Item 1. Business
Overview
General. LNB Bancorp, Inc., (the “Corporation”), is a diversified financial services company headquartered in Lorain, Ohio. It is organized as a financial holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). Its predecessor, the Lorain Banking Company was a state chartered bank founded in 1905. It merged with the National Bank of Lorain in 1961, and in 1984 became a wholly-owned subsidiary of LNB Bancorp, Inc. The Corporation received its financial holding company status on March 13, 2000.
The Corporation engages in banking, mortgage, and brokerage services. These services are generally offered through its wholly-owned subsidiary - The Lorain National Bank (the “Bank”). For brokerage services the Bank operates under an agreement with Investment Centers of America, Inc. Investment Centers of America, Inc. is a member of NASD/SIPC and offers mutual funds, variable annuity investment, variable annuity and life insurance products, along with investment in stocks and bonds.
The Bank specializes in personal, mortgage and commercial banking products along with investment management and trust services. The Lorain National Bank operates 23 banking centers and 26 ATMs in the Ohio communities of Lorain, Elyria, Amherst, Avon, Avon Lake, LaGrange, North Ridgeville, Oberlin, Olmsted Township, Vermilion and Westlake, as well as a business development office in Cuyahoga County.
The Bank’s commercial lending activities consist of commercial real estate loans, construction and equipment loans, letters of credit, revolving lines of credit, Small Business Administration loans and government guaranteed loans. The Bank’s wholly-owned subsidiary, North Coast Community Development Corporation, offers commercial loans with preferred interest rates on projects that meet the standards for the federal government’s New Markets Tax Credit Program.
The Bank’s residential mortgage lending activities consist of loans originated for portfolio. These loans are for the purchase of personal residences. Installment lending activities consist of traditional forms of financing for automobile and personal loans, indirect automobile loans, second mortgages, home equity lines of credit, and automobile loans that are purchased from another financial institution.
The Bank’s deposit services include traditional transaction and time deposit accounts as well as cash management services for corporate and municipal customers. The Bank supplements local deposit generation with time deposits generated through a broker relationship. Deposits of the Bank are insured by the Bank Insurance Fund administered by the Federal Deposit Insurance Corporation (the “FDIC”).
Other bank services offered include safe deposit boxes, night depository, U.S. savings bonds, travelers’ checks, money orders, cashiers checks, ATM’s, debit cards, wire transfer, ACH, foreign drafts, foreign currency, electronic banking by phone or through the internet, lockbox and other services tailored for both individuals and businesses.
Competition. The Corporation competes with sixteen other financial institutions in Lorain County, in Ohio, which range in size from approximately $107 million to over $435 billion in deposits. These competitors, as well as credit unions and financial intermediaries, compete for Lorain County deposits of approximately of $3.4 billion.
The Bank’s market share of total deposits in Lorain County was 18.96% in 2006 and 18.82% in 2005, and the Bank ranked number two in market share in Lorain County in 2006 and 2005.
The Bank has a limited presence in Cuyahoga County, competing with twenty-nine other financial institutions. Cuyahoga County deposits as of 2006 totaled $53.7 billion. The Bank’s market share of deposits in Cuyahoga County was 0.07% in 2006 and 0.07% in 2005.
Business Strategy. The Bank competes with larger financial institutions by providing exceptional local service that emphasizes direct customer access to the Bank’s officers. It competes against smaller local banks by providing distribution channels that are more convenient and by providing a wider array of products. It endeavors
to provide informed and courteous personal services. The Corporation’s management team (“Management”) believes that the Bank is well positioned to compete successfully in its market area. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, the relative level of service charges, the quality and scope of the services rendered, the convenience of the banking centers and, in the case of loans to commercial borrowers, relative lending limits. Management believes that the commitment of the Bank to provide quality personal service and its local community involvement give the Bank a competitive advantage.
On January 16, 2007, LNB Bancorp, Inc. and Morgan Bancorp, Inc. of Hudson, Ohio announced the signing of a definitive agreement for LNB to acquire Morgan and its wholly-owned subsidiary, Morgan Bank, N.A., in a stock and cash merger transaction valued at approximately $26.5 million. With approximately $129 million in assets, Morgan Bank operates from one location in Hudson, Ohio, which ranks as the fourth wealthiest city in Ohio as measured by median household income statistics, making it one of the most demographically appealing markets in Ohio for banking institutions and financial services providers. Morgan Bank enjoys the number one deposit market share position in Hudson with approximately 23% of this $450 million deposit market. This merger is consistent with our strategy to create shareholder value by expanding into attractive markets in contiguous counties. We expect Morgan, which operates in Summit County, to compliment our recently opened office in Cuyahoga County.
Supervision and Regulation. The Corporation is subject to the supervision and examination of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The BHC Act requires prior approval of the Federal Reserve Board before acquiring or holding more than a 5% voting interest in any bank. It also restricts interstate banking activities.
The Bank is subject to extensive regulation, supervision and examination by applicable federal banking agencies, including the FDIC, the Office of the Comptroller of the Currency (the “OCC”) and the Federal Reserve Board. Brokerage and Trust management are subject to supervision by the National Association of Securities Dealers (the “NASD”) and SPIC.
Employees. As of December 31, 2006, the Corporation employed 243 full-time equivalent employees. The Corporation is not a party to any collective bargaining agreement. Management considers its relationship with its employees to be good. Employee benefits programs are considered by the Corporation to be competitive with benefits programs provided by other financial institutions and major employers within the current market area.
Industry Segments
The Corporation and its subsidiary, The Lorain National Bank, are engaged in one line of business, which is banking services.
Available Information
LNB Bancorp, Inc.’s internet website is www.4LNB.com. Copies of the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are made available through this website, or directly through the Securities and Exchange Commission (“SEC”) website which is www.sec.gov.
Forward-Looking Statements
This Form 10-K contains forward-looking statements within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Terms such as “will,” “should,” “plan,” “intend,” “expect,” “continue,” “believe,” “anticipate” and “seek,” as well as similar comments, are forward-looking in nature. Actual results and events may differ materially from those expressed or anticipated as a result of risks and uncertainties which include but are not limited to:
significant increases in competitive pressure in the banking and financial services industries;
changes in the interest rate environment which could reduce anticipated or actual margins;
changes in political conditions or the legislative or regulatory environment;
general economic conditions, either nationally or regionally (especially in northeastern Ohio), becoming less favorable than expected resulting in, among other things, a deterioration in credit quality of assets;
changes occurring in business conditions and inflation;
changes in technology;
changes in monetary and tax policies;
changes in the securities markets;
changes in economic conditions and competition in the geographic and business areas in which the Corporation conducts its operations; as well as the risks and uncertainties described from time to time in the Corporation’s reports as filed with the Securities and Exchange Commission;
customer reaction to and unforeseen complications with respect to the Corporation’s integration of acquisitions;
difficulties in realizing expected cost savings from acquisitions; and
difficulties associated with data conversions in acquisitions.
Item 1A.
Item 1A. Risk Factors
As a competitor in the banking and financial services industries, the Corporation and its business, operations and financial condition are subject to various risks and uncertainties. You should carefully consider the risks and uncertainties described below, together with all of the other information in this annual report on Form 10-K and in the Corporation’s other filings with the SEC, before making any investment decision with respect to the Corporation’s securities. In particular, you should consider the discussion contained in Item 7 of this annual report, which contains Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The risks and uncertainties described below may not be the only ones the Corporation faces. Additional risks and uncertainties not presently known by the Corporation or that the Corporation currently deems immaterial may also affect the Corporation’s business. If any of these known or unknown risks or uncertainties actually occur or develop, the Corporation’s business, financial condition, results of operations and future growth prospects could change. Under those circumstances, the trading prices of the Corporation’s securities could decline, and you could lose all or part of your investment.
Competition. Strong competition may reduce our ability to generate loans and deposits in our market. The Corporation competes in a consolidating industry. Increasingly the Corporation’s competition are large regional companies which have the capital resources to substantially impact such things as loan and deposit pricing, delivery channels and products. This may allow those companies to offer what may be perceived in the market as better products and better convenience relative to smaller competitors like the Corporation, which could impact the Corporation’s ability to grow its assets and earnings.
Interest Rate Risk. Changes in interest rates could adversely affect the Corporation’s earnings and financial condition. The Corporation derives the majority of its revenue from net interest income. Net interest income may be reduced if more rate sensitive assets than interest-bearing liabilities reprice or mature during a time when rates are declining, or if more interest-bearing liabilities than rate sensitive assets reprice or mature during a time when rates are rising; however, the Corporation has historically experienced improved net interest income during periods of rising rates, so if rates fall, the Corporation’s revenue may be adversely impacted. Interest rate changes also impact customer preferences for products. Changing rates can lead to unpredicted cash flow from assets and liabilities, which can impact net interest income.
Integration Risk. We may not be able to achieve the expected integration and cost savings from our ongoing bank acquisition activities, including our anticipated acquisition of Morgan Bank. Difficulties may arise in the integration of the business and operations of the financial institutions that agree to merge with and into the Corporation and its subsidiaries and, as a result, we may not be able to achieve the cost savings and synergies that we expect will result from the merger activities. Achieving cost savings is dependent on consolidating certain operational and functional areas, eliminating duplicative positions and terminating certain agreements for outside services. Additional operational savings are dependent upon the integration of the banking businesses of the acquired financial institution with that of the Corporation, including the conversion of the acquired entity’s core operating systems, data systems and products to those of the Corporation and the standardization of business practices. Complications or difficulties in the conversion of the core operating systems, data systems and products of these other banks to those of the Corporation may result in the loss of clients, damage to our reputation within the financial services industry, operational problems, one-time costs currently not anticipated by us and/or reduced cost savings resulting from the merger activities.
Acquisition Risk . We may have difficulty in the future to continue to grow through acquisitions. Any future acquisitions or mergers by the Corporation or its subsidiaries, including our anticipated acquisition of Morgan Bank, are subject to approval by the appropriate federal and state banking regulators. The banking regulators evaluate a number of criteria in making their approval decisions, such as:
Safety and soundness guidelines;
Compliance with all laws including the USA Patriot Act of 2001, the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001, the Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated under such Act or the Exchange Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Community Reinvestment Act, the Home Mortgage Disclosure Act and all other applicable fair lending laws and other laws relating to discriminatory business practices; and
Anti-competitive concerns with the proposed transaction.
If the banking regulators or a commenter on our regulatory application raise concerns about any of these criteria at the time a regulatory application is filed, the banking regulators may deny, delay or condition their approval of a proposed transaction.
We intend to continue to grow through acquisitions of banks and other financial institutions. After these acquisitions, we may experience adverse changes in results of operations of acquired entities, unforeseen liabilities, asset quality problems of acquired entities, loss of key personnel, loss of clients because of change of identity, difficulties in integrating data processing and operational procedures and deterioration in local economic conditions. These various acquisition risks can be heightened in larger transactions.
Government Policies. The Corporation’s business may be adversely affected by changes in government policies. The Corporation competes in a highly regulated environment. Changes in regulation are continually being proposed which can substantially impact the Corporation’s products and cost of delivery. Regulatory burdens imposed by legislation such as The Sarbanes-Oxley Act of 2002, The USA Patriot Act of 2001, The International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001, The Equal Credit Opportunity Act, The Fair Housing Act, The Community Reinvestment Act and the Home Mortgage Disclosure Act can materially impact the ability of the Corporation to grow should the Corporation fail to develop the systems to adequately comply with these regulations. Failure to comply with these regulations can lead to loss of customer confidence, substantial fines and regulatory constraints on the Corporation’s operations. These burdens can also materially impact the earnings of the Corporation as additional resources are expended to comply with these requirements. The government, through the open market activities of the Federal Reserve Board, can also adversely impact our business. The Federal Reserve Board can change the discount rate which impacts the composition of the Corporation’s balance sheet by influencing the rates that the Corporation earns on its assets and pays on its liabilities.
General Economic Conditions. The Corporation may be adversely impacted by weakness in the local economies we serve. The Corporation is geographically concentrated in Lorain County, Ohio, where commercial activity is not expanding at a rate that is being experienced in other parts of Ohio or nationally. This is the result of continued reliance on a weak manufacturing sector, especially steel and automobiles. This can lead to unexpected deterioration in loan quality, slower asset and deposit growth and increased operating losses.
Credit Risk. The Corporation’s earnings and reputation may be adversely affected if credit risk is not properly managed. Originating and underwriting loans is critical to the success of the Corporation. This activity exposes the Corporation to credit risk, which is the risk of losing principal and interest income because the borrower cannot repay the loan in full. The Corporation depends on collateral in underwriting loans, and the value of this collateral is impacted by interest rates and economic conditions.
Concentration of Credit Risk. The Corporation’s earnings may be adversely affected if management does not understand and properly manage loan concentrations. The Corporation’s commercial loan portfolio is concentrated in commercial real estate. This includes significant commercial and residential development customers. This means that the Corporation’s credit risk profile is dependent upon, not only the general economic conditions in the market, but also the health of the local housing market. These loans involve greater risk because they generally are not fully amortizing over the loan period, but have a balloon payment due at maturity. The borrower’s ability to make a balloon payment typically will depend on being able to refinance the loan or to sell the underlying collateral. This factor, combined with others, including our geographic concentration, can lead to unexpected credit deterioration and higher provisions for loan losses.
Dependence on Technology and Systems. If the Corporation’s technology and systems are damaged, its ability to service customers, comply with regulation and grow asset and liabilities may be adversely impacted. The Corporation is dependent on the proper functioning of its hardware, software and communications. Security breaches, terrorist events, and natural disasters can all have a material impact on the Corporation’s ability to maintain accurate records which is critical to the Corporation’s operations.
Item 1B.
Item 1B. Unresolved Staff Comment Letters
Not applicable.
Item 2.
Item 2. Properties
The Corporate Offices are located at the Corporation’s Main Banking Center, 457 Broadway, Lorain, Ohio, 44052. The Corporation owns the land and buildings occupied by twelve of its banking centers, and it leases the other eleven banking centers from various parties on varying lease terms. There is no outstanding mortgage debt on any of the properties which the Corporation owns. Listed below are the banking centers, loan production offices and service facilities of the Corporation and their addresses, all of which are located in Lorain, eastern Erie and western Cuyahoga counties of Ohio:
Main Banking Center & Corporate Offices
Vermilion
Amherst
Lake Avenue
Avon
Avon Lake
Kansas Avenue
Sixth Street Drive-In
Pearl Avenue
Oberlin Office
West Park Drive-In
Ely Square
Cleveland Street
Oberlin Avenue
Olmsted Township
Kendal at Oberlin
The Renaissance
Chestnut Commons
North Ridgeville
Village of LaGrange
Westlake Village
Elyria United Methodist Village
Avon Point Loan Center
Operations
Maintenance
Purchasing
Training Center
457 Broadway, Lorain
4455 East Liberty Avenue, Vermilion
1175 Cleveland Avenue, Amherst
42935 North Ridge Road, Elyria Township
2100 Center Road, Avon
32960 Walker Road, Avon Lake
1604 Kansas Avenue, Lorain
200 Sixth Street, Lorain
2850 Pearl Avenue, Lorain
40 East College Street, Oberlin
2130 West Park Drive, Lorain
124 Middle Avenue, Elyria
801 Cleveland Street, Elyria
3660 Oberlin Avenue, Lorain
27095 Bagley Road, Olmsted Township
600 Kendal Drive, Oberlin
26376 John Road, Olmsted Township
105 Chestnut Commons Drive, Elyria
34085 Center Ridge Road, North Ridgeville
546 North Center Street, LaGrange
28550 Westlake Village Drive, Westlake
807 West Avenue, Elyria
36711 American Way, Avon
2130 West Park Drive, Lorain
2140 West Park Drive, Lorain
2150 West Park Drive, Lorain
521 Broadway, Lorain
The Corporation also owns and leases equipment for use in its business. The Corporate headquarters at 457 Broadway is currently 75% occupied. The remaining space is expected to be utilized as the Corporation continues to grow. The Corporation considers all its facilities to be in good condition, well maintained and more than adequate to conduct the business of banking.
Item 3.
Item 3. Legal Proceedings
There are no material legal proceedings pending to which the Corporation or its subsidiaries is a party or to which any of its property is subject. The Corporation is occasionally involved in ordinary routine litigation incidental to its business which it does not consider to be material.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
During the fourth quarter of the year ended December 31, 2006 there were no matters submitted to a vote of security holders.
SUPPLEMENTAL ITEM - EXECUTIVE OFFICERS OF THE REGISTRANT
Pursuant to Form 10-K, General Instruction G (3), the following information on Executive Officers is included as an additional item in Part I:
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information; Equity Holders; Dividends. The shares of LNB Bancorp, Inc. common stock, fixed par value $1.00 per share, are traded on The NASDAQ Stock Market ® under the ticker symbol “LNBB”. The prices below represent the high and low sales prices reported on The NASDAQ Stock Market ® for each specified period. All prices reflect inter-dealer prices without markup, markdown or commission and may not necessarily represent actual transactions. LNB Bancorp, Inc. has paid a cash dividend to shareholders each year since becoming a holding company in 1984. At present, the Corporation expects to pay comparable cash dividends to shareholders in 2007 if approved by the Board of Directors.
The common stock of LNB Bancorp, Inc. is usually listed in publications as “LNB Bancorp”. LNB Bancorp Inc.’s common stock CUSIP is 502100100.
As of February 23, 2007, LNB Bancorp, Inc. had 2,028 shareholders of record and a closing price of $15.34 on February 23, 2007. Prospective shareholders may contact our Investor Relations Department at (440) 244-7317 for more information.
Common Stock Trading Ranges and Cash Dividends Declared
The following graph shows a five-year comparison of cumulative total returns for LNB Bancorp, the Standard & Poor’s 500 Stock Index© and the Nasdaq Bank Index.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among LNB Bancorp, Inc., The S & P 500 Index
And The NASDAQ Bank Index
* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.
Copyright © 2007, Standard & Poor's, a division of The McGraw-Hill Companies, Inc. All rights reserved. www.researchdatagroup.com/S&P.htm
The graph shown above is based on the following data points:
Copyright © 2007 Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.
Issuer Purchases of Equity Securities
The following table summarizes share repurchase activity for the quarter ended December 31, 2006:
On July 28, 2005 the Corporation announced a share repurchase program of up to 5 percent, or about 332,000, of the common shares outstanding. Repurchased shares can be used for a number of corporate purposes, including the Corporation’s stock option and employee benefit plans. Under the share repurchase program, share repurchases are expected to be made primarily on the open market from time-to-time until the 5 percent maximum is repurchased or the earlier termination of the repurchase program by the Board of Directors. Repurchases under the program will be made at the discretion of Management based upon market, business, legal and other factors. At December 31, 2006, the Corporation had repurchased 202,500 shares under this program.
Item 6.
Item 6. Selected Financial Data
Five Year Consolidated Financial Summary
____________________
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Introduction
The Corporation competes in the Cleveland, Ohio market as defined by the Federal Reserve Bank. This market includes most of northeast Ohio. However, until 2006, the Corporation’s presence in this market was primarily limited to Lorain. In 2006, this changed with the opening of a Cuyahoga County loan production office which is staffed with commercial lending and treasury management professionals. A decision was also made to reposition the then existing Westlake, Ohio loan production office to the Avon, Ohio area for better customer service and visibility. During the year the Corporation opened a new full service office in North Ridgeville, Ohio which is in one of a limited number of high growth areas on the east side of the Corporation’s current market area. Finally, in January 2007 the Corporation announced plans to acquire Morgan Bancorp, Inc. in Hudson, Ohio. Morgan has approximately $129 million in assets and is located in one of the best demographic markets in Ohio. We expect that this market will provide a substantial boost to the Corporation’s ability to grow assets and revenue in future years. See “Contractual Obligations - Pending Acquisition” below for further discussion of this transaction.
As these expansion activities occurred the Corporation continued to address the economic realities in its historical market. Lorain County economic conditions reflect slow employment growth and business starts. In 2005 this was offset to some extent by a strong housing market as families migrated from the greater Cleveland area to new housing in eastern Lorain County, but this slowed substantially in 2006. The impact of this is reflected in the Corporation’s financial performance in 2006. While the expansion strategy is an important investment in the future, it added to the overall expense structure of the Corporation. As the local economy slowed, revenue was impacted by slower loan growth and fierce competition for the loans that are available in Lorain County. The slower economy is also reflected in an increase in nonperforming loans, potential problem loans and the resulting provision for loan losses during the year. It is management’s opinion that the asset quality issues that developed in the third and fourth quarters, as further discussed below, are manageable and that these trends will improve during 2007. Even as expansion continues, the Corporation is committed to strengthening its market presence in Lorain County with new offices like the North Ridgeville office in 2006 and a new office in a growing area of Elyria, Ohio in January 2007.
Key Indicators and Material Trends (Dollars in thousands)
Net interest income growth continues to be a challenge in the banking industry. The Corporation, like many Midwestern banks, is dealing with a flat Treasury yield curve, tougher competition and challenging local economic condition. Since the Corporation is highly dependent on net interest income for its revenue, minimizing net interest margin compression is critical. Historically, the Corporation has experienced net interest margin strength from the ability to grow and maintain a strong, low-cost retail deposit base, and to grow and maintain a strong commercial lending operation. While the Corporation continues to see improvement in its share of the deposit market in Lorain County, local funds are increasingly more expensive and we are increasingly more dependent on wholesale funding sources to supplement these local deposits. While marketing and sales efforts have been expanded to attract and retain local retail deposits, a higher dependence on alternative funding sources is anticipated as the Corporation grows.
Generation of noninterest income is important to the long-term success of the Corporation. The focus in 2006 was on strengthening those sources of noninterest income that recur each year. The trend in most fee types is encouraging.
The origination of 1-4 family mortgages is a critical relationship building product for the Corporation. In 2006 the Corporation restructured its mortgage operations and the products it offers. This was done to better meet the needs of its existing market and the new markets it is expanding into. At year-end, mortgage loan balances were growing and the pipeline of business was strong.
Asset quality generally is a key indicator of financial strength, and the Corporation continues to manage credit risk aggressively. At the beginning of 2005 there were indications that the Corporation’s credit quality had stabilized. However in the third and fourth quarters of 2006 it became evident that the slowing housing market, and general local economic weakness, was impacting our commercial and residential real estate portfolios. While net charge-offs were at the lowest level since 2002, they continue to be above the levels experienced by banks of comparable size. Nonperforming loans increased in 2006 and continue at levels that are not acceptable to Management and the Board of Directors. In 2006, the level of nonperforming loans increased over the prior year from $6,494 at December 31, 2005 to $12,812 at December 31, 2006. The majority of these loans are commercial real estate loans. The Corporation also monitors the level of potential problem loans. Potential problem loans are loans that the Corporation monitors very closely for performance and potential deterioration. Potential problem loans increased from $14.4 million at December 31, 2005 to $22.1 million at December 31, 2006. Management continues to work toward prompt resolution of nonperforming loan situations and to adjust underwriting standards as conditions warrant. The trends in nonperforming loans and potential problem loans necessitated a $1,365 addition to the allowance for loan losses in the fourth quarter.
Since the ability to generate deposits is a key indication of the Corporation’s ability to meet its liquidity needs and fund profitable asset growth, it is a significant measure of the success of the business plan. In 2006, as measured by the FDIC at June 30, 2006, the Corporation’s market share of deposits grew to 18.96% from 18.82% in 2005. This compares to 16.56% five years ago. The Corporation continues to do well in its historically strong city markets of Lorain, Elyria and Amherst, and is pleased with the early performance in the new offices recently opened in the eastern parts of the county.
Results of Operations (Dollars in thousands except per share data)
Summary of Earnings
Net income in 2006 was $5,424 or $.84 per diluted share, down from $6,413 or $.97 per diluted share in 2005, and down from $7,475 or $1.13 per diluted share in 2004. Included in 2005 earnings were approximately $1,218 of expenses associated with the recruitment of senior management, severance costs, a goodwill impairment charge related to the Corporation’s prior subsidiary LNB Mortgage, LLC and the write-off of several telecommunications contracts. Included in 2004 earnings was a $1,158 non-cash pretax charge to recognize other than temporary impairment of the Corporation’s investment in FNMA and FHLMC preferred securities which were sold in 2005.
In 2006, net interest income decreased 4.7% to $28,607 from $30,030 in 2005. This decrease was the result, in part, of net interest margin compression. During 2006, the flattening of the Treasury yield curve and the impact of competition on loan and deposit pricing, combined with a shift in deposit mix from low-cost noninterest bearing and savings accounts to higher cost money market accounts and time deposits resulted in prolonged compression in the net interest margin. Noninterest income was $9,751, a decline of $626 from 2005. Included in 2005 was $959 in mortgage banking revenue generated by LNB Mortgage, LLC which discontinued operations in 2005. Of the core sources of noninterest income, investment and trust services and deposit service charges were up 7.2% and 7.4% respectively. Electronic banking fees and income from bank owned life insurance were also improved over 2005. The provision for loan losses increased to $2,280 in 2006 from $1,248 in 2005 primarily due to increases in nonperforming loans and in potential problem loans. Noninterest expenses decreased in 2006 by 4.2%. There were modest increases in net occupancy, Ohio franchise tax, marketing and public relations and expenses related to the higher level of other real estate under management. All other expenses were consistent with 2005 or down year-over-year. As a percent of average assets, net income in 2006 represents a return of .66%. This compares to .81% and .98% in 2005 and 2004, respectively. Return on assets is one measurement of operating efficiency. As a
percent of average shareholders’ equity this represents a return of 7.89% as compared to 9.11% and 10.75% in 2005 and 2004, respectively. Return on shareholders’ equity is a measure of how well the Corporation employs leverage to maximize the return on the capital it employs.
2006 versus 2005 Net Interest Income Comparison
Net interest income is the difference between interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities. The Corporation reviews net interest income on a fully taxable equivalent basis, which presents interest income with an adjustment for tax-exempt interest income on an equivalent pre-tax basis assuming a 34% statutory Federal tax rate in 2006 and 2005 and a 35% statutory Federal tax rate in 2004. These rates may differ from the Corporation’s actual effective tax rate. Net interest income is affected by changes in the volumes, rates and the composition of interest-earning assets and interest-bearing liabilities. The net interest margin is net interest income as a percentage of average earning assets.
Table 1 summarizes net interest income and the net interest margin for the three years ended December 31, 2006.
Table 1: Net Interest Income
Yields
Table 2 reflects the detailed components of the Corporation’s net interest income for each of the three years ended December 31, 2006. Rates are computed on a tax equivalent basis and nonaccrual loans are included in the average loan balances.
The Corporation’s net interest income on a fully tax equivalent basis was $28,876 in 2006, which compares to $30,231 in 2005, and is a decrease of $1,355, or 4.5%, from 2005. This follows an increase in net interest income of $1,894 in 2005 as compared to 2004. The net interest margin, which is determined by dividing tax equivalent net interest income by average earning assets, was 3.78% in 2006, or a decrease of 31 basis points from 2005. This follows an increase of 8 basis points in 2005 as compared to 2004. The decline in net interest income in 2006 was the result of a flat Treasury yield curve, competitive pressures and a change in deposit mix from low-cost to higher-cost sources.
Table 2: Condensed Consolidated Average Balance Sheets
Interest, Rate, and Rate/ Volume differentials are stated on a Fully-Tax Equivalent (FTE) Basis.
Average Balances
Average earning assets increased $24,379, or 3.3%, to $763,899 in 2006 as compared to $739,520 for the same period of 2005. Average loans increased $16,357, or 2.8%, to $601,119 in 2006 as compared to $584,762 in 2005. The average increase of $16,357 is due primarily to an increase in the commercial loan portfolio of $10,807, an increase in installment loans of $2,111, an increase in home equity loans of $2,199 and an increase of $4,872 in purchased installment loans. Partially offsetting this growth was runoff of real estate mortgages of $3,632. Loan growth in all areas, except installment loans, was slower in 2006 than what had been experienced in 2005 and 2004. The increase in average loans was primarily funded with $44,033 of deposit growth. Noninterest-bearing deposits were weak in 2006 declining $8,953, or 9.7%, however interest- bearing deposits grew $52,986, or
9.8%. The interest-bearing deposit growth experienced in consumer time deposits was $32,754, or 18.2%, interest-bearing demand growth was $15,838, or 9.1%, brokered time deposit growth was $12,774, or 31.2% and public time deposit growth was $7,103, or 15.1%. Offsetting a portion of this growth was a $15,483 decline in savings deposits. The Bank began to use brokered time deposits in 2004 as an alternative wholesale funding source. Brokered time deposits have become an important and comparably priced substitute for FHLB advances, and they require no collateralization as compared to FHLB advances which require collateral in the form of real estate mortgage loans and securities.
Rate/Volume
Net interest income may also be analyzed by segregating the volume and rate components of interest income and interest expense. Table 3 presents an analysis of increases and decreases in interest income and expense in terms of changes in volume and interest rates during the two years ended December 31, 2006 and during the two years ended December 31, 2005. Changes that are not due solely to either a change in volume or a change in rate have been allocated proportionally to both changes due to volume and rate. The table is presented on a tax-equivalent basis.
Table 3: Rate/Volume Analysis of Net Interest Income (FTE)
The impact of balance sheet growth and changing rates can be seen in Table 3, which segments the change in net interest income into volume and rate components. Total FTE interest income was $49,511 in 2006 as compared to $43,633 in 2005. This is an increase of $5,878 or 13.5%. Of this increase, $1,756 was due to volume and $4,123 to rate. When comparing 2006 to 2005, the contribution from balance sheet growth improved, and rates provided a positive contribution as well. Total interest expense was $20,635 in 2006 as compared to $13,402 in 2005. This is an increase of $7,233, or 54.0%. Of this increase, $1,991 was due to volume and $5,242 to rate.
Although difficult to isolate, changing customer preferences and competition impact the rate and volume factors. While rising rates remain a benefit to the Corporation, competitive margin pressure and stiff competition in our markets resulted in a $1,120 reduction in net interest income due to rising rates. Also impacting the net interest margin is a continuing shift of savings accounts to higher cost money market accounts and retail time deposits. The deposit mix changes during 2006 resulted in a $235 reduction in net interest income due to volume decreases. Additionally, the Corporation continues to increase its use of brokered time deposits. While these funds are not more expensive than other wholesale funding sources, they are more expensive than deposits generated through our retail branch system.
2005 versus 2004 Net Interest Income Comparison
The Corporation’s net interest income on a fully tax equivalent basis was $30,231 in 2005, which compares to $28,337 in 2004, and is an increase of $1,894, or 6.7%, from 2004. The net interest margin was 4.09% in 2005, or an increase of 8 basis points from 2004. Net interest income improvement in 2005 was the result of the rising interest rate environment and an increase in average earning assets. Offsetting a portion of this improvement was competitive pricing pressures on loan and deposit yields. The positive impact of rates is evident in 2005 as compared to the negative impact of rates in 2004. The rise in short-term interest rates, triggering a 200 basis point increase in the Corporation’s prime lending rate in 2005, produced an increase in the yield on earning assets. The yield on earnings assets was 5.90% in 2005, or 60 basis points higher, as compared to 5.30% in 2004. The yield on loans was 6.52% in 2005, or 62 basis points higher, as compared to 5.90% in 2004. The rise in short-term interest rates also produced an increase in the cost of total interest-bearing liabilities. The cost of total interest-bearing liabilities was 2.15% in 2005, or 61 basis points higher, as compared to 1.54% in 2004.
Average earning assets increased $32,489, or 4.6%, to $739,520 in 2005 as compared to $707,031 for the same period of 2004. Average loans increased $33,247, or 6.0%, to $584,762 in 2005 as compared to $551,515 in 2004. The average increase of $33,247 is due primarily to an increase in the commercial loan portfolio of $37,551, an increase in home equity loans of $4,261 and an increase of $17,754 in purchased installment loans. Partially offsetting this growth was runoff of real estate mortgages, direct installment and indirect installment loans. Commercial and home equity loan growth in 2005 was comparable with 2004. The large increase in purchased loans is comprised of high-quality new automobile loans originated by Morgan Bank, N.A. Since 2001 the Corporation has been reducing its presence in the indirect installment loan market due to excessive losses. It also had not fully developed its retail loan products such as home equity lines to be competitive in the market. The purchased loan program has been utilized as a short-term substitute for the lack of locally generated installment loans. In 2005, the retail loan products were redesigned, and it is anticipated that the Corporation’s dependence on this source of loans will be less in future years. The increase in average loans was primarily funded with growth in deposits. Noninterest-bearing deposit growth was $425, or .5%, and interest-bearing deposits grew $46,013, or 9.3%. The interest-bearing deposit growth was composed of retail time deposit growth of $15,404, or 9.4%, brokered time deposit growth of $33,930, or 483.9% and public time deposit growth of $1,569, or 3.4%. The Bank began to use brokered time deposits in 2004 as an alternative wholesale funding source. Brokered time deposits have become an important and comparably priced substitute for FHLB advances, and they require no collateralization as compared to FHLB advances which require collateral in the form of real estate mortgage loans and securities.
Historically, the Corporation has been structured to experience better net interest income performance when interest rates rise. This basic balance sheet structure was evident in improved 2005 net interest income performance. Conversely, this structure was the primary reason for the margin deterioration experienced by the Corporation during the falling rate environment in 2001-2004.
Total interest income on a fully tax equivalent basis was $43,633 in 2005 as compared to $37,439 in 2004. This is an increase of $6,194, or 16.5%. Of this increase, $1,581 was due to volume and $4,613 to rate. When comparing 2005 to 2004, the contribution from balance sheet growth improved, and rates provided a positive contribution as well, as compared to 2004 when total interest income was adversely impacted by rates. Total interest expense was $13,402 in 2005 as compared to $9,102 in 2004. This is an increase of $4,300, or 47.2%. Of this increase, $1,137 was due to volume and $3,163 to rate. In 2004, the impact of volume increased interest expense while the rates reduced interest expense.
Noninterest Income
Table 4: Details of Noninterest Income
2006 vs 2005 Noninterest Income Comparison
Total noninterest income was $9,751 in 2006 as compared to $10,377 in 2005. This was a decrease of $626, or 6.0%. Core noninterest income, which consists of noninterest income before other income and gains and losses, was $9,299 in 2006 as compared to $9,613 in 2005. This was a decrease of $314, or 3.3%.
Trust and investment management fees increased $139, or 7.2%, during 2006 in comparison to 2005. Net trust commission increased $121, or 5.8%, in 2006 over the same period in 2005. Net brokerage fee income, through Investment Centers of America, Inc., was $35 in 2006, in comparison to $8 in 2005. Trust and investment management fee revenue was positively impacted by the performance of the S&P 500 index and pricing adjustments, which more than offset competitive pressures.
Deposit service charges were $4,533 in 2006 as compared to $4,219 in 2005. This was an increase of $314, or 7.4%. Charges and fees consisting primarily of overdraft fees, increased $471, or 14.1%, in 2006 over the same period 2005. Management attributes this overall growth to aggressive sales and marketing efforts this year. The Corporation, however, experienced weaker business account growth during 2006 compared in 2005.
Electronic banking fees were $1,948 in 2006 as compared to $1,895 in 2005. This is an increase of $53, or 2.8%. Electronic banking fees include debit, ATM and merchant services. Merchant service income, which is outsourced and a fee is received, increased $58, or 7.2%, over 2005. ATM fees increased $13, or 1.8%, over 2005.
During the fourth quarter 2005, the operations of LNB Mortgage, LLC were closed. This eliminated this revenue as well as the expenses related to its generation.
Income from bank owned life insurance increased $139, or 23.2%, in 2006 as compared to 2005. This increase is attributed to improvement in market performance which is reflected in the credit rates.
Other income was $215 in 2006 as compared to $479 in 2005. This was a decrease of $264, or 55.1%. During 2005 certain loans, which were not appropriate for the Corporation’s portfolio, were placed with another financial institution for a fee. This resulted in $196 in revenue during 2005. There were no such transactions during 2006. Charleston Title Agency, a 49% owned subsidiary of the Corporation, was dissolved during the third quarter of 2006. Revenue generated from this Agency was $23 in 2006 as compared to $35 in 2005.
During the fourth quarter of 2006, the land and building formerly housing the Westlake LPO, were sold resulting in a gain of $231. During 2005 several small equity securities and non-rated municipal bonds were sold resulting in a gain of $173. Gain on sale of loans was $132 in 2005. During 2006, a gain of $5 was recognized on the sale of other real estate owned.
2005 versus 2004 Noninterest Income Comparison
Total noninterest income was $10,377 in 2005 as compared to $10,442 in 2004. This is a decrease of $65, or .6%. Total fees and other income was $10,092 in 2005 as compared to $10,660 in 2004. This is a decrease of $568, or 5.3%.
Investment and trust services were $1,940 in 2005 as compared to $2,091 in 2004. Approximately one-third of this decrease was due to the loss of three accounts, while the remaining difference was the result of competitive pricing pressures and mediocre market conditions during the year.
Deposit service charges were $4,219 in 2005 as compared to $4,187 in 2004. Deposit services charges are influenced by economic activity and were weaker in the first two quarters of 2005, before improving in the second half of 2005 and ending the year up $32, or .8%.
Electronic banking fees were $1,895 in 2005 as compared to $2,794 in 2004. This is a decline of $899, or 32.2%. Electronic banking fees include debit, ATM and merchant services. In the fourth quarter of 2004, the Corporation exited the merchant services business due to anticipated lower margins, higher operating costs and escalating risk. Since 2005 the Corporation has offered an outsourced solution for this product for which it receives a small fee. These fees were $27 in 2005 as compared to $945 in 2004. Excluding this factor, the fees on ATM and debit transactions were up $19 in 2005 as compared to 2004.
Mortgage banking revenue was $959 in 2005 as compared to $364 in 2004, increasing $595, or 163.5%. 2005 was the first full year of operations for LNB Mortgage, LLC which began business in September 2004. The Corporation reevaluated this business line and the decision was made in mid 2005 to wind up the business of LNB Mortgage, LLC and to re-establish the mortgage operation in the Bank, which was accomplished by the end of 2005.
Income from bank owned life insurance was $600 in 2005, as compared to $632 in 2004. This decline of $32, or 5.1%, was due to lower crediting rates. These rates are tied to long-term rates which started to improve in the second half of 2005.
Other income was $479 in 2005 as compared $592 in 2004. This is a decrease of $113, or 19.1%, from 2004. Other income includes revenue from safe deposit box rental, EDP services and many small customer fees. Also included in other income are transaction lending fees resulting from loans placed with another financial institution for a fee. In 2005 this activity generated revenue of $196 as compared to $265 in 2004, a decrease of $69, or 26.0%. The rest of the decline is attributable primarily to reductions in the small dollar customer fees.
Positively impacting 2005 were gains on the sale of securities which were $173, as compared to a loss of $777 in 2004. The gains in 2005 were from the sale of several small equity securities and non-rated municipal bonds. In 2004, the Corporation recorded an other than temporary impairment charge of $1,158 related to the write-down of variable rate, agency preferred stock which was sold in 2005. The sale of these securities in 2005 was at their carrying value, so no additional gain or loss was recognized. Gain on the sale of loans was $132 in 2005, a decrease of $49, or 27.1%, from 2004. In 2004, these gains were generated on loans originated by the Bank and sold to FHLMC and other investors. Both activities were deemphasized in 2005. In 2005, losses on sale of assets were $20, as compared to gains of $378 in 2004. In 2004, the Corporation recognized gains on the sale of its former Avon Lake office after the new office opened in May and the sale of a parking lot in the fourth quarter of 2004.
Noninterest Expense
Table 5: Details on Noninterest Expense
2006 versus 2005 Noninterest Expense Comparison
Noninterest expense was $28,985 in 2006 as compared to $30,267 in 2005. This is a decrease of $1,282, or 4.2%. During the second quarter of 2005, $1,218 of noninterest expense was recorded in salary and benefits and other noninterest expense categories that were specifically attributable to activities related to building a long-term business plan, including several management and personnel changes, and job eliminations. In addition, during the fourth quarter 2005, the Corporation closed the operations of LNB Mortgage, LLC as a separate business entity and absorbed mortgage lending into the operations of the Bank. As a result, $1,716 of operating expense which was present during 2005 was no longer a factor with respect to noninterest expense during 2006.
Salaries and employee benefits were $14,894 in 2006 as compared to $15,057 in 2005. Included in 2005 was $972 of this expense from LNB Mortgage, LLC. Eliminating this expense, salary and employee benefit expense in 2006 increased $809, or 5.7%, in comparison to 2005. The increase in salary and benefit expense reflects the addition of sales personnel related to market expansion into Cuyahoga County during 2006, as well as personnel for two new branches.
Furniture and equipment decreased $17, or 0.6%, in 2006 as compared to 2005. Leased equipment expense increased $81 over 2005, primarily due to new mainframe computer and telephone equipment leases placed in service in mid 2005. 2006 carried the full expense of these leases. The increase in leased equipment cost was offset by a decrease in depreciation expense of $97.
Net occupancy expense was $1,905 in 2006 as compared to $1,830 in 2005. This was an increase of $75, or 4.1%. This was primarily attributable to expansion into Cuyahoga County in June of 2006 and the addition of the North Ridgeville office, and increased real estate taxes and facilities maintenance costs associated with the addition of these facilities. This was somewhat offset by the elimination of expenses related to LNB Mortgage, LLC.
Outside services decreased $316, or 16.4%, in 2006 as compared to 2005. Legal expenses in 2005 were approximately $200 higher due to corporate governance and executive compensation work, as well as $150 for consulting work related to the technology area and commercial portfolio.
Marketing and public relations expense increased $30, or 2.4% in 2006 as compared to 2005. This was primarily the result of increased media advertising for deposits and higher productions costs, as well as promotion of new facilities.
Postage and supplies expense approximated that of 2005, with a decrease of $9, or .7% in 2006.
Telecommunications expense was $751 in 2006 as compared to $1,167 in 2005. This was a decrease of $416, or 35.6%. During 2005, the Bank upgraded its voice and data telecom systems to provide enhanced service and reliability. All redundant expenses related to this project were eliminated in 2006.
Ohio Franchise tax expense in 2006 increased $45, or 5.8%, over 2005. This is an equity based tax paid by the Corporation and its subsidiaries. In 2006, the Bank and its subsidiary, North Coast Community Development Corporation, were paying higher franchise taxes based on equity accumulation.
Electronic banking expense was $618 in 2006 as compared to $542 in 2005. This increase is primarily the result of increased fees associated with bank-issued debit cards as a result of the transaction growth experienced in the number of new checking accounts.
Other expense decreased $587, or 16.9%, in 2006 as compared to 2005. Included in this decrease was a single charge-off for an ATM loss of $82 during the first quarter 2005. Also included in other noninterest expense for 2005 was a goodwill impairment expense of $311 for LNB Mortgage, LLC. Charge-off’s associated with overdrafts decreased $51 during 2006 as compared to 2005. Loan and collection expense decreased $71 in 2006 as compared to 2005.
2005 versus 2004 Noninterest Expense Comparison
Total noninterest expense in 2005 was $30,267, an increase of $3,977, or 15.1%, as compared to $26,290 in 2004. Of this total increase, salaries and employee benefits were $15,057 in 2005 as compared to $12,995 in 2004. This is a $2,062, or 15.9% increase. This increase partially reflects the recruitment of new management, severance costs related to staff reductions and the operations for nine months in 2005 of LNB Mortgage, LLC before it ceased operations on December 31, 2005. These factors resulted in approximately $1,089 of the $2,062 increase. Of the remaining increase of $973, $467 was due to new commission programs in the trust, retail and commercial divisions, as well as bonuses to senior management. The remaining increase of $506 was due to normal merit increases and higher healthcare costs.
Furniture and equipment was $3,001 in 2005 as compared to $2,784 in 2004. This is an increase of $217, or 7.8%. This was primarily due to higher leased equipment costs associated with a new mainframe computer and telephone equipment which was up $209 in 2005 as compared to 2004.
Net occupancy was $1,830 in 2005, as compared to $1,633 in 2004, an increase of $197, or 12.1%. Depreciation was up $68 and is attributable to the full year impact of the two new offices. Also contributing to this increase was utilities which were up $30 and other occupancy such as snow removal, landscaping and maintenance which was up $99.
Outside services were $1,925 in 2005 as compared to $1,182 in 2004. This is an increase of $743, or 62.9%. Of this increase, $358 was due to internal audit expenses. Since 2005, the Corporation has outsourced internal audit services. Legal expenses were approximately $200 higher due to corporate governance and executive compensation work. Also contributing to this increase was approximately $150 for consulting work in the technology area and an outside credit review of the commercial portfolio.
Marketing and public relations expense was $1,249 in 2005, as compared to $1,047 in 2004. This is an increase of $202, or 19.3%, for the year. This was due to higher production costs, increased media advertising for deposits and costs associated with the Bank’s 100th anniversary celebration.
Supplies, postage and freight were $1,245 in 2005 as compared to $1,208 in 2004. This is an increase of $37, or 3.1%. Postage expense increased $54 in 2005 as compared to 2004, reflecting more direct mail advertising. Supplies were well controlled during 2005.
Telecommunications expense was $1,167 in 2005 as compared to $713 in 2004. This is a $454, or 63.7% increase. Included in this increase was a $129 write-off of telecommunications contracts. Also impacting this expense in 2005 was the conversion to an IP telephony phone system. During the conversion, for a portion of the year, there were duplicate circuits and equipment costs.
Ohio franchise tax was $772 in 2005, as compared to $729 in 2004. This is an increase of $43, or 5.9%. This is an equity based tax paid by the Corporation and its subsidiaries.
Electronic banking expense was $542 in 2005 as compared to $1,257 in 2004. This is a reduction of $715, or 56.9%. This reduction is the result of the exiting of the merchant service business. As mentioned in the “2005 versus 2004 Noninterest Income Comparison” section of this report, the revenue from this business declined $899 in 2005. Consequently the net impact to the Corporation in 2005 was a reduction in pretax income of $184.
Other expense was $3,479 in 2005 as compared to $2,742 in 2004. This is a $737, or 26.9% increase. Operating charge-offs were $565 in 2005 as compared to $400 in 2004. This is an increase of $165, or 41.3% in 2005. This is primarily the result of an increase in overdraft charge-offs of $40 and losses associated with a branch robbery and an ATM loss. Also impacting other expense was an impairment charge for the goodwill related to LNB Mortgage, LLC. This charge totaled $311. Loan and collection expenses were $835 in 2005, as compared to $603 in 2004. This is a $232, or 38.5% increase. Of this total, $75 were fees related to a substandard loan sale in the fourth quarter. Also contributing were legal services related to loan collections which were up $53 in 2005 as compared to 2004. The remaining increase is primarily attributable to the nine months of operations by LNB Mortgage LLC before it ceased operations in the fourth quarter of 2005.
2006 versus 2005 Income taxes
The Corporation recognized tax expense of $1,669 during 2006 and $2,479 for 2005. This is a decrease of $810, or 32.7% from 2005. The Corporation’s effective tax rate was 23.5% for 2006 as compared to 27.9% for the same period 2005. New market tax credit being generated by North Coast Community Development, a wholly owned subsidiary of The Lorain National Bank, was at a higher level during the 2006 as compared to 2005. On December 29, 2003, NCCDC received official notification of this tax credit award. Over the remaining ten years, it is expected that projects will be financed, which should improve the overall economic conditions in Lorain County, and generate additional interest income through the funding of qualified loans to these projects and tax credits for the Corporation. The Corporation had total qualified investments in NCCDC of $8,020 at December 31, 2006, generating a tax credit of $401. At December 31, 2005 qualified investments in NCCDC were $5,500, generating a tax credit of $276.
2005 versus 2004 Income taxes
In 2005 income tax expense was $2,479 as compared to $3,051 in 2004. This represents a decrease of $572 to 18.7% from 2004. The Corporation’s effective tax rate was 27.9% in 2005 as compared to 29.0% in 2004. This decrease reflected the impact of the Corporation’s BOLI investment and the impact in 2005 and 2004 of new markets tax credits generated by NCCDC.
Balance Sheet Analysis
Overview
The Corporation’s total assets at December 31, 2006 were $851,098 as compared to $801,121 at December 31, 2005. This is an increase of $49,977, or 6.2%. Total securities increased $3,784, or 2.4%, over December 31, 2005. Portfolio loans increased $39,908, or 6.8%, over December 31, 2005. Total deposits at December 31, 2006 were $717,261 as compared to $640,216 at December 31, 2005. Total interest-bearing liabilities were $683,294 as compared to $639,131 at December 31, 2005.
Securities
The distribution of the Corporation’s securities portfolio at December 31, 2006 and December 31, 2005 is presented in Note 5 to the Consolidated Financial Statements contained within this Form 10-K. The Corporation continues to employ the securities portfolio to manage interest rate risk and to manage its liquidity needs. Currently, the portfolio is comprised of 46.7% U.S. Government agencies, 43.8% U.S. agency mortgage backed securities, and 7.4% municipal securities. Other securities, consisting of Federal Home Loan Bank stock and Federal Reserve Bank stock represent 2.1% of the portfolio. At December 31, 2006 the securities portfolio had a temporary unrealized loss of $2,771, representing 1.7% of the total amortized cost of the Bank’s securities. The unrealized loss at December 31, 2005 was $3,664. The change year-over-year reflects the maturity of securities in 2006 that have been reinvested at current market rates. New investments are primarily in three to four year average life agencies and four to five year average life mortgage backed securities and intermediate, high quality municipal bonds. Tables 6 and 7 present the maturity distribution of securities and the weighted average yield for each maturity range for the year ended December 31, 2006.
Table 6: Maturity Distribution of Securities at Amortized Cost
Table 7: The Weighted Average Yield for Each Range of Maturities of Securities
____________________
(1)
Yields on tax-exempt obligations are computed on a tax equivalent basis based upon a 34% statutory Federal income tax rate.
Loans
The detail of loan balances is presented in Note 7 to the Consolidated Financial Statements contained within this Form 10-K.
Total loans at December 31, 2006 were $628,333. This is an increase of $37,322, or 6.3% over December 31, 2005. At December 31, 2006, commercial loans represented 59.5% of total loans. There were no commercial loans held for sale at December 31, 2006. Consumer loans, consisting of installment loans and home equity loans, comprised 24.7% of total portfolio loans. Consumer loans are made to borrowers on both secured and unsecured terms dependent on the maturity and nature of the loan. The Corporation also purchases consumer loans from Morgan Bank, N.A, consisting primarily of high quality car loans. On January 16, 2007, the Corporation announced the execution of a definitive agreement to acquire Morgan Bancorp, Inc. (“Morgan”) of Hudson, Ohio in which LNB Bancorp would acquire Morgan and its wholly-owned subsidiary, Morgan Bank, N.A. Completion of the merger is anticipated in the third quarter of 2007, pending certain regulatory and Morgan shareholder approvals.
Real estate mortgages are construction and 1-4 family mortgage loans. Construction loans comprised $2,216 of the $99,182 real estate mortgage loan portfolio at December 31, 2006. Real estate mortgages comprised 15.8% of total portfolio loans. At December 31, 2006, mortgage loans had increased $17,815, or 21.9%, in comparison to December 31, 2005. The Corporation generally requires a loan-to-value ratio of 80% or private mortgage insurance for loan-to-value ratios in excess of 80%.
Loan balances and loan mix are presented by type for the five years ended December 31, 2006 in Table 8.
Table 8: Loan Portfolio Distribution
Table 9 shows the amount of commercial loans outstanding as of December 31, 2006 based on the remaining scheduled principal payments or principal amounts repricing in the periods indicated. Amounts due after one year which are subject to more frequent repricing are included in the due in one year or less classification.
Table 9: Commercial Loan Maturity and Repricing Analysis
Funding Sources
The following table shows the various sources of funding for the Corporation.
Table 10: Funding Sources
The Corporation obtains funding through many sources. The primary source of funds continues to be the generation of deposit accounts within our primary market. In order to achieve deposit account growth, the Corporation offers retail and business customers a full line of deposit products that includes checking accounts, interest checking, savings accounts, and time deposits. The Corporation also generates funds through wholesale sources that include local borrowings generated by a business sweep product. The Corporation utilizes brokered time deposits to provide term funding at rates comparable to other wholesale funding sources. Wholesale funding sources include lines of credit with correspondent banks, advances through the Federal Home Loan Bank of Cincinnati, and a secured line of credit with the Federal Reserve Bank of Cleveland. Table 10 highlights the average balances and the average rates paid on these sources of funds for the three years ended December 31, 2006.
Average deposit balances grew 6.9% in 2006 compared to increases of 7.9% in 2005 and 1.2% in 2004. The Corporation continues to benefit from a large concentration of low-cost local deposit funding. These sources continued to decrease in 2006, following a slight decline in 2005 as compared to 2004. Sources such as demand deposit accounts, interest checking accounts and savings accounts comprised 48.3% of the Corporation’s average funding in 2006, as compared to 51.3% and 54.3% in 2005 and 2004 respectively. On an average balance basis, these sources declined by 2.3% in 2006 as compared to 2005, following a decline of 1.2% in 2005 as compared to 2004. These funds had an average yield of 1.2% in 2006 as compared to .62% in 2005 and .45% in 2004. Included in these funds are the Corporation’s money market accounts. These were much more aggressively priced in 2006 which accounts for the increase in the average cost of these low-cost sources. The average yield on money market accounts was 3.24% in 2006, compared to 1.87% in 2005. Although these remain important sources of funds, the Corporation is more dependent, at varying times and amounts, on brokered time deposits, public fund time deposits and borrowings. Average time deposits were $320,543, an increase of $52,631 or 19.6% in 2006 as compared to 2005. This follows an increase of $50,903, or 23.5% in 2005 as compared to 2004. The increase in time deposits resulted from increased consumer, brokered and public fund time deposit balances.
Average borrowings decreased 20.3% in 2006 as compared to a decrease of 15.2% in 2005 and an increase of 15.3% in 2004. The Corporation’s borrowings are primarily sweep accounts and Federal Home Loan Bank advances. In 2005 the Corporation increased its use of brokered time deposits and reduced its use of FHLB borrowings. These time deposits are priced comparably to FHLB advances and are not collateralized. These products continue to be an important part of the Corporation’s interest rate risk management strategy. The Corporation expects these trends to continue.
Liquidity
Management of liquidity is a continual process in the banking industry. The liquidity of the Bank reflects its ability to meet loan demand, the possible outflow of deposits and its ability to take advantage of market opportunities made possible by potential rate environments. Assuring adequate liquidity is achieved by managing the cashflow characteristics of the assets the Bank originates and the availability of alternative funding sources. The Bank monitors liquidity according to limits established in its liquidity policy. The policy establishes minimums for the ratio of cash and cash equivalents to total assets and the loan to deposit ratio. At December 31, 2006 the Bank was in compliance with these policy limits.
In addition to maintaining a stable source of core deposits, the Bank manages adequate liquidity by assuring continual cashflow in the securities portfolio. At December 31, 2006, the Corporation expects the securities portfolio to generate cash flow in the next 12 months of $39,014 and $101,381 in the next 36 months.
The Bank maintains borrowing capacity at the Federal Home Loan Bank of Cincinnati, the Federal Reserve Bank of Cleveland and Federal Fund lines with correspondent banks. Table 11 highlights the liquidity position of the Bank including total borrowing capacity and current unused capacity for each borrowing arrangement at December 31, 2006.
Table 11: Liquidity
LNB Bancorp, Inc. is the financial holding company of The Lorain National Bank and conducts no operations. Its only ongoing need for liquidity is the payment of the quarterly shareholder dividend if declared and miscellaneous expenses related to the regulatory and reporting requirements of a publicly traded corporation. The holding company’s main source of operating liquidity is the dividend that it receives from The Lorain National Bank. Dividends from The Lorain National Bank are restricted by regulation. At December 31, 2006, the Corporation also had certain short-term investments in the amount of $28 which may be used for dividends and other corporate purposes. The holding company from time-to-time, has access to additional sources of liquidity through correspondent lines of credit, but no such agreements were in place and there was no amount outstanding as of December 31, 2006.
Capital Resources
Shareholders’ equity at year-end 2006 totaled $68,697, compared to $68,406 and $70,574 at year-end 2005 and 2004 respectively. This increase in 2006 resulted from net income of $5,424, a change of $903 in comprehensive income, and a change of $48 for share-based compensation income. These were offset by the payment of dividends of $4,641, and an increase of $1,443 in treasury stock. The comprehensive income change was due to the change in the fair value of securities classified as available for sale and the change in the minimum pension liability.
The change in treasury stock is part of the Corporation’s previously disclosed program to buyback up to 5% of the Corporation’s outstanding common shares. The Corporation purchased 77,500 shares pursuant to this plan in 2006.
Total cash dividends declared in 2006 by the Board of Directors was $4,641 as compared to $4,760 in 2005. In each of the last 20 years, the Board of Directors has approved a regular cash dividend. Any future dividend is subject to Board approval.
The dividend payout ratio, representing dividends per share divided by earnings per share, was 85.7% and 74.2% for the years 2006 and 2005, respectively. The increase in the dividend payout ratio is above the long-term target ratio established by the Board of Directors, but represents the Corporation’s expectation for the near-term recovery of both revenue and earnings growth.
At December 31, 2006, the Corporation’s market capitalization was $103,421 compared to $117,055 at December 31, 2005. There were 2,052 shareholders of record at December 31, 2006. LNB Bancorp, Inc.’s common stock is traded on the NASDAQ Stock Market under the ticker symbol “LNBB.”
The Federal Reserve Board has established risk-based capital guidelines that must be observed by financial holding companies and banks. The Corporation has consistently maintained the regulatory capital ratios of the Corporation and its bank subsidiary, The Lorain National Bank, above “well capitalized” levels. For further information on capital ratios see Notes 1 and 14 of the Consolidated Financial Statements.
Contractual Obligations and Commitments
Contractual obligations and commitments of the Corporation at December 31, 2006 are as follows:
Table 12: Contractual Obligations
Pending Acquisition
On January 16, 2007, the Corporation announced the execution of a definitive agreement to acquire Morgan Bancorp, Inc. (“Morgan”) of Hudson, Ohio. The Corporation’s transaction is for the acquisition of Morgan and its wholly-owned subsidiary, which had approximately $129 million in assets at the date of the agreement.
Under the terms of the agreement, shareholders of Morgan will be entitled to receive cash, common shares of LNB, or a combination thereof, based upon an election process to occur prior to closing. Cash consideration is valued at $52.00 per Morgan share and stock consideration is fixed at an exchange ratio of 3.162 common shares of LNB Bancorp for each share of Morgan. The agreement further provides that, in the aggregate, 50% of the Morgan common shares will be exchanged for common shares of LNB Bancorp and the remaining 50% of the Morgan common shares will be exchanged for cash.
The transaction is valued at $26.5 million and is expected to close in the third quarter of 2007. The exchange is expected to qualify as a tax-free transaction to the Morgan shareholders. Following the merger, and upon receipt of all necessary regulatory approvals, Morgan Bank, N.A. will be merged with and into the Corporation.
Not considering the merger-related charges discussed below, the merger is expected to be accretive to earnings per share by approximately $.08 or 6.7 percent in the first full fiscal year of operations (2008), due to the expected cost-saving benefits achieved through the integration of systems and support functions, improved branch efficiencies and increased alternative delivery channels for financial products and services. The Corporation expects to reduce noninterest expenses of the combined entity by approximately $1.7 million. This expense reduction, while not expected to be totally from the Morgan Bank operation, represents about 48 percent of Morgan’s expense base. The Corporation intends to recognize these expense reductions as quickly and prudently as possible. After-tax merger-related costs of approximately $1.5 - $2.0 million will be incurred to complete the merger.
Critical Accounting Policies and Estimates
The Corporation’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The Corporation follows general practices within the banking industry and application of these principles requires the Corporation’s management (“Management”) to make assumptions, estimates and judgments that affect the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements.
The most significant accounting policies followed by the Corporation are presented in Note 1 to the Consolidated Financial Statements. These policies are fundamental to the understanding of results of operation and financial conditions.
The accounting policies considered to be critical by Management are as follows:
Allowance for loan losses
The allowance for loan losses is an amount that Management believes will be adequate to absorb probable credit losses inherent in the loan portfolio taking into consideration such factors as past loss experience, changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current economic conditions that affect the borrower’s ability to pay. Determination of the allowance is subjective in nature. Loan losses are charged off against the allowance when Management believes that the full collectibility of the loan is unlikely. Recoveries of amounts previously charged-off are credited to the allowance.
A loan is considered impaired when it is probable that not all principal and interest amounts will be collected according to the loan contract. Residential mortgage, installment and other consumer loans are evaluated collectively for impairment. Individual commercial loans exceeding size thresholds established by Management are evaluated for impairment. Impaired loans are written down by the establishment of a specific allowance where necessary. The fair value of all loans currently evaluated for impairment is collateral-dependent and therefore the fair value is determined by the fair value of the underlying collateral.
The Corporation maintains the allowance for loan losses at a level adequate to absorb Management’s estimate of probable credit losses inherent in the loan portfolio. The allowance is comprised of a general allowance, a specific allowance for identified problem loans and an unallocated allowance representing estimations pursuant to either Statement of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies,” or SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.”
The general allowance is determined by applying estimated loss factors to the credit exposures from outstanding loans. For commercial and commercial real estate loans, loss factors are applied based on internal risk grades of these loans. Many factors are considered when these grades are assigned to individual loans such as current and past delinquency, financial statements of the borrower, current net realizable value of collateral and the general economic environment and specific economic trends affecting the portfolio. For residential real estate, installment and other loans, loss factors are applied on a portfolio basis. Loss factors are based on the Corporation’s historical loss experience and are reviewed for appropriateness on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio.
Specific allowances are established for all classified loans when Management has determined that, due to identified significant conditions, it is probable that a loss has been incurred that exceeds the general allowance loss factor from these loans. The unallocated allowance recognizes the estimation risk associated with the allocated general and specific allowances and incorporates Management’s evaluation of existing conditions that are not included in the allocated allowance determinations. These conditions are reviewed quarterly by Management and include general economic conditions, credit quality trends and internal loan review and regulatory examination findings.
Management believes that it uses the best information available to determine the adequacy of the allowance for loan losses. However, future adjustments to the allowance may be necessary and the results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations.
Income Taxes
The Corporation’s income tax expense and related current and deferred tax assets and liabilities are presented as prescribed in SFAS No. 109 “Accounting for Income Taxes”. SFAS No. 109 requires the periodic review and adjustment of tax assets and liabilities based on many assumptions. These assumptions include predictions as to the Corporation’s future profitability, as well as potential changes in tax laws that could impact the deductibility of certain income and expense items. Since financial results could be significantly different than these estimates, future adjustments may be necessary to tax expense and related balance sheet accounts.
New Accounting Pronouncements
Management is not aware of any proposed regulations or current recommendations by the Financial Accounting Standards Board or by regulatory authorities, which, if they were implemented, would have a material effect on the liquidity, capital resources, or operations of the Corporation. However, the potential impact of certain accounting pronouncements warrants further discussion.
SFAS No. 123 (revised) “Share Based Payments”
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004) (“SFAS No. 123R”), Share Based Payments. SFAS No. 123R requires the Corporation to expense share-based payments, including employee stock options, based on their fair value. The Corporation adopted SFAS No. 123R effective as of January 1, 2006. Accordingly, the impact of the adoption of SFAS No. 123R’s fair value method is included in the Corporation’s results of operations. The adoption of SFAS No. 123R did not have a material impact on the Corporation’s results of operations, financial position or liquidity.
SFAS No. 154 “Accounting Changes and Error Corrections”
This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. This applies to accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 did not have a material impact on the Corporation’s results of operations, financial position or liquidity.
FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes - An Intrepretation of FASB Statement No. 109”
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“Fin No. 48”). The interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Specifically, Fin No. 48 prescribes a recognition threshold and a measurement
attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Fin No. 48 also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. Fin No. 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 is not expected to have a material effect on our consolidated balance sheet, results of operations or cash flows.
FASB Statement No. 158, Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R
In September 2006, the FASB issued Statement No. 158, Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R (“SFAS 158”). SFAS 158 requires an entity to recognize in its balance sheet the funded status of its defined benefit postretirement plans, measured as the difference between the fair value of the plan assets and the benefit obligation. SFAS 158 also requires an entity to recognize changes in the funded status of a defined benefit postretirement plan within accumulated other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of periodic net benefit cost. SFAS 158 is effective as of the end of the fiscal year ending after December 15, 2006. The adoption of FASB Statement No. 158 did not have a material effect on our consolidated balance sheet, results of operations or cash flows.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk.
Risk Elements
Risk management is an essential aspect in operating a financial services company successfully and effectively. The most prominent risk exposures, for a financial services company, are credit, operational, interest rate, market, and liquidity risk. Credit risk involves the risk of uncollectible interest and principal balance on a loan when it is due. Fraud, legal and compliance issues, processing errors, technology and the related disaster recovery, and breaches in business continuation and internal controls are types of operational risks. Changes in interest rates affecting net interest income are considered interest rate risks. Market risk is the risk that a financial institution’s earnings and capital or its ability to meet its business objectives are adversely affected by movements in market rates or prices. Such movements include fluctuations in interest rates, foreign exchange rates, equity prices that affect the changes in value of available-for-sale securities, credit spreads, and commodity prices. The inability to fund obligations due to investors, borrowers, or depositors is liquidity risk. For the Corporation, the dominant risks are market risk and credit risk.
Credit Risk Management
Uniform underwriting criteria, ongoing risk monitoring and review processes, and well-defined, centralized credit policies dictate the management of credit risk for the Corporation. As such, credit risk is managed through the Bank’s allowance for loan loss policy which requires the loan officer, lending officers, and the loan review committee to manage loan quality. The Corporation’s credit policies are reviewed and modified on an ongoing basis in order to remain suitable for the management of credit risks within the loan portfolio as conditions change. The Corporation uses a loan rating system to properly classify and assess the credit quality of individual commercial loan transactions. The loan rating system is used to determine the adequacy of the allowance for loan losses for regulatory reporting purposes and to assist in the determination of the frequency of review for credit exposures.
Credit quality measures in the last six months of 2006 deteriorated as compared to the same period in 2005. Weaker general economic conditions, especially in residential and commercial development lending, combined with the need to further strengthen underwriting and portfolio management controls resulted in higher levels of nonperforming loans and potential problem loans.
Nonperforming Assets
Total nonperforming assets consist of nonperforming loans, loans which have been restructured, and other foreclosed assets. As such, a loan is considered nonperforming if it is 90 days past due and/or in Management’s estimation the collection of interest on the loan is doubtful. Nonperforming loans no longer accrue interest and are accounted for on a cash basis. The classification of restructured loans involves the deterioration of a borrower’s financial ability leading to original terms being favorably modified or either principal or interest being forgiven.
Nonperforming loans at December 31, 2006 were $12,812 as compared to $6,494 at December 31, 2005, an increase of $6,318. Of this total, commercial loans were $10,322 as compared to $5,129 at December 31, 2005. These are commercial loans that are primarily secured by real estate and, in some cases, by SBA guarantees, and have either been charged-down to their realizable value or a specific reserve has been established for any collateral short-fall. At December 31, 2006, specific reserves on these loans totaled $1,115 as compared to $356 specifically reserved at December 31, 2005. The $5,194 increase in commercial nonperforming loans was the result of four commercial relationships totaling $4,393. These four loans are either well secured by real estate, or had specific reserves established at December 31, 2006. Potential problem loans are loans identified on Management’s classified credits list which include both loans that Management has concern with the borrowers’ ability to comply with the present repayment terms and loans that Management is actively monitoring due to changes in the borrowers financial condition. At December 31, 2006, potential problem loans increased $7,663, to $22,103. This compares to $14,440 at December 31, 2005, and reflects the categorization of three large real estate development relationships totaling $7,740 as potential loan problems.
Other foreclosed assets were $1,289 as of December 31, 2006, an increase of $857 from December 31, 2005. The $1,289 is comprised of eight commercial properties totaling $945 and four 1-4 family residential properties totaling $344. This compares to $211 in 1-4 family residential properties with the remainder in commercial properties as of December 31, 2005.
Table 13 sets forth nonperforming assets for the period ended December 31, 2006 and December 31, 2005.
Table 13: Nonperforming Assets
Provision and Allowance for Loan Losses
The allowance for loan losses is maintained by the Corporation at a level considered by Management to be adequate to cover probable credit losses inherent in the loan portfolio. The amount of the provision for loan losses charged to operating expenses is the amount necessary, in the estimation of Management, to maintain the allowance for loan losses at an adequate level. Management determines the adequacy of the allowance based upon past experience, changes in portfolio size and mix, relative quality of the loan portfolio and the rate of loan growth, assessments of current and future economic conditions, and information about specific borrower situations, including their financial position and collateral values, and other factors, which are subject to change over time.
While Management’s periodic analysis of the allowance for loan losses may dictate portions of the allowance be allocated to specific problem loans, the entire amount is available for any loan charge-offs that may occur. Table 14 presents the detailed activity in the allowance for loan losses and related charge-off activity for the five years ended December 31, 2006.
Table 14: Analysis of Allowance for Loan Losses
The allowance for loan losses at December 31, 2006 was $7,300 or 1.16% of outstanding loans, compared to $6,622 or 1.13% of outstanding loans at December 31, 2005. The allowance for loan losses was 57% and 102% of nonperforming loans at December 31, 2006 and 2005, respectively.
Net charge-offs for the year ended December 31, 2006 were $1,602, as compared to $2,012 for the year ended December 31, 2005. Net charge-offs as a percent of average loans in 2006 was .27% , as compared to .34% in 2005. Net charge-offs in 2006 were at the lowest level since 2002.
Direct deposit account overdrafts were charged to the allowance for loan losses for the first time in 2006 and accounted for $126 of the net charge-offs in 2006. These charges were previously expensed directly to noninterest expense. For comparison purposes the net overdraft charge-offs expensed to noninterest expense in 2005 was $31.
The provision charged to expense was $2,280 for the year ended December 31, 2006 as compared to $1,248 for the same period 2005. The provision for loan losses for the year ended December 31, 2006 was, in the opinion of management, adequate when balancing the lower charge-off trends, with the higher level of nonperforming loans and the level of potential problem loans at December 31, 2006. The resulting allowance for loan losses is, in the opinion of management, sufficient given its analysis of the information available about the portfolio at December 31, 2006. Management continues to work toward prompt resolution of nonperforming loan situations and to adjust underwriting standards as conditions warrant.
Market Risk Management
The Corporation manages market risk through its Asset/Liability Management Committee (“ALCO”) at the Bank level governed by policies set forth and established by the Board of Directors. This committee assesses interest rate risk exposure through two primary measures: rate sensitive assets divided by rate sensitive liabilities and earnings-at-risk simulation of net interest income over the one year planning cycle and the longer term strategic horizon in order to provide a stable and steadily increasing flow of net interest income.
The difference between a financial institution’s interest rate sensitive assets and interest rate sensitive liabilities is referred to as the interest rate gap. An institution that has more interest rate sensitive assets than interest rate sensitive liabilities in a given period is said to be asset sensitive or has a positive gap. This means that if interest rates rise a corporation’s net interest income may rise and if interest rates fall its net interest income may decline. If interest sensitive liabilities exceed interest sensitive assets then the opposite impact on net interest income may occur. The usefulness of the gap measure is limited. It is important to know the gross dollars of assets and liabilities that may re-price in various time horizons, but without knowing the frequency and basis of the potential rate changes the predictive power of the gap measure is limited.
Two more useful tools in managing market risk are earnings-at-risk simulation and economic value of equity simulation. An earnings-at-risk analysis is a modeling approach that combines the repricing information from gap analysis, with forecasts of balance sheet growth and changes in future interest rates. The result of this simulation provides management with a range of possible net interest margin outcomes. Trends that are identified in earnings-at-risk simulation can help identify product and pricing decisions that can be made currently to assure stable net interest income performance in the future. At December 31, 2006, a “shock” treatment of the balance sheet, in which a parallel shift in the yield curve occurs and all rates increase immediately, indicates that in a +200 basis point shock, net interest income would increase $1,150, or 4.02%, and in a -200 basis point shock, net interest income would decrease $1,316, or 4.60%. The reason for the lack of symmetry in these results is the implied floors in many of the Corporation’s core funding which limits their downward adjustment from current offering rates. This analysis is done to describe a best or worst case scenario. Factors such as non-parallel yield curve shifts, management pricing changes, customer preferences and other factors are likely to produce different results.
The economic value of equity approach measures the change in the value of the Corporation’s equity as the value of assets and liabilities on the balance sheet change with interest rates. At December 31, 2006, this analysis indicated that a +200 basis point change in rates would reduce the value of the Corporation’s equity by 12.86% while a -200 basis point change in rates would increase the value of the Corporation’s equity by 11.65%.
Table 15: GAP Analysis:
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
LNB Bancorp, Inc.
We have audited the accompanying consolidated balance sheet of LNB Bancorp, Inc. and subsidiaries (the Corporation) as of December 31, 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for the year then ended. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether 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 consolidated financial position of LNB Bancorp, Inc. and subsidiaries as of December 31, 2006, and the consolidated results of their operations and their cash flows for the year then ended in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of LNB Bancorp, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 23, 2007 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an adverse opinion on the effectiveness of internal control over financial reporting.
/s/ Plante Moran PLLC
Auburn Hills, Michigan
February 23, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
LNB Bancorp, Inc.:
We have audited the accompanying consolidated balance sheet of LNB Bancorp, Inc. and subsidiaries (Company) as of December 31, 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2005.. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LNB Bancorp, Inc. and subsidiaries as of December 31, 2005 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles.
Cleveland, Ohio
March 13, 2006
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per share amounts)
(1) Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the accounts of LNB Bancorp, Inc. (the “Corporation”) and its wholly-owned subsidiary, The Lorain National Bank (the “Bank”). The consolidated financial statements also include the accounts of North Coast Community Development Corporation which is a wholly-owned subsidiary of the Bank. All intercompany transactions and balances have been eliminated in consolidation.
During the third quarter of 2006, dissolutions were filed with the Ohio Secretary of State for Charleston Insurance Agency, Inc., a wholly-owned subsidiary of LNB Bancorp, Inc., Charleston Title Agency, a 49%-owned subsidiary of LNB Bancorp, Inc., and LNB Mortgage, LLC, a wholly-owned subsidiary of The Lorain National Bank.
Use of Estimates
LNB Bancorp Inc. prepares its financial statements in conformity with U.S. generally accepted accounting principles (GAAP). As such, GAAP requires the Corporation’s management (“Management”) to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Actual results could differ from those estimates. Areas involving the use of Management’s estimates and assumptions include the allowance for loan losses, the realization of deferred tax assets, fair values of certain securities, net periodic pension expense, and accrued pension costs recognized in the Corporation’s consolidated financial statements. Estimates that are more susceptible to change in the near term include the allowance for loan losses and the fair value of certain securities.
Segment Information
The Corporation’s activities are considered to be a single industry segment for financial reporting purposes. LNB Bancorp, Inc. is a financial holding company engaged in the business of commercial and retail banking, investment management and trust services, title insurance, and insurance with operations conducted through its main office and banking centers located throughout Lorain, eastern Erie and western Cuyahoga counties of Ohio. This market provides the source for substantially all of the Bank’s deposit, loan and trust activities and title insurance and insurance activities. The majority of the Bank’s income is derived from a diverse base of commercial, mortgage and retail lending activities and investments.
Statement of Cash Flows
For purposes of reporting in the Consolidated Statements of Cash Flows, cash and cash equivalents include currency on hand, amounts due from banks, Federal funds sold, and securities purchased under resale agreements. Generally, Federal funds sold and securities purchased under resale agreements are for one day periods.
Securities
Securities that are bought and held for the sole purpose of selling them in the near term are deemed trading securities with any related unrealized gains and losses reported in earnings. As of December 31, 2006 and December 31, 2005, LNB Bancorp, Inc. did not hold any trading securities. Securities that the Corporation has a positive intent and ability to hold to maturity are classified as held to maturity. As of December 31, 2006 and December 31, 2005, LNB Bancorp, Inc. did not hold any held to maturity securities. Securities that are not classified as trading or held to maturity are classified as available for sale. As of December 31, 2006 and December 31, 2005 all securities held by the Corporation are classified as available for sale and are carried at their fair value with unrealized gains and losses, net of tax, included as a component of accumulated other comprehensive income, net of tax. A decline
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
in the fair value of securities below cost that is deemed other than temporary is charged to earnings, resulting in establishment of a new cost basis for the security. Interest and dividends on securities, including amortization of premiums and accretion of discounts using the effective interest method over the period to maturity or call, are included in interest income.
Federal Reserve Bank (FRB) and Federal Home Loan Bank (FHLB) Stock
These stocks are required investments for institutions that are members of the Federal Reserve and Federal Home Loan Bank systems. The required investment in the common stock is based on a predetermined formula. These stocks are recorded at redemption value which approximates fair value.
Loans
Loans are reported at the principal amount outstanding, net of unearned income and premiums and discounts. Unearned income includes deferred fees, net of deferred direct incremental loan origination costs. Unearned income is amortized to interest income, over the contractual life of the loan, using the interest method. Deferred direct loan origination fees and costs are amortized to interest income, over the contractual life of the loan, using the interest method.
Held for sale loans are carried at the lower of amortized cost or estimated fair value, determined on an aggregate basis for each type of loan available for sale. Net unrealized losses are recognized by charges to income. Gains and losses on loan sales (sales proceeds minus carrying value) are recorded in noninterest income.
Loans are generally placed on nonaccrual status when they are 90 days past due for interest or principal or when the full and timely collection of interest or principal becomes uncertain. When a loan has been placed on nonaccrual status, the accrued and unpaid interest receivable is reversed against interest income. Generally, a loan is returned to accrual status when all delinquent interest and principal becomes current under the terms of the loan agreement and when the collectibility is no longer doubtful.
A loan is impaired when full payment under the original loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as real estate mortgages and installment loans, and on an individual loan basis for commercial loans that are graded substandard. Factors considered by Management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis. If a loan is impaired, a portion of the allowance may be 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.
Allowance for Loan Losses
The allowance for loan losses is Management’s estimate of credit losses inherent in the loan portfolio at the balance sheet date. Management’s determination of the allowance, and the resulting provision, is based on judgments and assumptions, including general economic conditions, loan portfolio composition, loan loss experience, Management’s evaluation of credit risk relating to pools of loan and individual borrowers, sensitivity analysis and expected loss models, value of underlying collateral, and observations of internal loan review staff or banking regulators.
The provision for loan losses is determined based on Management’s evaluation of the loan portfolio and the adequacy of the allowance for loan losses under current economic conditions and such other factors which, in Management’s judgment, deserve current recognition. In addition, various regulatory agencies, as an integral part
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examinations.
Bank Premises and Equipment
Bank premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed generally on the straight-line method over the estimated useful lives of the assets. Upon the sale or other disposition of assets, the cost and related accumulated depreciation are retired and the resulting gain or loss is recognized. Maintenance and repairs are charged to expense as incurred, while renewals and improvements are capitalized. Software costs related to externally developed systems are capitalized at cost less accumulated amortization. Amortization is computed on the straight-line method over the estimated useful life.
Goodwill and Core Deposit Intangibles
Intangible assets arise from acquisitions and include goodwill and core deposit intangibles. Goodwill is the excess of purchase price over the fair value of identified net assets in acquisitions. Core deposit intangibles represent the value of depositor relationships purchased. The Corporation follows Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 147 “Acquisitions of Certain Financial Institutions”. Goodwill is tested at least annually for impairment.
Core deposit intangible assets are amortized using the straight-line method over ten years and are subject to annual impairment testing.
Other Real Estate Owned
Other real estate owned (OREO) represent properties acquired through customer loan default. Real estate and other tangible assets acquired through foreclosure are carried as OREO on the Consolidated Balance Sheet at fair value, net of estimated costs to sell, not to exceed the cost of property acquired through foreclosure.
Investment and Trust Services Assets and Income
Property held by the Corporation in fiduciary or agency capacity for its customers is not included in the Corporation’s financial statements as such items are not assets of the Corporation. Income from the Investment and Trust Services Division is reported on an accrual basis.
Income Taxes
The Corporation and its wholly-owned subsidiaries file a consolidated Federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be removed or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded when necessary to reduce deferred tax assets to amounts which are deemed more likely than not to be realized.
Comprehensive Income
The Corporation displays the accumulated balance of other comprehensive income as a separate component of shareholders’ equity.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
Stock-Based Compensation
A broad based stock option incentive plan, the 2006 Stock Incentive Plan, was adopted by the Corporation’s shareholders on April 18, 2006. No awards are currently outstanding under the plan; however, at December 31, 2006 and December 31, 2005 the Corporation did have stock option agreements with two individuals outside of the 2006 Stock Incentive Plan. The Corporation also issued Stock Appreciation Rights (SAR’s) on January 20, 2006 to eight employees. SFAS No. 123R has been adopted for the accounting and disclosure of the stock option agreements and the SAR’s.
Common stock issued in 2005 under an employment agreement was charged to expense at the fair value of the common stock issued.
(2) Earnings Per Share
Basic earnings per share are computed by dividing income available to common shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share is computed based on the weighted average number of shares outstanding plus the effects of dilutive stock options outstanding during the year. Basic and diluted earnings per share are calculated as follows:
(3) Cash and Due from Banks
Federal Reserve Board regulations require the Bank to maintain reserve balances on deposits with the Federal Reserve Bank of Cleveland. The average required reserve balance was $12,834 and $13,116 during 2006 and 2005. The required ending reserve balance was $12,692 on December 31, 2006 and $12,619 on December 31, 2005.
(4) Goodwill and Intangible Assets
The Corporation assesses goodwill for impairment annually and more frequently in certain circumstances. Goodwill was assessed at a reporting unit level by applying a fair-value based test using discounted estimated future net cash flows. During 2005 it was determined that goodwill relating to LNB Mortgage, LLC had been impaired and all goodwill relating to this entity in the amount of $311 was written off.
The Corporation recorded core deposit intangibles in 1997, related to the acquisition of three branch offices from another bank. These core deposit intangibles are tested annually for impairment.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
Core deposit intangibles are amortized over their estimated useful life of 10 years in accordance with SFAS No. 142. A summary of core deposit intangible assets follows:
The following intangible assets are included in the accompanying consolidated financial statements and are summarized as follows at December 31, 2006 and December 31, 2005 net of accumulated amortization:
Amortization expense for intangible assets was $164, $169 and $130 for the years ended December 31, 2006, 2005 and 2004, respectively. The following table shows the estimated future amortization expense for amortizable intangible assets based on existing asset balances and the interest rate environment as of December 31, 2006. The Company’s actual amortization expense in any given period may be significantly different from the estimated amounts depending upon the addition of new intangible assets, changes in mortgage interest rates, prepayment rates and market conditions.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(5) Securities
The amortized cost, gross unrealized gains and losses and fair values of securities at December 31, 2006 and 2005 follows:
The amortized cost, fair value and weighted average yield of debt securities by contractual maturity date at December 31, 2006 follows:
Realized gains and losses related to securities available for sale for each of the three years ended December 31 follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
U.S. Government agencies and corporations include callable and bullet agency issues and agency-backed mortgage backed securities. The maturity of mortgage backed securities is shown based on contractual maturity of the security although repayments occur each year. The carrying value of securities pledged to secure trust deposits, public deposits, line of credit, and for other purposes required by law amounted to $125,947 and $136,143 at December 31, 2006 and 2005, respectively. The fair value of securities is based on quoted market prices, where available. If quoted market prices are not available, fair value is estimated using the quoted market prices of comparable instruments. In 2004, the Corporation reclassified all held to maturity securities to available for sale. This transfer was made recognizing that the primary purpose of the securities portfolio is liquidity. The Corporation does not anticipate classifying any securities as held to maturity in the future. The securities portfolio contained $448 and $490 in non-rated securities of state and political subdivisions at December 31, 2006 and 2005, respectively. Based upon yield, term to maturity and market risk, the fair value of these securities was estimated to be $444 and $490 at December 31, 2006 and 2005, respectively. This portfolio of non-rated securities are short-term debt issues of two (2) local political subdivisions. Management reviewed these non-rated securities and has determined that there was no other than temporary impairment to their value at December 31, 2006 and 2005.
At December 31, 2004, the Corporation recorded a $1,158 pre-tax charge to earnings to recognize other than temporary impairment of the Corporation’s investment in FNMA and FHLMC preferred securities which were subsequently sold in 2005. Management has reviewed the securities portfolio and has determined that there is no other than temporary impairment to their value as of December 31, 2006.
The following is a summary of securities that had unrealized losses at December 31, 2006. The information is presented for securities that have been in an unrealized loss position for less than 12 months and for more than 12 months. There are temporary reasons why securities may be valued at less than amortized cost. Temporary reasons are that the current levels of interest rates as compared to the coupons on the securities held by the Corporation are higher and impairment is not due to credit deterioration. The Corporation has the ability to hold these securities until their value recovers. At December 31, 2006, the total unrealized losses of $2,771 were temporary in nature and due to the current level of interest rates.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(6) Transactions with Related Parties
The Corporation, through its subsidiary Bank, makes loans to its officers, directors and their affiliates. These loans are made on substantially the same terms and conditions as transactions with non-related parties. A comparison of loans outstanding to related parties follows:
The Corporation, through its subsidiary Bank, maintains deposits accounts for officers, directors and their affiliates. These deposits are made on substantially the same terms and conditions as transactions with non-related parties. The balances of deposit accounts for related parties at December 31, 2006 follows:
(7) Loans and Allowance for Loan Losses
Loan balances at December 31, 2006 and December 31, 2005 are summarized as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
Activity in the allowance for loan losses for 2006, 2005 and 2004 is summarized as follows:
In 2005, substandard loans totaling $5.7 million were sold. As a result, loans charged-off in 2005 include $1,173 from the sale of these loans.
Information regarding impaired loans is as follows:
(8) Bank Premises, Equipment and Leases
Bank premises and equipment are summarized as follows:
Depreciation of Bank premises and equipment charged to noninterest expense amounted to $1,389 in 2006, $1,503 in 2005 and $1,460 in 2004. Amortization of purchased software charged to noninterest expense amounted to $242 in 2006, $273 in 2005 and $348 in 2004.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
At December 31, 2006, the Bank was obligated to pay rental commitments under noncancelable operating leases on certain Bank premises and equipment as follows:
Rentals paid under leases on Corporation premises and equipment amounted to $879 in 2006, $663 in 2005 and $378 in 2004.
(9) Deposits
Deposit balances at December 31, 2006 and December 31, 2005 are summarized as follows:
The aggregate amount of certificates of deposit in denominations of $100,000 or more amounted to $161,655 and $124,626 at December 31, 2006 and 2005, respectively. Brokered time deposits totaling $65,093 and $55,266 at December 31, 2006 and 2005, respectively, are included in these totals.
The maturity distribution of certificates of deposit as of December 31, 2006 follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(10) Short-Term Borrowings
The Corporation has a line of credit for advances and discounts with the Federal Reserve Bank of Cleveland. The amount of this line of credit varies on a monthly basis. The line is equal to 85% of the balances of qualified home equity lines of credit that are pledged as collateral. At December 31, 2006, the Bank had pledged approximately $7,965 in qualifying home equity lines of credit, resulting in an available line of credit of approximately $6,770. No amounts were outstanding at December 31, 2006 or December 31, 2005.
Short-term borrowings include securities sold under repurchase agreements and Federal funds purchased from correspondent banks. The table below presents information for short-term borrowings for the three years ended December 31, 2006.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(11) Federal Home Loan Bank Advances
Federal Home Loan Bank advances amounted to $35,086 and $53,896 at December 31, 2006 and December 31, 2005 respectively. All advances are bullet maturities with no call features. At December 31, 2006, collateral pledged for FHLB advances consisted of qualified real estate mortgage loans, home equity lines of credit and investment securities of $98,574, $40,454 and $1,000 respectively. The maximum borrowing capacity of the Bank at December 31, 2006 was $79,474 with unused collateral borrowing capacity of $44,388. The Bank maintains a $40,000 cash management line of credit (CMA) with the FHLB. The following table presents the activity on this line of credit for the three years ended December 31, 2006.
Maturities of FHLB advances outstanding at December 31, 2006 and 2005 are as follows:
(12) Income Taxes
The provision for income taxes consists of the following:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
The following presents a reconciliation of income taxes as shown on the Consolidated Statements of Income with that which would be computed by applying the statutory Federal tax rate of 34% to income before taxes in 2006 and 2005, and 35% to income before income taxes in 2004.
Net deferred Federal tax assets are included in other assets on the consolidated Balance Sheets. Management believes that it is more likely than not that the deferred Federal tax assets will be realized. At December 31, 2006 and 2005 there was no valuation allowance required. The tax effects of temporary differences that give rise to significant portions of the deferred Federal tax assets and deferred Federal tax liabilities are presented below.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(13) Shareholders’ Equity
Preferred Stock
The Corporation is authorized to issue up to 1,000,000 shares of Voting Preferred Stock, no par value. As of December 31, 2006 and 2005, no such stock had been issued. The Board of Directors of the Corporation is authorized to provide for the issuance of one or more series of Voting Preferred Stock and establish the dividend rate, dividend dates, whether dividends are cumulative, liquidation prices, redemption rights and prices, sinking fund requirements, conversion rights, and restrictions on the issuance of any series of Voting Preferred Stock. The Voting Preferred Stock may be issued with conversion rights to common stock and may rank prior to the common stock in dividends, liquidation preferences, or both. The Corporation has authorized 750,000 Series A Voting Preferred Shares none of which have been issued.
Common Stock
The Corporation is authorized to issue up to 15,000,000 shares of common stock. Common shares outstanding were 6,443,673 and 6,521,173 at December 31, 2006 and December 31, 2005, respectively.
Common Stock Repurchase Plan and Treasury Stock
On July 28, 2005, the Board of Directors authorized the repurchase of up to 5% of the outstanding shares of the common stock of the Corporation, or approximately 332,000 shares. The repurchased shares will be used primarily for qualified employee benefit plans, incentive stock option plans, stock dividends and other corporate purposes. At December 31, 2006 and December 31, 2005, LNB Bancorp, Inc. held 328,194 shares and 250,694 shares of common stock as Treasury Stock under this plan at a total cost of $6,092 and $4,649 respectively.
Shareholder Rights Plan
On October 24, 2000, the Board of Directors of LNB Bancorp, Inc. adopted a Shareholder Rights Plan which was amended as of May 17, 2006. The rights plan is designed to prevent a potential acquirer from exceeding a prescribed ownership level in LNB Bancorp, Inc., other than in the context of a negotiated acquisition involving the Board of Directors. If the prescribed level is exceeded, the rights become exercisable and, following a limited period for the Board of Directors to redeem the rights, allow shareholders, other than the potential acquirer that triggered the exercise of the rights, to purchase Preferred Share Units of the Corporation having characteristics comparable to the Corporation’s Common Shares, at 50% of market value. This would dilute the potential acquirer’s ownership level and voting power, making an acquisition of the Corporation without prior Board approval prohibitively expensive.
The Shareholder Rights Plan provided for the distribution of one Preferred Share Purchase Right as a dividend on each outstanding LNB Bancorp, Inc. Common Share held as of the close of business on November 6, 2000. One Preferred Share Purchase Right will also be distributed for each Common Share issued after November 6, 2000. Each right entitles the registered holder to purchase from LNB Bancorp, Inc. Units of a new series of Voting Preferred Shares, no par value, at 50% of market value, if a person or group acquires 15% or more of LNB Bancorp, Inc.’s Common Shares. Each Unit of the new Preferred Shares has terms designed to make it the economic equivalent of one Common share.
LNBB Direct Stock Purchase and Dividend Reinvestment Plan
The Board of Directors adopted the LNBB Direct Stock Purchase and Dividend Reinvestment Plan (the Plan) effective June 2001, replacing the former LNB Bancorp, Inc. Dividend Reinvestment Plan. The Plan authorized the sale of 500,000 shares of the Corporation’s common shares to shareholders who choose to invest all or a portion of their cash dividends plus additional cash payments for LNB Bancorp, Inc. common stock. The Corporation
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
did not issue shares pursuant to the Plan in 2006 and no shares were purchased in the open market at the current market price. Similarly, the Corporation did not issue shares pursuant to the Plan in 2005 while 12,538 shares were purchased in the open market at the current market price.
Dividend Restrictions
Dividends paid by the Bank are the primary source of funds available to the Corporation for payment of dividends to shareholders and for other working capital needs. The payment of dividends by the Bank to the Corporation is subject to restrictions by the Office of the Comptroller of Currency. These restrictions generally limit dividends to the current and prior two years’ retained earnings. At December 31, 2006, approximately $5,523 of the Bank’s retained earnings was available for dividends to the Corporation. In addition to these restrictions, as a practical matter, dividend payments cannot reduce regulatory capital levels below the Corporation’s regulatory capital requirements and minimum regulatory guidelines. These restrictions do not presently limit the Corporation from paying normal dividends.
(14) Regulatory Capital
The Corporation and the Bank are subject to risk-based capital guidelines issued by the Board of Governors of the Federal Reserve Board and the Office of Comptroller of Currency. These guidelines are used to evaluate capital adequacy and include required minimums as discussed below. The Corporation and the Bank are subject to an array of banking, Federal Deposit Insurance Corporation, U.S. Federal, including the FDIC Improvement Act. The FDIC Improvement Act established five capital categories ranging from “well capitalized” to “critically undercapitalized.” These five capital categories are used by the Federal Deposit Insurance Corporation to determine prompt corrective action and an institution’s semi-annual FDIC deposit insurance premium assessments.
Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the consolidated financial statements.
The prompt corrective action regulations provide for five categories which in declining order are: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically under-capitalized.” To be considered “well capitalized”, an institution must generally have a leverage capital ratio of at least five percent, a Tier I risk-based capital ratio of at least six percent, and a total risk-based capital ratio of at least ten percent.
Total capital (Tier 1 and Tier 2) amounted to $74,629 at December 31, 2006, representing 10.56% of net risk-adjusted assets and $74,975 and 11.39%, respectively, at December 31, 2005. Tier 1 capital of $67,329 at December 31, 2006 represented 9.53% of risk weighted assets, and $68,353 and 10.38% at December 31, 2005.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
At December 31, 2006 and 2005, the capital ratios for the Corporation and its wholly-owned subsidiary, The Lorain National Bank, exceeded the ratios required to be “well capitalized.” The “well capitalized” status affords the Bank the ability to operate with the greatest flexibility under current laws and regulations. The Comptroller of the Currency’s most recent notification categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that Management believes have changed the Bank’s category. Analysis of The Lorain National Bank and LNB Bancorp, Inc.’s Regulatory Capital and Regulatory Capital Requirements follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(15) Parent Company Financial Information
LNB Bancorp, Inc.’s (parent company only) condensed balance sheets as of December 31, 2006 and 2005, and the condensed statements of income and cash flows for the years ended December 31, 2006, 2005 and 2004 are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(16) Retirement Pension Plan
The Bank’s non-contributory defined benefit pension plan (the Plan) covers substantially all of its employees. In general, benefits are based on years of service and the employee’s level of compensation. The Bank’s funding policy is to contribute annually an actuarially determined amount to cover current service cost plus amortization of prior service costs.
The Company adopted the provisions of SFAS No. 158 as of December 31, 2006, which require that the funded status of the defined benefit pension retirement plan be fully recognized in the balance sheet. Effective December 31, 2002, the benefits under this plan have been frozen and the Accumulated Benefit Obligation (ABO) is equal to the Projected Benefit Obligation (PBO). As a result, the funded status of the plan has been fully recognized in the balance sheet and the implementation of SFAS 158 will not require an additional liability accrual.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
The net periodic pension costs charged to expense amounted to $9 in 2006, $32 in 2005 and $179 in 2004. The following table sets forth the defined benefit pension plan’s Change in Projected Benefit Obligation, Change in Plan Assets and Funded Status, including the Prepaid Asset or Accrued Liability for the years ended December 31, 2006, 2005, and 2004. Effective December 31, 2002, the benefits under the Plan were frozen and no additional benefits are accrued under the Plan after December 31, 2002. The losses recognized due to settlement in the amount of $85, $135 and $105 results from significant lump sum distributions paid in 2006, 2005 and 2004, but not actuarially projected.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
Amounts recognized in the consolidated balance sheets consist of:
The following items included in accumulated other comprehensive income have not yet been recognized as components of periodic benefit cost:
Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31, 2006, 2005 and 2004:
Amounts recognized in the consolidated balance sheets consist of:
The actuarial assumptions used in the pension plan valuation are reviewed annually. The plan reviews Moody’s Aaa and Aa corporate bond yields as of each plan year-end to determine the appropriate discount rate to calculate the year-end benefit plan obligation and the following year’s net periodic pension cost.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
Plan Assets
The Lorain National Bank’s Retirement Pension Plan’s weighted-average assets allocations at December 31, 2006, 2005 and 2004 by asset category are as follows:
The investment strategy for 2007 will continue to be an equity security allocation percent of 60% and a debt security position of 40%. This strategy will be employed in order to position more assets to benefit from the anticipated increase in the equities market in 2007.
The Lorain National Bank has not yet decided the contribution to The Lorain National Bank Retirement Pension Plan in 2007.
The following estimated future benefit payments, which reflect no expected future service as the plan is frozen, are expected to be paid as follows:
(17) Stock Options and Stock Appreciation Rights
At December 31, 2006 and December 31, 2005, the Corporation had nonqualified stock option agreements with two executives granted in 2005 and 2006. On January 20, 2006 the Corporation issued 30,000 Stock Appreciation Rights (SAR’s) to eight employees. The expense recorded as of December 31, 2006 was $21 for SAR’s and $73 for stock options. The number of options or SAR’s and the exercise prices for these nonqualified incentive options or SAR’s outstanding as of December 31, 2006 follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
The activity in stock options outstanding for the three years ended December 31, 2006 follows:
The weighted average remaining contractual life of options exercisable at December 31, 2006 was 6.96 years with an aggregate intrinsic value of $0.
A summary of the status of the Corporation’s nonvested shares as of December 31, 2006, and changes during the year ended December 31, 2006, is presented below:
As of December 31, 2006, there was $46 of total unrecognized compensation cost related to nonvested stock options. The unrecognized compensation is expected to be recognized over a period of 2.25 years.
In accordance with the disclosure requirements of Statement of Financial Accounting Standard, or SFAS, No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - An amendment of FASB Statement No. 123,” the following table provides the pro forma effect on net income and earnings per share if the fair value method of accounting for stock-based compensation had been used for all awards for the period ended December 31, 2005 and 2004.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(18) Employee Stock Ownership Plan
The Lorain National Bank Employee Stock Ownership Plan (ESOP) is a non-contributory plan that covers substantially all employees. Contributions by the Bank to the ESOP are discretionary and subject to approval by the Board of Directors. Contributions are expensed in the year in which they are approved. No contributions were made to this plan in 2006, 2005 and 2004. Under the terms of the ESOP agreement, the Corporation’s common stock is to be the Plan’s primary investment.
(19) 401(k) Plan
The Bank adopted the The Lorain National Bank 401(k) Plan (the Plan) effective January 1, 2001. This Plan amended and restated the previous plan - The Lorain National Bank Stock Purchase Plan. The Plan allows for the purchase of up to 80,000 shares of LNB Bancorp, Inc. treasury shares. No shares were purchased out of Treasury during 2006, 2005 or 2004.
Under provisions of the Plan, a participant can contribute a percentage of their compensation to the Plan. The Bank makes a non-discretionary 50% contribution to match each employee’s contribution. The Bank’s match is limited to the first six percent of an employee’s wage. The Plan uses the contributions of the Corporation to purchase LNB Bancorp, Inc. common stock. Effective January 1, 2001, the Plan permits the investment of plan assets, contributed by employees, among different funds.
The Bank’s matching contributions are expensed in the year in which the associated participant contributions are made and totaled $271, $252, and $221, in 2006, 2005 and 2004, respectively.
(20) Commitments, Credit Risk, and Contingencies
In the normal course of business, the Bank enters into commitments with off-balance sheet risk to meet the financing needs of its customers. These instruments are currently limited to commitments to extend credit and standby letters of credit. Commitments to extend credit involve elements of credit risk and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the commitment is represented by the contractual amount of the commitment. The Bank uses the same credit policies in making commitments as it does for on-balance sheet instruments. Interest rate risk on commitments to extend credit results from the possibility that interest rates may have moved unfavorably from the position of the Bank since the time the commitment was made.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates of 30 to 120 days or other termination clauses and may require payment of a fee. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The Bank evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained by the Bank upon extension of credit is based on Management’s credit evaluation of the applicant. Collateral held is generally single-family residential real estate and commercial real estate. Substantially all of the obligations to extend credit are variable rate. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
A summary of the contractual amount of commitments at December 31, 2006 follows:
Most of the Bank’s business activity is with customers located within the Bank’s defined market area. As of December 31, 2006 and 2005, the Bank had no significant concentrations of credit risk in its loan portfolio. The Bank also has no exposure to highly leveraged transactions and no foreign credits in its loan portfolio.
The nature of the Corporation’s business may result in litigation. Management, after reviewing with counsel all actions and proceedings pending against or involving LNB Bancorp, Inc. and subsidiaries, considers that the aggregate liability or loss, if any, resulting from them will not be material to the Corporation’s financial position, results of operation or liquidity.
(21) Estimated Fair Value of Financial Instruments
The Corporation discloses estimated fair values for its financial instruments. Fair value estimates, methods and assumptions are set forth below for the Corporation’s financial instruments.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
The carrying value of Cash and due from banks, Federal funds sold, short-term investments and accrued interest receivable and other financial assets is a reasonable estimate of fair value due to the short-term nature of the asset.
The fair value of investment securities is based on quoted market prices, where available. If quoted market prices are not available, fair value is estimated using the quoted market prices of comparable instruments.
For variable rate loans with interest rates that may be adjusted on a quarterly, or more frequent basis, the carrying amount is a reasonable estimate of fair value. The fair value of other types of loans is estimated by discounting future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
The carrying value approximates the fair value for bank owned life insurance.
The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market, checking and interest-bearing checking, is equal to the amount payable on demand as of December 31, for each year presented. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. For variable rate certificates of deposit, the carrying amount is a reasonable estimate of fair value.
Securities sold under repurchase agreements, other short-term borrowings, accrued interest payable and other financial liabilities approximate fair value due to the short-term nature of the liability.
The fair value of Federal Home Loan Bank advances is estimated by discounting future cash flows using current FHLB rates for the remaining term to maturity.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
The fair value of commitments to extend credit approximates the fees charged to make these commitments; since rates and fees of the commitment contracts approximates those currently charged to originate similar commitments. The carrying amount and fair value of off-balance sheet instruments is not significant as of December 31, 2006 and 2005.
Limitations
Estimates of fair value are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Estimates of fair value are based on existing on-and-off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the Bank has a substantial Investment and Trust Services Division that contributes net fee income annually. The Investment and Trust Services Division is not considered a financial instrument and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial instruments include property, plant, and equipment and deferred tax liabilities. In addition, it is not practicable for the Corporation to estimate the tax ramifications related to the realization of the unrealized gains and losses and they have not been reflected in any of the estimates of fair value. The impact of these tax ramifications can have a significant effect on estimates of fair value. The estimated fair values of the Corporation’s financial instruments at December 31, 2006 and 2005 are summarized as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
(22) Quarterly Financial Data (Unaudited)
During the second quarter of 2005, the Corporation recorded expenses totaling $1,218 associated with the recruitment of senior management, severance costs, a goodwill impairment charge related to the Corporation’s subsidiary LNB Mortgage, LLC and the write-off of several telecommunications contracts.
(23) Subsequent Events
On January 16, 2007, the Corporation announced the execution of a definitive agreement to acquire Morgan Bancorp, Inc. (“Morgan”) of Hudson, Ohio. The Corporation’s transaction is for the acquisition of Morgan and its wholly-owned subsidiary, which had approximately $129 million in assets at the date of the agreement.
Under the terms of the agreement, shareholders of Morgan will be entitled to receive cash, common shares of LNB, or a combination thereof, based upon an election process to occur prior to closing. Cash consideration is valued at $52.00 per Morgan share and stock consideration is fixed at an exchange ratio of 3.162 common shares of LNB Bancorp for each share of Morgan. The agreement further provides that, in the aggregate, 50% of the Morgan common shares will be exchanged for common shares of LNB Bancorp and the remaining 50% of the Morgan common shares will be exchanged for cash.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in thousands except per share amounts)
The transaction is valued at $26.5 million and is expected to close in the third quarter of 2007. The exchange is expected to qualify as a tax-free transaction to the Morgan shareholders. Following the merger, and upon receipt of all necessary regulatory approvals, Morgan Bank, N.A. will be merged with and into the Corporation.
Not considering the merger-related charges discussed below, the merger is expected to be accretive to earnings per share by approximately $.08 or 6.7% in the first full fiscal year of operations (2008), due to the expected cost-saving benefits achieved through the integration of systems and support functions, improved branch efficiencies and increased alternative delivery channels for financial products and services. The Corporation expects to reduce noninterest expenses of the combined entity by approximately $1.7 million. This expense reduction, while not expected to be totally from the Morgan Bank operation, represents about 48 percent of Morgan’s expense base. The Corporation intends to recognize these expense reductions as quickly and prudently as possible. After-tax merger-related costs of approximately $1.5 - $2.0 million will be incurred to complete the merger.
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosures
None.
Item 9A.
Item 9A. Controls and Procedures
1. Disclosure Controls and Procedures
The Corporation maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
The Corporation’s Management carried out an evaluation, under the supervision and with the participation of the chief executive officer and the chief financial officer, of the effectiveness of the design and operation of LNB Bancorp, Inc.’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934) as of December 31, 2006, pursuant to the evaluation of these controls and procedures required by Rule 13a-15 of the Securities Exchange Act of 1934.
Based upon that evaluation, Management concluded as of the end of the period covered by this Annual Report on Form 10-K that our disclosure controls and procedures were ineffective due to the material weakness that existed in our internal control over financial reporting.
2. Internal Control over Financial Reporting
The Management of LNB Bancorp, Inc. is responsible for establishing and maintaining adequate internal control over its financial reporting. LNB Bancorp, Inc.’s internal control over financial reporting is a process designed under the supervision of the Corporation’s chief executive officer and chief financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Corporation’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
LNB Bancorp, Inc.’s Management assessed the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2006 based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control Integrated Framework.”
During the course of its audit, Plante & Moran PLLC advised management and the Audit and Finance Committee that it had identified control deficiencies, which when aggregated, constituted a material weakness in the Corporation’s internal control over financial reporting. A material weakness is a significant deficiency, or a combination of significant deficiencies which when aggregated, results in there being more than a remote likelihood that a material misstatement of the annual or interim financials statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions. As a result, Management concluded that the Corporation’s internal control over financial reporting was not effective as of December 31, 2006 because of the material weakness described below. This material weakness did not result in an adjustment to the financial statements.
The material weakness identified resulted from the aggregation of significant deficiencies arising out of the lack of comprehensive procedural documentation of the loan grading process, the system of monitoring the collateral values of impaired loans and the controls on preventing the improper recognition of interest income on nonperforming loans. Management, with the oversight of the Audit and Finance Committee, has been systematically addressing these issues and is committed to effective remediation of this weakness. The Corporation has taken the following remediation measures:
Additional training is being completed to reinforce the existing procedures to assure that adequate evidence exists to support all decisions made regarding classification of individual loans.
Additional training is being completed to reinforce the requirement that once a loan meets the impairment criteria, such loans are deemed impaired and the impairment is valued based on a current appraisal of the collateral securing the loan.
Training has been completed to reinforce the documentation requirements for the recognition of interest income once a loan is classified as nonperforming. Management has also revised the approval process for recording all nonperforming loan transactions.
In addition to these specific responses to these control deficiencies, the Corporation has contracted with an independent third party to assess the completeness of the commercial loan documentation supporting the current grade classifications of all commercial relationships greater than $500,000. This represents approximately 75 percent of the commercial loan portfolio balances.
Management has discussed these corrective actions with the Audit and Finance Committee and Plante & Moran, PLLC. Plante & Moran, PLLC has issued an attestation report on Management’s assessment of the Corporation’s internal control over financial reporting. That report appears on page 71 of this annual report on Form 10-K.
3. Changes in Internal Control over Financial Reporting
No change in the Corporation’s internal control over financial reporting occurred during the fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting. Since December 31, 2006, the Corporation has implemented actions for the remediation of the identified material weakness, as described above.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
LNB Bancorp, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that LNB Bancorp, Inc. (the “Corporation”) did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effect of the material weakness described below, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”). LNB Bancorp, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Corporation’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following deficiencies are significant deficiencies. The aggregation of these significant deficiencies represents a material weakness that has been identified and included in management’s assessment. Management determined that it did not have adequate controls over: the documentation of the loan grading process, the system for monitoring the collateral values of impaired loans, and the controls designed to prevent and detect the improper recognition of interest income on nonperforming loans. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2006 financial statements, and this report does not affect our report dated February 23, 2007 on those statements. We do not express an opinion or any other form of assurance on management’s statements referred to in “Management’s Report on Internal Control Over Financial Reporting.”
In our opinion, management’s assessment that LNB Bancorp, Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, LNB Bancorp, Inc. has not maintained effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
/s/ Plante Moran PLLC
Auburn Hills, Michigan
February 23, 2007
Item 9B.
Item 9B. Other Information
On January 23, 2007, the Board of Directors of the Corporation approved the terms of the Corporation’s 2007 Management Incentive Plan for Key Executives (the “2007 Key Executive Plan”) and the 2007 CEO Short-Term Incentive Plan (the “2007 CEO Plan”). Employees of the Company, including executive officers other than the CEO, as are designated by the Compensation Committee, in its discretion, will participate in the 2007 Key Executive Plan. The Corporation’s CEO will participate in the 2007 CEO Plan. The 2007 Key Executive Plan and the 2007 CEO Plan both provide for the payment of cash bonuses to participants based upon the Corporation’s achievement of profitability goals for 2007, as determined by the Compensation Committee. In order for any bonus to be payable to any employee under either plan, the Corporation must achieve 100% of the specified target profitability goal. The size of the bonuses available under both plans increases as the Corporation’s profitability increases above the specified target profitability goal. If the Corporation achieves 100% or more of the specified target profitability amount, the Compensation Committee will determine, in its sole discretion, the total amount of the bonus that is to be distributed to the CEO under the 2007 CEO Plan, and the total bonuses to be distributed to the participants under the 2007 Key Executive Plan will be as determined by the CEO, subject to approval of the Compensation Committee in its sole discretion.
The 2007 Key Executive Plan also contains confidentiality and non-solicitation obligations of the participants which apply during the term of each participant’s employment with the Corporation and following termination of their employment under certain circumstances.
A copy of the form of the 2007 Key Executive Plan is included as Exhibit 10(z) to this annual report on Form 10-K and a copy of the form of the 2007 CEO Plan is included as Exhibit 10(aa) to this annual report on Form 10-K, both of which are incorporated by reference into this Item 9B, and the above summary is qualified in its entirety by reference to those Exhibits.
PART III
Item 10.
Item 10. Directors, Executive Officers, Promoters and Control Persons of the Registrant
Information regarding the executive officers of the Corporation is set forth in Part I, Item 4 of this Form 10-K. Other information required to be included under this item is incorporated by reference herein from the information about our directors provided in the section captioned “Election of Directors,” the information provided in the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance,” and the information about the Corporation’s Audit and Finance Committee, audit committee financial expert and procedures for recommending nominees to the Board of Directors and Corporate Governance provided in the sections captioned “Committees of the Board” and “Corporate Governance” in the Corporation’s Proxy Statement for the 2007 Annual Meeting of Shareholders filed with the SEC.
Item 11.
Item 11. Executive Compensation
The information required by this item is incorporated by reference herein from the information provided in the sections captioned “Executive Compensation and Other Information,” in the Corporation’s Proxy Statement for the 2007 Annual Meeting of Shareholders filed with the SEC.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information about security ownership of certain beneficial owners and management required by this item is incorporated by reference herein from the information provided in the section captioned “Ownership of Voting Shares” in the Corporation’s Proxy Statement for the 2007 Annual Meeting of Shareholders filed with the SEC. The following table shows information about the Corporation’s common shares that may be issued upon the exercise of options, warrants and rights under all of the Corporation’s equity compensation plans as of December 31, 2006:
Equity Compensation Plan Table
____________________
(1)
Consists of common shares of the Corporation covered by outstanding options.
(2)
Represents shares available for grant under the LNB Bancorp, Inc. 2006 Stock Incentive Plan. The LNB Bancorp, Inc. 2006 Stock Incentive Plan allows for the granting of an aggregate of 600,000 common shares, no more than 400,000 of which may be granted in the form of stock options and no more than 200,000 of which may be granted in the form of restricted shares.
(3)
All common shares included in equity compensation plans not approved by shareholders are covered by outstanding options awarded to two current officers under agreements having the same material terms. Each of these options is a nonqualified option, meaning a stock option that does not qualify under Section 422 of the Internal Revenue Code for the special tax treatment available for qualified, or “incentive,” stock options. Mr. Klimas was granted a stock option on February 1, 2005 and another on February 1, 2006, each to purchase 30,000 shares which vest in 10,000 increments on the first, second and third anniversaries of the date of grant. Mr. Klimas’ employment agreement also contemplates that he will be issued an additional option to purchase 30,000 shares on February 1, 2007. Mr. Soltis has an option to purchase 2,500 shares which vest on the first year anniversary of the date of grant. Each option may be exercised for a term of 10 years from the date the option vests, subject to earlier termination in the event of death, disability or other termination of the employment of the option holder. The option holder has up to 12 months following termination of employment due to death or disability to exercise the options. The options terminate three months after termination of employment for reasons other than death, disability or termination for cause, and immediately upon termination of employment if for cause. The exercise price and number of shares covered by the option are to be adjusted to reflect any share dividend, share split, merger or other recapitalization of the common shares of the Corporation. The options are not transferable other than by will or state inheritance laws. Exercise prices for these options are at fair market value at the date of grant. The stock option for 30,000 shares awarded to Mr. Klimas on February 1, 2005 has an exercise price of $19.17 per share, the stock option for 30,000 shares awarded to Mr. Klimas on February 1, 2006 has an exercise price of $19.10 per share, and the 2,500 shares awarded Mr. Soltis have an exercise price of $16.50 per share. The remaining contractual terms of the options are 10 years from the date of vesting.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this item is incorporated by reference from the information provided in section captioned “Certain Transactions” in the Corporation’s Proxy Statement for the 2007 Annual Meeting of Shareholders filed with the SEC.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item is incorporated by reference herein from the information provided in section captioned “Principal Accounting Firm Fees” in the Corporation’s Proxy Statement for the 2007 Annual Meeting of Shareholders filed with the SEC.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a) The following Consolidated Financial Statements and related Notes to Consolidated Financial Statements, together with the report of Independent Registered Public Accounting Firm dated February 23, 2007, appear on pages 36 through 68 of this annual report on Form 10-K:
(b)
the following exhibits required by Item 601 of Regulation S-K are filed as part of this report:
Form 10-K Exhibit Index
Exhibit Index
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated:
/s/ Daniel P. Batista
Director
DANIEL P. BATISTA
/s/ Robert M. Campana
Director
ROBERT M. CAMPANA
/s/ Terry D. Goode
Director
TERRY D. GOODE
/s/ James F. Kidd
Vice Chairman and Director
JAMES F. KIDD
/s/ David M. Koethe
Director
DAVID M. KOETHE
/s/ Kevin C. Martin
Director
KEVIN C. MARTIN
/s/ Benjamin G. Norton
Director
BENJAMIN G. NORTON
/s/ Jeffrey F. Riddell
Director
JEFFREY F. RIDDELL
/s/ John W. Schaeffer, Md
Director
JOHN W. SCHAEFFER, M.D.
/s/ Eugene M. Sofranko
Director
EUGENE M. SOFRANKO
STANLEY G. PIJOR
Director
/s/ Lee C. Howley
Director
LEE C. HOWLEY
/s/ Donald F. Zwilling
Director
DONALD F. ZWILLING
/s/ James R. Herrick
Chairman and Director
JAMES R. HERRICK
/s/ Daniel E. Klimas
Director and Chief Executive Officer
DANIEL E. KLIMAS
/s/ Terry M. White
Chief Financial Officer
TERRY M. WHITE