Item 1. - Business
General
University Bancorp, Inc. The Company is a Delaware corporation which operates as a bank holding company for its wholly-owned subsidiary, University Bank. The Company changed its name to `University Bancorp, Inc.' from `Newberry Bancorp, Inc.' in 1996, in order to better identify itself with the Bank.
University Bank. The Bank is a state chartered community bank. The Bank began business in 1890 and was chartered by the state of Michigan in 1908. In 1994, we sold the bank's offices in Newberry, Michigan and Sault Ste. Marie, Michigan. In 1995 we relocated the Bank's main office to Ann Arbor, Michigan and, changed the Bank's name from `The Newberry State Bank' to `University Bank'to more closely identify with its current place of business. Ann Arbor is a university town, home to the University of Michigan and is the largest city in Washtenaw County, just west of the Detroit Metropolitan Statistical Area. The Bank's primary market area is defined as the City of Ann Arbor and surrounding areas in greater Washtenaw County.
Midwest Loan Services. In 1995, University Bank acquired 80% of the common stock of Midwest Loan Services ("Midwest"). Midwest specializes in the origination, servicing and subservicing of mortgage loans for various credit unions, financial institutions and mortgage brokers. Most of their servicing and subservicing portfolio is comprised of residential mortgage loans sold to Fannie Mae, Freddie Mac and other private residential mortgage conduits, the most important of which is a jumbo and subprime loan conduit established by Lehman Brothers.
University Insurance & Investment Services. In 1996, University Bank established an insurance and investment products sales agency. This subsidiary of the Bank, called "University Insurance & Investment Services, Inc." (the Agency) is based in the Bank's Ann Arbor office. The Agency is licensed by the State of Michigan to sell insurance as agent for licensed insurance companies. A d/b/a of the Agency, University Insurance Center, commenced business in 1999, adding a full service property and casualty insurance agency offering insurance for homes, autos, apartments and businesses in addition to the original products which included life and health care insurance, annuities and mutual fund sales. Employees of the Agency are also licensed to sell investment products such as annuities and mutual funds, and the President of the Bank, who is also Chairman of the Agency, also offers broker-dealer investment services including money management through a clearing arrangement with Equitas America LLC and Pershing, a division of the Bank of New York.
Employees
The Company employed 63 full-time equivalents as of March 3, 2005:
University Bank, Ann Arbor 24 Midwest Loan Services 35 University Insurance & Investment 4
Lines of Business
Deposit Products & Services
University Bank offers traditional retail savings products and services to its customers. These include demand deposit and NOW interest-bearing checking accounts, money market deposit accounts, regular savings accounts and term deposit certificates ranging in maturity from three to three hundred months. The Bank also offers Sharia'a compliant profit-sharing deposits for Muslim depositors. The Bank also offers free access to 24-Hour ATM machines, telephone banking, internet banking, debit cards, online bill payment, Western Union(TM) money transfer services and Gold VISA accounts. From time to time to raise liquidity, the Bank relies on brokers to sell CDs. At December 31, 2004, the Bank had approximately $3.7 million in CDs issued through brokers.
Lending Products
University Bank offers a range of traditional lending products, including commercial small business loans, residential real estate mortgage loans, home equity loans, commercial real estate mortgage loans, consumer installment loans, and land development and construction loans. The Bank also offers Sharia'a compliant mortgage alternative loan transactions (MALTs) for Muslim customers.
Classifications of the loan portfolio as of December 31, 2004 are as follows:
Amount Outstanding(1) % of Total Commercial, Real Estate & Other $15,079,343 35.07% Residential Construction 1,238,530 2.88% Residential Real estate 20,761,659 48.28% Residential Home equity 5,542,571 12.89% Consumer 173,363 0.40% Credit Card 204,334 0.48% ------------ --------- Gross Loans $42,999,800 100.00% ============ =========
(1) - Excludes loans held for sale.
The Bank's loan portfolio is geographically concentrated in Ann Arbor and Washtenaw County, Michigan. The ability of individual loan customers to honor their debts is partially dependent on the local economy. The Ann Arbor area is primarily dependent on the education, healthcare, services and manufacturing (automotive and other) industries.
Most of the Bank's commercial loans are secured by commercial real estate. Commercial real estate loans have a loan to value ratio typically less than 80% at the time the loan is originated. In no cases is the loan to value ratio for commercial real estate loans greater than 85%. The primary risk of commercial loans is that the area's economy declines and rents decrease while vacancy increases, thereby decreasing the value of the building. If the guarantor suffers a financial reverse, the Bank is then exposed to a loss.
Residential loans typically have a loan to value ratio less than 80% at the time the loan is originated, unless the borrower's financial position is very strong, in which case a loan to value ratio of up to 90% or private mortgage insurance is considered. To meet the Bank's goals for first time homebuyers, the Bank has originated 97% to 100% loan to value residential loans and currently has about $2 million of these loans in its loan
portfolio. Home equity secured residential loans have loan to value ratios of less than 90% at time of origination in the case of fixed rate fully-amortizing loans and 80% for home equity lines of credit, with a few exceptions with higher ratios for borrowers with strong credit. As of December 31, 2004, the Bank had also originated $8.46 million of mortgage alternative loan transactions which are Sharia'a-compliant mortgage alternatives for Muslim customers. The primary risk of residential lending is that home prices drop (typically this occurs during recessions) and borrowers walk away from their home or file for bankruptcy. All of the Bank's construction loans are secured by residential properties with a loan to value ratio of 80% or less. The Bank controls the risk of construction lending by performing inspections prior to disbursing interim construction funds to avoid cost overruns.
The Bank makes few unsecured loans, typically for borrowers who have a high net worth, but even in these cases; the Bank usually takes collateral out of an abundance of caution. Most of the Bank's credit card loans are secured by residential properties. Consumer loans are generally secured by vehicles (primarily cars or trucks). The primary risk of these loans is that the value of the car depreciates faster than the loan balance amortizes, and the borrower loses their job or has a severe medical problem in their family. In these circumstances, the collateral could be insufficient to repay the loan if the borrower files for bankruptcy. In addition, if the economy is soft, used vehicle prices tend to deteriorate creating additional risk of insufficient collateral in the event of a default.
The Bank makes very few business loans that are not secured by real estate. Business Lines of Credit are typically made up to a 50% ratio of inventory and other equipment at current market value, and 70% of current receivables. Business Manager Loans are also structured as Lines of Credit and are secured by individual receivables up to 90% of face value individually purchased with recourse to the borrower and additional insurance to protect the bank against fraud and bankruptcy of the issuer of the account that is receivable to the borrower. The primary risk of this type of lending backed by non-real estate business assets is that if the business suffers a financial reverse, an unscrupulous borrower can easily dissipate the collateral, causing the Bank a loss. For this reason, the Bank de-emphasizes this type of lending.
Typically with respect to all personal and residential loans, a ratio of total debt payments to total income of all borrowers and guarantors less than 42% is required. With respect to commercial real estate and business loans, a ratio of income to all debt payments of greater than 1.25x is required. Therefore, the Bank typically has both income and asset backing to secure its loans. However, there can always be valid reasons to have exceptions to each rule. The Bank's loan committee retains the power to take unusual circumstances into account when evaluating each loan request versus the Bank's policies. Loans that are lacking current demonstrated income are classified and increased reserves are established for those loans. Loans that are lacking both current demonstrated income and asset backing are allocated even higher reserves equal to the amount estimated to be realized upon the sale of the collateral less all estimated costs.
Mortgage Banking
The Bank and Midwest originate internally or via other financial institutions residential home loans that generally qualify for sale to secondary market investors under the underwriting criteria of the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association and the Government National Mortgage Association. Loans purchased or originated
internally are either sold directly to FHLMC, FNMA or GNMA, or are pooled into mortgage-backed securities and the securities are sold to investors in the secondary market. With the exception of Midwest, the Bank is currently selling the servicing rights on all mortgages originated that are sold to the secondary market. Some residential mortgages are held in the Bank's loan portfolio as an investment.
University Bank became a seller/servicer and began originating Federal Home Loan Mortgage Corporation (FHLMC) insured mortgages in 1991 and became a seller/servicer and began originating Federal National Mortgage Association (FNMA) insured mortgages 1994. The Bank has also been approved as a seller/servicer of Government National Mortgage Association (GNMA) mortgages for many years but only began using its license in 1999 to originate and sell these loans without retaining the servicing rights. Midwest is also licensed with FNMA and FHLMC.
Mortgage Servicing and Subservicing
Mortgage servicing firms receive monthly payments from loan customers, aggregate and account for these payments, and send the funds to mortgage-backed securities holders, including pension funds and financial institutions. For some mortgage customers, escrow funds are also accumulated, and funds sent to taxing authorities and insurance companies as needed. Mortgage servicers also dun delinquent accounts and foreclose loans, if required. Mortgage servicers receive a fixed monthly fee for performing this service. When these services are performed for the Bank, it is called `servicing'. When these services are performed for other institutions, it is called `subservicing'. The Bank's 80%-owned subsidiary, Midwest, specializes in subservicing residential mortgage loans sold to FNMA and FHLMC and other non-agency private conduits for the account of credit unions, other financial institutions and mortgage brokers.
Investment Securities
The Bank maintains surplus available funds in investments consisting of short-term money market instruments, U.S. government bonds, U.S. federal agency obligations and mortgage-backed securities backed by federal agency obligations. The Bank's President, who is a licensed Registered Representative, manages these investments. All purchase/sale decisions are subject to the review and prior approval of the Asset Liability Committee of the Bank and the Board of Directors. The securities portfolio provides a source of liquidity to meet Bank's operating needs. At December 31, 2004, the portfolio had a net unrealized loss of $51,356 versus a net unrealized loss of $38,795 at December 31, 2003, and $81,997 at December 31, 2002.
Information regarding securities where cost exceeded more than 10% of the Company's stockholders' equity at December 31, 2004 is as follows:
(1) The rate varies quarterly. The Bank is required to maintain the investment in Federal Home Loan Bank of Indianapolis common stock in an amount related to the Bank's single family mortgage related assets and FHLBI advances. Shares can be redeemed or sold at par value to the FHLBI upon five year prior notice.
(2) This Principal Only strip has an expected average life of about five years. The bond is rated AAA.
Competition
Community Banking, Ann Arbor
The attraction and retention of deposits depend on the Bank's ability to provide investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk and other factors. The Bank competes for these deposits by offering personal service and attention, fair and competitive rates, low fees, and a variety of savings programs including tax-deferred retirement programs.
The Bank competes for loan originations primarily through the quality of services provided to the loan customers, competitive interest rates and reasonable loan fees, rapid and local decision-making and the range of services offered. Competition in originating loans comes principally from other commercial banks, credit unions, insurance companies, mortgage banking companies and savings and loans.
The following table shows market share of deposits for Washtenaw County by financial institution for June 2004, June 2003 and June 2002, respectively from the FDIC and National Credit Union Association's annual branch deposit survey.
2004 2003 2002 National City 13.28% 12.81% 12.51% TCF National 12.19% 14.03% 15.63% Comerica 11.47% 11.03% 11.08% Bank One 9.80% 8.79% 8.89% Bank of Ann Arbor 7.21% 6.06% 4.59% Keybank 6.16% 6.19% 6.41% University of Michigan CU 5.92% 5.51% 5.21% Standard Federal 5.85% 4.19% 4.95% Ann Arbor Commerce 5.62% 5.61% 5.22% Flagstar 5.51% 4.86% 4.91% Huron River Area CU 3.57% 3.54% 3.36% Chelsea State 3.27% 3.09% 3.09% United Bank & Trust 2.84% 2.53% 2.56% Midwest Financial CU 2.70% 2.41% 2.24% Citizens 2.52% 2.54% 2.61% Republic 2.11% 2.00% 2.03% Bank of Washtenaw 1.26% 1.13% 1.05% Automotive FCU 1.22% 1.28% 1.31% Charter One 0.84% 0.87% 0.71% University Bank 0.83% 0.76% 0.89% Ypsilanti Area FCU 0.41% 0.42% 0.39% Eastern Michigan University CU 0.27% 0.27% 0.24% Guaranty Bank 0.17% 0.01% 0.06% Milan FCU 0.04% 0.03% 0.03% Ann Arbor Postal FCU 0.02% 0.03% 0.03% Total deposits (in billions) $5.14 $4.89 $4.53 Annual Increase 5.12% 7.95% 4.23%
Total deposits in the county increased 5.07% to $5.14 billion from June 2003 to June 2004. Total deposits in the county increased 8.01% to $4.89 billion from June 2002 to June 2003. In attracting deposits, the Bank's primary competitors for deposits are mutual funds, other commercial banks, credit unions, savings and loans and insurance companies.
The Bank's main office is adjacent to the University of Michigan Hospital complex. The complex employs a total of 7,800 persons. While the Bank competes with all of these financial institutions for loans and deposits and in particular the eight financial institutions that have branch offices in the northeast Ann Arbor market area, the major competitor in the immediate local deposit market is Midwest Financial Credit Union, formerly known as Hospital & Health Services Credit Union. The Bank's main office was formerly the headquarters of this credit union, which moved its office to a new office building three miles from the Medical Center Complex.
Banks owned by out-of-state holding companies dominate the Ann Arbor banking market. The University of Michigan Credit Union is the largest locally-owned financial institution. The only locally-owned community financial institutions, excluding University Bank, are University of Michigan Credit Union, Bank of Ann Arbor, Huron River Area Credit Union, Midwest Financial Credit Union, Automotive Federal Credit Union and several smaller credit unions.
Mortgage Banking
The Bank and Midwest's retail mortgage origination operations encounter competition for the origination of residential real estate loans primarily from savings institutions, commercial banks, insurance companies and other mortgage banking firms. Many of these firms have a well-established customer and/or borrower client base. Some competitors, primarily savings institutions, insurance companies and commercial banks, have the ability to create unique loan products from time to time because they are able to hold the loans in their own portfolio rather than sell into the secondary market. The Bank's ability to hold mortgage loans in its portfolio helps it to compete more effectively. Most loans sold into the secondary market, however, go to the same sources, those being FHLMC, FNMA, and GNMA. Most lenders have access to these secondary market sources; therefore, competition often becomes more a matter of service and pricing than that of product. As a mortgage loan originator and a purchaser of mortgage loans through correspondents, Midwest and the Bank must be able to compete with respect to the types of loan products offered by competitors to borrowers and correspondents, including the price of the loan in terms of origination fees or fee premium or discount, loan processing costs, interest rates, and the service provided by our staff. An important element to competing is master purchase agreements negotiated periodically with FNMA and FHLMC with low and competitive loan guarantee fees, a wide variety of mortgage programs, and a variety of flexible underwriting criteria. Our ability to secure these master purchase agreements is dependent upon the performance from a quality perspective of loans previously sold to the agencies.
During lower interest rate environments, competition for loans is less intense due to the large number of loans available for origination. As interest rates rise and the number of loans available for origination diminishes, competition becomes quite intense and companies with larger investor bases, flexibility with respect to type of product offered and
greater experience in dealing in these types of markets tend to be the most successful.
The Bank also originates residential loans to be held in portfolio, and management believes that this product together with the product offerings from FHLMC, FNMA and GNMA are sufficient for the Bank to meet its customers' needs. The Bank also is licensed as a HUD Title 1 and Multi-family seller/servicer, but has no plans at this time to expand utilization of HUD or GNMA programs.
Mortgage Servicing and Subservicing. Servicing competition is somewhat less intense than the loan origination aspect of mortgage banking. Due to net worth and management requirements, many mortgage origination companies do not have the capacity to service loans. Falling interest rates present competitive challenges for the mortgage servicing operation in that mortgagors are more likely to refinance existing mortgages. The quality of service and the ability of the origination operation to compete on price and service are important in retaining these customers by refinancing them internally, rather than losing the refinancing transaction to a competitor. Increased refinancing activity as a result of falling interest rates decreases profitability of mortgage servicing by increasing amortization charges on purchased mortgage servicing rights.
In the subservicing business, Midwest competes primarily with about 30 firms nationwide, including specialized subservicing units of mortgage banking companies, and specialized firms owned by banks and savings and loans. Most of these companies have substantially larger financial resources than Midwest, and some of them are also located in rural areas with low prevailing wages.
Midwest is located in Houghton, Michigan in the western upper peninsula of Michigan. Personnel and occupancy costs are the largest costs in a mortgage servicing operation. However, the prevailing wages and occupancy costs in the upper peninsula of Michigan are generally lower than the national average. Midwest has developed a unique business extranet website for its business partners and their retail customers. Through its website at www.subservice.com, Midwest provides the opportunity for all customers to access their mortgage information 24 hours a day 7 days a week in an environment which provides seamless access to all information. Business partners have access to all mortgage data as easily as if it were serviced on their in-house computer system. Customers can access all information about their accounts and perform any type of transaction through the internet. As a result of low personnel costs, its internet technology and the relationships it has developed in the credit union industry over time, the Company believes that Midwest' mortgage servicing operation has a competitive advantage.
Regulation
Primary Regulators of University Bancorp. The Company is a bank holding company registered under the Federal Bank Holding Company Act of 1956. The Federal Reserve Bank of Chicago is the Company's primary regulator and the Company is subject to regulation, supervision and examination by the Federal Reserve. The Company is required to file semi-annual reports with the Federal Reserve and other information as required under the rules of the Board of Governors of the Federal Reserve System. Additionally, the Federal Reserve Board possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and
regulations. Among these powers is the ability to bar the payment of dividends by banks and bank holding companies.
Acquisitions. The Company is generally prohibited from engaging in non-banking activities since it is a bank holding company. The Company cannot acquire more than 5% of the shares of another company engaged in non-banking activities. The Company can only acquire direct or indirect control of more than 5% of the voting shares of a company engaged in a banking related activity with the prior approval by the Federal Reserve Board to acquire these shares or by regulatory exemption. The Federal Reserve Board has identified specific banking related activities in which a bank holding company may engage with notice to the Federal Reserve. The Federal Reserve considers managerial, capital and other financial factors, including the impact on local competition of any proposal and past performance under the Community Reinvestment Act in acting on acquisition or merger applications. Bank holding companies may acquire other banks located in any state in the United States without regard to geographic restrictions or reciprocity requirements imposed by state law, but subject to certain conditions, including limitations on the aggregate amount of deposits that may be held by the acquiring company and all of its insured depository institution affiliates.
Commitments. In connection with obtaining the consent of the Federal Reserve to a 1989 merger transaction when the Company obtained public listing on the NASDAQ Small-Cap Market, certain commitments were made to the Federal Reserve. Management agreed that the Employee Stock Ownership Plan would not purchase more than 10% of the common stock or 5% of any other class of our voting shares, without the prior approval of the Federal Reserve. Management also agreed not to incur additional debt or to have the Bank pay dividends to us without the prior approval of the Federal Reserve.
Capital Requirements. The Federal Reserve Board imposes certain capital requirements on the Company under the Federal Bank Holding Company Act, including a minimum leverage ratio and a minimum ratio of "qualifying" capital to risk-weighted assets. These requirements are described below under "Capital Regulations". The Federal Reserve 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 additional banks or non-bank businesses. The "prompt corrective action" provisions of federal law and regulation authorizes the Federal Reserve to restrict the payment of dividends to us from an insured bank which fails to meet specified capital levels.
Source of Strength. In accordance with Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances in which the Company may not otherwise wish to do so. Under the Federal Bank Holding Company Act, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a bank subsidiary if the agency determines that divestiture may aid the depository institution's financial condition. In addition, if the Commissioner deems our Bank's capital to be impaired, the Commissioner may require the Bank to restore its capital by a special assessment upon us as University Bank's sole stockholder. If the Company were to fail to pay an assessment, the directors of the Bank would be required, under Michigan law, to sell the shares of the Bank's stock owned by the Company to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the Bank's capital.
Financial Holding Companies. Beginning March 11, 2000, bank holding companies may apply to become Financial Holding Companies. We have not applied to become a Financial Holding Company. Financial Holding Companies may engage in a wider range of non-banking activities than Bank Holding Companies, including greater authority to engage in securities and insurance activities. The expanded powers are available to a bank holding company only if the bank holding company and its bank subsidiaries remain well-capitalized and well-managed. The new law also imposes various restrictions on transactions between the depository institution subsidiaries of bank holding companies and their non-bank affiliates. These restrictions are intended to protect the depository institutions from the risks of the new non-banking activities permitted to affiliates.
Public Company Regulation. Our common stock is registered with the Securities and Exchange Commission ("SEC") under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the "Exchange Act"). We are therefore subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act. The Sarbanes-Oxley Act of 2002 provides for numerous changes to the reporting, accounting, corporate governance and business practices of companies as well as financial and other professionals who have involvement with the U.S. public markets.
The Sarbanes-Oxley Act was enacted in 2002. This Act is not a banking law, but applies to all public companies, including the Corporation. Sarbanes-Oxley is designed to restore investor confidence. Sarbanes-Oxley adopts new standards of corporate governance and imposes new requirements on the board and management of public companies. The chief executive officer and chief financial officer of a public company must now certify the financial statements of the company. New definitions of "independent directors" have been adopted, and new responsibilities and duties have been established for the audit and other committees of the board. In addition, the reporting requirements for insider stock transactions have been revised, requiring most transactions to be reported within two business days.
Section 404 of the Sarbanes-Oxley Act. requires a company to include in its annual reports a report by management on the company's internal control over financial reporting and an accompanying auditor's report. The Commission extended the original Section 404 compliance dates for all issuers in February 2004. Under the latest extension, the Company must re-measure its market capitalization as of June 30, 2005 to determine if it will be classified as an accelerated filer. The Company does not expect to be an accelerated filer and, therefore, must begin to comply with the internal control over financial reporting requirements for its first fiscal year ending on or after July 15, 2006. This is a one-year extension from the previously established July 15, 2005, compliance date for non-accelerated filers and foreign private issuers. While complying with Sarbanes-Oxley will result in increased costs to the Corporation, the additional costs are not expected to have a material effect on the Corporation
Primary Regulators of University Bank. The Bank is a Michigan banking corporation and its deposit accounts are insured by the Bank Insurance Fund (BIF) of the Federal Deposit Insurance Corporation (FDIC). As a Michigan-chartered commercial bank, University Bank is subject to the examination, supervision, reporting and enforcement powers of the Commissioner, as the chartering authority for Michigan banks, and the FDIC, as administrator of the BIF. These agencies and the federal and state laws applicable to the Bank and its operations, extensively regulate various aspects of the banking business including, among other things, reserves against loans, capital
levels relative to operations, lending activities and practices, collateral for loans, establishment of branches, mergers, acquisitions and consolidations, payment of dividends, internal controls, permissible types and amounts of loans, investments and other activities, interest rates on loans and on deposits, and the safety and soundness and scope of banking practices. As an insured bank, University Bank is also required to file quarterly reports and other information as required with the FDIC.
All subsidiaries of University Bank including Midwest and University Insurance & Investment Services are all also subject to all regulations applicable to University Bank itself, including regular on-site examination by both the OFIS and the FDIC.
Other Regulators. As a FHLMC, FNMA, and HUD Title 1 and Title 2 and HUD multifamily seller/servicer, University Bank's mortgage banking operation is subject to regulation and regular on-site examination by FHLMC, FNMA and HUD.
Other Regulations. University Bank and its subsidiaries are also subject to various regulations including: o the Community Reinvestment Act, o the Federal Truth-in-Lending Act, o the Home Mortgage Disclosure Act, o the Gramm-Leach Bliley Privacy Act o the Patriot Act o the Check 21 Act o the Equal Credit Opportunity Act, o the Fair Credit Reporting Act, o the Fair Debt Collection Act, o the Right to Privacy Act, o the Real Estate Settlement Procedures Act, o the Bank Secrecy Act, o the Electronic Funds Transfer Act, o Federal Reserve regulations, o State usury laws, and o Federal laws concerning interest rates.
Also, University Bank may not engage in any activity not authorized by the Michigan Banking Code unless it is authorized by the Commissioner of the OFIS as being closely related to banking.
These laws and regulations are primarily intended to protect depositors and the deposit insurance fund of the FDIC, not the Bank or the Company's stockholders. The following is a summary of certain statutes and regulations affecting University Bank. The following information is qualified in its entirety by reference to the particular statutory and regulatory provisions.
Various changes to the Federal Deposit Insurance Act (FDIA) are currently proposed in Congress. Any change in applicable laws, regulations or regulatory policies of various governmental regulatory authorities may have a material effect on the Company's business, operations and prospects. Those authorities include, but are not limited to, the Board of Governors of the Federal Reserve System, the FDIC, the Commissioner of the Michigan Office of Financial and Insurance Services, the Internal Revenue Service, and state taxing authorities. The Company is unable to predict the nature or extent of
the effects that fiscal or monetary policies, economic controls or new federal or state legislation may have on future business and earnings.
Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums, based upon their respective levels of capital and results of supervisory evaluation. Banks classified as well-capitalized, as defined by the FDIC, and considered healthy pay the lowest premium while institutions that are less than adequately capitalized, as defined by the FDIC, and considered to be of substantial supervisory concern pay the highest premium. A risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.
The Federal Deposit Insurance Act (FDIA) requires the FDIC to establish assessment rates at levels that will maintain the Deposit Insurance Fund at a mandated reserve ratio of not less than 1.25% of estimated insured deposits.
The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution or its directors have engaged or are engaging in unsafe or unsound practices, or have violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC, or if the institution is in an unsafe or unsound condition to continue operations. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital.
Commissioner Assessments. Michigan banks are required to pay supervisory fees to the Commissioner to fund the operations of the Commissioner. The amount of supervisory fees paid by a bank is based upon the bank's total assets, as reported to the Commissioner.
FICO Assessments. Pursuant to federal legislation enacted in 1996, University Bank, as a member of the BIF, is subject to assessments to cover the payments on outstanding obligations of the Financing Corporation (FICO). FICO was created in 1987 to finance the re-capitalization of the Federal Savings and Loan Insurance Corporation, the predecessor to the FDIC's Savings Association Insurance Fund (SAIF), which insures the deposits of thrift institutions. Between January 1, 2000 and the maturity of the outstanding FICO obligations in 2019, BIF members and SAIF members will share the cost of the interest on the FICO bonds on a pro rata basis. It is estimated that FICO assessments during this period will be less than 0.025% of deposits. In addition, the Federal Home Loan Banks, including the Federal Home Loan Bank of Indianapolis, in which University Bank is an investor, pay 20% of their annual net income to a sinking fund to retire the FICO bonds until they are paid in full.
Capital Regulations. The FDIC has established the following minimum capital standards for state-chartered, FDIC-insured non-member banks, like University Bank:
o a leverage requirement consisting of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly-rated banks with minimum requirements of 4% to 5% for all others; o and a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital.
Tier 1 capital consists principally of stockholders' equity. These capital requirements are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, FDIC regulations provide that higher capital may be required to take adequate account of, among other things, interest rate risk and the risks posed by concentrations of credit, nontraditional activities or securities trading activities.
Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. Depending upon the capital category to which an institution is assigned, the regulators' corrective powers include: requiring the submission of a capital restoration plan; placing limits on asset growth and restrictions on activities; requiring the institution to issue additional capital stock, including additional voting stock, or to be acquired; restricting transactions with affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and ultimately, appointing a receiver for the institution.
In general, a depository institution may be reclassified to a lower category than is indicated by its capital levels if the appropriate federal depository institution regulatory agency determines the institution to be otherwise in an unsafe or unsound condition or to be engaged in an unsafe or unsound practice. This could include a failure by the institution, following receipt of a less-than-satisfactory rating on its most recent examination report, to correct the deficiency.
The extent of the regulators' powers depends on whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." An institution is critically undercapitalized if it has a tangible equity to total assets ratio that is equal to or less than 2%. An institution is well capitalized if it has a total risk-based capital ratio of 10% or greater, core risk-based capital of 6% or greater, and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. An institution is adequately capitalized if it has a total risk-based capital ratio of not less than 8%, a core risk-based capital of not less than 4%, and a leverage ratio of not less than 4%.
These capital guidelines can affect the Bank in several ways. Capital levels are currently adequate, however, rapid growth, poor loan portfolio performance, or poor earnings performance, or a combination of these factors, could change our capital position in a relatively short period of time, making an additional capital infusion necessary. In general, if the FDIC's assessment of a Bank's financial and managerial strength changes negatively, the Bank's cost of FDIC insurance will rise in subsequent semi-annual periods. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate.
Dividends. Under Michigan law, the Bank is restricted as to the maximum amount of dividends it may pay on its common stock. The Bank may not pay dividends except out of net profits after deducting its losses and bad debts. The Bank may not declare or pay a dividend unless the Bank will have
a surplus amounting to at least 20% of its capital after the payment of the dividend. If the Bank has a surplus less than the amount of its capital, it may not declare or pay any dividend until an amount equal to at least 10% of net profits for the preceding one-half year (in the case of quarterly or semi-annual dividends) or full-year (in the case of annual dividends) has been transferred to surplus. The Bank may not declare or pay any dividend until the cumulative dividends on any issued preferred stock have been paid in full.
Federal law generally prohibits the Bank from making any capital distribution, including payment of a dividend, or paying any management fee to us if the Bank would thereafter be undercapitalized. The FDIC may prevent the Bank from paying dividends if the Bank is in default of payment of any assessment due to the FDIC. In addition, the FDIC may prohibit the payment of dividends by the Bank, if a payment is determined, by reason of the financial condition of the Bank, to be an unsafe and unsound banking practice. The Company has an agreement with the Federal Reserve Bank of Chicago that requires us to seek permission before paying any cash dividends. The Bank can pay dividends to the Company with the permission of the Commissioner of OFIS provided that the Bank has audited net income for the prior year and provided that the Bank's cumulative earnings deficit is erased through retained earnings. The deficit currently is $1,978,688.
Insider Transactions. The Bank is subject to certain restrictions imposed by the Federal Reserve Act including any extensions of credit to us, investments in our stock or other securities, and the acceptance of our stock as collateral for loans. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to our directors and officers, to our principal stockholders, and to "related interests" of the directors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon which any person becoming one of our directors or officers or one of our principal stockholders may obtain credit from banks with which the Bank maintains a correspondent relationship.
Safety and Soundness Standards. Federal banking agencies have adopted guidelines to promote the safety and soundness of federally insured depository institutions. These guidelines establish standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.
In general, the guidelines prescribe the goals to be achieved in each area, and each institution is 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 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 the 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.
State Bank Activities. Under federal law and FDIC regulations, FDIC-insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law, as implemented by FDIC regulations, also prohibits FDIC-insured state banks and their subsidiaries,
subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member. Impermissible investments and activities must be divested or discontinued within certain time frames set by the FDIC in accordance with federal law.
Consumer Protection Laws. 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 various federal statutes, including:
o the Equal Credit Opportunity Act, o the Fair Credit Reporting Act, o the Truth in Lending Act, o the Real Estate Settlement Procedures Act, and o the Home Mortgage Disclosure Act.
Regulations flowing from these laws prohibit discrimination, specify disclosures to be made to borrowers regarding credit and settlement costs, and regulate the mortgage loan servicing activities of Midwest, including the maintenance and operation of escrow accounts and the transfer of mortgage loan servicing.
In receiving deposits, the Bank is subject to extensive regulation under State and federal law and regulations, including: o the Truth in Savings Act, o the Expedited Funds Availability Act, o the Bank Secrecy Act, o the Electronic Funds Transfer Act and o the Federal Deposit Insurance Act o the Patriot Act o the Check 21 Act o the Gram-Leach Bliley Privacy Act.
Violation of these laws could result in the imposition of significant damages and fines upon the Bank and its directors and officers.
Real Estate Lending Regulations. Federal regulators have adopted uniform standards for appraisals of loans secured by real estate or made to finance improvements to real estate. Banks are required to establish and maintain written internal real estate lending policies consistent with safe and sound banking practices and appropriate to the size of the institution and the nature and scope of its operations. The regulations establish maximum loan to value ratio limitations on real estate loans, which generally are equal to or greater than the loan to value limitations established under the Bank's lending policies.
Branching Authority. Michigan banks, including University Bank, have authority under Michigan law to establish branches anywhere in the State of Michigan, subject to receipt of all required regulatory approvals, including approval of the Commissioner and the FDIC. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allows banks to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state, rather
than the acquisition of an out-of-state bank in its entirety, is allowed only if specifically authorized by state law.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allowed individual states to "opt-out" of interstate branching authority by enacting appropriate legislation prior to June 1, 1997. Michigan did not opt out, and now permits both U.S. and non-U.S. banks to establish branch offices in Michigan. The Michigan Banking Code permits the following in appropriate circumstances and with the approval of the Commissioner:
o acquisition of all or substantially all of the assets of a Michigan-chartered bank by an FDIC-insured bank, savings bank, or savings and loan association located in another state; o acquisition by a Michigan-chartered bank of all or substantially all of the assets of an FDIC-insured bank, savings bank or savings and loan association located in another state; o consolidation of one or more Michigan-chartered banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting this consolidation, with the resulting organization chartered by Michigan; o establishment by a foreign bank, which has not previously designated any other state as its home state under the International Banking Act of 1978, of branches located in Michigan; o establishment or acquisition of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting Michigan-chartered banks to establish branches in these jurisdictions.
Further, the Michigan Banking Code permits the following, upon written notice to the Commissioner:
o acquisition by a Michigan-chartered bank of one or more branches, not comprising all or substantially all of the assets, of an FDIC-insured bank, savings bank or savings and loan association located in another state, the District of Columbia, or a U.S. territory or protectorate; o establishment by Michigan-chartered banks of branches located in other states, the District of Columbia, or U.S. territories or protectorates; and o consolidation of one or more Michigan-chartered banks and FDIC-insured banks, savings banks or savings and loan associations located in other states, with the resulting organization chartered by one of the other states.
Primary Regulator of Midwest. Midwest is an approved seller/servicer of single family mortgage loans for FNMA, FHLMC and HUD Title II (GNMA), and is subject to their rules, regulations and examinations.
Primary Regulator of University Insurance & Investment Services. University Insurance & Investment Services is licensed by the State of Michigan's Office of Financial and Insurance Services, Insurance Division as both a life and health and a property casualty insurance agency, and is subject to their rules, regulations and examinations. University Insurance & Investment Services also sells broker-dealer investment products and it and its licensed employees are subject to the rules, regulations and examinations of the National Association of Securities Dealers, the Securities & Exchange Commission, and the Insurance Division of Michigan's Office of Financial and Insurance Services.
Item 2.
Item 2. - Properties
Properties
In June 2003, the Bank sold a building in Ann Arbor, Michigan that is the Bank's main office and sole branch location to Lowertown Development, LLC ("Lowertown") for $1,173,833, which represented a gain of $342,851. As part of this transaction, the Bank received an option to purchase 10,000 square feet of office space in a new facility to be constructed by Lowertown which was valued at $200,000. Simultaneously, the Bank entered into a 24 month lease agreement with Lowertown to leaseback the building sold. The lease included 5 six-month options to extend the lease until the earlier of the completion of the new building or December 2007. Lowertown is developing the neighboring area with a major office, retail and apartment development. Under the terms of the agreement, the Bank has an option to purchase 10,000 square feet of office space in this new development for fair market value up to a maximum of $2,000,000. It is currently anticipated that the new facility will be occupied in February 2007. Both the gain on the sale of the building and the purchase option are being amortized into income over the life of the expected lease term. Lowertown is obligated to pay the Bank $200,000 if the office space is not completed prior to the end of the extended lease period in December 2007.
The Bank leases a site that includes a registered historic building in Ann Arbor, at the corner of Washtenaw Avenue and Stadium Boulevard as a ATM drive-through location, and an off-site storage facility. The minimum lease period ends May 2006 with two optional five-year extensions. The Bank also owns 1/3 of the Company which owns the site, Tuomy, LLC.
The Bank leases an ATM location in Ann Arbor at the corner of State and Liberty near the University of Michigan Campus. The minimum period of this lease ends December 2005.
Midwest leases an office in Houghton, Michigan under a year-to-year lease.
The Company believes that the office facilities are adequate to support the anticipated level of future expansion of business.
Contractual Obligations
The following table summarizes the existing contractual obligations of the Company: Payments Due By Period ---------------------- Less than 1-3 3-5 More than Total year years years 5 years --------------------------------------------------- Operating leases $ 769,153 $ 196,752 $ 393,504 $178,897 $ 0 Certificates of deposit 12,440,182 8,152,465 3,636,762 209,614 441,341 Long term borrowings 34,000 34,000 0 0 0 ----------- ---------- ---------- -------- --------- Totals $13,243,335 $8,383,217 $4,030,266 $388,511 $ 441,341 =========== ========== ========== ======== ========= Item 3.
Item 3. - Legal Proceedings
At December 31, 2004 the Company had no outstanding legal proceedings that would have a material affect on the financial statements.
Item 4.
Item 4. - Submission of Matters to a Vote of Security Holders
No matters were submitted during the fourth quarter of 2004 to a vote of our shareholders.
PART II.
Item 5.
Item 5. - Market for Registrant's Common Equity and Related Stockholder Matters
Common Stock and Dividend Information
Our common stock trades on the NASDAQ Small-Cap Market under the symbol UNIB. The high and low sales prices of our common stock as quoted by NASDAQ, for each quarter since January 1, 2003 are listed below:
High Low
First Quarter through March 7 $2.24 $1.63
First Quarter $2.80 $2.05 Second Quarter 2.47 1.30 Third Quarter 1.72 1.05 Fourth Quarter 3.48 0.60
First Quarter $3.00 $0.62 Second Quarter 2.25 0.91 Third Quarter 5.73 1.06 Fourth Quarter 3.38 2.22
As of the March 7, 2005 we had approximately 540 stockholders including approximately 200 beneficial owners of shares held by brokerage firms or other institutions.
Our shareholders authorized a 1 for 2 reverse stock split in November 2002; however, management has opted, at this time, not to implement the reverse stock split. No cash dividends have been paid on our common stock. We do not currently anticipate declaring or paying dividends in 2005.
Certain Sales of Equity Securities
We sold 18,421 shares of our common stock at $1.90 in a private placement in February 2005.
Item 7.
Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations
The purpose of the following discussion and analysis is to assist the reader in understanding and evaluating the changes in financial position and results of operations over the past several years. Investors should refer to the consolidated financial statements, the related notes thereto, and statistical information presented elsewhere in this report when reading this section of the report.
The cautionary statements described below are for the purpose of qualifying for the "safe harbor" provisions of Section 21E of the Securities Exchange Act of 1934.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures. On an on-going basis, we evaluate these estimates, including those related to the allowance for loan losses, servicing rights, other real estate owned and deferred tax assets. Estimates are based on historical experience, information received from third parties and on various other assumptions that are believed to be reasonable under the circumstances, which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
ALLOWANCE FOR LOAN LOSSES - The allowance for loan losses is determined based on management estimates of the amount required for losses inherent in the portfolio. These estimates are based on past loan loss experience, known and inherent risks in the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off.
SERVICING RIGHTS - Servicing rights are evaluated quarterly for possible impairment and are valued based on the lower of amortized cost or fair value of the rights, using independent appraisals and grouping of the underlying loans as to type, term and interest rates. Assumptions as to prepayment speeds and retention rates may change and thereby impact the valuation. Any impairment of a grouping is reported as a valuation allowance.
OTHER REAL ESTATE OWNED - Real estate properties acquired in collection of a loan are recorded at fair value upon acquisition based on appraisals. Any reduction to fair value from the carrying value of the related loan at the time of foreclosure is accounted for as a loan loss. Subsequent reductions in the value of the real estate owned are charged to earnings when probable and estimable. Changes in real estate value in the future may impact the carrying value.
DEFERRED TAX ASSETS - Deferred tax assets are recorded based on estimates of future taxable income and utilization of existing net operating loss carry-forwards. A valuation allowance adjusts deferred tax assets to the net
amount that is more likely than not to be realized. Actual results will impact the estimates of these deferred tax assets.
RISK FACTORS
Our business involves a high degree of risk. The reader of this report should carefully consider the risks and uncertainties described below and the other information in this report before deciding whether to invest in shares of our common stock. If any of the following risks actually occur, our business, financial condition and results of operations could be materially adversely affected. This could cause the trading price of our common stock to decline, with the loss of all or part of an investment in our common stock.
Described below, are the material risks of investing in University Bancorp's common stock. Investors should carefully consider these prior to purchasing any shares.
University Bank Has Incurred Significant Losses And May Never Achieve Sustained Profitability
University Bank sold its profitable Upper Peninsula operations in late 1994 and relocated to Ann Arbor in early 1996. University Bank had a net loss from operations each year between 1995 and 2001 and again in 2004. University Bank had a profit in 2002 and 2003. Although the Bank has been profitable for the past five months ending February 28, 2005, the Bank's future profitability is not assured. Management of the Bank believes that as the size of loan portfolio and retail deposits continue to increase that the Bank should become more profitable, but there is no assurance that expenses will not rise at a faster rate than expected as the Bank grows. There is no assurance that University Bank will grow to a size that will enable it to sustain profitability. University Bancorp had an accumulated deficit from operations of $2,490,224 at December 31, 2004.
The Company's Stock Is Controlled By Insiders Of The Company, Which May Not Provide You With The Best Possible Return On Your Investment
Insiders hold a majority of the shares outstanding of the Company. The Ranzini Group (Mr. Stephen Lange Ranzini, Dr. Joseph Lange Ranzini, Mr. Paul Lange Ranzini, Orpheus Capital, L.P. and the Ranzini Family Trust dated 12/20/89) beneficially owns 2,995,968, or 72.21% of the issued and outstanding shares at March 7, 2005. These individuals are able to exert a significant measure of control over University Bancorp's affairs and policies. This control could be used, for example, to help prevent an acquisition of University Bancorp, precluding shareholders from possibly realizing any possible premium that may be offered for the common stock by a potential acquirer.
Your Ownership Of The Company May Be Further Diluted If The Bank Requires Additional Capital
There can be no assurance that the Bank will not need additional capital in the future to support the Bank's growth or to counter operating losses. Funds necessary to meet the Bank's working capital needs and to finance its expansion might not be available. If additional equity securities are needed to finance future expansion, such sale could result in significant dilution to the existing shareholders.
The Small Size Of University Bank Limits Its Ability To Compete With Larger Financial Institutions
University Bank faces strong competition for deposits, loans and other financial services from numerous Michigan and out-of-state banks, thrifts, credit unions and other financial institutions. Some of the financial institutions with which University Bank competes are not subject to the same degree of regulation as University Bank. Many of these financial institutions aggressively compete for business in the Ann Arbor area. Most of the Bank's competitors have been in business for many years, have established customer bases, have numerous branches, have substantially higher lending limits, and offer certain services that we do not provide. The dominant competitors in the Ann Arbor area are TCF National Bank, National City Bank, Comerica Bank, Chase Bank and Key Bank. There can be no assurance that University Bank will be able to compete effectively with these competitors unless it can continue to grow its operations.
The Year Ended December 31, 2004 Compared to the Years Ended December 31, 2003 and 2002
Summary of Results of Operations
The Company's net loss was $584,820 in 2004, versus net income of $94,442 in 2003 and $205,598 in 2002. Basic and diluted (loss) earnings per share for 2004, 2003 and 2002 were $(0.14), $0.02 and $0.05, respectively.
The net loss in 2004 includes an $80,000 tax expense. This resulted from a reduction in a deferred tax asset which was not expected to be realized in the future due to the loss in 2004 from operations. Net income in 2003 included an income tax benefit of $80,000.
Community Banking incurred a pretax loss of $388,000 during the current year as opposed to a loss of $301,000 in 2003. In 2004, Community Banking incurred approximately $305,000 in expense related to the resolution of other real estate owned. Additionally, Community Banking recorded a $156,000 impairment charge against the investment in Michigan Capital Fund, L.P. I. The charge will eliminate related expense and will therefore increase income by $100,000 in 2005 and $56,000 in 2006. Community Banking is a tax benefit partner in a low to moderate income housing partnership. The investment provides Community Banking with tax credits that can be used to offset federal income taxes. The Company's overall tax status does not allow for the tax credits to be carried as an asset. Accordingly, an impairment charge was deemed appropriate. The expenses for other real estate owned and the impairment more than offset general operational improvement in Community Banking in 2004 as compared to 2003, including a 23.1% increase in loans and a 14.9% increase in deposits.
Midwest had a loss of $27,000 in 2004 as compared to income of $426,000 in 2003. In 2003, Midwest benefited from a significant volume of income derived from the high level of mortgage refinancing due to lower rates. In 2004, this income was substantially less. Income at Midwest was negatively impacted in the first half of 2004 by investments of about $30,000 a month in overhead intended to grow Midwest's jumbo and non-standard originations through a secondary market conduit established with Lehman Brothers. The decrease in mortgage originations offset improvements in other areas including a 21% increase in mortgage loans subserviced, to 18,233 loans at December 31, 2004.
Community Banking incurred a pre-tax loss of $301,000 in 2003 as opposed to pre-tax income of $20,000 in 2002. A drop in net interest margin and an increase in the provision for loan losses accounted for most of this variance. In contrast, pre-tax income at Midwest increased to $426,000 in 2003 from $281,000 in 2002. Income at Midwest increased with rapidly increasing mortgage originations and a 61% increase in mortgage loans sub-serviced, to 15,033 loans from 9,319.
The following table summarizes the pre-tax (loss)income of each profit center of the Company for the years ended December 31, 2004, 2003, and 2002 (in thousands):
2004 2003 2002 ---- ---- ---- Community Banking $(388) $(301) $ 20 Midwest Loan Services (27) 426 281 Corporate Office (90) (111) (95) ------- ------- ------ Total $(505) $ 14 $ 206 ======= ======= ======
Net Interest Income
Net interest income increased to $1,960,313 for year ended December 31, 2004 from $1,890,462 for same period in 2003. The yield on average earning assets dropped from 6.91% in 2003 to 6.55% in 2004. This drop occurred as loans repriced in a generally lower medium term interest rate environment throughout most of 2004. Additionally, the mix of assets changed. The Company increased its single family real estate loans while other loans dropped. Single family real estate loans have a lower yield as compared with commercial and installment loans. Management directed its efforts in increasing this category since real estate loans, specifically single family homes, tend to have lower credit risk. Overall, average interest bearing assets increased to $41,921,020 in 2004 from $39,511,963 in 2003.
The cost of interest bearing liabilities decreased from 2.21% for the 2003 period to 1.98% in 2004. Average interest bearing liabilities increased to $39,575,806 in 2004 from $38,113,218 in 2003. The decrease in interest bearing liabilities occurred despite rapidly rising short term interest rates because the bank increased its mix of lower cost deposits relative to higher cost deposits.
The net yield on interest earning assets decreased from 4.78% in 2003 to 4.68% in 2004 due principally to lower yields on loans. In an effort to improve margins, management is targeting lower cost deposits to fund asset growth.
For 2003, net interest income declined 12.29% year-over-year, falling to $1,890,462 for the year ended December 31, 2003 compared to $2,155,289 for the prior year. During 2002 and 2003 short term interest rates remained at 45-year lows while long-term interest rates showed a decline. Net interest income for 2003 declined from the previous period because the average yield on earning assets declined at a higher rate than the average yield on interest bearing deposits. The yield on average earning assets dropped from 7.85% in 2002 to 6.91% in 2003. The cost of interest bearing liabilities decreased from 2.66% for the 2002 period to 2.21% for the year ended December 31, 2003. The net yield on interest earning assets decreased from 5.30% to 4.78%. In 2003, management actively sought to attract lower cost deposits to offset the decline in the net yield.
The following tables present for the average balances, the interest earned or paid, and the weighted average yield for the period indicated:
NET INTEREST INCOME
The tables above do not specify the average level of non-interest bearing demand deposits, which were $2,768,253, $1,979,705, and $2,432,737 for the years ended December 31, 2004, 2003 and 2002, respectively.
The following table presents information regarding fluctuations in our interest income and interest expense for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate); and (2) changes in rate (changes in rate multiplied by old volume); with the rate/volume variance allocated to changes in rate:
Loan Portfolio
Information regarding the Bank's loan portfolio as of December 31, 2004 and 2003 is set forth under Note 5 to University Bancorp's consolidated financial statements included with this report.
Provision for Loan Losses
The Bank charges to operations a provision for loan losses which is intended to create an allowance for future loan losses inherent in the Bank's portfolio. Each year's provision reflects management's analysis of the amount necessary to maintain the allowance for loan losses at a level adequate to absorb anticipated losses. In its evaluation, management considers factors like historical loan loss experience, specifically identified problem loans, composition and growth of the loan portfolio, current and projected economic conditions, and other pertinent factors. A loan is charged-off by management as a loss when deemed uncollectible, although collection efforts continue and future recoveries may occur.
Non-performing loans are defined as loans which have been placed on non-accrual status and loans over 90 days past due as to principal or interest and still in an accrual status. Where serious doubt exists as to the collectibility of a loan, the accrual of interest is discontinued. See Note 5 of the Consolidated Financial Statements for additional information regarding impaired and past due loans. Non-performing loans amounted to $648,020, $1,117,127 and $679,560at December 31, 2004, 2003and 2002, respectively. At December 31, 2004, there were loans totaling $371,109 that were past due over 90 days, but still accruing interest. Payments were made to bring these loans to a current status shortly after year end.
The provision for loan losses in 2004 was $(87,500) compared to $189,400 in 2003 and $100,000 in 2002. In 2004, the analysis of the loan loss reserve resulted in a reduction in the provision of $87,500. This resulted from lower chargeoffs, payoffs of previously classified problem loans and an improvement in the quality of the loans in the portfolio. The Bank determined the required reserve was less than in previous years.
Loans charged off, net of recoveries, were $13,494, $143,501 and $270,874 in 2004, 2003 and 2002, respectively. The allowance for possible loan losses totaled $353,124, $454,118 and $408,219 at the end of 2004, 2003 and 2002, respectively. The following table summarizes the loan loss expense for the Bank for the years ended December 31, 2004, 2003 and 2002.
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES ($ amounts in thousands)
The Bank's overall loan portfolio is geographically concentrated in Ann Arbor and the future performance of these loans is dependent upon the performance of relatively limited geographical areas. As a result of the weak Michigan economy, the Bank's future loss ratios may exceed historical loss ratios. Management believes that the allowance for loan losses is adequate to absorb losses inherent in the loan portfolio, although the ultimate adequacy of the allowance for loan losses is dependent upon future economic factors beyond our control. A downturn in the general nationwide economy will tend to aggravate, for example, the problems of local loan customers currently facing some difficulties. A general nationwide business expansion could result in fewer loan customers being unable to repay their loans.
Non-Interest Income and Non-Interest Expense
Non-interest income. Total non-interest income decreased to $3,822,548 for the year ended December 31, 2004 from $5,932,492 for period ended in 2003. The decrease was principally a result of decreases in loan origination and gain on the sales of mortgage loans at Midwest. In 2003, the rates on mortgages were historically low which spurred an increase in the re-financing market. In 2004, the rates were still relatively low, but the re-financing activity decreased significantly. The Bank's wholly-owned insurance and investment subsidiary, University Insurance & Investment Services, enjoyed a record year, producing $219,631 in fee income compared to $168,577, a 30% increase.
Non-interest income was $5,932,492 in 2003 compared to $4,441,019 in 2002. Income generated in this category is principally from Midwest. During 2003, the mortgage re-financing market was stimulated by record low long-term interest rates. Midwest and the Bank significantly increased income from loan origination, loan sub-servicing fee income, and gain on the sale of mortgage loans originated for sale into the secondary market. University Insurance & Investment Services produced $168,577 in fee income compared to $113,870, a 48.0% increase.
Mortgage banking. At December 31, 2004, Midwest was sub-servicing 18,233 mortgages, an increase of 21.12% from 15,033 mortgages at December 31, 2003. The balance of loans sub-serviced was $2.3 billion at December 31, 2004 as compared with over $2.0 billion at December 31, 2003. Mortgage banking, servicing and origination fees, and gain on the sale of loans decreased to $3,300,052 in 2004 from $5,267,418 in 2003. In 2003, the market for mortgage refinancing was extremely active due to historically low rates. In 2004, mortgage refinancing activity curtailed sharply. In 2005, mortgage rates are expected to rise and this will further retard the re-financing market. Midwest has devoted significant resources during 2004 to diversify its mortgage originations away from the refinancing market and to increase the volume of its purchase business by establishing the Lehman Brothers conduit and by increasing the number of credit unions that originate mortgages through Midwest's outsourcing origination services Mortgage banking, servicing and origination fees, and gain on the sale of loans increased to $5,267,418 in 2003 from $4,040,363 in 2002. In 2003, Midwest originated 670 mortgage loans, an increase of 31% over last year. During the year, Midwest increased its credit union partners so that at year-end 2003 it had credit union partners with a total of 1,585,000 active members, 20,434,000 potential members and aggregate assets of $11.48 billion.
Securities. Proceeds from sales of marketable and non marketable equity securities included in proceeds from sales of investment securities was $49,981 for the year ended December 31, 2003. Gross losses of $446 were realized in this period. Proceeds from sales of available for sale debt securities were $0, $58,879 and $1,034,160 for the years ended December 31, 2004, 2003 and 2002, respectively, excluding sales associated with the Bank's mortgage banking operation. There were gross gains of $3,607, $0 and $69,733 on 2004, 2003 and 2002 sales, respectively and a gross loss of $54,011 on 2003 sales. At December 31, 2004 gross unrealized losses in our available-for-sale securities were $51,357 and gross unrealized gains were $0. At December 31, 2002 gross unrealized losses in our available-for-sale securities were $38,795 and gross unrealized gains were $0.
Non-interest expense. Non-interest expense decreased to $6,375,181 in the period ended December 31, 2004 from $7,619,112 for the same period in 2003. The decrease was due principally to decreases in salaries and benefits, mortgage banking expense, and amortization of servicing rights. The higher mortgage interest rates in 2004 resulted in lower income from mortgage origination as well as lower expenses. These decreases in costs were partially offset by an increase in other real estate owned expense and an impairment charge as noted previously.
In 2003, non-interest expenses increased by $1,328,402 or 21.1% to $7,619,112 million from $6,290,710 in 2002. All but $200,353 of the increase was due to increased non-interest expenses at Midwest, as Midwest's origination and sub-servicing activity increased. As the volume expanded Midwest increased its workforce to perform the required tasks. Other servicing and sub-servicing related expenses, such as occupancy, supplies and postage also increased. Non-interest expense was also impacted by an increase in the amortization of the mortgage servicing rights due to the low long-term interest rate environment. Personnel expenses at Community Banking were higher due to higher commissions paid to mortgage and deposit origination personnel.
Income Taxes
Income tax expense (benefit) in 2004 was $80,000, and $(80,000) and $0 in 2003 and 2002. The tax benefit recognized in 2003
was reversed in 2004 because of the operating loss recognized during the year and uncertainty of recoverability of the deferred tax asset. The tax benefit was recognized because of the operating profit in 2003, and therefore a portion of existing net operating loss carry-forwards were reasonably expected to reduce future amounts of taxable income. In 2002 no tax benefit was realized due to prior period net taxable losses from operations and uncertainties of future taxable income. The effective tax (benefit) rate was 34% or 2004, (34)% for 2003 and 0% for 2002.
At December 31, 2004, the Company had net operating loss carryforwards that could be utilized to shelter approximately $2,080,000 of future taxable income. Realization of income tax benefits are not recorded in the financial statements as realization of these benefits is dependent upon generating sufficient future taxable income. See footnote 13 to the financial statements for more information.
Liquidity and Capital Resources
Liquidity. Loans receivable, net of reserves and excluding loans held for sale, increased to $42.65 million from $34.47 million in 2004 and 2003, respectively. Cash and cash equivalents including Federal Funds sold on an overnight basis at the end of 2004 were $1.73 million, while securities were $1.11 million. At year-end 2004, the Bank had an unused line of credit from the Federal Home Loan Bank of Indianapolis of $1.6 million, and an unused line of credit from the Federal Reserve Bank of Chicago of $5.7 million. University Bank, as an FDIC-insured bank, is subject to certain regulations that require the maintenance of minimum liquidity levels of cash and eligible investments. The Bank has historically exceeded this minimum as a result of its investments in federal funds sold, U.S. government and U.S. agency securities and cash. In addition, University Bancorp had $5,626 in cash at the end of 2004 to meet cash needs, primarily operating expenses and interest and principal reductions on the University Bancorp's note payable. The balance of the loan was $34,000 and $166,000 at year-end 2004 and 2003. The note was paid in full in early 2005. Management intends that the cash on hand, the exercise of stock options and possible sale of stock will be sufficient to cover our operating expenses during 2005 and 2006. Capital. The Company's total stockholders' equity at December 31, 2004 was approximately $3.00 million (or 6.0% of total assets) compared to $3.43 million (or 7.9% of total assets) at December 31, 2003. The Bank's Tier 1 Capital at December 31, 2004 was $3.16 million or 6.5% of the Bank's total regulatory assets. The risk-adjusted capital ratio of 9.5% exceeded the 8.0% level which categorized the Bank as "adequately capitalized" as defined by the FDIC. At December 31, 2003, the Bank's 12.3% risk-based capital ratio exceeded the FDIC's threshold of 10.0% which placed the Bank in the "well capitalized" category. The following table provides detailed information about the Bank's risk-adjusted assets and actual capital percentages:
TIER 1 CAPITAL 2004 2003 -------- --------
Total Equity Capital $2,880 $3,511 Add: Unrealized losses on available-for-sale securities 52 39 Add: Minority interest 440 445 Less: Other identifiable intangible assets 214 287 -------- -------- Total Tier 1 Capital 3,158 3,708 TIER 2 CAPITAL Allowance for loan & lease losses 353 454 Less: Excess Allowance 0 33 -------- -------- Total Tier 2 Capital 353 421 -------- -------- Total Tier 1 & Tier 2 Capital $3,511 $4,129 ======== ========= CAPITAL RATIOS Tier 1/Total Average Assets 6.45% 8.58% Tier 1/Total Risk-Weighted Assets 8.52% 11.03% Tier 1 & 2/Total Risk-Weighted Assets 9.47% 12.28%
Recently Issued Accounting Standards
In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123(R) (revised 2004), Share-Based Payment. SFAS No. 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. The cost will be measured based on the fair value of the instruments issued. SFAS No. 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB Opinion No. 25. As originally issued in 1995, SFAS No. 123 established as preferable the fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. We will be required to apply SFAS No. 123(R) as of the first interim reporting period that begins after June 15, 2005, and we plan to adopt it using the modified-prospective method, effective July 1, 2005. We are currently evaluating the impact SFAS No. 123(R) will have on us. Based on our preliminarily analysis, the impact of the additional compensation expense will not be material during as a result of this new accounting standard.
Recent Events
The Bank signed an amendment on March 31, 2005 to its agreement with Lower Town Development Group, LLC, the developer of the site on which its current headquarters is located that could produce income of approx. $850,000 with respect to 2005 minus relocation costs estimated to be $100,000. Under the agreement, if University Bank, in is sole discretion, can give notice on or before June 15, 2005 that it will vacate the premises commonly known as 959 Maiden Lane, Ann Arbor, Michigan by August 1, 2005, Lower Town
Development Group, LLC shall pay to University Bank $800,000 upon the closing of the construction financing pertaining to the project commonly known as Lower Town or December 31, 2005, which ever occurs first; and Lower Town Development Group, L.L.C. shall pay the $200,000 that was deferred from the sale of 959 Maiden Lane on or before December 31, 2005. The purchase price for the new 10,000 ft2 headquarters under the Agreement shall be $2,000,000 instead of $1,800,000. Management of the Bank is advised by local real estate experts that the market value of the 10,000 ft2 headquarters office condominium that is being built for it is worth $2,400,000 to $2,600,000 in the current market.
ITEM 7A.
ITEM 7A. MARKET RISK
Impact of Inflation
The primary impact of inflation on our operations is reflected in increased operating costs. Since our assets and liabilities are primarily monetary in nature, changes in interest rates have a more significant impact on our performance than the general effects of inflation. However, to the extent that inflation affects interest rates, it also affects our net income.
Quantitative and Qualitative Disclosures about Market Risk
All financial institutions are significantly affected by fluctuations in interest rates commonly referred to as "interest rate risk." The principal exposure of a financial institution's earnings to interest rate risk is the difference in time between interest rate adjustments or maturities on interest-earning assets compared to the time between interest rate adjustments or maturities on interest-bearing liabilities. This difference is commonly referred to as a financial institution's "gap position." In periods when interest rates are increasing, a negative gap position will result in generally lower earnings as long-term assets are repricing upward slower than short-term liabilities. However during a declining rate environment, the opposite effect on earnings is true, with earnings rising due to long-term assets repricing downward slower than short-term liabilities.
Rising long term and short term interest rates tend to increase the value of Midwest' investment in mortgage servicing rights and improve Midwest' current return on these rights by lowering required amortization rates on the rights and decreasing the opportunity for customers to refinance those loans. Rising interest rates tend to decrease new mortgage origination activity, negatively impacting current income from the Bank's retail mortgage banking operations and Midwest's mortgage banking operations. Rising interest rates also slow Midwest' rate of growth, but increases the duration of its existing mortgages being sub-serviced under contract.
The Bank's securities portfolio is designed to offset a portion of the market value risk associated with the servicing rights. During period of declining interest rates, the estimated duration period for the Bank's FNMA CMO tends to shorten, thus accelerating the income from the accretion of the bond's discount. This income mitigates the rapid amortization of the servicing rights. In a rising rate environment, the accretion of income on the bond tends to lessen.
The table on the following page details our interest sensitivity gap between interest-earning assets and interest bearing liabilities at December 31, 2004. Certain items in the table are based upon various assumptions that may not necessarily reflect future experience, and therefore, certain assets and liabilities may in fact mature or re-price differently from what is illustrated. The one-year static gap position at December 31, 2004 was estimated at ($15.2 million) or (29.83%):
The following repricing information is provided for the Bank's investment portfolio, using book values, as of December 31, 2004:
Investment Portfolio Maturities ($ amounts in thousands) and Yield by Type:
Additional information regarding the Bank's investments is set forth under Note 4 to the consolidated financial statements.
The following information illustrates maturities and sensitivities of the Bank's loan portfolio to changes in interest rates as of December 31, 2004:
(1) Excludes loans held for sale of $846,400 and the allowance for loan losses.
Item 8.
Item 8. - Financial Statements and Supplementary Data
UNIVERSITY BANCORP, INC.
--------------------
CONSOLIDATED FINANCIAL STATEMENTS
--------------------
DECEMBER 31, 2004, 2003 2002
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholder University Bancorp, Inc.
We have audited the accompanying consolidated balance sheet of University Bancorp, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each of the three years ended December 31, 2004. 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 did not audit the financial statements of Midwest Loan Services, Inc., an eighty percent owned subsidiary, which statements reflect total assets of 5.2 percent and 5.4 percent as of December 31, 2004 and 2003, respectively, and total revenues of 44.7 percent, 48.7 percent and 39.9 percent, respectively, for each of the three years ended December 31, 2004. Those statements were audited by other auditors, whose report thereon has been furnished to us, and our opinion, insofar as it relates to the amounts included for Midwest Loan Services, Inc., is based solely on the report of the other auditors.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors the consolidated financial statements referred to above present fairly, in all material respects, the financial position of University Bancorp, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for the each of the three years ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America.
/S/ GRANT THORNTON LLP
Southfield, Michigan March 29, 2005
The accompanying notes are an integral part of the consolidated financial statements.
1. Summary of significant accounting policies
Principles of Consolidation and Nature of Operations The consolidated financial statements of University Bancorp, Inc. (the Company) include the operations of its wholly-owned subsidiary, University Bank (the Bank), the Bank's wholly-owned subsidiary, University Insurance & Investment Services, Inc. (Agency) and an 80% owned subsidiary, Midwest Loan Services, Inc. ("Midwest"). The accounts are maintained on an accrual basis in accordance with generally accepted accounting principles and predominant practices within the banking and mortgage banking industries. All significant intercompany balances and transactions have been eliminated in preparing the consolidated financial statements.
The Company is a bank holding company. University Bank, which is located in Michigan, is a full service community bank, which offers all customary banking services, including the acceptance of checking, savings and time deposits. The Bank also makes commercial, real estate, personal, home improvement, automotive and other installment, credit card and consumer loans, and provides fee based services such as annuity and mutual fund sales, stock brokerage and money management, life insurance, property casualty insurance and foreign currency exchange. The Bank's customer base is primarily located in the Ann Arbor, Michigan area. The Bank established its main office in Ann Arbor in February 1996, by relocating from the eastern upper peninsula of Michigan.
University Bank's loan portfolio is concentrated in Ann Arbor and Washtenaw County, Michigan. While the loan portfolio is diversified, the customers' ability to honor their debts is partially dependent on the local economy. The Ann Arbor area is primarily dependent on the education, healthcare, services and manufacturing (automotive and other) industries. Most real estate loans are secured by residential or commercial real estate and business assets secure most business loans. Generally, installment loans are secured by various items of personal property.
The Agency is engaged in the sale of insurance products including life, health, property and casualty, and investment products including annuities, mutual funds, stock brokerage and money management. The Agency is located in the Bank's Ann Arbor main office. The Agency also has a limited partnership investment in low-income housing tax credits through Michigan Capital Fund for Housing Limited Partnership I with financing assistance from the General Partner, Michigan Capital Fund for Housing.
Midwest is engaged in the business of servicing and subservicing residential mortgage loans. Midwest began operations in 1992 and was acquired by University Bank in December, 1995. Midwest is based in Houghton, Michigan, and also originates mortgage loans for itself and other financial institutions, including the Bank (See Note 3).
1. Summary of significant accounting policies (continued)
Use of Estimates in Preparing Financial Statements: -------------------------------------------------- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions based upon available information. These estimates and assumptions affect the reported amounts and disclosures. Actual results could differ from those estimates.
The significant estimates incorporated into these consolidated financial statements which are more susceptible to change in the near term include the value of mortgage servicing rights, the allowance for loan losses, the identification and valuation of impaired loans, the valuation of other real estate owned, the fair value of financial instruments, and the valuation of deferred tax assets.
Cash flow reporting For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents is defined to include the cash on hand, non-interest bearing deposits in other institutions, federal funds sold and other investments with a maturity of three months or less when purchased. Net cash flows are reported for customer loan and deposit transactions and interest bearing deposits with other banks.
Securities Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income or loss. Realized gains are based on specific identification of amortized cost. Securities are written down to fair value when a decline in fair value is not temporary. Interest income includes amortization of purchase premium or discount. Other securities such as Federal Home Loan Bank stock are carried at cost.
Loans Loans are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days. Payments received on such loans are reported as principal reductions, unless all interest and principal payments in arrears are paid in full.
1. Summary of significant accounting policies (continued)
Mortgage banking activities Mortgage banking activities includes retail and servicing operations. Mortgage loans held for sale are valued at the lower of cost or market as determined by bid prices for loans in the secondary market. The loans are sold without recourse, except in the event that documentation errors are made during the origination process. Loan servicing and subservicing fees are contractually based and are recognized monthly as earned over the life of the loans.
Allowance for loan losses The allowance for loan losses is a valuation allowance for probable credit losses, increased by the provision for loan losses and recoveries and decreased by charge-offs. Management estimates the balance required based on past loan loss experience, known and inherent risks in the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off.
Loan impairment is reported when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when it is probable that all principal and interest amounts will not be collected according to the original terms of the loan.
Premises and equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily on the straight-line method for bank premises and the accelerated method for equipment and land improvements over their estimated useful lives. The Company uses the following useful lives as of December 31, 2004:
Buildings and building improvements 39 years Land and leasehold improvements 15 years Furniture, fixtures, and equipment 3-7 years Software 2-5 years
Other real estate owned Real estate properties acquired in collection of a loan are recorded at fair value upon foreclosure. Any reduction to fair value from the carrying value of the related loan is accounted for as a loan loss.
1. Summary of significant accounting policies (continued)
After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and losses on disposition, and changes in the valuation allowance are reported in other expenses.
Servicing rights Servicing rights represent both purchased rights and the allocated value of servicing rights retained on loans originated and sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using grouping of the underlying loans as to type, term and interest rates. Any impairment of a grouping is reported as a valuation allowance.
Income taxes Income tax expense/benefit is the sum of the current year estimated tax obligation or refund per the income tax return and the change in the estimated future tax effects of temporary differences and carry-forwards. Deferred tax assets or liabilities are computed by applying enacted income tax rates to the expected reversals of temporary differences between financial reporting and income tax reporting, and by considering carry-forwards for operating losses and tax credits. A valuation allowance adjusts deferred tax assets to the net amount that is more likely than not to be realized.
Retirement plan The Bank has a 401(K) Plan that allows an employee to contribute up to 15% of salary pre-tax, to the allowable limit prescribed by the Internal Revenue Service. Management has discretion to make matching contributions to the Plan. However, the Bank made no matching contributions for the years ended December 31, 2004, 2003 and 2002.
Employees Stock Ownership Plan (ESOP) The Company has a noncontributory ESOP covering all full-time employees who have met certain service requirements. The employees' share in the Company's contribution is based on their current compensation as a percentage of the total employee compensation. As shares are contributed to the plan they are allocated to employees and compensation expense is recorded at the shares' fair value. The Company made no contribution in 2004, 2003 and 2002.
Stock options At December 31, 2004, the Company has a stock-based employee compensation plan, which is described more fully in Note 8. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price greater than or equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net (loss) income and earnings per share if the company
Dividend restriction Banking regulations require the maintenance of certain capital levels and may limit the amount of dividends that may be paid by the bank to the holding company or by the holding company to shareholders. In addition, the Bank cannot pay a dividend until it has net retained earnings or unless it receives a waiver from the State of Michigan banking regulators. The accumulated deficit of the Bank was $1,978,688 and $1,483,994 at December 31, 2004 and 2003, respectively.
(Loss) earnings per share Basic earnings per share are computed by dividing net (loss) income available to common shareholders by the weighted average common shares outstanding. Diluted earnings per share reflect the potential dilution that would occur if dilutive securities were exercised or converted into common stock. The following table presents a reconciliation of the weighted average common shares outstanding for the earnings per share calculation for the years ended December 31:
2004 2003 2002 ----- ----- ----- Weighted average shares outstanding 4,085,244 3,940,433 3,859,433
Net dilutive effect of stock options - 133,982 198,909 ---------------------------------- Diluted average shares outstanding 4,085,244 4,074,415 4,058,342 =================================
For December 31, 2004, the Company incurred a net loss. Accordingly, anti-dilutive impact of the effect of stock options is not shown.
1. Summary of significant accounting policies (continued)
Comprehensive (Loss) Income Comprehensive (loss) income includes both the net loss and the change in unrealized gains and losses on securities available for sale.
Segment Reporting The Company's segments are determined by the products and services offered, primarily distinguished between banking and mortgage banking operations. Loans, investments, and deposits provide the revenues in the banking operation, and servicing fees, underwriting fees and loan sales provide the revenues in mortgage banking. All operations are domestic.
Reclassification Certain items in the 2003 and 2002 consolidated financial statements and notes have been reclassified to conform to the 2004 presentation.
2. Michigan BIDCO, Inc. BIDCO was incorporated for the purpose of providing financing to small businesses located in Michigan for the purpose of creating business and industrial development in the State of Michigan. BIDCO is licensed under the Michigan BIDCO Act, and is regulated by the Michigan Office of Financial and Insurance Services, Bank and Trust Division. The President of the Company serves as Chairman and President of BIDCO.
At December 31, 2003 University Bancorp owned 6.10% of the BIDCO and the Bank held a $600,000, 7.5% note collateralized by all assets of the company. The note was paid off in December 2004. Additionally, the shares of the BIDCO were sold. At December 31, 2004, the company no longer had a financial interest in the BIDCO
3. Secondary Market Operations Midwest provides servicing and subservicing of real estate mortgage loans for University Bank and several other financial institutions. The unpaid principal balance of these loans was approximately $2.31 billion, $1.94 billion and $1.06 billion as of December 31, 2004, 2003 and 2002 respectively. Custodial escrow balances maintained in connection with these respective loans was $30.2 million, $26.8 million, and $23.4 million, at December 31, 2003, 2002 and 2001 respectively. Most of these funds are off balance sheet and maintained at various financial institutions. The following summarizes the operations of Midwest for the years ended December 31:
University Bank and Midwest sell conforming residential mortgage loans to the secondary market. These loans are owned by other institutions and are not included in the Company's consolidated balance sheets. Such mortgage loans have been sold predominately without recourse or with limited recourse. The unpaid principal balance of these loans was $120.6 million, $112.3 million and $87.0 million at December 31, 2004, 2003 and 2002 respectively.
The following summarizes the activity pertaining to mortgage servicing rights, along with the aggregate activity in related valuation allowances. Table A is calculated net of the valuation allowance described in Table B.
Market interest rate conditions can quickly affect the value of mortgage servicing rights in a positive or negative fashion, as long-term interest rates rise and fall. The amortization of these rights is based upon the level of principal pay downs received and expected prepayments of the mortgage loans. The servicing rights are recorded at the lower of cost or market.
4. Securities available for sale (continued) The following is a summary of the amortized cost, gross unrealized gains, gross unrealized losses and fair value of securities available for sale at December 31, 2004, 2003 and 2002:
At December 31, 2004 and 2003, the fair value of securities pledged to secure certain borrowings were $1,106,607 and $1,649,169, respectively. Unrealized losses at December 31, 2004 and 2003 have existed for longer than twelve months. This decline is considered temporary as the values of the mortgage-backed securities fluctuate based on changes in current interest rates and prepayment assumptions related to the underlying mortgages. Furthermore, the Company expects to hold these securities sufficiently long enough to recover these unrealized losses.
Sales of available for sale securities: 2004 2003 2002 ---- ---- ---- Proceeds $49,981 $59,879 $1,034,160 Realized gains 3,605 - 69,733 Realized losses 4,051 54,011 -
The scheduled maturity date of the securities available for sale at December 31, 2004 is:
Amortized Fair Cost Value 2005-2008 $ 0 $ 0 2009-2013 0 0 After 2013 1,157,964 1,106,607 ---------- ---------- $1,157,964 $1,106,607 ========== ==========
In June 2003, the Bank sold its main office and sole branch location to Lowertown Development, LLC ("Lowertown") for $1,173,833, and a gain of $342,851. As part of this transaction, the Bank received an option to purchase 10,000 square feet of office space in a new facility to be constructed by Lowertown which was valued at $200,000. Simultaneously, the Bank entered into a 24 month lease agreement with Lowertown to leaseback the building sold. The lease included 5 six-month options to extend the lease until the earlier of the completion of the new building or December 2007. Lowertown is developing the neighboring area with a major office, retail and apartment development. Under the terms of the agreement, the Bank has an option to purchase 10,000 square feet of office space in this new development for fair market value up to a maximum of $2,000,000. It is currently anticipated that the new facility will be occupied in February 2007. Both the gain on the sale of the building and the purchase option are being amortized into income over the life of the expected lease term. Lowertown is obligated to pay the Bank $200,000 if the office space is not completed prior to the end of the extended lease period in December 2007.
Depreciation expense amounted to $318,584, $305,741 and $290,516 for the years ended December 31, 2004, 2003 and 2002, respectively.
The Bank began leasing its Maiden Lane building in June 2003. The rent for 2004 totaled $106,740. The Bank leases an ATM drive-thru location in Ann Arbor for $28,656 per year and one off-site ATM location for $9,000 per year. Midwest leases its office space for approximately $50,424 per year in Houghton, Michigan. Total rental expense for all operating leases was $192,663, $144,778 and $55,861 in 2004, 2003 and 2002.
7. Time deposits Time deposit liabilities issued in denominations of $100,000 or more were $1,854,614 and $2,632,451 at December 31, 2004 and 2003 respectively.
At December 31, 2004, stated maturities of time deposits were:
2005 $8,199,043 2006 3,068,588 2007 521,596 2008 95,870 2009 113,744 Thereafter 441,341 ------------- $12,440,182 =============
7. Time deposits (continued) The Bank had issued through brokers $3,651,000 and $1,101,000 of time deposits as of December 31, 2004 and 2003, respectively. These time deposits have maturities ranging from one to five months and are included in the table above. These deposits are issued in denominations of less than $100,000.
The Bank had deposits of $1,400,430 and $1,550,233 from directors, officers and their affiliates as of December 31, 2004 and 2003, respectively.
8. Stock options In 1995, the Company adopted a stock option and stock award plan (the 1995 Stock Plan), which provides for the grant of incentive stock options, as defined in Section 422(b) of the Internal Revenue Code of 1986, as amended, as well as the grant of non-qualified stock options and other stock awards. The plan provides for the grant to officers, directors and key employees of the Company, and independent contractors providing services to the Company, of options to purchase and other awards of common stock. The exercise price of options granted under the plan shall be determined by the Board of Directors, or a compensation committee thereof. Options shall expire on the date specified by the Board of Directors or such committee, but not more than 10 years from the date of grant (or five years from the date of grant for incentive stock options if the grantee owned 10% of the Company's voting stock at the date of grant). Unless amended, the 1995 Stock Plan will terminate on November 15, 2005. The following table summarizes the activity relating to options to purchase the Company's common stock:
Number of Weighted Average Options Exercise price
Outstanding at December 31, 2001 251,909 $1.60 Forfeited - 2002 (47,000) 1.61 Granted - 2002 ($0.08 Fair Value) 75,000 1.00 ---------- Outstanding at December 31, 2002 279,909 1.44 Granted - 2003 ($0.10 Fair Value) 54,000 1.85 Exercised - 2003 (36,000) 1.33 Forfeited - 2003 (26,500) 1.26 ---------- Outstanding at December 31, 2003 271,409 1.60 ---------- Granted - 2004 ($0.46 Fair Value) 64,500 2.29 Exercised - 2004 (103,909) 1.65 Forfeited - 2004 (36,000) 2.00 ---------- Outstanding at December 31, 2004 196,000 1.69 ===========
At December 31, 2004: Number of options immediately exercisable 117,200 Weighted average exercise price of immediately exercisable options $1.39 Range of exercise price of options outstanding $1.00 - $2.47 Weighted-average remaining life of options outstanding 4.62 years
8. Stock options (continued)
The following summarizes assumptions used to value stock options.
2004 2003 2002 ---- ---- ----
Risk-free interest rate 4.50% 4.00% 4.13% Expected option life 5.0 years 5.0 years 5.0 years Expected stock price Volatility 23.4% 22.5% 21.2% Expected dividends $0 $0 $0
9. Employee stock ownership plan (ESOP) The employees' allocation of ESOP assets is based on their current compensation, after 1 year of service and upon reaching the age of 21. The annual contribution to the ESOP is at the discretion of the Board of Directors. Assets of the plan are comprised entirely of 77,018 shares of the Company's stock at December 31, 2004 and 2003, all of which were fully allocated at December 31, 2004. Upon retirement from the plan, participants can receive distributions of their allocated shares of the Company's stock. The assets of the ESOP are held in trust and were valued at approximately $139,000, and $199,000 at December 31, 2004 and 2003, respectively.
10. Minority Interest The Bank owns an 80% interest in the common stock of Midwest, with the remaining 20% owned by the President of Midwest. At December 31, 2004 and 2003, total common stockholders' equity of Midwest was $2,200,229 and $2,226,820 resulting in a $440,118 and $445,324 minority interest reflected on the Company's consolidated balance sheet, respectively. The results of Midwest's operations for 2004, 2003 and 2002 are included in the Company's consolidated statement of operations.
11. Commitments and contingencies The 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 buy, sell and fund loans, letters of credit and unused lines of credit. The Bank's exposure to credit loss in the event of non-performance is equal to or less than the contractual amount of these instruments. The Bank follows the same credit policy to make such commitments as that followed by loans recorded in the consolidated financial statements. The following is a summary of commitments as of December 31:
2004 2003 2002 ---- ---- ---- Unused lines of credit $ 4,907,000 $ 3,762,000 $2,094,000 Commitments to fund loans 3,366,000 2,562,000 3,748,000 Foreign exchange futures 75,000 ----------- ----------- ---------- Total $ 8,273,000 $ 6,399,000 $5,842,000 =========== =========== ==========
12. Related party transactions The Company's President also serves as President and Chairman of Michigan BIDCO. As such, the President is actively involved in the BIDCO's operations, including investment activity and estimation of the fair value of its equity investments. In December, 2004, the BIDCO paid in full its $600,000 note to the Bank. Additionally, the Bancorp sold its 6.10% in the BIDCO. At December 31, 2004, neither the Bank nor the Bancorp had a financial interest in or with BIDCO.
The Bank had loans outstanding of $44,232 and $280,690 to related officers and directors at December 31, 2004 and 2003, respectively. During 2004, two loans totaling $620,000 were originated. There were no related party loans that were originated during 2003 that were outstanding at year end. During 2003, a construction line of credit issued in 2002 was terminated. Available lines of credit to related parties at the December 31, 2004 and 2003, totaled $118,768 and $156,373 respectively. Related party loans were made in the normal course of business and were performing pursuant to terms at December 31, 2004.
13. Income taxes At December 31, 2004 income tax expense of $80,000 was recorded due to uncertainties as to the future benefits of the net operating losses.
At December 31, 2003, the Company recorded an $80,000 tax benefit as a deferred tax asset which represented a portion of the existing net operating loss carry-forward that was expected to be utilized to offset future taxable income.
The net deferred tax asset at December 31, 2004 and 2003 is comprised of the following:
2004 2003
Allowance for loan losses $ 123,732 $ 276,579 Net operating loss carry-forward 707,369 487,663 Tax credit carry-forward 1,111,810 989,123 Deferred gain on sale leaseback 71,715 85,568 Donation carry-forward 9,058 46,819 Other 138,189 57,708 ------------- ------------ Deferred tax assets 2,161,873 1,943,460 ------------- ------------
Servicing rights (373,247) (339,009) Depreciation (32,839) (32,661) ------------- ------------ Deferred tax liabilities (406,086) (371,670) ------------- ------------ Net deferred tax asset 1,755,787 1,571,790 Valuation allowance for deferred tax assets (1,755,787) (1,491,790) ------------- ------------ Net deferred tax asset $ 0 $ 80,000 ============= ============
The Company has net operating loss carry-forwards of approximately $2,080,000 which expire beginning in 2012 and general business credit carry-forwards of approximately $1,112,000 which expire beginning in 2011. Financial statement tax expense amounts differ from the amounts computed by applying the statutory federal tax rate of 34% to pretax income because of operating losses and valuation allowances recorded to reduce deferred tax assets as noted above.
14. Short Term Borrowings The Bank had a line of credit available from the Federal Home Loan Bank (the FHLB) in the amount of $4.0 million and $3.0 million at December 31, 2004 and 2003, respectively. At December 31, 2004, borrowings were secured by the pledge of specific mortgage loans held for investment with unpaid principal balances of $5.4 million and available-for-sale securities with a balance of $1.1 million.
The Bank had a line of credit available from the Federal Reserve Bank of Chicago (the FRB) in the amount of $5.7 million. There were no amounts outstanding on this line from the FRB at December 31, 2004 and 2003. Borrowings are secured by the pledge of specific commercial loans held for investment with unpaid principal balances of $7.8 million. The following information provides a summary of short-term borrowings for the years indicated: 2004 2003 ---- ---- Amount outstanding at the end of the year and interest rate $2,416,000 1.65% $ 0
Maximum amount of borrowing outstanding at any month end during the year $2,601,000 $991,000
Average amount outstanding during the year and weighted average rate $972,076 1.75% $227,063 1.29%
15. Long Term Borrowings The Company had a note payable to North Country Bank & Trust (NCB&T) secured by the stock of the Bank with a balance of $34,000 and $166,000 at December 31, 2004 and 2003, respectively. The note has a maturity date of February 15, 2005. Interest is payable quarterly at the prime rate of NCB&T plus 1.00 percent.
Dividends by the Bank to the holding company in excess of the prior year's annual net income are not permitted without prior permission from NCB&T under the terms of the Company's credit facility.
16. Regulatory matters University Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors.
The Bank is also subject to prompt corrective action capital requirement regulations set forth by the FDIC. The FDIC requires the Bank to maintain a minimum of total capital and Tier 1 capital (as defined) to risk-weighted assets (as defined), and of Tier I capital (as defined) to
16. Regulatory matters (continued)
average total assets (as defined). As of December 31, 2004, the Bank did not meet all capital adequacy requirements to which it is subject as the Bank presently has a written understanding with its regulators that the Bank will maintain the ratio of Tier 1 Capital to average assets at 7% or more. Management has submitted a plan of corrective action to the FDIC. This plan includes the possible issuance of preferred stock.
As of December 31, 2004, the most recent guidelines from the FDIC categorized the Bank as "adequately capitalized" under the regulatory framework for prompt corrective action. At December 31, 2003 the Bank was classified as "well capitalized." To be categorized as "well capitalized," or "adequately capitalized" the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table.
17. Management's Plan Regarding Continuing Operations At December 31, 2004, University Bancorp had an accumulated deficit of $2,490,224 and recurring losses from operations for 3 of the past 5 years. University Bancorp's operations are intended to continue in the future. Management has reviewed operating results, prepared projections of possible future results, performed other analyses of its operations to reduce operating costs and entered new product lines of business.
17. Management's Plan Regarding Continuing Operations (continued)
Management of the Company has implemented a plan to improve core earnings by adding low-cost deposits, adjusting fees, growing the loan portfolio of the Bank, reducing loan delinquencies, liquidating other real estate owned, improving the synergy between its subsidiary operations, and eliminating inefficient or redundant costs at the Bank level. Both the Bank and Midwest are projected to have net income in 2005, however, the Company's continued operation is dependent upon its ability to maintain profitable operations and retain adequate capital levels.
18. Fair Value of Financial Instruments The following methods and assumptions were used to estimate fair values for financial instruments. The carrying amount is considered to estimate fair value for cash and short-term instruments, demand deposits, short-term borrowings, accrued interest, and variable rate loans or deposits that reprice frequently and fully. Securities fair values are based on quoted market prices or, if no quotes are available, on the rate and term of the security and on information about the issuer. For fixed rate loans or deposits and for variable rate loan or deposits with infrequent repricing or repricing limits, the fair value is estimated by the discounted cash flow analysis using current market rates for the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analyses of underlying collateral values, where applicable. Fair value of loans held for sale is based on market estimates. Fair value of mortgage servicing rights is estimated using discounted cash flows based on current market interest rates net of estimated costs of servicing loans. Fair value of mortgage subservicing rights is based on a multiple of servicing contract revenue. The fair value of debt is based on currently available rates for similar financing. The fair value of off-balance sheet items is based on the fees or cost that would normally be charged to enter into or terminate such agreements. Fair value of unrecognized financial instruments includes commitments to extend credit and the fair value of letters of credit is considered immaterial.
18. Fair Value of Financial Instruments (continued)
The carrying amounts and fair values of the Company's financial instruments were as follows:
December 31, 2004 Carrying Fair Financial Assets Amount Value ---------------- ------ ----- Cash and short term investments $ 1,732,000 $ 1,732,000 Securities available for sale 1,106,000 1,106,000 Federal Home Loan Bank stock 922,000 922,000 Loans held for sale 846,000 846,000 Loans, net 42,647,000 43,436,000 Mortgage servicing rights 1,097,000 1,097,000 Accrued interest receivable 148,000 148,000
Financial Liabilities Deposits 44,588,000 44,640,000 Short term borrowings 2,416,000 2,416,000 Long term borrowings 34,000 34,000 Accrued interest payable 50,000 50,000
December 31, 2003 Carrying Fair Financial Assets Amount Value ---------------- ------ ----- Cash and short term investments $ 2,171,000 $ 2,171,000 Securities available for sale 1,649,000 1,649,000 Federal Home Loan Bank stock 881,100 881,100 Loans held for sale 206,000 206,000 Loans, net 34,474,000 35,630,000 Mortgage servicing rights 1,032,000 1,032,000 Accrued interest receivable 130,000 130,000
Financial Liabilities Deposits 38,808,000 39,048,000 Long term borrowings 166,000 166,000 Accrued interest payable 52,000 52,000
19. Segment Reporting
The Company's operations include two primary segments: retail banking and mortgage banking. Through its banking subsidiary's branch in Ann Arbor, the Company provides traditional community banking services such as accepting deposits, making loans, and providing cash management services to individuals and local businesses. Mortgage banking activities includes servicing of residential mortgage loans for others (See Note 2).
19. Segment Reporting (continued)
The Company's two reportable segments are strategic business units that are separately managed as they offer different products and services and have different marketing strategies. In addition, the mortgage banking segment services a different customer base from that of the retail banking segment.
The segment financial information provided below has been derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company. The accounting policies of the three segments are the same as those described in the summary of significant accounting policies. The Company evaluates segment performance based on profit or loss before income taxes, not including nonrecurring gains and losses. Certain indirect expenses have been allocated based on actual volume measurements and other criteria, as appropriate. The Company accounts for transactions between segments at current market prices. Segment profit is measured before allocation of corporate overhead and income tax expense.
Information about reportable segments for the year ended December 31, 2004 follows:
21. Parent Company Only Condensed Financial Information Condensed Balance Sheet
December 31, December 31, 2004 2003 --------------------- ----------------- ASSETS Cash and cash equivalents $ 5,626 $ 669 Securities available for sale - 12,316 Investment in University Bank 3,050,721 3,557,977 Investment in Michigan BIDCO - 29,258 Other assets 3,137 3,768 ----------- ----------- Total Assets $ 3,059,484 $ 3,603,988 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Notes payable $ 34,000 $ 166,000 Accounts payable 23,601 2,000 Accrued interest payable 257 1,361 ----------- ----------- Total Liabilities 57,858 169,361 Stockholders' Equity 3,001,626 3,434,627 ----------- ----------- Total Liabilities and Stockholders' Equity $ 3,059,484 $3,603,988 =========== ===========
21 Parent Company Only Condensed Financial Information (continued) Condensed Statements of Income
2004 2003 2002 ----------- --------- -------- INCOME: Interest and dividends on investments $ 266 $ 339 $ 328 Net security losses (446) (26,574) - ----------- --------- ------- Total (loss)income (180) (26,235) 328
EXPENSES: Interest 4,907 12,144 20,675 Public listing 45,696 43,088 38,202 Professional fees 36,976 24,000 33,513 Other miscellaneous 2,726 5,250 3,014 ---------- -------- ------- Total Expense 90,305 84,482 95,404 Loss before federal income taxes and equity in undistributed net loss of subsidiaries (90,125) (110,717) (95,076) Federal income taxes - - - ---------- -------- ------- Loss before equity in undistributed net loss of subsidiaries (90,125) (110,717) (95,076) Equity in undistributed net (loss)income of subsidiaries (494,695) 205,159 300,674 ---------- -------- -------- Net(loss)income $(584,820) $ 94,442 $205,598 ========== ======== ========
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures.
None
ITEM 9A.
ITEM 9A. Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures. As of the end of the period covered by this report, an ----------------------------------------------------- evaluation was carried out under the supervision and with the participation of the Company's management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-14(c) under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, except as described below, the operation of these disclosure controls and procedures were effective for gathering, analyzing and disclosing information required to be disclosed in connection with the Company's filing of its Annual Report on Form 10-K for the year ended December 31, 2004. During the course of the audit of our financial statements for the year ended December 31, 2004, our independent registered public accounting firm, Grant Thornton LLP, indicated that the following material deficiencies, in the aggregate, constitute a material weakness in our internal controls pursuant to standards established by the Public Company Accounting Oversight Board:
(1) The Company lacks sufficiently formalized accounting policies and procedures, including written procedures for the preparation of the Quarterly Report on Form 10-Q in accordance with applicable SEC guidelines.
(2) The Company's manual procedures for performing consolidations increase the possibility that errors could occur and our dual controls may not be sufficient to guarantee avoidance of all errors in consolidation.
(3) The Company may have insufficient staff in the accounting and financial reporting departments to meet the needs of Sarbanes-Oxley Section 404 standards by June 2006
(4) The Company replaced its core banking software application during the summer of 2004. The core banking system is now out-sourced to a service bureau whereas previously the bank maintained the core banking system in house. During the transition and for a period afterwards it was necessary to give certain members of senior management additional access rights for training and the transition requirements in the new system. In March 2005, access rights for the banking software were revised and access rights were reassigned to levels appropriate for a routine operating environment. The controls in the new core banking application in place today are significantly better than the overall control levels in the system that was replaced.
Management has begun implementing plans to address each of items 1-3, further improving on the systems and procedures already in place. Management believes that its plans with respect to each of these items will be completed and implemented in the second quarter of 2005.
With respect to policies and procedures for the Quarterly Report on Form 10-Q, management notes that it uses a checklist prepared by the American Institute of Certified Public Accountants to assist in the preparation of SEC reports and that it maintains a reference library of SEC and accounting handbooks. Management is implementing plans to further formalize its procedures and
expects to complete and implement this in the second quarter of 2005.
Management believes that the Company's general ledger and core processing systems for each entity in the consolidation are effective and are consistent with systems used by others in our industry. We have evaluated our procedures and made changes to increase the automation and dual controls for preparing consolidated results.
Management believes that the current staff in the accounting and financial reporting is sufficient and properly trained to implement appropriate internal controls and to generate accurate financial statements. We continue to provide training and to document our systems and procedures to make sure that the Company is able to comply with the internal control report requirements by the applicable deadline.
(b) Changes in Internal Controls. Except as described above, there were no significant changes in the Company's internal controls over financial reporting during the fourth quarter of the fiscal year ended December 31, 2004, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting
Item 9B.
Item 9B. - Recent Events
On March 31, 2005, the Bank signed a Fourth Amendment to its Purchase Agreement dated September 14, 2002, with Lower Town Development Group, LLC, the developer of the site on which the Bank's current headquarters is located. The Purchase Agreement, as amended, contemplates that the Bank will purchase an office condominium from Lower Town Development Group, LLC, an entity affiliated with the current owner and lessor of the Bank's headquarters. The office condominium would be built on land currently occupied by the Bank's headquarters.
The Bank has previously sold and leased back its headquarters facility at 959 Maiden Lane, Ann Arbor, Michigan. The purchaser of the property, an affiliate of Lower Town Development Group, L.L.C., owes the Bank a deferred payment of $200,000. Under the amended purchase agreement, if University Bank, in is sole discretion, can give notice on or before June 15, 2005 that it will vacate its 959 Maiden Lane, Ann Arbor, Michigan headquarters by August 1, 2005, then Lower Town Development Group, LLC agrees to pay University Bank $800,000. The $800,000 will be payable upon either (i) the closing of the construction financing pertaining to the office condominium project or (ii) by December 31, 2005, whichever occurs first. The amended purchase agreement provides that the purchase price for the new 10,000 square foot headquarters will be $2,000,000 instead of $1,800,000.
PART III.
Item 10.
Item 10. - Directors and Executive Officers of the Registrant
The information required by this item is incorporated by reference herein from the portions of the Company's Proxy Statement for its 2004 Annual Meeting (the "Proxy Statement") to be under the captions:
Election of Directors Executive Officers Section 16(a) Beneficial Ownership Reporting Compliance
We have adopted a Code of Ethics for all employees. A copy of the Code of Ethics is available upon request by writing to the Chief Financial Officer, University Bancorp, Inc.,959 Maiden Land, Ann Arbor, Michigan 48105.
Item 11.
Item 11. - Executive Compensation
The information required by this item is incorporated by reference herein from the portions of the Company's Proxy Statement to be under the captions:
Executive Compensation Compensation Plans
Item 12.
Item 12. - Security Ownership of Certain Beneficial Owners and Management
The information required by this item is incorporated by reference herein from the portion of the Company's Proxy Statement to be under the caption:
Security Ownership of Certain Beneficial Owners and Management
Equity Compensation Plan Information
The University Bancorp, Inc. 1995 Stock Option Plan authorizes stock options for issuance to employees, consultants and directors in exchange for services.
The following table sets forth certain information regarding the above referenced equity compensation plan as of December 31, 2004.
(1) University Bancorp has not granted rights or warrants applicable to this chart.
Item 13.
Item 13. - Certain Relationships and Related Transactions
The information required by this item is incorporated by reference herein from the portion of the Company's Proxy Statement to be under the caption:
Certain Relationships and Related Transactions
ITEM 14:
ITEM 14: Principal Accountant Fees and Services.
Information relating to principal accountant fees and services is contained on page 20, under the caption "Independent Public Accountants" in the University Bancorp, Inc. definitive Proxy Statement dated April 30, 2005, relating to the 2004 Annual Meeting of Stockholders and the information within that section is incorporated by reference.
PART IV.
Item 15.
Item 15. - Exhibits, Financial Statement Schedules
(a) Index of Financial Statements: The following statements are filed as part of this Report:
Audited consolidated balance sheets as of December 31, 2004 and December 31, 2003, and consolidated statements of operations, comprehensive (loss) income, stockholders' equity and cash flows for the years ended December 31, 2004, 2003, and 2002 of the Company.
(b) Schedules to the consolidated financial statements required by Article 9 of Regulation S-X are not required under the related instructions or are inapplicable, and therefore have been omitted.
(c) Form S-8 relating to the University Bancorp, Inc. 1995 Stock Option Plan
(d) Exhibits:
(3) Certificate of Incorporation and By-laws:
3.1 Composite Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996).
3.1.1 Certificate of Amendment, dated June 10, 1998, of the Company's Certificate of Incorporation (incorporated by reference to Exhibit 3.1.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998).
3.2 Composite By-laws of the Company (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989).
(10) Material Contracts.
10.1 Loan Agreement and Promissory Note dated December 31, 1997 issued to North Country Bank & Trust (incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.2 University Bancorp, Inc. Employee Stock Ownership Plan (the "ESOP"), as amended November 27, 1990 (incorporated by reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990). *
10.2.1 Amendment to the ESOP, effective as of December 31, 1991 (incorporated by reference to Exhibit 10.2.A to the Company's Annual Report on Form 10-K for the year ended December 31, 1991). *
10.3 University Bank 401(k) Profit Sharing Plan, adopted August 1, 1996, effective as of January 1, 1996 (incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). *
10.4 1995 Stock Plan of the Company (incorporated by reference to Exhibit A to the definitive Proxy Statement of the Company for 1996 Annual Meeting of Stockholders). *
10.4.1 Form of Stock Option Agreement related to the 1995 Stock Plan (incorporated by reference to Exhibit 10.7.1 to the Annual Report on Form 10-K for the year ended December 31, 1995). *
10.5 Letter, dated December 1, 1989, from Federal Reserve Bank of Minneapolis (incorporated by reference to Exhibit 10.9).
10.6 Federal Income Tax Allocation Agreement Between Newberry State Bank and Newberry Holding Inc. dated March 21, 1992 (incorporated by reference to Exhibit 10.11).
10.6.1 Federal Income Tax Allocation Agreement Between Newberry Holding Inc. and University Bancorp, Inc. dated May 21, 1991 (incorporated by reference to Exhibit 10.11.1).
21 Subsidiaries of Registrant: List of subsidiaries filed herewith.
23.1 Reports of Independent Auditors, Richard C. Woodbury, P.C., dated February 25, 2005 regarding Midwest Loan Services, Inc.
23.2 Consent of Grant Thornton, LLP, Certified Public Accountants
31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certificate of the Chief Executive Officer and of University Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.1 Certificate of the Chief Financial Officer of University Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of Sections 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.
UNIVERSITY BANCORP, INC.
By: /s/Stephen Lange Ranzini Stephen Lange Ranzini, President and Chief Executive Officer Date: March 29, 2005 By: /s/Nicholas K. Fortson Chief Financial Officer Date: March 29, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/Stephen Lange Ranzini Director, President March 29, 2005 - ------------------------ Stephen Lange Ranzini
/s/Robert Goldthorpe Director, Chairman March 29, 2005 - -------------------- Robert Goldthorpe
/s/Gary Baker Director March 29, 2005 - ------------- Gary Baker
/s/Michael Talley Director March 29, 2005 - ----------------- Michael Talley
/s/Dr. Joseph L. Ranzini Director March 29, 2005 - ------------------------ Dr. Joseph Lange Ranzini
/s/Paul Lange Ranzini Director March 29, 2005 - --------------------- Paul Lange Ranzini
/s/Charles McDowell Director March 29, 2005 - ------------------- Charles McDowell
Exhibit 21. Subsidiaries of Registrant.
University Bank, a Michigan state chartered bank.
University Insurance & Investment Services, Inc., a Michigan Corporation (100% owned by Bank)
Midwest Loan Services, Inc., a Michigan Corporation (80% owned by University Bank)
EXHIBIT 23.1 Richard C. Woodbury, P.C. Certified Public Accountant 20017 E. Sharon Avenue Houghton, MI 49931-1904 ---------------------- Phone: (906) 482-1305 Fax: (906) 482-9555 Email: rwoodbury@charterinternet.com Website: www.rcwpc.com INDEPENDENT AUDITOR'S REPORT
Board of Directors Midwest Loan Services, Inc. Houghton, MI 49931
We have audited the accompanying balance sheet of Midwest Loan Services, Inc., as of December 31, 2004 and 2003, and the related statements of income, retained earnings, and cash flows for the years then ended. 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 audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Governmental Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Midwest Loan Services Inc. as of December 31, 2004, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
In accordance with Government Auditing Standards, we have also issued our report dated February 26, 2004, on our consideration of Midwest Loan Services, Inc., internal control and on our tests of its compliance with certain provisions of laws, regulations, contracts, and grants. Those reports are an integral part of the audit performed in accordance with Government Auditing Standards and should be read in conjunction with this report in considering the results of our audit.
The accompanying supplemental information (shown on pages 18-24) is presented for the purposes of additional analysis and is not a required part of the basic financial statements of Midwest Loan Services Inc. Such information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, In our opinion, is fairly stated, in all material respects, in relation to the financial statements taken as a whole.
Richard C. Woodbury, CPA February 25, 2005
EXHIBIT 23.2
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We have issued our report dated March 29, 2005 accompanying the consolidated financial statements incorporated by reference in the annual report of University Bancorp, Inc. on Form 10-K for the year ended December 31, 2004. We hereby consent to the incorporation by reference of said report in the Registration Statement of University Bancorp, Inc. on Form S-8 (File No. 333- 109930 ) effective October 23, 2003.
/S/ GRANT THORNTON LLP
Southfield, Michigan April 13, 2005
EXHIBIT 23.3
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUTING FIRM
We have issued our report dated February 25, 2005 accompanying the consolidated financial statements incorporated by reference in the annual report of University Bancorp, Inc. on Form 10-K for the year ended December 31, 2004. We hereby consent to the incorporation by reference of said report in the Registration Statement of University Bancorp, Inc. on form S-8 (File No. 333-10993) effective October 23, 2003.
/S/ Richard C. Woodbury, P.C., CPA
Houghton, Michigan April 13, 2005
Exhibit 31.1 FORM 10-K 302 CERTIFICATION I I, Stephen Ranzini certify that:
1) I have reviewed this annual report on Form 10-K of University Bancorp, Inc.;
2) Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3) Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4) The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of the annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. s; and
Date: March 29, 2005 /s/Stephen Lange Ranzini ------------------ ---------------------------------- Stephen Lange Ranzini President and Chief Executive Officer
Exhibit 31.2 FORM 10-K 302 CERTIFICATION
I, Nicholas K. Fortson certify that:
1) I have reviewed this annual report on Form 10-K of University Bancorp, Inc.;
2) Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3) Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4) The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
d) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
e) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
f) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of the annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
6. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. s; and
Date: March 29, 2005 /s/Nicholas K. Fortson ------------------ ---------------------- Nicholas K. Fortson Chief Financial Officer
Exhibit 32.1
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the annual report of University Bancorp, Inc. (the "Registrant") on Form 10-K for the period ended December 31, 2002 as filed with the Securities and Exchange Commission on March 29, 2005, hereof (the "Report"), the undersigned officers certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and
(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
University Bancorp, Inc
Date: March 29, 2005 By: /s/ Stephen Lange Ranzini ------------------ -------------------------- Stephen Lange Ranzini President and Chief Executive Officer
Exhibit 32.2
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the annual report of University Bancorp, Inc. (the "Registrant") on Form 10-K for the period ended December 31, 2002 as filed with the Securities and Exchange Commission on March 29, 2005, hereof (the "Report"), the undersigned officers certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and
(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Registrant.
University Bancorp, Inc
Date: March 29, 2005 By: /s/ Nicholas K. Fortson ----------------------- Nicholas K. Fortson Chief Financial Officer