategy of maintaining a sufficient level of liquidity to accommodate fluctuations in funding sources and will at times take advantage of specific opportunities to temporarily invest excess funds at narrower than normal rate spreads while still generating additional interest revenue. At December 31, 2003, the Bank had no federal funds sold.
The scheduled maturity of loans can provide a source of additional liquidity. The Bank has $250.0 million of loans maturing within one year, or 35.9% of total loans. Factors affecting liquidity relative to loans are loan origination volumes, loan prepayment rates and the maturity structure of existing loans. The Bank's liquidity position is influenced by changes in interest rates, economic conditions and competition. Conversely, loan demand as a need for liquidity will cause the Company to acquire other sources of funding which could be harder to find; therefore more costly to acquire.
Within the classification of short-term borrowings and other borrowings at year-end 2003, federal funds purchased and securities sold under agreements to repurchase totaled $23.3 million compared with $10.1 million at the end of 2002. Federal funds are purchased from various upstream correspondent banks while securities sold under agreements to repurchase are obtained from a base of business customers. Borrowings from FHLB, short-term or term, are another source of funds. They totaled $65.0 million at end of year 2002.
The Bank's liquidity resources were sufficient in 2003 to fund the growth in loans and investments, increase the volume of interest earning assets and meet other cash needs when necessary.
Management expects that deposit growth will continue to be the primary funding source of the Bank's liquidity on a long-term basis, along with a stable earnings base, the resulting cash generated by operating activities, and a strong capital position. Although federal funds purchased and borrowings from the FHLB provided funds in 2003, management expects deposit growth, including brokered CD's, to be a reliable funding source in the future as a result of branch expansion efforts and marketing efforts to attract and retain core deposits. Shorter-term liquidity needs will mainly be derived from growth in short-term borrowings, maturing federal funds sold and portfolio investments, loan maturities and access to other funding sources.
In assessing liquidity, historical information such as seasonality (loan demand's affect on liquidity which starts before and during the tourist season and deposit draw down which affects liquidity shortly before and during the early part of the tourist season), local economic cycles and the economy in general are considered along with the current ratios, management goals and the unique characteristics of the Company. Management believes that, in the current economic environment, the Company's and the Bank's liquidity position is adequate. To management's knowledge, there are no known trends nor any known demands, commitments, events or uncertainties that will result or are reasonably likely to result in a material increase or decrease in the Bank's or the Company's liquidity.
Interest Rate Risk
Interest rate risk is the exposure to a bank's earnings and capital arising from changes in future interest rates. All banks assume interest rate risk as an integral part of normal banking operations. Control and monitoring of interest rate risk is a primary objective of asset/liability management. Baylake's Asset/Liability Committee ("ALCO") manages risks associated with changing interest rates, changing asset and liability mixes, and the impact on such changes on earnings. The sensitivity of net interest income to market rate changes is evaluated monthly by ALCO.
In order to limit exposure to interest rate risk, the Company has developed strategies to manage its liquidity, shorten the effective maturities of certain interest-earning assets, and increase the effective maturities of certain interest-bearing liabilities. The Company has focused on the establishment of adjustable rate mortgages ("ARM's") in its residential lending product line; the concerted efforts made to attract and sell core deposit products through the use of Company's branching and delivery systems and marketing efforts; and the use of other available sources of funding to provide longer term funding possibilities.
Interest rate sensitivity analysis can be performed in several different ways. The traditional method of measuring interest sensitivity is called "gap" analysis. The mismatch between asset and liability re-pricing characteristics in specific time intervals is referred to as "interest rate sensitivity gap." If more liabilities than assets re-price in a given time interval a liability gap position exists. In general, liability sensitive gap positions in a declining interest rate environment increase net interest income. Alternatively, asset sensitive positions, where assets re-price more quickly than liabilities, negatively impact the net interest income in a declining rate environment. In the event of an increasing rate environment, opposite results would occur in that a liability sensitive gap position would decrease net interest income and an asset sensitive gap position would increase net interest income. The sensitivity of net interest income to changing interest rates can be reduced by matching the re-pricing characteristics of assets and liabilities.
The following table entitled "Asset and Liability Maturity Re-pricing Schedule" indicates that the Company is in an asset sensitive position, which means within a one-year time frame that assets will re-price more quickly than liabilities. The analysis considers money market index accounts and 25% of NOW accounts to be rate sensitive within three months. Regular savings, money market deposit accounts and 75% of NOW accounts are considered to be rate sensitive within one to five years. While these accounts are contractually short-term in nature, it is the Company's experience that re-pricing occurs over a longer period of time. The Company views its savings and NOW accounts to be core deposits and relatively non-price sensitive, as it believes it could make re-pricing adjustments for these types of accounts in small increments without a material decrease in balances. All other earning categories (including loans and investments) as well as other paying liability categories such as time deposits are scheduled according to their contractual maturities. The "static gap analysis" provides a representation of the Company's earnings sensitivity to changes in interest rates. It is a static indicator and does not reflect various repricing characteristics. Accordingly, a "static gap analysis" may not be indicative of the sensitivity of net interest income in a changing rate environment.
TABLE 21: INTEREST RATE SENSITIVITY ANALYSIS
In addition to the "static gap analysis", determining the sensitivity of future earnings to a hypothetical plus or minus 100 basis point parallel rate shock can be accomplished through the use of simulation modeling. Simulation of earnings includes the modeling of the balance sheet as an ongoing entity. Balance sheet items are modeled to project income based on a hypothetical change in interest rates and the resulting net income projections for the next twelve-month period are compared to the net interest income projection calculated under a steady rate scenario. This difference represents the Company's earnings sensitivity to a plus or minus 100 basis point parallel rate shock. The resulting simulations for the year ended December 31, 2004 indicated that net interest income would increase by approximately 2.9% if the Fed Funds rate immediately increased by 100 basis points, and further indicate that net interest income would decrease by approximately decrease by 3.5% if the Fed Funds rate immediately decreased by 100 basis points. These results are within the policy limits established by the Company. For an immediate 200 basis point increase in the Fed Funds rate, the estimated change in net interest income from the steady rate scenario would be an increase of 4.9% for the year ended December 31, 2004. The presentation is limited to a 100 basis point decline due to the currently historically low interest rate environment. The magnitude of the effects of the declining rate scenario are impacted by the absolute level of rates, and the inability of the Company to reduce its core deposit funding costs by the entire amount of the change assumed. This impact is also exacerbated by the expected increase in prepayments on higher yielding loans and mortgage-backed securities under the declining rate scenario.
In addition, the results of the simulations are also impacted by the assumption that the slope of the yield curve will change with an increase or decrease in the Fed Funds rate. In the rising rate scenarios, the model will reflect a greater increase in short-term rates than long-term rates, thereby resulting in a decrease in the slope of the curve. In the falling rate scenario the slope is predicted to increase which means that short-term rates would fall further than long-term rates. Also impacting the modeling results is the assumption that the rates on certain types of accounts will not change to the same degree as the yield curve. In particular, the adjustment in rates on money market accounts, savings accounts and NOW accounts will be less than the adjustment in the Fed Funds rate.
There can be no assurance that the results of operations would be impacted as indicated if interest rates did move by the amounts discussed above. Management continually reviews its interest risk position through the ALCO process. Management's philosophy is to maintain relatively matched rate sensitive asset and liability positions within the range described above in order to provide earnings stability in the event of significant interest rate changes.
Capital Resources
Stockholders' equity at December 31, 2003 increased $4.2 million or 6.5% to $69.6 million, compared with $65.4 million at end of year 2002. The increase in stockholders' equity in 2003 was primarily composed of the retention of earnings and the exercise of stock options with offsetting decreases to stockholders' equity from the payment of cash dividends. Additionally, stockholders' equity at year-end 2003 included $2.1 million of accumulated other
comprehensive income, related to unrealized gains on securities. At December 31, 2002, stockholders' equity included $3.2 million of comprehensive income related to unrealized gains on securities. Stockholders' equity to assets at December 31, 2003 was 7.14%, compared to 7.23% at the end of 2002.
In 2001, the Company formed Baylake Capital Trust I ("the Trust") as a statutory business trust organized for the sole purpose of issuing trust preferred securities and investing the proceeds thereof in junior subordinated debentures of the Company, the sole asset of the Trust. The trust preferred securities enhanced regulatory capital and added liquidity. The common securities of the Trust are wholly-owned by the Company. The trust preferred securities and common securities of the trust represent preferred undivided beneficial interests as the assets of Baylake Capital Trust I, and the holder of the preferred securities will be entitled to a preference over the common securities of the Trust upon an event of default with respect to distributions and amounts payable on redemption or liquidation. These trust preferred securities are tax-advantaged issues for the Company that qualify for Tier 1 capital treatment to the Company. Distributions on these securities are included in interest expense on guaranteed preferred beneficial interest. The preferred securities are traded on the American Stock Exchange under the symbol BYL_p.
As pf December 31, 2003, the Company deconsolidated the Trust, which had issued the trust preferred securities (discussed above), and replaced the presentation of such instruments with the Company's junior subordinated debentures issued to the Trust. Such presentation reflects adoption of FASB Interpretation No. 46 (FIN 46 R) issued in December 2003.
The Company had $16.6 million of junior subordinated debentures outstanding to the Trust and the Trust had $16.1 million of trust preferred securities outstanding at December 31, 2003. Under applicable regulatory guidelines, the Trust Preferred Securities qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion of Trust Preferred Securities would qualify as Tier 2 capital. As of December 31, 2003, all $16.1 million of the Trust Preferred Securities qualify as Tier 1 Capital.
The Company's capital base (before SFAS 115 change) increased primarily due to the retention of earnings. The Company's dividend reinvestment plan typically provides capital improvement, as the holders of approximately 21% of Company's Common Stock participate in the plan.
Cash dividends paid in 2003 were $0.53 per share compared with $0.49 in 2002. The Company provided an 8.2% increase in normal dividends per share in 2003 over 2002 as a result of earnings for 2003.
In 1997, the Company's Board of Directors authorized management to repurchase up to 7,000 shares of the Company's common stock each calendar quarter in the market. The shares repurchased would be used to fill its needs for the dividend reinvestment program, any future benefit plans, and the Company's stock purchase plan. Shares repurchased are held as treasury stock and, accordingly, are accounted for as a reduction of stockholders' equity. The Company repurchased none of its common shares in 2003 for treasury stock purchases.
The adequacy of the Company's capital is regularly reviewed to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management. Management is confident that because of current capital levels and projected earnings levels, capital levels are more than adequate to meet the ongoing and future concerns of the Company.
The Federal Reserve Board has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory -and possible additional discretionary- actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements.
At December 31, 2003 and 2002, the Company was categorized as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category.
To be "well capitalized" under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.
The following table presents the Company's and the Bank's capital ratios as of December 31 for each of the previous two years.
TABLE 22: CAPITAL
Management believes that a strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share, and to provide depositor and investor confidence. The Company's capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. Management actively reviews capital strategies for the Company to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements.
Recent Accounting Pronouncements
In January 2003, the FASB issued FASB Interpretations No. 46 ("FIN 46"), Consolidation of Variable Interest Entities." The objective of this interpretation is to provide guidance on how to identify a variable interest entity ("VIE") and determine when the assets, liabilities, non-controlling interests and results of operations of a VIE need to be included in a company's consolidated financial statements. A company that holds variable interests in an entity will need to consolidate the entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or receive a majority of the entity's expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. FIN 46 was effective for all VIE's created after January 31, 2003. However, the FASB has postponed that effective date to December 31, 2003. In December 2003, the FASB issued a revised FIN 46 (FIN 46 R), which further delayed this effective date until March 31, 2004 for VIE's created prior to February 1, 2003, except for special purpose entities, which must adopt either FIN 46 or FIN 46 R as of December 31, 2003. The requirements of FIN 46 resulted in the deconsolidation of the Company's wholly owned subsidiary trusts, formed to issue mandatorily redeemable preferred securities ("trust preferred securities"). The deconsolidation, as of December 31, 2003, results in the recognition of the trust preferred securities as junior subordinated obligations on the related consolidated statement of financial condition. The junior subordinated obligations of the trusts also include common interests, which aggregate $497,940, and are offset by an identical amount representing the Company's investment and included in other assets. The provisions of FIN 46 R had no impact on the Company's consolidated statements of income or cash flows for 2003.
The FASB issued Statement No. 149, "Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities". The statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivatives instruments embedded in other contracts and for hedging activities. This statement amends Statement 133 for decisions made as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133, in connection with other FASB projects dealing with financial instruments and in connection with implementation issues raised in relation to the application of the definition of a derivative. The adoption of this statement did not have a significant impact on the Company's consolidated financial statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." This statement requires an issuer to classify three types of freestanding financial instruments as liabilities. One type is financial instruments issued in the form of shares requiring the issuer to redeem them by transferring its assets. The second type is financial instruments that embody an obligation to repurchase the issuer's equity shares by transferring assets. The third type of financial instruments is one that embodies an unconditional obligation that the issuer must or may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation meets certain criteria. The statement also requires disclosures about the terms of the instruments and settlement alternatives. The statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. The effective date has been deferred indefinitely for certain types of mandatorily redeemable financial instruments. The provisions of this statement did not have a material impact on the Company's consolidated financial statements.
Item 7 A.
Item 7 A. Quantitative and Qualitative Disclosure about Market Risk.
Information required by this item is set forth in Item 7 under the caption "Interest Rate Risk" and is incorporated in this schedule by reference.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements and notes to related statements thereto are set forth on the following pages.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED FINANCIAL STATEMENTS and REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
For the Years Ended December 31, 2003, 2002, and 2001
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Shareholders and Board of Directors Baylake Corp. Sturgeon Bay, Wisconsin
We have audited the accompanying consolidated balance sheets of Baylake Corp. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholder equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly the consolidated financial position of Baylake Corp. and subsidiaries at December 31, 2003 and 2002, and the results of its operations and cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
Madison, Wisconsin /s/ SMITH & GESTELAND, LLP January 21, 2004 SMITH & GESTELAND, LLP
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED BALANCE SHEETS December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED BALANCE SHEETS December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER EQUITY For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31
The accompanying notes are an integral part of the financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements of Baylake Corp. (the company) include the accounts of the company, its wholly-owned subsidiaries; Kewaunee County Banc-Shares, Inc., (KCB) and Baylake Capital Trust I, and KCB's wholly-owned subsidiary Baylake Bank, and its wholly-owned subsidiaries; Bank of Sturgeon Bay Building Corporation, Cornerstone Financial, Inc., Baylake Investments, Inc., Baylake Insurance Agency, Inc. and Arborview, LLC. All significant intercompany items and transactions have been eliminated.
Baylake Bank owns a 49% interest in United Financial Services, Inc., (UFS) a data processing service. The investment in this entity is carried under the equity method of accounting and the pro rata share of its income is included in other revenue. Amounts paid to UFS for data processing services for Baylake bank were $962,000, $909,000, and $850,000 in 2003, 2002, and 2001, respectively. At December 31, 2003 and 2002, Baylake Bank had loans of $350,000 and $200,000, respectively, to UFS.
Baylake Bank makes commercial, mortgage, and installment loans to customers substantially all of whom are located in Door, Brown, Kewaunee, Manitowoc, Waushara, Outagamie, Green Lake and Waupaca Counties of Wisconsin. Although Baylake Bank has a diversified portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic condition of the local industrial businesses, and commercial, agricultural and tourism industries.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
The company's financial instruments that are exposed to concentrations of credit risk consist primarily of cash and due from banks. The company places these assets with high credit quality institutions. At times such assets may be in excess of FDIC insurance limit.
Investment securities classified as held to maturity are those securities which the bank has both the intent and the ability to hold until maturity. Under this classification, securities are stated at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income. Gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method.
Investment securities classified as available for sale are those securities which Baylake Bank has determined might be sold to manage interest rate risk or in response to changes in interest rates or other economic factors. While the company has no current intention of selling these securities, they may not be held to maturity.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Investment securities available for sale are carried at market value. Adjustments up or down to market value are recorded as a separate component of equity, net of tax. Premium amortization and discount accretion are recognized as adjustments to interest income. Realized gains or losses on disposition are based on the net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method.
Loans, including loans held for sale, are stated at face value, net of deferred loan origination fees (net of costs) and the allowance for loan losses. Interest on loans is calculated using the simple interest method on daily balances of the principal amount outstanding or an amortized method.
Loan origination fees and related costs are deferred and the net deferred revenue is amortized over the term of the loans using the effective interest rate or straight-line method.
The allowance for loan losses is maintained at a level that is management's best estimate of probable loan losses incurred as of the balance sheet date. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current domestic and international economic conditions, volume, growth and composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged against income.
The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collectibility is in doubt, cash receipts on nonaccrual loans are used to reduce principal rather than recorded as interest income.
Depreciable assets are stated at cost less accumulated depreciation. Depreciation is charged to operating expense over the estimated useful lives of the assets, using the straight-line and accelerated methods.
Mortgage servicing rights of $539,000, $308,000, and $400,000 were capitalized and $411,000, $260,000, and $204,000 were amortized during 2003, 2002, and 2001, respectively. The amount of impairment was not material. The amount of loans serviced for the benefit of others as of December 31, 2003, 2002, and 2001 was $144,748,000, $105,180,000, and $87,165,000, respectively.
Bank owned life insurance (BOLI) is carried at the cash surrender value of the underlying policies. Income of $686,000 and $332,000 in 2003 and 2002, respectively, is included in other income.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Other real estate, which is included in other assets, comprises properties acquired through a foreclosure proceeding or acceptance of a deed in lieu of foreclosure. These properties are carried at the lower of cost or fair value, minus estimated costs to sell, based on appraised value at the date acquired. Loan losses arising from the acquisition of such property are charged against the allowance for loan losses. An allowance for losses on other real estate is maintained for subsequent valuation adjustments on a specific property basis.
During 2002, the company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangibles," which requires that goodwill no longer be amortized but, instead, tested annually for impairment. There was no impairment of goodwill in 2003 or 2002. Prior to 2002, goodwill was being amortized on a straight-line basis over 15 years. Amortization expense was $486,000 in 2001.
The company expenses all advertising costs as they are incurred. Total advertising costs for the years ended December 31, 2003, 2002, and 2001 were $269,000, $274,000, and $293,000, respectively.
The company applies APB Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25) and related interpretations in accounting for its stock-based compensation plans. Under Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation", companies may elect to recognize stock-based compensation expense based on the fair value of the awards or continue to account for stock-based compensation under APB No. 25. The company has elected to continue to apply the provisions of APB No. 25 with the disclosure requirements of SFAS No. 123 in Note 18.
Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of the allowance for loan losses, deferred loan origination fees, deferred compensation, mortgage loan servicing, market value adjustments of securities, and depreciation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.
The company and its subsidiaries file a consolidated federal income tax return. The subsidiaries provide for income taxes on a separate-return basis, and remit to the company amounts determined to be currently payable, if any.
Earnings per share are based on the weighted average number of shares outstanding during each year.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
For purposes of the statement of cash flows, the company considers cash, due from banks, and federal funds sold as cash and cash equivalents.
For comparability, certain 2002 and 2001 amounts have been reclassified to conform with classification adopted in 2003.
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No.46 ("FIN 46"), "Consolidation of Variable Interest Entities." The objective of this interpretation is to provide guidance on how to identify a variable interest entity ("VIE") and determine when the assets, liabilities, non-controlling interests and results of operations of a VIE need to be included in a company's consolidated financial statements. A company that holds variable interests in an entity will need to consolidate the entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or receive a majority of the entity's expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. FIN 46 was effective for all VIE's created after January 31, 2003. However, the FASB has postponed that effective date to December 31, 2003. In December 2003, the FASB issued a revised FIN 46 (FIN 46 R), which further delayed this effective date until March 31, 2004 for VIE's created prior to February 1, 2003, except for special purpose entities, which must adopt either FIN 46 or FIN 46 R as of December 31, 2003. The requirements of FIN 46 R resulted in the deconsolidation of the company's wholly owned subsidiary trust, formed to issue mandatorily redeemable preferred securities ("trust preferred securities"). The deconsolidation, as of December 31, 2003, results in the recognition of the trust preferred securities as junior subordinated debentures on the related consolidated balance sheets. The junior subordinated debentures of the trust also include common interests, which aggregate approximately $498,000 and are offset by an identical amount representing the company's investment and included in other assets. The provisions of FIN 46 R had no impact on the company's consolidated statements of income or cash flows for 2003.
The FASB issued Statement No. 149, "Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities". The statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. This statement amends Statement 133 for decisions made as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133, in connection with other FASB projects dealing with financial instruments and in connection with implementation issues raised in relation to the application of the definition of a derivative. The adoption of this statement did not have a significant impact on the company's consolidated financial statements.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - INFORMATION ABOUT THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." This statement requires an issuer to classify three types of freestanding financial instruments as liabilities. One type is financial instruments issued in the form of shares requiring the issuer to redeem them by transferring its assets. The second type is financial instruments that embody an obligation to repurchase the issuer's equity shares by transferring assets. The third type of financial instruments is one that embodies an unconditional obligation that the issuer must or may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation meets certain criteria. The statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the first interim period beginning after June 15, 2003. The effective date has been deferred indefinitely for certain types of mandatorily redeemable financial instruments. The provisions of this statement did not have a material impact on the company's consolidated financial statements.
NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS
The company's subsidiary, Baylake Bank, is required to maintain average reserve balances by the Federal Reserve Bank. The average amount of those reserve balances for the year ended December 31, 2003, was approximately $6,325,000.
NOTE 3 - INVESTMENT SECURITIES
The amortized cost and estimated market values of investments are as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - INVESTMENT SECURITIES (continued)
Results of sales of securities were as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3 - INVESTMENT SECURITIES (continued)
The amortized cost and estimated market value of investments at December 31, 2003, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Securities pledged to secure public and trust deposits and borrowed funds had a carrying value of $91,228,000 and $50,065,000 at December 31, 2003 and 2002, respectively.
NOTE 4 - LOANS
Major classifications of loans are as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - LOANS (continued)
Loans having a carrying value of $25,678,000 are pledged as collateral for borrowings from the Federal Home Loan Bank at December 31, 2003.
Certain directors and officers of the company and Baylake bank, including their immediate families, companies in which they are principal owners, and trusts in which they are involved, were loan customers of Baylake Bank during 2003 and 2002. Such loans were made in the ordinary course of business at normal credit terms, including interest rate and collateralization, and do not represent more than a normal risk of collection.
A summary of the changes in those loans is as follows:
Loans on which the accrual of interest has been discontinued or reduced amounted to $11,079,000 and $12,244,000 at December 31, 2003 and 2002, respectively. If these loans had been current throughout their terms, interest income for the nonaccrual period would have approximated $995,670 and $1,639,000 for 2003 and 2002, respectively. Interest income which has been recorded amounted to $352,000 and $357,000 for 2003 and 2002, respectively, for these nonaccrual loans.
Changes in the allowance for loan losses were as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4 - LOANS (continued)
The provision for credit losses charged to expense is based upon management's best estimate of probable loan losses incurred at the balance sheet date, including consideration of Baylake bank's credit loss experience and an evaluation of impaired loans under SFAS 114. A loan is considered to be impaired when, based upon current information and events, it is probable that the bank will be unable to collect all amounts due according to the contractual terms of the loan.
The following is a summary of activity in investment in loans that have declined in value and related interest income and allowance for credit losses accounts:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - BANK PREMISES AND EQUIPMENT
NOTE 6 - OTHER REAL ESTATE
Other real estate ($2,318,000 in 2003, $929,000 in 2002, and $1,716,000 in 2001, net of an allowance for other real estate losses of $47,000 in 2003, $33,000 in 2002, and $43,000 in 2001) is included in other assets.
Net cost of operation of other real estate is summarized below:
Changes in the allowance for losses on other real estate were as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7 - DEPOSITS
At December 31, 2003, the scheduled maturities of time deposits were as follows:
Deposits from the company's directors and officers held by Baylake Bank at December 31, 2003 and 2002, amounted to $3,280,000 and $3,130,000, respectively.
NOTE 8 - SHORT-TERM BORROWINGS
Short-term borrowings consisted of the following at December 31:
The average outstanding balance of total short-term borrowings amounted to $9,562,000 in 2003 and $21,039,000 in 2002. The weighted-average interest rate on these borrowings was 1.32% for 2003 and 1.97% for 2002. The average outstanding balance is determined on a daily average basis and the weighted-average interest rate is calculated by dividing the actual interest paid on all short-term borrowings by the average balance for the year.
The maximum amount outstanding at any month end was $32,641,000 during 2003 and $48,197,000 during 2002.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9 - LONG-TERM DEBT
Long-term debt consisted of a land contract requiring annual principal payments of $53,000 plus interest calculated at prime +1/4%. The balance at December 31, 2003 and 2002, was $53,000 and $106,000, respectively.
NOTE 10 - OTHER BORROWINGS
Other borrowings consists of Federal Home Loan Bank loans secured by real estate mortgages and mortgage backed agency securities. Interest rates range from 1.2% to 4.73%. The total outstanding at December 31, 2003 is $75,092,000, of which $50,000,000 matures in 2004, $92,000 matures in 2008, and the remaining $25,000,000 mature in 2011.
NOTE 11 - JUNIOR SUBORDINATED DEBENTURES ISSUED TO UNCONSOLIDATED SUBSIDIARY TRUST
In 2001, Baylake Corp. formed Baylake Capital Trust I (the trust) as a statutory business trust organized for the sole purpose of issuing trust preferred securities and investing the proceeds thereof in junior subordinated debentures of the company, the sole asset of the trust. The common securities of the trust are wholly-owned by the company. The trust preferred securities and common securities of the trust represent preferred undivided beneficial interests in the assets of Baylake Capital Trust I, and the holder of the preferred securities will be entitled to a preference over the common securities of the trust upon an event of default with respect to distributions and amounts payable on redemption or liquidation. These trust preferred securities are tax-advantaged issues that qualify for Tier 1 capital treatment to the company. Distributions on these securities are included in interest expense on guaranteed preferred beneficial interest. The preferred securities are traded on the American Stock Exchange under the symbol BYL_p.
The company had $16.6 million of junior subordinated debentures outstanding to the trust and the trust had $16.1 million of trust preferred securities outstanding at December 31, 2003 and 2002, as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11 - JUNIOR SUBORDINATED DEBENTURES ISSUED TO UNCONSOLIDATED SUBSIDIARY TRUST (continued)
The trust's ability to pay amounts due on the trust preferred securities is solely dependent upon the company making payment on the related junior subordinated debentures to the trust. The company's obligations under the junior subordinated debentures constitute a full and unconditional guarantee by the company of the trust's obligations under the trust securities issued by the trust.
As of December 31, 2003, the company deconsolidated the subsidiary trust, which had issued the trust preferred securities (discussed above), and replaced the presentation of such instruments with the company's junior subordinated debentures issued to the subsidiary trust. Such presentation reflects adoption of FASB Interpretation No. 46 (Fin 46 R) issued in December 2003.
NOTE 12 - DIVIDENDS AND CAPITAL RESTRICTIONS
Cash dividends per share to shareholders were $.53, $.49, and $.45 in 2003, 2002, and 2001, respectively.
As of December 31, 2003, undistributed earnings of Baylake Bank, included in consolidated retained earnings, available for distribution to the company as dividends without prior approval of regulatory authorities was $34,204,000.
Federal banking regulatory agencies have established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8%. Of the 8% required, at least half must be comprised of core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banking organizations must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to total assets, while lower rated banking organizations must maintain a ratio of at least 4% to 5%. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements.
At December 31, 2003 and 2002, the company was categorized as "well capitalized" under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the company's category.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12 - DIVIDENDS AND CAPITAL RESTRICTIONS (continued)
To be "well capitalized" under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.
The company's risk-based capital and leverage ratios are as follows (thousands of dollars):
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
Baylake Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees.
Baylake Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contract or notional amount of those instruments. The bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Baylake Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Baylake Bank upon extension of credit, is based on management's credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK (continued)
Standby letters of credit and financial guarantees written are conditional commitments issued by Baylake Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. The guarantees expire in decreasing amounts through 2008, with the majority expiring within five years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Baylake Bank does not require collateral as support for the commitments. Collateral is obtained based on loan policies upon use of a commitment by a customer.
NOTE 14 - PENSION PLAN
The subsidiaries have 401(k) Profit Sharing Plans covering all employees who qualify as to age and length of service. The employer contributions paid and expensed under all plans for 2003, 2002, and 2001, totaled $835,000, $810,000, and $713,000, respectively.
Certain officers and directors of the company and its subsidiaries are covered by nonqualified deferred compensation plans. Payments to be made under these plans are accrued over the anticipated years of service of the individuals covered. Amounts charged to expense were $231,000 in 2003, $227,000 in 2002, and $224,000 in 2001.
NOTE 15 - INCOME TAX EXPENSE
The taxes applicable to income before income taxes were as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15 - INCOME TAX EXPENSE (continued)
The provision for income taxes differs from the amount of income tax determined by applying the statutory federal income tax rate to pretax income as a result of the following differences:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance has been recognized to offset the related deferred tax assets due to the uncertainty of realizing tax benefits of a portion of loan loss and mortgage servicing differences.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15 - INCOME TAX EXPENSE (continued)
The following is a summary of the significant components of the company's deferred tax assets and liabilities as of December 31, 2003 and 2002:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16 - EARNINGS AND DIVIDENDS PER SHARE
Earnings and dividends per share are based on the weighted average number of shares outstanding for the year. A reconciliation of the basic and diluted earnings per share amounts is as follows:
There is no difference between basic and diluted income available to common stockholders.
See Note 18 for information on additional stock options issued subsequent to year end. These shares would not have changed materially the calculation of the number of common shares or potential common shares outstanding at the end of the period if the transaction had occurred before December 31, 2003.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - ADOPTION OF STATEMENT OF FINANCIAL ACCOUNTING STANDARDS (SFAS) NO. 142
Prior to the adoption of SFAS No. 142, goodwill had a stated cost of $7,192,000 and accumulated amortization of $2,222,000 as of December 31, 2001.
A summary of the effects of the adoption of SFAS No. 142 on net income is as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - STOCK OPTION PLAN
The company has a non-qualified stock option plan under which certain officers and key salaried employees may purchase shares of the company's stock at an established exercise price. Unless earlier terminated, these options will expire ten years from the date of grant. The options become exercisable 20% per year, commencing one year from date of grant.
Activity in the plan is summarized as follows:
Subsequent to year-end 2003, options to purchase up to an additional 25,000 shares were granted. The exercise price was established at 100% of the fair market value of the stock on the date of grant, or $14.15 per share.
The options outstanding at December 31, 2003, were:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - STOCK OPTION PLAN (continued)
Options exercisable at December 31, 2002 and 2001, were 556,195 and 476,500, respectively. The weighted average exercise price for options exercisable at December 31, 2002 and 2001, was $11.19 and $10.66, respectively.
Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation" establishes financial accounting and reporting standards for stock-based employee compensation plans.
SFAS 123 defines a fair value based method of accounting for employee stock option or similar equity instruments. Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award using an option-pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, expected dividends and the risk-free interest rate over the expected life of the option. The resulting compensation cost is recognized over the service period, which is usually the vesting period.
Compensation cost can also be measured and accounted for using the intrinsic value based method of accounting prescribed in Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees." Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount paid to acquire the stock.
The largest difference between SFAS 123 and APB 25 as it relates to the company is the amount of compensation cost attributable to the company's stock option plan. Under APB 25 no compensation cost is recognized for the stock option plan because the exercise price is equal to the quoted market price at the date of grant and therefore there is no intrinsic value. SFAS 123 compensation cost would equal the calculated fair value of the options granted.
As permitted by SFAS 123, the company continues to measure compensation cost for the stock option plan using the accounting method prescribed by APB 25.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18 - STOCK OPTION PLAN (continued)
Had compensation cost for the company's options granted after January 1, 1995, been determined according to SFAS 123, the company's net income and earnings per share would have been reduced to the following proforma amounts:
The fair value of each option grant was estimated as of the date of grant using the Black-Scholes option pricing model. The resulting compensation cost was amortized over the vesting period.
The grant date fair values and assumptions used to determine such values are as follows:
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 19 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Provided below is the information required by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107). These amounts represent estimates of fair values at a point in time. Significant estimates regarding economic conditions, loss experience, risk characteristics associated with particular financial instruments and other factors were used for the purposes of this disclosure. These estimates are subjective in nature and involve matters of judgment. Therefore, they cannot be determined with precision. Changes in the assumptions could have a material impact on the amounts estimated.
Many of the company's financial instruments lack an available trading market. Furthermore, most of the financial instruments are intended to be held to maturity. Therefore, it is not probable that the fair values shown will be realized in a current transaction.
The estimated fair values disclosed do not reflect the value of assets and liabilities that are not considered financial instruments. In addition, the significant value of long-term relationships with depositors and other customers are not reflected.
A. CASH AND DUE FROM BANKS
These instruments are, by definition, short-term and do not present any unanticipated credit issues. Therefore, the carrying amount is a reasonable estimate of fair value.
B. INVESTMENT SECURITIES
The estimated fair values of securities are provided in Note 3 to the financial statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
C. LOANS
The carrying amount (total outstandings excluding unearned income and reserve for loan losses) and estimated fair value of loans outstanding at December 31, 2003, are $695,990,000 and $695,435,000, and for December 31, 2002, are $664,286,000 and $667,832,000. In order to determine the fair values for loans, the loan portfolio was segmented based on loan type, credit quality and repricing characteristics. For certain variable rate loans with no significant credit concerns and frequent repricings, estimated fair values are based on the carrying values. The fair values of other loans are estimated using discounted cash flow analyses. The discount rates used in these analyses are generally based on origination rates for similar loans of comparable credit quality. However, where appropriate, adjustments have been made to more accurately reflect market rates. Maturity estimates are based on historical experience with prepayments and current economic and lending conditions.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 19 - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS (continued)
D. DEPOSITS
The carrying amount and estimated fair value of deposits outstanding at December 31, 2003, are $783,292,000 and $785,727,000 and for December 31, 2002, are $740,324,000 and $746,024,000. Under SFAS 107, the fair value of deposits with no stated maturity is equal to the amount payable on demand. Therefore, the fair value estimates for these products do not reflect the benefits that the company receives from the low-cost, long-term funding they provide. These benefits are significant. The estimated fair values of fixed rate time deposits are based on discounted cash flow analyses. The discount rates used in these analyses are based on market rates currently offered for deposits of similar remaining maturities. Because of the repricing characteristics and the competitive nature of the company's rates offered on variable rate time deposits, carrying amount is a reasonable estimate of the fair value.
E. SHORT-TERM BORROWINGS
Short-term borrowings reprice frequently and therefore the carrying amount is a reasonable estimate of fair value.
F. JUNIOR SUBORDINATED DEBENTURES ISSUED TO UNCONSOLIDATED SUBSIDIARY TRUST
The carrying amount and estimated fair value of the company's junior subordinated debentures and other borrowings outstanding at December 31, 2003, are $91,690,000 and $93,945,000 and for December 31, 2002, are $81,100,000 and $83,973,000. The estimated fair values of fixed rate time borrowings are based on discounted cash flow analyses. The discount rates used in these analyses are based on market rates currently offered for borrowings of similar remaining maturities.
G. COMMITMENTS TO EXTEND CREDIT, STANDBY LETTERS OF CREDIT, AND LETTERS OF CREDIT
Pricing of these financial instruments is based on the credit quality and relationship, fees, interest rates, probability of funding, and compensating balance and other covenants or requirements. Loan commitments generally have fixed expiration dates, are variable rate and contain termination and other clauses which provide for relief from funding in the event that there is a significant deterioration in the credit quality of the customer. Many loan commitments are expected to, and typically do, expire without being drawn upon. The carrying amounts are reasonable estimates of the fair value of these financial instruments. Carrying amounts are comprised of the unamortized fee income and, where necessary, reserves for any expected credit losses from these financial instruments.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20 - COMMITMENTS AND CONTINGENCIES
The company has a ten year lease to rent space in a building in Green Bay that began in 2000. The annual base rent is $79,000 and increases as of the beginning of each December based on the Consumer Price Index.
The company has a seven year lease to rent space for a branch bank location in Howard, Wisconsin that began in 2000. The annual base rent is $37,000 and increases by 15% after five years. The company must also pay its proportional share of costs for common areas at the mall.
Rent expense for 2003, 2002 and 2001 was $120,000, $117,000 and $110,000, respectively.
Future minimum lease payments under these agreements are as follows:
As part of the Evergreen Bank, N.A. ("Evergreen") acquisition, the company was required to contribute $7 million of capital to Evergreen. No payments to the seller of Evergreen have been made, but are contingently payable based on a formula set forth in the stock purchase agreement, not to exceed $2 million, however, management does not anticipate that the amount will exceed $1 million. The contingent payments are not accrued at December 31, 2003, since the amount, if any, is not estimable.
The acquisition was accounted for using the purchase method of accounting. Under the purchase method, net assets purchased are recorded at their fair market values on the date of acquisition. Any excess of the purchase price over the value of the net assets is recorded as goodwill. The goodwill recorded on the Evergreen acquisition is the result of assumption of liabilities having a market value in excess of market value of assets received. Any payments made in the future to the former shareholder of Evergreen may affect the goodwill recorded.
At December 31, 2003, the company had commitments totaling $2.4 million to purchase a property and construct a building on a second property.
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY
BAYLAKE CORP. (Parent Company Only) CONDENSED BALANCE SHEETS December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY (continued)
BAYLAKE CORP. (Parent Company Only) CONDENSED STATEMENTS OF INCOME For the Years Ended December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY (continued)
BAYLAKE CORP. (Parent Company Only) CONDENSED STATEMENT OF CASH FLOWS For the Years Ended December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21 - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY (continued)
BAYLAKE CORP. (Parent Company Only) CONDENSED STATEMENT OF CASH FLOWS For the Years Ended December 31
BAYLAKE CORP. AND SUBSIDIARIES Sturgeon Bay, Wisconsin
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 22 - BUSINESS SEGMENTS
The company has two business segments for which discrete financial information is available: banking and non-banking.
Banking provides commercial, mortgage, and consumer lending, deposit services, trust services, and other traditional bank services. These services are provided primarily through branch banks, and ATMs.
Non-banking includes insurance agency services, conference facilities, and an assisted living facility through three of the company's wholly-owned subsidiaries.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
In 2003, Baylake Corp. had no change in or disagreements with its accountants on accounting and financial disclosures required in the annual report.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of December 31, 2003. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.
INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) subsequent to the date of the evaluation performed by the Company's Chief Executive Officer and Chief Financial Officer.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information set forth under the sections titled "Proposal No. 1, Election of Directors," "Information on Executive Officers" and "Compliance with Section 16(a) of the Exchange Act" contained in the definitive proxy statement for the Company's 2004 Annual Meeting of Stockholders is incorporated herein by reference.
The Board of Directors has determined that, except as noted below, all of the members of the Board are "independent directors" within the meaning of NASDAQ Rule 4200, although the Company is not governed by those standards.
Mr. Herlache is not considered independent because he is an executive officer of the Company and the Bank. Mr. Braun is not considered independent because he is an executive officer of the Company.
AUDIT COMMITTEE MATTERS
The company has a standing Audit Committee. The Audit Committee currently has four members: Mr. Berg (Chairman), Mr. Parsons, Mr. Bunda; and Mr. Agnew. As of the date of this report, each of the members of the Audit Committee is an "independent director" under NASDAQ Rule 4200. The Audit Committee's functions and responsibilities are described in a written policy statement and charter that was adopted by the Company's Board of Directors. The Board of Directors has made no determination as to "audit committee financial expert" at this date, though the makeup of the Audit Committee meets the applicable standards set forth by the Securities and Exchange Commission rules through the work experience they have accumulated and the varied background that each possess.
THE NOMINATING AND CORPORATE GOVERNANCE COMMITTEE
The Nominating and Corporate Governance Committee met quarterly in fiscal 2003. The Nominating and Corporate Governance Committee evaluates and oversees corporate governance and related issues. The committee consists of members of the board of directors and certain officers of the Bank. All directors of the Nominating and Corporate Governance Committee are currently independent directors. Although the Company has not to date developed formal processes by which shareholders may communicate directly to directors, it believes that the informal process, in which any communication sent to the board in care of the Chief Executive Officer or corporate Secretary is forwarded to the board, has served the board's and its shareholders' needs.
CODE OF ETHICS
The Company has adopted a code of ethics that all applies to all employees, as well as each member of the Company's Board of Directors. The code of ethics is available at the Company's website at www.baylake.com.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information set forth under the sections titled "Director Fees and Benefits", "Executive Compensation", "Board of Directors Compensation Committee Report on Management Compensation", "Compensation Committee Interlocks and Insider Participation" and "Performance Graph" contained in the definitive proxy statement for the Company's 2004 Annual Meeting of Stockholders is incorporated herein by reference.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information set forth under the section titled "Ownership of Baylake Common" contained in the definitive proxy statement for the Company's 2004 Annual Meeting of Stockholders is incorporated herein by reference.
EQUITY COMPENSATION PLAN INFORMATION:
The following table sets forth information regarding options and shares reserved for future issuance under the equity compensation plans as of December 31, 2003.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information set forth in the section titled "Certain Transactions with Management" in the definitive proxy statement for the Company's 2004 Annual Meeting of Stockholders is incorporated herein by reference.
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The following table presents fees for professional audit services rendered by Smith & Gesteland, LLP for the audit of the Company's annual consolidated financial statements for the years ended December 31, 2003 and December 31, 2002 and fees billed for other services rendered by Smith & Gesteland, LLP during those periods
(1) Audit fees consist of fees billed for professional services rendered for the audit of the Company's consolidated annual financial statements and review of the interim consolidated financial statements included in quarterly reports, and services that are normally provided by Smith & Gesteland, LLP in connection with statutory and regulatory filings or engagements.
(2) Audit-related fees consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of the Company's consolidated financial statements and are not reported under "Audit Fees." This category includes fees related to employee benefit plan and pooled fund audits.
(3) Tax fees consist of fees for professional services rendered for federal and state tax compliance, tax advice and tax planning.
(4) All other fees consist of fees for services other than the services reported above. In fiscal 2003, this category included fees related to advisory services, related to accounting for derivatives, cash surrender value of insurance, branch purchase issues, and trust preferred securities.
POLICY ON AUDIT COMMITTEE PRE-APPROVAL OF AUDIT AND NON-AUDIT SERVICES OF INDEPENDENT AUDITOR
Consistent with Securities and Exchange Commission requirements regarding auditor independence, on November 18, 2003, the Audit Committee adopted a policy to pre-approve all audit and permissible non-audit services provided by the independent auditor. All engagements of the independent auditor to perform any auditor services and permissible non-audit services since November 18, 2003 have been pre-approved by the Audit Committee in accordance with the adopted policy. Pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service or category of services and is generally subject to a specific budget. The Audit Committee has not delegated a pre-approval dollar limitation with respect to audit and non-audit services at this time.
PART IV
Item 15.
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. and 2.
The consolidated financial statements and supplementary data contained in Item 8 of this report are filed as part of this report. All schedules are omitted because of the absence of the conditions under which they are required or because the required information is included in the consolidated financial statements or related notes.
(a) 3.
See Item 15(c) below.
(b) Reports on Form 8-K
Reports on Form 8-K during the quarter ended December 31, 2003. Fourth quarter earnings release-Regulation FD Disclosures.
(c) Exhibits Required by Item 601 of Regulation S-K
Reference is made to the Exhibit Index on page 93 for exhibits filed as part of this report.
(d) Additional Financial Statements
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
BAYLAKE CORP.
By: /s/ Steven D. Jennerjohn ------------------------ Steven D. Jennerjohn Treasurer
Date: March 11, 2004
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each individual whose signature appears below hereby designates and appoints Thomas L. Herlache and Steven D. Jennerjohn, and each of them, any one of whom may act without the joinder of the other, as such person's true and lawful attorney-in-fact and agents (the "Attorneys-in-Fact") with full power of substitution and resubstitution, for such person and in such person's name, place and stead, in any and all capacities, to sign any and all amendments to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, the Securities and Exchange Commission and any state securities commission, granting unto said Attorneys-in-Fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and conforming all that said Attorneys-in-Fact and agents or any of them, or their or his substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons in the capacities and on these dates indicated.
*Each of the above signatures is affixed as of March 11, 2004.
*Designates compensation plans or agreements
(1) Incorporated by reference to Exhibit 2.1 from the Company's Current Report on Form 8-K filed October 15, 1998.
(2) Incorporated by reference to Exhibit 3.1 from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
(3) Incorporated by reference to Exhibit 3.2 from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
(4) Incorporated by reference to Exhibit 3.3 from the Company's Proxy Statement for the 2001 Annual Meeting of Shareholders.
(5) Incorporated by reference to Exhibit 4.1 from the Company's Form S-3 filed February 12, 2001 for Trust Preferred Securities issued under Baylake Capital Trust I on February 16, 2001.
(6) Incorporated by reference to Exhibit A from the Company's Proxy Statement for the 1993 Annual Meeting of Shareholders.
(7) Incorporated by reference to Description thereof under "Board Directors/Compensation Committee Report on Management's Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders.
(8) Incorporated by reference to Exhibit 10.3 from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
(9) Incorporated by reference to Exhibit 10.4 from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
(10) Incorporated by reference to Exhibit 10.5 from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
(11) Incorporated by reference to Exhibit 4 from the Company's Form S-8 filed on February 10, 1998.
(12) Incorporated by reference to Exhibit 99.1 from the Company's Form S-8 filed on September 21, 1998.