Item 1.
Business
The Company
Midwest Banc Holdings, Inc. (the “Company”), a Delaware corporation founded in 1983, is a community-based bank holding company under the Bank Holding Company Act of 1956, as amended, for its bank subsidiary and is headquartered in Melrose Park, Illinois. Through its wholly owned subsidiaries, the Company provides a wide range of services, including traditional banking services, personal and corporate trust services, residential mortgage services, insurance brokerage and retail securities brokerage services. The Company’s principal operating subsidiary is Midwest Bank and Trust Company (the “Bank”), an Illinois state bank that operates 24 banking centers in the Chicago metropolitan area. The Company operates in one business segment, community banking, providing a full range of services to individual and corporate customers. Midwest Financial and Investment Services, Inc., a subsidiary of the Company, provides securities brokerage services to customers of the Bank. Midwest Bank Insurance Services, L.L.C., a subsidiary of the Bank, acts as an insurance agency for individuals and corporations. Royal American Investment Services, a subsidiary of the Bank, is a NASD registered broker/dealer.
The Company focuses on establishing and maintaining long-term relationships with customers and is committed to serving the financial services needs of the communities it serves. In particular, the Company has emphasized in the past and intends to continue to emphasize its relationships with individual customers and small-to-medium-sized businesses. The Company actively evaluates the credit needs of its markets, including low- and moderate-income areas, and offers products that are responsive to the needs of its customer base. The markets served by the Company provide a mix of real estate, commercial and industrial, and consumer lending opportunities, as well as a stable core deposit base. The Company has expanded its trust administration and trust services activities along with broker/dealer activities.
Developments
On February 8, 2006, the Company, as part of its expansion strategy, entered into an agreement to acquire Royal American Corporation (“Royal American”), a bank holding company, in a cash and stock merger transaction. This transaction closed on June 30, 2006 with an effective date of July 1, 2006 when Royal American merged into the Company. At acquisition, Royal American had total assets of $561.2 million. The Company’s stock comprised approximately 50% of the purchase price, at an exchange ratio of 3.58429 shares of Company common stock for each Royal American common share, and the remainder was paid in cash at the rate of $80 for each share of Royal American common shares. The Company issued 2.9 million common shares, paid $64.6 million in cash, and paid $795,000 in costs that were capitalized for a total purchase price of $129.2 million.
The acquisition of Royal American diversified the Company’s deposit and lending mix as well as sources of noninterest income. Mr. J. J. Fritz, Chairman and Chief Executive Officer of Royal American, along with Mr. Thomas A. Rosenquist, joined the Boards of Directors of the Company and Bank. In addition, Mr. Fritz, now serves as an Executive Vice President of the Company and President and Chief Operating Officer of the Bank. The executive management team of the Bank was expanded with the additions of other Royal American executives. Each key revenue producer from Royal American has been retained.
During 2006, the Company repurchased 204,188 shares of its common stock at an average price of $23.37. These shares were acquired in private and public transactions as part of the Company’s 5% stock repurchase program. There are 1.0 million shares still authorized to be repurchased under this program.
Earnings for 2006 were reduced by provisions for loan losses recorded to reflect the deterioration of one large lending relationship. Developments in this customer’s operations, relating to uncertainty of the customer’s ability to collect a large account receivable, prompted the Company to record a $5.5 million provision for loan losses and charge off $7.5 million of these loans in the fourth quarter of 2006. The Company recorded a loan loss provision of $5.0 million relating to this problem relationship in the second quarter of 2006.
The Company reduced its loan concentrations in 2006. The balance outstanding for borrowing relationships of $30.0 million or more decreased by $124.0 million, or 56.7% compared to 2005.
Developments
From the fourth quarter of 2004 through 2005, the Company implemented several initiatives to focus on growth in the Chicago market. Repositioning initiatives, which were essentially complete as of the end of the third quarter of 2005, included:
Company repositioning. From September 2004 through June 2005, the Company completed a number of repositioning steps, including asset write downs and other steps to reduce earnings volatility and risk of the Company’s investment securities portfolio, reduce asset and liability risk, and increase asset quality. These initiatives included redemption of high-rate trust preferred securities and the issuance of lower-rate trust preferred securities, as replacement therefor, exiting hedge accounting, unwinding of interest rate swaps, sale of debt securities, prepayment of Federal Home Loan Bank advances, and other actions. In connection with these actions, the Company recognized pre-tax costs from continuing operations of $30.8 million in 2005 and $11.3 million in 2004.
Expansion of management depth. From September 2004 through 2005, the Company expanded the senior management group, both at the holding company level and at the Bank, to increase asset quality oversight, loan growth, branch management depth, and other functions. James J. Giancola became Director, President, and Chief Executive Officer of the Company and Bank in September 2004.
Board of Directors Alignment. In May 2005, two new directors were elected at the annual stockholders’ meeting. In June 2005, the Company aligned the membership of the holding company board with that of the Bank’s Board of Directors, resulting in the addition of two new directors to the Company’s Board. By creating identical boards for the two entities, the Company intends to increase the consistency and depth of oversight for both organizations. The Company’s By-laws were amended to reduce the number of director’s qualifying shares to 3,000 and eliminate the staggered board so that each director would be nominated and stand for election on an annual basis. In May 2006, two directors retired from the Board. In July 2006, two new directors were appointed as part of the Royal American acquisition.
Issuance of 3,450,000 shares of common stock. In August 2005, the Company raised $67.9 million, net of issuance costs, through an offering of 3,450,000 shares of common stock, including the over-allotment exercise by underwriters, at $21 per share. The infusion of capital strengthened the Company’s balance sheet, following a number of charges related to its repositioning.
Sale of Midwest Bank of Western Illinois. In September 2005, the Company sold Midwest Bank of Western Illinois (“MBWI”), a six-branch bank subsidiary with $282.5 million in assets, to an investor group including members of the subsidiary’s management team and board of directors. The Company recognized a $6.9 million gain, net of tax, in the third quarter as a result of the transaction.
Exit from Regulatory Process. In September 2005, the Company successfully completed a number of initiatives included in a written agreement among the Company, the Bank, the Federal Reserve Bank of Chicago and the Illinois Department of Financial and Professional Regulation, which led to the termination of the then existing written agreement. The Company had entered the written agreement with the regulators in March 2004, after a regulatory review led to a call for improved oversight of asset quality, internal controls, and certain risk management processes.
As described in greater detail later in this document, the Company’s performance includes a number of one-time items, special charges, and discontinued operations that can make comparisons of 2006, 2005, and 2004 results difficult. To provide increased clarity to investors and other interested parties, additional tables and discussions of ongoing or core operations are included herein.
Strategy
The Company’s strategic plan emphasizes expanded penetration of the community banking market in the Chicago metropolitan area, along with strong management of asset quality and risk. Initiatives implemented in 2005 and 2006 have increased the level of stockholders’ equity, added to the depth of management at the Bank and
Company, reduced the risk in the securities portfolio and improved operational controls. Among the strategies developed to achieve growth targets are:
Expand and diversify loan portfolio. The Company has increased its staff of commercial loan officers and assigned more aggressive goals for loan origination. The Royal American acquisition significantly enhanced loan portfolio diversification along with adding seasoned management with strong credit and new business development skills. Further growth is expected in commercial and industrial lending; as commercial real estate and construction lending should continue to decline as a percentage of the total loan portfolio. Beyond loan growth itself, the Company is seeking more commercial and industrial loans and retail loans to balance better the strong penetration of real estate lending in the Bank’s markets.
Expand deposit base. To fund loan growth, the Company is focused on deposit generation, including demand deposits, interest-bearing demand deposits, money market, and savings accounts. The Royal American acquisition added a strong core deposit base. The Company has changed and expanded staffing and management at its banking centers and initiated a number of customer outreach initiatives to expand deposits in a highly competitive market environment. The Company is in the process of creating a performance-driven sales environment and increasing customer activity in its branches. The competitive Chicago market continues to be a challenging environment for attracting low cost core deposits.
Expand footprint in Chicago market. The Company plans to expand in the Chicago market through acquisitions and selective branch opportunities, in addition to internal growth. The Company opened a branch in Franklin Park, Illinois in June 2006. Management, however, believes the Chicago market to be saturated and that its preferred strategy is to acquire additional branches through acquisition. As part of this strategy, the Company consummated the acquisition of Royal American Corporation as of July 1, 2006, as discussed further in Note 3 of the Notes to the Audited Consolidated Financial Statements. The merger expanded the Company’s number of branches from 18 to 24. The new branches are located in the following suburbs of Chicago: Bensenville, Buffalo Grove, Bloomingdale, Inverness, Naperville, and Elgin.
The acquisition of Royal American promotes the Company’s strategic plans by:
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Expanding the community banking market penetration;
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Adding experienced key executives;
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Expanding the size of the loan portfolio and diversifying its risk profile by increasing the percentage of commercial and industrial loans and owner-occupied commercial real estate loans, while decreasing the percentage of construction loans;
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Expanding the deposit base by adding a higher percentage of noninterest-bearing and interest-bearing demand deposit, money market, and savings accounts; and
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Acquiring approximately $200.0 million in managed trust assets.
Expand noninterest income. The Company is focusing on opportunities to build the contribution of fees as a percentage of revenue, emphasizing corporate cash management, insurance and investment services, trust services, and secondary-market mortgage lending.
Management believes its growth strategies to be fundamentally sound and based on reasonable opportunities available in the Chicago market. The Company has established internal benchmarks for each growth initiative and has taken a number of steps to align compensation with achievement of these benchmarks.
Certain information with respect to the Bank and the Company’s nonbank subsidiaries as of December 31, 2006, is set forth below:
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Provides insurance products.
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Provides additional investment portfolio management to the Bank.
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Provides real estate management services to the Bank.
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The trust is a statutory business trust formed as a financing subsidiary of the Company.
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Provides securities brokerage services.
History
The Bank
Midwest Bank and Trust Company was established in 1959 in Elmwood Park, Illinois to provide community and commercial banking services to individuals and businesses in the neighboring western suburbs of Chicago. The Company pursued growth opportunities through acquisitions and the establishment of new branches. The more recent are described below.
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On January 3, 2003, the Company completed the acquisition of Big Foot Financial Corp. (“BFFC”). BFFC was the holding company for Fairfield Savings Bank, F.S.B. with approximately $200 million in total assets at December 31, 2002, and three branches in Chicago, Long Grove, and Norridge which were merged into the Bank. The Company issued a total of 1,599,088 shares in the transaction.
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In 2004, the Bank added new branches in Addison and Glenview, Illinois.
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In September 2005, the Company sold Midwest Bank of Western Illinois and its insurance agency subsidiary in order to focus on the Chicago metropolitan area.
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The Company opened an additional branch in Franklin Park, Illinois in 2006.
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On July 1, 2006, the Company, as part of its expansion strategy, completed its acquisition of Royal American The Company issued 2.9 million common shares, paid $64.6 million in cash, and paid $795,000 in costs that were capitalized for a total purchase price of $129.2 million.
As discussed in the “Strategy” section, the Company plans to enlarge its presence in the Chicago market and will be selective in the manner in which it accomplishes this expansion. Management believes that there will be limited branch opportunities; however it is looking to acquire targets that would meet its objectives including diversifying the loan and deposit mix and reducing the Company’s risk profile.
Non-bank Subsidiaries
The Company’s non-bank subsidiaries were established to support the retail and commercial banking activities of the Bank.
Midwest Bank Insurance Services, L.L.C. is an independent insurance agency established in 1998. This subsidiary concentrates in commercial and individual insurance products.
In March 2002, the Company acquired the assets of Service 1st Financial Corp. through its newly formed subsidiary, Midwest Financial and Investment Services, Inc. This subsidiary provides securities brokerage services to both bank and non-bank customers.
In August 2002, the Bank established MBTC Investment Company. This subsidiary was capitalized through the transfer of investment securities from the Bank and was formed to diversify management of that portion of the Company’s securities portfolio. In May 2006, MBTC Investment Company established Midwest Funding, L.L.C. This subsidiary holds real estate assets.
In July 2006, the Bank acquired Royal American Investment Services, Inc., a registered bank-affiliated securities broker-dealer and registered investment advisor, through the Royal American merger. Royal American Investment Services, Inc. is registered with the Securities and Exchange Commission as a broker-dealer and is a member of the National Association of Securities Dealers. It operates a general securities business as an introducing broker-dealer.
The Company formed four statutory trusts between October 2002 and June 2005 to issue $54.0 million in floating-rate trust preferred securities through four statutory trusts. Through the Royal American merger in July 2006, the Company acquired a statutory trust that in April 2004 had issued $10.0 million in trust preferred securities. These trust preferred securities have a fixed rate until the optional redemption date and a floating rate thereafter until maturity. These offerings were pooled private placements exempt from registration under the Securities Act pursuant to Section 4(2) thereunder. The Company has provided a full, irrevocable, and unconditional subordinated guarantee of the obligations of the five trusts under the preferred securities. The Company is obligated to fund dividends on these securities before it can pay dividends on its shares of common stock. See Note 13 to the Notes to the Consolidated Financial Statements. These five trusts and its trust preferred securities are detailed below as follows:
Markets
The largest segments of the Company’s customer base live and work in relatively mature markets in Cook, DuPage, Lake, and McHenry Counties. The Company considers its primary market areas to be those areas immediately surrounding its offices for retail customers and generally within a 10-20 mile radius for commercial relationships. The Bank operates 24 full-service locations in the Chicago metropolitan area. The communities in which the Bank’s offices are located have a broad spectrum of demographic characteristics. These communities include a number of densely populated areas as well as suburban areas, and some extremely high-income areas as well as many middle-income and some low-to-moderate income areas.
Competition
The Company competes in the financial services industry through the Bank, Midwest Bank Insurance Services, L.L.C., Midwest Financial and Investment Services, Inc. and Royal American Investment Services, Inc. The financial services business is highly competitive. The Company encounters strong direct competition for deposits, loans, and other financial services with the Company’s principal competitors including other commercial banks, savings banks, savings and loan associations, mutual funds, money market funds, finance companies, credit unions, mortgage companies, insurance companies and agencies, private issuers of debt obligations and suppliers of other investment alternatives, such as securities firms.
Several major multi-bank holding companies operate in the Chicago metropolitan market. Generally, these financial institutions are significantly larger than the Company and have access to greater capital and other resources. In addition, many of the Company’s non-bank competitors are not subject to the same degree of regulation as that imposed on bank holding companies, federally insured banks, and Illinois-chartered banks. As a result, such non-bank competitors have advantages over the Company in providing certain services.
The Company addresses these competitive challenges by creating market differentiation and by maintaining an independent community bank presence with local decision-making within its markets. The Bank competes for deposits principally by offering depositors a variety of deposit programs, convenient office locations and hours, and other services. The Bank competes for loan originations primarily through the interest rates and loan fees charged, the efficiency and quality of services provided to borrowers, the variety of loan products, and a trained staff of professional bankers.
The Company competes for qualified personnel by offering competitive levels of compensation, management and employee cash incentive programs, and by augmenting compensation with stock options and restricted stock grants pursuant to its stock and incentive plan. Attracting and retaining high quality employees is important in enabling the Company to compete effectively for market share.
The Chicago market is highly competitive making it more difficult to retain and attract customer relationships. The Company recognizes this and has initiatives to address the competition. Part of the Company’s marketing strategy is to create a performance-driven sales environment, increase activity in its branches, build and launch a renewed promotional image, and build and market a strong private banking program.
Products and Services
Deposit Products
Management believes the Bank offers competitive deposit products and programs which address the needs of customers in each of the local markets served. These products include:
Checking and Interest-bearing Checking Accounts. The Company has developed a range of different checking account products designed and priced to meet specific target segments (e.g., Free Checking and Business Advantage Checking) of the local markets served by each branch.
Savings and Money Market Accounts. The Company offers multiple types of money market accounts and savings accounts.
Time Deposits. The Company offers a wide range of innovative time deposits (including traditional and Roth Individual Retirement Accounts), usually offered at premium rates with special features to protect the customer’s interest earnings in changing interest rate environments.
Lending Services
The Company’s loan portfolio consists of commercial loans, construction loans, commercial real estate loans, consumer real estate loans, and consumer loans. Management emphasizes credit quality and seeks to avoid undue concentrations of loans to a single industry or based on a single class of collateral. The Company generally requires personal guarantees of the principal except on cash secured, state or political subdivision, or not-for-profit organization loans. The Company has focused its efforts on building its lending business in the following areas:
Commercial Loans. Commercial and industrial loans are made to small- to medium-sized businesses that are sole proprietorships, partnerships, and corporations. Generally, these loans are secured with collateral including accounts receivable, inventory and equipment. The personal guarantees of the principals may also be required. Frequently, these loans are further secured with real estate collateral.
Construction Loans. Construction loans include loans for land development and for commercial and residential development and improvements. The majority of these loans are in-market to known and established borrowers and have pre-sale requirements.
Commercial Real Estate Loans. Commercial real estate loans are loans secured by the real estate including farmland, multifamily residential properties, and other nonfarm-nonresidential properties. These loans are generally short-term balloon loans, with fixed or adjustable rates mortgages and terms of one to five years.
Consumer Real Estate Loans. Consumer real estate loans are made to finance residential units that will house from one to four families. While the Company originates both fixed and adjustable rate consumer real estate loans, most medium-term fixed-rate loans originated pursuant to Fannie Mae and Freddie Mac guidelines are sold in the secondary market. In the normal course of business, the Company retains one- to five-year adjustable rate loans.
Consumer Loans. Consumer loans (other than consumer real estate loans) are collateralized loans to individuals for various personal purposes such as automobile financing.
Home equity lines of credit, included within the Company’s consumer loan portfolio, are secured by the borrower’s home and can be drawn at the discretion of the borrower. These lines of credit are generally at variable interest rates. Home equity lines, combined with the outstanding loan balance of prior mortgage loans, generally do not exceed 80% of the appraised value of the underlying real estate collateral.
Lending officers are assigned various levels of loan approval authority based upon their respective levels of experience and expertise. Loan approval is also subject to the Company’s formal loan policy, as established by the Bank’s Board of Directors. The Bank’s loan policies establish lending authority and limits on an individual and committee basis. The loan approval process is designed to facilitate timely decisions while adhering to policy parameters and risk management targets.
ATMs
The Bank maintains a network of 26 ATM sites generally located within the Bank’s local market. All except two ATMs are owned by the Bank. Twenty-two of the ATM sites are located at various banking centers and four are maintained off-site. The Bank is now a member of the STARsf Surcharge-Free Network. The Bank’s participation allows customers to access their accounts at several hundred ATMs nationwide without incurring additional transaction fees.
Trust Activities
The Bank offers personal and corporate trust, employee benefit trust, land trust, and agencies, custody, and escrow services. As of December 31, 2006, the Bank maintained trust relationships holding an aggregate market value of $220.0 million in assets and administered 1,647 land trust accounts.
Insurance Services
Midwest Bank Insurance Services, L.L.C. is an independent insurance agency which concentrates in commercial and individual insurance products including fixed rate annuities. Insurance services are also offered through Royal American Investment Services, Inc., a subsidiary of the Bank, which concentrates in life insurance and annuity products.
Securities Brokerage
The Company’s subsidiary, Midwest Financial and Investment Services, Inc. and the Bank’s subsidiary, Royal American Investment Services, Inc., a registered bank-affiliated securities broker-dealer and registered investment advisor, offer securities-brokerage services through the Bank’s investment centers. Licensed brokers serve all branches and provide investment-related services, including securities trading, financial planning, mutual funds sales, fixed and variable rate annuities, and tax-exempt and conventional unit trusts. This activity furthers one of the Company’s strategic goals of increasing revenues from investment sources to enhance the Company’s profitability.
Employees
As of December 31, 2006, the Company and its subsidiaries had 496 full-time equivalent employees compared to 402 full-time equivalent employees a year ago. The Royal American acquisition accounted for 50 full-time equivalent employees of the increase. Management considers its relationship with its employees to be good.
Available Information
The Company’s internet address is www.midwestbanc.com. The Company is an SEC registrant and posts its SEC filings, including Forms 10-K, 10-Q, 8-K, and amendments thereto, on its website on the day they are filed under Investor Relations. The Company will also provide free copies of its filings upon written request to: Chief Financial Officer, 501 West North Ave., Melrose Park, IL 60160.
The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company is an electronic filer. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at the SEC’s site: http://www.sec.gov.
SUPERVISION AND REGULATION
Bank holding companies and banks are extensively regulated under federal and state law. References under this heading to applicable statutes or regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to those statutes and regulations. Any change in applicable laws or regulations may have a material adverse effect on the business of commercial banks and bank holding companies, including the Company and the Bank. However, management is not aware of any current recommendations by any regulatory authority which, if implemented, would have or would be reasonably likely to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Finally, please remember that the supervision, regulation and examination of banks and bank holding companies by bank regulatory agencies are intended primarily for the protection of depositors rather than stockholders of banks and bank holding companies.
Bank Holding Company Regulation
The Company is registered as a “bank holding company” with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and, accordingly, is subject to supervision and regulation by the Federal Reserve under the Bank Holding Company Act (the Bank Holding Company Act and the regulations issued thereunder are collectively referred to as the “BHC Act”). The Company is required to file with the Federal Reserve periodic reports and such additional information as the Federal Reserve may require pursuant to the BHC Act. The Federal Reserve examines the Company and the Bank, and may examine the Company’s other subsidiaries.
The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined, by regulation or order, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto, such as performing functions or activities that may be performed by a trust company, or acting as an investment or financial advisor. The Federal Reserve, however, expects bank holding companies to maintain strong capital positions while experiencing growth. In addition, the Federal Reserve, as a matter of policy, may require a bank holding company to be well-capitalized at the time of filing an acquisition application and upon consummation of the acquisition.
Under the BHC Act, the Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with an extension of credit, lease, sale of property or furnishing of services. This means that, except with respect to traditional banking products, the Company may not condition a customer’s purchase of one of its services on the purchase of another service.
The passage of the Gramm-Leach-Bliley Act allows bank holding companies to become financial holding companies. Financial holding companies do not face the same prohibitions on entering into certain business transactions that bank holding companies currently face.
Under the Illinois Banking Act, any person who acquires 25% or more of the Company’s stock may be required to obtain the prior approval of the Illinois Department of Financial and Professional Regulation (“IDFPR”). Under the Change in Bank Control Act, a person may be required to obtain the prior approval of the Federal Reserve before acquiring the power to directly or indirectly control the management, operations or policies of the Company or before acquiring 10% or more of any class of its outstanding voting stock.
It is the policy of the Federal Reserve that the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank. The Federal Reserve takes the position that in implementing this policy, it may require the Company to provide such support when the Company otherwise would not consider itself able to do so.
The Federal Reserve has adopted risk-based capital requirements for assessing bank holding company capital adequacy. These standards define regulatory capital and establish minimum capital ratios in relation to assets, both on an aggregate basis and as adjusted for credit risks and off-balance-sheet exposures. The Federal Reserve’s risk-based guidelines apply on a consolidated basis for bank holding companies with consolidated assets of $150 million or more. Under the Federal Reserve’s risk-based guidelines, capital is classified into two categories. For bank holding companies, Tier 1, or “core”, capital consists of common stockholders’ equity, qualifying noncumulative perpetual preferred stock (including related surplus), qualifying cumulative perpetual preferred stock (including related surplus) (subject to certain limitations) and minority interests in the common equity accounts of consolidated subsidiaries, and is reduced by goodwill, and specified intangible assets (“Tier 1 Capital”). Tier 2, or “supplementary” capital consists of the allowance for loan and lease losses, perpetual preferred stock and related surplus, “hybrid capital instruments,” unrealized holding gains on equity securities, perpetual debt and mandatory convertible debt securities, and term subordinated debt and intermediate-term preferred stock, including related surplus.
Under the Federal Reserve’s capital guidelines, bank holding companies are required to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 Capital. The Federal Reserve also requires a minimum leverage ratio of Tier 1 Capital to total assets of 3% for strong bank holding companies (those rated a composite “1” under the Federal Reserve’s rating system). For all other bank holding companies, the minimum ratio of Tier 1 capital to total assets is 4%. In addition, the Federal Reserve continues to consider the Tier 1 leverage ratio in evaluating proposals for expansion or new activities.
In its capital adequacy guidelines, the Federal Reserve emphasizes that the foregoing standards are supervisory minimums and that banking organizations generally are expected to operate well above the minimum ratios. These guidelines also provide that banking organizations experiencing growth, whether internally or by making acquisitions, are expected to maintain strong capital positions substantially above the minimum levels.
As of December 31, 2006, the Company had regulatory capital in excess of the Federal Reserve’s minimum requirements. The Company had a total capital to risk-weighted assets ratio of 13.0%, a Tier 1 capital to risk-weighted assets ratio of 11.9%, and a leverage ratio of 9.4% as of December 31, 2006. See “Capital Resources.”
The Sarbanes-Oxley Act of 2002 implemented legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board which enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies, the legislation and the related regulations restrict provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client require pre-approval by the company’s audit committee. In addition, audit partners must be rotated. The legislation and the related regulations require the principal chief executive officer and the principal chief financial officer to certify to the accuracy of periodic reports filed with the SEC and subject them to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.
The legislation provides for disgorgement of bonuses issued to top executives prior to restatement of a company’s financial statements if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during pension fund “blackout” periods, and loans to company executives are restricted. The legislation and the related regulations accelerated the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company’s securities within two business days of the change.
The legislation and the related regulations also increase the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company’s registered public accounting firm. Audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the company. In addition, companies must disclose whether at least one member of the committee is a “financial expert” as defined by the SEC and if not, why not. The SEC has also prescribed rules requiring inclusion of an internal control report and assessment by management in the annual report to shareholders. The registered public accounting firm issues the audit report to attest to and report on management’s assessment of the company’s internal controls. See “Item 9A. Controls and Procedures” of this Annual Report on Form 10-K.
As a bank holding company, the Company is primarily dependent upon dividend distributions from its operating subsidiaries for its income. Federal and state statutes and regulations impose restrictions on the payment of dividends by the Company and the Bank.
Federal Reserve policy provides that a bank holding company should not pay dividends unless (i) the bank holding company’s net income over the prior year is sufficient to fully fund the dividends and (ii) the prospective rate of earnings retention appears consistent with the capital needs, asset quality and overall financial condition of the bank holding company and its subsidiaries.
Delaware law also places certain limitations on the ability of the Company to pay dividends. For example, the Company may not pay dividends to its stockholders if, after giving effect to the dividend, the Company would not be able to pay its debts as they become due. Because a major source of the Company’s revenues is dividends the Company receives and expects to receive from the Bank, the Company’s ability to pay dividends is likely to be dependent on the amount of dividends paid by the Bank. No assurance can be given that the Bank will continue to pay such dividends to the Company on its stock.
Bank Regulation
Under Illinois law, the Bank is subject to supervision and examination by IDFPR. The Bank is a member of the Federal Reserve System and as such is also subject to examination by the Federal Reserve. The Federal Reserve also supervises compliance with the provisions of federal law and regulations, which place restrictions on loans by member banks to their directors, executive officers and other controlling persons. The Bank is also a member of the FHLB of Chicago and may be subject to examination by the FHLB of Chicago. Any affiliates of the Bank and the Company are also subject to examination by the Federal Reserve.
The deposits of the Bank are insured by the Deposit Insurance Fund (“DIF”) under the provisions of the Federal Deposit Insurance Act (the “FDIA”), and the Bank is, therefore, also subject to supervision and examination by the FDIC. The FDIA requires that the appropriate federal regulatory authority approve any merger and/or consolidation by or with an insured bank, as well as the establishment or relocation of any bank or branch office. The FDIA also gives the Federal Reserve and other federal bank regulatory agencies power to issue cease and desist orders against banks, holding companies or persons regarded as “institution affiliated parties.” A cease and desist order can either prohibit such entities from engaging in certain unsafe and unsound bank activity or can require them to take certain affirmative action.
Furthermore, banks are affected by the credit policies of the Federal Reserve, which regulates the national supply of bank credit. Such regulation influences overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans and paid on deposits. The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.
As discussed above, under Illinois law, the Bank is subject to supervision and examination by IDFPR, and, as a member of the Federal Reserve System, by the Federal Reverse. Each of these regulatory agencies conducts routine, periodic examinations of the Bank and the Company.
Financial Institution Regulation
Transactions with Affiliates. Transactions between a bank and its holding company or other affiliates are subject to various restrictions imposed by state and federal regulatory agencies. Such transactions include loans and other extensions of credit, purchases of securities and other assets and payments of fees or other distributions. In general, these restrictions limit the amount of transactions between a bank and an affiliate of such bank, as well as the aggregate amount of transactions between a bank and all of its affiliates, impose collateral requirements in some cases and require transactions with affiliates to be on terms comparable to those for transactions with unaffiliated entities.
Dividend Limitations. As a state member bank, the Bank may not, without the approval of the Federal Reserve, declare a dividend if the total of all dividends declared in a calendar year exceeds the total of its net income for that year, combined with its retained net income of the preceding two years, less any required transfers to the surplus account. Under Illinois law, the Bank may not pay dividends in an amount greater than its net profits then on hand, after deducting losses and bad debts. For the purpose of determining the amount of dividends that an Illinois bank may pay, bad debts are defined as debts upon which interest is past due and unpaid for a period of six months or more, unless such debts are well-secured and in the process of collection.
In addition to the foregoing, the ability of the Company and the Bank to pay dividends may be affected by the various minimum capital requirements and the capital and noncapital standards established under the Federal Deposit Insurance Corporation Improvements Act of 1991 (“FDICIA”), as described below. The right of the Company, its stockholders and its creditors to participate in any distribution of the assets or earnings of its subsidiaries is further subject to the prior claims of creditors of the respective subsidiaries.
Capital Requirements. State member banks are required by the Federal Reserve to maintain certain minimum capital levels. The Federal Reserve’s capital guidelines for state member banks require state member banks to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 Capital. In addition, the Federal Reserve requires a minimum leverage ratio of Tier 1
Capital to total assets of 3% for strong banking institutions (those rated a composite “1” under the Federal Reserve’s rating system) and a minimum leverage ratio of Tier 1 Capital to total assets of 4% for all other banks.
At December 31, 2006, the Bank has a Tier 1 capital to risk-weighted assets ratio and a total capital to risk-weighted assets ratio which meets the above requirements. The Bank has a Tier 1 capital to risk-weighted assets ratio of 11.2% and a total capital to risk-weighted assets ratio of 12.2%.
Standards for Safety and Soundness. The Federal Reserve and the other federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards pursuant to FDICIA. The guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, the Federal Reserve adopted regulations that authorize, but do not require, the Federal Reserve to order an institution that has been given notice by the Federal Reserve that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the Federal Reserve must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized association is subject under the “prompt corrective action” provisions of FDICIA. If an institution fails to comply with such an order, the Federal Reserve may seek to enforce such order in judicial proceedings and to impose civil money penalties. The Federal Reserve and the other federal bank regulatory agencies also adopted guidelines for asset quality and earnings standards.
A range of other provisions in FDICIA include requirements applicable to closure of branches; additional disclosures to depositors with respect to terms and interest rates applicable to deposit accounts; uniform regulations for extensions of credit secured by real estate; restrictions on activities of and investments by state-chartered banks; modification of accounting standards to conform to generally accepted accounting principles including the reporting of off-balance-sheet items and supplemental disclosure of estimated fair market value of assets and liabilities in financial statements filed with the banking regulators; increased penalties in making or failing to file assessment reports with the FDIC; greater restrictions on extensions of credit to directors, officers and principal stockholders; and increased reporting requirements on agricultural loans and loans to small businesses.
In addition, the federal banking agencies adopted a final rule, which modified the risk-based capital standards to provide for consideration of interest rate risk when assessing the capital adequacy of a bank. Under this rule, the Federal Reserve and the FDIC must explicitly include a bank’s exposure to declines in the economic value of its capital due to changes in interest rates as a factor in evaluating a bank’s capital adequacy. The federal banking agencies also have adopted a joint agency policy statement providing guidance to banks for managing interest rate risk. The policy statement emphasizes the importance of adequate oversight by management and a sound risk management process. The assessment of interest rate risk management made by the bank’s examiners will be incorporated into the bank’s overall risk management rating and used to determine the effectiveness of management.
As part of their ongoing supervisory monitoring process, the federal regulatory agencies use certain criteria to identify institutions that are potentially exposed to significant loan concentration risks. In 2007, the regulatory agencies issued new guidelines relating to commercial real estate (“CRE”) lending risks. An institution experiencing rapid growth in CRE lending, having notable exposure to a specific type of CRE, or approaching or exceeding the specified CRE supervisory criteria may be subjected to further supervisory analysis. Because these are guidelines, the supervisory monitoring criteria do not constitute limits on an institution’s lending activity but rather serve as high-level indicators to identify institutions potentially exposed to CRE concentration risk. The criteria do not constitute a “safe harbor” for institutions if other risk indicators are present. Existing capital adequacy guidelines require an institution to hold capital commensurate with the level and nature of the risks to which it is exposed. Regulatory agencies may consider the level and nature of inherent risk in an institution’s CRE portfolio along with other factors to determine if an institution is maintaining an adequate capital level to serve as a
buffer against unexpected losses and can require such an institution to develop a plan for reducing its CRE concentrations or for increasing or maintaining capital appropriate to the level and nature of its lending concentration risk.
Prompt Corrective Action. FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that fall below minimum capital standards and prohibits any depository institution from making any capital distribution that would cause it to be undercapitalized. Institutions that are not adequately capitalized may be subject to a variety of supervisory actions including, but not limited to, restrictions on growth, investment activities, capital distributions and affiliate transactions and will be required to submit a capital restoration plan which, to be accepted by the regulators, must be guaranteed in part by any company having control of the institution (such as the Company). In other respects, FDICIA provides for enhanced supervisory authority, including greater authority for the appointment of a conservator or receiver for undercapitalized institutions. The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions. However, federal banking agencies have indicated that, in regulating bank holding companies, the agencies may take appropriate action at the holding company level based on their assessment of the effectiveness of supervisory actions imposed upon subsidiary insured depository institutions pursuant to the prompt corrective action provisions of FDICIA.
Insurance of Deposit Accounts. The Bank is required to pay deposit insurance premiums based on the risk it poses to the insurance fund. The FDIC has authority to raise or lower assessment rates on insured deposits in order to achieve statutorily required reserve ratios in the insurance funds and to impose special additional assessments. Each depository institution is assigned to one of three capital groups: “well capitalized,” “adequately capitalized” or “undercapitalized.” An institution is considered well capitalized if it has a total risk-based capital ratio of 10% or greater, has a Tier 1 risk-based capital ratio of 6% or greater, has a leverage ratio of 5% or greater and is not subject to any order or written directive to meet and maintain a specific capital level. An “adequately capitalized” institution is defined as one that has a total risk-based capital ratio of 8% or greater, has a Tier 1 risk-based capital ratio of 4% or greater, has a leverage ratio of 4% or greater and does not meet the definition of a well capitalized bank. An institution is considered “undercapitalized” if it does not meet the definition of “well-capitalized” or “adequately capitalized.” Within each capital group, institutions are assigned to one of three supervisory subgroups: “A” (institutions with few minor weaknesses), “B” (institutions which demonstrate weaknesses which, if not corrected, could result in significant deterioration of the institution and increased risk of loss to DIF), and “C” (institutions that pose a substantial probability of loss to DIF unless effective corrective action is taken). Accordingly, there are nine combinations of capital groups and supervisory subgroups to which varying assessment rates would be applicable. An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned.
During 2006, the Bank was assessed deposit insurance in the aggregate amount of $233,000. Deposit insurance may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Such terminations can only occur, if contested, following judicial review through the federal courts. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
On February 8, 2006, President Bush signed into law the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”). Major provisions in the legislation include: merging the Bank Insurance Fund and the Savings Association Insurance Fund (“SAIF”); maintaining basic deposit and municipal account insurance coverage at $100,000 but providing for a new basic insurance coverage for retirement accounts of $250,000 (insurance coverage for basic deposit and retirement accounts could be increased for inflation every five years in $10,000 increments beginning in 2011); providing the FDIC with the ability to set the designated reserve ratio within a range of between 1.15% and 1.50%, rather than maintaining 1.25% at all times regardless of prevailing economic conditions; providing a one-time assessment credit to banks and savings associations in existence on December 31, 1996 (the Bank’s one-time credit amount is $1.1 million, which the Bank may use to offset future premiums with certain limitations); requiring the payment of dividends of 100% of the amount that the insurance fund exceeds 1.50% of the estimated insured deposits and the payment of 50% of the amount that the insurance fund exceeds 1.35% of the estimated insured deposits (when the reserve is greater than 1.35% but no more than 1.50%).
The Federal Deposit Insurance Act, as amended by the Reform Act, continues to require that the assessment system be risk-based and allows the FDIC to define risk broadly. It defines a risk-based system as one based on an institution’s probability of causing a loss to the deposit insurance fund due to the composition and concentration of the institution’s assets and liabilities, the amount of loss given failure, and revenue needs of the BIF. At the same time, the Reform Act also restores to the FDIC’s discretion to price deposit insurance according to risk for all insured institutions regardless of the level of the fund reserve ratio.
The Reform Act leaves in place the existing statutory provision allowing the FDIC to “establish separate risk-based assessment systems for large and small members of the DIF. Under the Reform Act, however, no insured depository institution shall be barred from the lowest-risk category solely because of size. Regulations implementing the risk-based assessment provision of the Reform Act (the “Final Rule”) were effective on January 1, 2007.
Risk Category I contains all well-capitalized institutions (generally those with a “CAMELS” composite rating of 1 or 2). Risk Category II contains all institutions with CAMELS composite ratings of 1, 2 or 3, except those in Risk Category I and undercapitalized institutions. Risk Category III contains all undercapitalized institutions and institutions with CAMELS composite ratings of 4 or 5 that are not undercapitalized. Risk Category IV contains all undercapitalized institutions.
The Final Rule sets actual rates beginning January 1, 2007, as follows:
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Rates for institutions that do not pay the minimum or maximum rate vary between these rates.
The Final Rule continues to allow the FDIC Board to adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points. In addition, cumulative adjustments cannot exceed a maximum of three basis points higher or lower than the base rates without further notice-and-comment rulemaking.
The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. There are no pending proceedings to terminate the deposit insurance of the Bank.
Federal Reserve System. The Bank is subject to Federal Reserve regulations requiring depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve regulations generally require 3% reserves on the first $48.3 million of transaction accounts and 10% on the remainder. The first $7.8 million of otherwise reservable balances (subject to adjustments by the Federal Reserve) are exempted from the reserve requirements. The Bank is in compliance with the foregoing requirements.
Community Reinvestment. Under the Community Reinvestment Act (“CRA”), a financial institution has a continuing and affirmative obligation, consistent with the safe and sound operation of such institution, to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. However, institutions are rated on their performance in meeting the needs of their communities. Performance is judged in three areas: (a) a lending test, to evaluate the institution’s record of making loans in its assessment areas; (b) an investment test, to evaluate the institution’s record of investing in community development projects, affordable housing and programs benefiting low or moderate income individuals and
business; and (c) a service test to evaluate the institution’s delivery of services through its branches, ATMs and other offices. The CRA requires each federal banking agency, in connection with its examination of a financial institution, to assess and assign one of four ratings to the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by the institution, including applications for charters, branches and other deposit facilities, relocations, mergers, consolidations, acquisitions of assets or assumptions of liabilities and savings and loan holding company acquisitions. The CRA also requires that all institutions make public disclosure of their CRA ratings. The Bank received a “satisfactory” rating on its most recent CRA performance evaluation.
Consumer Compliance. The Bank has been examined for consumer compliance on a regular basis.
Brokered Deposits. Well-capitalized institutions are not subject to limitations on brokered deposits, while an adequately capitalized institution is able to accept, renew or rollover brokered deposits only with a waiver from the FDIC and subject to certain restrictions on the yield paid on such deposits. Undercapitalized institutions are not permitted to accept brokered deposits.
Enforcement Actions. Federal and state statutes and regulations provide financial institution regulatory agencies with great flexibility to undertake enforcement action against an institution that fails to comply with regulatory requirements, particularly capital requirements. Possible enforcement actions range from the imposition of a capital plan and capital directive to civil money penalties, cease and desist orders, receivership, conservatorship or the termination of deposit insurance.
Interstate Banking and Branching Legislation. Under the Interstate Banking and Efficiency Act of 1994 (“the Interstate Banking Act”), bank holding companies are allowed to acquire banks across state lines subject to various requirements of the Federal Reserve. In addition, under the Interstate Banking Act, banks are permitted, under some circumstances, to merge with one another across state lines and thereby create a main bank with branches in separate states. After establishing branches in a state through an interstate merger transaction, a bank may establish and acquire additional branches at any location in the state where any bank involved in the interstate merger could have established or acquired branches under applicable federal and state law.
The State of Illinois has adopted legislation “opting in” to interstate bank mergers, and allows out of state banks to enter the Illinois market through de novo branching or through branch-only acquisitions if Illinois state banks are afforded reciprocal treatment in the other state. It is anticipated that this interstate merger and branching ability will increase competition and further consolidate the financial institutions industry.
Insurance Powers. Under state law, a state bank is authorized to act as agent for any fire, life or other insurance company authorized to do business in the State of Illinois. Similarly, the Illinois Insurance Code was amended to allow a state bank to form a subsidiary for the purpose of becoming a firm registered to sell insurance. Such sales of insurance by a state bank may only take place through individuals who have been issued and maintain an insurance producer’s license pursuant to the Illinois Insurance Code.
State banks are prohibited from assuming or guaranteeing any premium on an insurance policy issued through the bank. Moreover, state law expressly prohibits tying the provision of any insurance product to the making of any loan or extension of credit and requires state banks to make disclosures of this fact in some instances. Other consumer oriented safeguards are also required.
Midwest Bank Insurance Services, L.L.C. is an independent insurance agency established by Midwest Bank and Trust Company in 1998. Insurance products are also sold through Royal American Investment Services, Inc., a subsidiary of the Bank acquired in 2006 through the acquisition of Royal American Corporation. Midwest Bank Insurance Services, L.L.C. and Royal American Investment Services, Inc. are registered with, and subject to examination by, the Illinois Department of Insurance.
Securities Brokerage. Midwest Financial and Investment Services, Inc., a subsidiary of the Company, makes available investment services through Raymond James, a broker dealer and investment advisory firm registered with the SEC and a member of the National Association of Securities Dealers. Royal American Investment Services, Inc., a registered bank-affiliated securities broker-dealer and registered investment advisor, operates a
general securities business as an introducing broker-dealer. It is registered with the Securities and Exchange Commission as a broker-dealer and is a member of the National Association of Securities Dealers.
The Bank is subject to many federal consumer protection statutes and regulations including the Equal Credit Opportunity Act, the Fair Housing Act, the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act and the Home Mortgage Disclosure Act. Among other things, these acts:
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require lenders to disclose credit terms in meaningful and consistent ways;
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prohibit discrimination against an applicant in any consumer or business credit transaction;
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prohibit discrimination in housing-related lending activities;
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require certain lenders to collect and report applicant and borrower data regarding loans for home purchases or improvement projects;
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require lenders to provide borrowers with information regarding the nature and cost of real estate settlements;
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prohibit certain lending practices and limit escrow account amounts with respect to real estate transactions; and
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prescribe possible penalties for violations of the requirements of consumer protection statutes and regulations.
Federal Fair Lending Laws. The federal fair lending laws prohibit discriminatory lending practices. The Equal Credit Opportunity Act prohibits discrimination against an applicant in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs or good faith exercise of any rights under the Consumer Credit Protection Act. Under the Fair Housing Act, it is unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. Among other things, these laws prohibit a lender from denying or discouraging credit on a discriminatory basis, making excessively low appraisals of property based on racial considerations, or charging excessive rates or imposing more stringent loan terms or conditions on a discriminatory basis. In addition to private actions by aggrieved borrowers or applicants for actual and punitive damages, the U.S. Department of Justice and other regulatory agencies can take enforcement action seeking injunctive and other equitable relief for alleged violations.
Home Mortgage Disclosure Act. The Federal Home Mortgage Disclosure Act, or HMDA, grew out of public concern over credit shortages in certain urban neighborhoods. One purpose of the HMDA is to provide public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. The HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. The HMDA requires institutions to report data regarding applications for loans for the purchase or improvement of one-to four-family and multi-family dwellings, as well as information concerning originations and purchases of such loans. Federal bank regulators rely, in part, upon data provided under the HMDA to determine whether depository institutions engage in discriminatory lending practices.
The appropriate federal banking agency, or in some cases, U.S. Department of Housing and Urban Development, enforces compliance with the HMDA and implements its regulations. Administrative sanctions, including civil money penalties, may be imposed by supervisory agencies for violations of this act.
Real Estate Settlement Procedures Act. The Federal Real Estate Settlement Procedures Act, or RESPA, requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. RESPA also prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Violations of RESPA may result in imposition of penalties, including: (1) civil liability equal to three times the amount of any charge paid for the settlement services or civil liability of up to $1,000 per claimant,
depending on the violation; (2) awards of court costs and attorneys’ fees; and (3) fines of not more than $10,000 or imprisonment for not more than one year, or both.
Truth in Lending Act. The federal Truth in Lending Act is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As result of the act, all creditors must use the same credit terminology and expressions of rates, and disclose the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule for each proposed loan.
Violations of the Truth in Lending Act may result in regulatory sanctions and in the imposition of both civil and, in the case of willful violations, criminal penalties. Under certain circumstances, the Truth in Lending Act and Regulation Z of the Federal Reserve Act also provide a consumer with a right of rescission, which if exercised would require the creditor to reimburse any amount paid by the consumer to the creditor or to a third party in connection with the offending transaction, including finance charges, application fees, commitment fees, title search fees and appraisal fees. Consumers may also seek actual and punitive damages for violations of the Truth in Lending Act.
Federal Home Loan Bank System The Bank is a member of the Federal Home Loan Bank system, which consists of 12 regional FHLBs. The FHLB system provides a central credit facility primarily for member institutions. The Bank, as a member of the FHLB of Chicago, is required to acquire and hold shares of capital stock in the respective FHLB in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the respective FHLB, whichever is greater. At December 31, 2006, the Bank had advances from the FHLB of Chicago with aggregate outstanding principal balances of $320.0 million, and the Bank’s investment in FHLB of Chicago stock of $16.0 million was at its minimum requirement. FHLB advances must be secured by specified types of collateral and are available to member institutions primarily for funding purposes.
Regulatory directives, capital requirements and net income of the FHLBs affect their ability to pay dividends to the Bank. In addition, FHLBs are required to provide funds to cover certain obligations and to fund the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members.
Monetary Policy and Economic Conditions
The earnings of banks and bank holding companies are affected by general economic conditions and by the fiscal and monetary policies of federal regulatory agencies, including the Federal Reserve. Through open market transactions, variations in the discount rate and the establishment of reserve requirements, the Federal Reserve exerts considerable influence over the cost and availability of funds obtainable for lending or investing.
The above monetary and fiscal policies and resulting changes in interest rates have affected the operating results of all commercial banks in the past and are expected to do so in the future. Banks and their respective holding company cannot fully predict the nature or the extent of any effects which fiscal or monetary policies may have on their business and earnings.
Regulatory Developments
On April 16, 2004, the Company was informed by a letter from the Securities and Exchange Commission that the Commission was conducting an inquiry in connection with the Company’s restatement of its September 30, 2002 financial statements. The Company is cooperating fully with the Commission on this matter. No further inquires have been made since the initial contact.
On September 21, 2005, the Company and the Bank received a letter from the Federal Reserve Bank of Chicago and Illinois Department of Financial and Professional Regulation stating that the written agreement entered into by the parties has been terminated.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995
This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended: Statement under the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. The Company and its representatives may, from time to time, make written or oral statements that are “forward-looking” and provide information other than historical information, including statements contained in the Form 10-K, the Company’s other filings with the Securities and Exchange Commission or in communications to its stockholders. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from any results, levels of activity, performance or achievements expressed or implied by any forward-looking statement. These factors include, among other things, the factors listed below.
In some cases, the Company has identified forward-looking statements by such words or phrases as “will likely result,” “is confident that,” “expects,” “should,” “could,” “may,” “will continue to,” “believes,” “anticipates,” “predicts,” “forecasts,” “estimates,” “projects,” “potential,” “intends,” or similar expressions identifying “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including the negative of those words and phrases. These forward-looking statements are based on management’s current views and assumptions regarding future events, future business conditions, and the outlook for the Company based on currently available information. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in, or implied by, these statements. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.
In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the Company is hereby identifying important factors that could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any forward-looking statements.
Among the factors that could have an impact on the Company’s ability to achieve operating results, growth plan goals, and the beliefs expressed or implied in forward-looking statements are:
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Management’s ability to reduce and effectively manage interest rate risk and the impact of interest rates in general on the volatility of the Company’s net interest income;
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Fluctuations in the value of the Company’s investment securities;
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The ability to attract and retain senior management experienced in banking and financial services;
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The sufficiency of allowances for loan losses to absorb the amount of actual losses inherent in the existing portfolio of loans;
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The ability to ultimately collect on the downgraded long-standing loan relationship;
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The Company’s ability to adapt successfully to technological changes to compete effectively in the marketplace;
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Credit risks and risks from concentrations (by geographic area and by industry) within the Bank’s loan portfolio and individual large loans;
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The effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds, and other financial institutions operating in the Company’s market or elsewhere or providing similar services;
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The failure of assumptions underlying the establishment of allowances for loan losses and estimation of values of collateral and various financial assets and liabilities;
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Volatility of rate sensitive deposits;
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Operational risks, including data processing system failures or fraud;
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Asset/liability matching risks and liquidity risks;
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The ability to successfully acquire low cost deposits or funding;
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The ability to successfully execute strategies to increase noninterest income;
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The ability to successfully to grow non-commercial real estate loans;
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The ability of the Company to fully realize expected cost savings and revenues in connection with the Royal American Corporation acquisition, or the ability to realize them on a timely basis;
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Changes in the economic environment, competition, or other factors that may influence the anticipated growth rate of loans and deposits, the quality of the loan portfolio and loan and deposit pricing, and the Company’s ability to successfully pursue acquisition and expansion strategies and integrate any acquired companies;
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The impact from liabilities arising from legal or administrative proceedings on the financial condition of the Company;
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Possible administrative or enforcement actions of banking regulators in connection with any material failure of the Company or the Bank to comply with banking laws, rules or regulations;
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Possible administrative or enforcement actions of the Securities and Exchange Commission (the “SEC”) in connection with the SEC inquiry of the restatement of the Company’s September 30, 2002 financial statements;
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Governmental monetary and fiscal policies, as well as legislative and regulatory changes, that may result in the imposition of costs and constraints on the Company through higher FDIC insurance premiums, significant fluctuations in market interest rates, increases in capital requirements, and operational limitations;
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Changes in general economic or industry conditions, nationally or in the communities in which the Company conducts business;
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Changes in accounting principles, policies, or guidelines affecting the businesses conducted by the Company;
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Acts of war or terrorism; and
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Other economic, competitive, governmental, regulatory, and technical factors affecting the Company’s operations, products, services, and prices.
The Company wishes to caution that the foregoing list of important factors may not be all-inclusive and specifically declines to undertake any obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.
With respect to forward-looking statements set forth in the notes to consolidated financial statements, including those relating to contingent liabilities and legal proceedings, some of the factors that could affect the ultimate disposition of those contingencies are changes in applicable laws, the development of facts in individual cases, settlement opportunities, and the actions of plaintiffs, judges, and juries.
EXECUTIVE OFFICERS OF THE REGISTRANT
Listed below are the executive officers of the Company as of March 1, 2007.
James J. Giancola (58) was named Director, President, and Chief Executive Officer of the Company and Midwest Bank and Trust Company (the “Bank”) in September 2004. In November 2004, Mr. Giancola was named Chairman, Director, President, Chief Executive Officer of MBTC Investment Company. In February 2005, he was named Director of Midwest Financial and Investment Services, Inc. Prior to joining the Company, he was semi-retired and a private investor. Mr. Giancola has over 30 years experience in the banking industry. He served as president of Fifth Third Bank, Indiana from 1999 to 2000. He also served as president and CEO of CNB Bancshares, Inc., a seven billion dollar bank holding company in Evansville, Indiana from 1997 to 1999. Mr. Giancola also served as president of Gainer Bank located in Northwest Indiana.
Daniel R. Kadolph, CPA, (44) was named Executive Vice President of the Company in 2006. Mr. Kadolph has served as Chief Financial Officer of the Company since 2000. Mr. Kadolph was also named director of Midwest Financial and Investment Services, Inc. in March 2002 and a director, secretary, and treasurer of MBTC Investment Company in 2002. He has served as Treasurer of the Company since 1997 and was Comptroller of the Company from 1994 to 2006. Mr. Kadolph has served in various management capacities at the Company and its subsidiaries since 1988. Mr. Kadolph is a member of the Illinois CPA Society.
J. J. Fritz (58) was named Director and Executive Vice President of the Company and Director, President, and Chief Operating Officer of the Bank in July 2006. Mr. Fritz was also named director, president, and chief executive officer of Royal American Investment Services, Inc. in July 2006. Mr. Fritz and other investors founded Royal American in 1991, where he served as chairman and chief executive officer, after he served as chief executive officer of First Chicago Bank of Mt. Prospect. His lengthy career in the Chicago metropolitan area also includes positions at Northern Trust, First National Bank of Libertyville and Continental Illinois National Bank.
Mary C. Ceas, SPHR, (49) was named Senior Vice President - Human Resources of the Company in 2000. Previously, Ms. Ceas was Vice President - Human Resources since 1997 and served as Director - Training and Development from 1995 to 1997.
Jan R. Thiry, CPA (54) was named Chief Accounting Officer of the Company effective March 15, 2007. Mr. Thiry was hired in December 2006 as Senior Vice President and Controller of the Company and the Bank. Mr. Thiry was named manager of Midwest Funding, L.L.C. in December 2006. He served as senior vice president and controller of CIB Marine Bancshares in Pewaukee, Wisconsin from 1999 to 2006. Mr. Thiry has also held senior positions at M&I Corporation and Security Bank in Milwaukee, Wisconsin. Additionally, he was a senior auditor at KPMG LLP. Mr. Thiry is a member of the American Institute of Certified Public Accountants and the Wisconsin Institute of Certified Public Accountants.
Donald L. Wiest II (53) was named Executive Vice President and Chief Investment Officer of the Company in October 2006 and a director of MBTC Investment Company in November 2006. He has served as executive vice president and chief investment officer for Waypoint Bank in Harrisburg, Pennsylvania. Before joining Waypoint Bank, Wiest was an assistant vice president and trust and private asset manager at Mellon Bank in Harrisburg.
Sheldon Bernstein (60) was named Executive Vice President of the Bank in January 2005. He previously served as Senior Vice President of the Company from 2001 to 2005. Mr. Bernstein has served as President of the Bank, Cook County Region from 2000 to 2004. From 2000 through 2002, he served as Chief Operating Officer of the Bank. Previously, Mr. Bernstein served as Executive Vice President-Lending of the Bank since 1993. He was also served as director of Midwest Financial and Investment Services, Inc. from 2002 to 2005. Mr. Bernstein was a director of First Midwest Data Corp from 2001 to 2002.
Thomas A. Caravello (58) was named Executive Vice President and Chief Credit Officer of the Bank in January 2005. Mr. Caravello was named manager, president, and chief executive officer of Midwest Funding, L.L.C. in May 2006. He has served as Senior Vice President - Credit Administration from 2003 to 2005. Previously he served as Vice President - Credit Administration from 1998 to 2003.
Bruno P. Costa (46) was named Executive Vice President and Chief Operations and Technology Officer of the Bank in January 2005. He served as President of the Information Services Division of the Bank from 2002 to 2005.
Mr. Costa served as President and Chief Executive Officer of First Midwest Data Corp. from 1995 to 2002. He held various management positions at the Bank since 1983.
Thomas H. Hackett (59) was named Executive Vice President of the Bank in November 2003. Mr. Hackett was named manager and vice president of Midwest Funding, L.L.C. in May 2006. He previously was division manager at Banc One, Chicago, Illinois from 2002 to 2003. Prior, he was first vice president of American National Bank of Chicago from 1997 to 2002. He has also served in similar capacities at First Chicago/NBD, Park Ridge, IL, NBD of Woodridge and Heritage Bank of Woodridge, Illinois.
Mary M. Henthorn (49) was named Executive Vice President of the Bank in January 2005. She previously served as Senior Vice President of the Company from 2001 to 2005 and served as President of the Bank, DuPage County Region from 2002 to 2004. Ms. Henthorn served as President and Chief Executive Officer of Midwest Bank of Hinsdale from 2000 to 2002. She held various management positions at Midwest Bank of Hinsdale and the Bank from 1992 until 2000.
Dennis M. Motyka (56) was named Executive Vice President of the Bank and director of Midwest Financial and Investment Services, Inc. in October 2005. He previously was senior vice president and director of banking centers for Cole Taylor Bank in Rosemont from 2002 to 2005. He served as senior vice president and Illinois regional manager for LaSalle Bank in Chicago from 1996 to 2002. He also held positions with Comerica Bank and Affiliated Bank, both in Franklin Park, as well as with Western National Bank in Cicero.
Kelly J. O’Keeffe (46) was named Executive Vice President of the Bank in July 2006. Mr. O’Keeffe was a founder of Royal American Bank and its president from 1997 to 2006. He served at First Chicago Bank of Mt. Prospect and Northern Trust, in addition to a public service career with the Illinois Department of Financial and Professional Regulation.
Brogan M. Ptacin (46) was named Executive Vice President of the Bank in July 2006. Mr. Ptacin was named manager of Midwest Funding, L.L.C. in September 2006. Mr. Ptacin previously was executive vice president and senior loan officer at Royal American Bank. Ptacin joined Royal American Bank in 1995 after a twelve year career with American National Bank leaving as president of its Melrose Park subsidiary.
William H. Stoll (51) was named Executive Vice President of the Bank in January 2005. Mr. Stoll was named manager of Midwest Funding, L.L.C. in May 2006. In February 2005, he was named director of Midwest Financial and Investment Services, Inc. He served as senior vice president and chief lending officer of Mercantile Bank, Hammond, Indiana from 2002 to 2005. He was national bank examiner of the Comptroller of the Currency, Chicago, IL from 2000 to 2002 and senior vice president - manager - commercial lending of Fifth Third Bank, Merrillville, Indiana from 1999 to 2000. He has also served in similar capacities at Mercantile National Bank, Hammond, Indiana and NBD - Gainer Bank, Merrillville, Indiana.
Item 1A.
Item 1A.
Risk Factors
The Company’s business, financial condition or results of operations could be materially adversely affected by any of these risks.
Changes in economic conditions, in particular an economic slowdown in Chicago, Illinois, could hurt the Company’s business materially.
The Company’s business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond its control. Deterioration in economic conditions, in particular an economic slowdown in Chicago, Illinois, could result in the following consequences, any of which could hurt the Company’s business materially:
•
loan delinquencies may increase;
•
problem assets and foreclosures may increase;
•
demand for its products and services may decline;
•
low cost or noninterest bearing deposits may decrease; and
•
collateral for loans made by us, especially real estate, may decline in value, in turn reducing customers’ borrowing power, and reducing the value of assets and collateral associated with the Company’s existing loans.
A large percentage of the Company’s loans are collateralized by real estate, and an adverse change in the real estate market may result in losses and adversely affect its profitability.
A majority of the Company’s loan portfolio is comprised of loans at least partially collateralized by real estate; a substantial portion of this real estate collateral is located in the Chicago market. An adverse change in the economy affecting real estate values generally or in the Chicago market specifically could significantly impair the value of the Company’s collateral and its ability to sell the collateral upon foreclosure. In the event of a default with respect to any of these loans, amounts received upon sale of the collateral may be insufficient to recover outstanding principal and interest on the loan. As a result, the Company’s profitability could be negatively impacted by an adverse change in the real estate market.
The Company’s business is subject to interest rate risk and fluctuations in interest rates may adversely affect its earnings.
The majority of the Company’s assets and liabilities are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, the Company’s earnings and profitability depend significantly on its net interest income, which is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company expects that it will periodically experience “gaps” in the interest rate sensitivities of its assets and liabilities, meaning that either its interest-bearing liabilities will be more sensitive to changes in market interest rates than its interest-earning assets, or vice versa. However, the actual effect of changing interest rates on the Company’s earnings may vary due to the speed and magnitude of the changes, the degree to which short-term and long-term rates are similarly affected, and other factors. The Company’s asset-liability management strategy may not be able to control its risk from changes in market interest rates, and it may not be able to prevent changes in interest rates from having a material adverse effect on its results of operations and financial condition.
In addition, the Company is unable to predict or control fluctuations of market interest rates, which are affected by many factors, including the following:
•
inflation;
•
recession;
•
changes in unemployment;
•
the money supply; and
•
international disorder and instability in domestic and foreign financial markets.
Changes in interest rates may also adversely affect the growth rate of the Company’s loans and deposits, the quality of its loan portfolio, loan and deposit pricing, the volume of loan originations in its mortgage banking business and the value that it can recognize on the sale of mortgage loans in the secondary market.
The Company’s allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect its results of operations.
As a lender, the Company is exposed to the risk that its loan customers may not repay their loans according to their terms and that the collateral securing the payment of these loans may be insufficient to assure repayment. The Company may experience significant loan losses which could have a material adverse effect on its operating results. Management makes various assumptions and judgments about the collectibility of the Company’s loan portfolio, which are based in part on:
•
current economic conditions and their estimated effects on specific borrowers;
•
an evaluation of the existing relationships among loans, potential loan losses and the present level of the allowance;
•
results of examinations of the Company’s loan portfolios by regulatory agencies; and
•
management’s internal review of the loan portfolio.
The Company maintains an allowance for loan losses in an attempt to cover probable incurred loan losses inherent in its loan portfolio. Additional loan losses will likely occur in the future and may occur at a rate greater than the Company has experienced to date. In determining the size of the allowance, the Company relies on an analysis of its loan portfolio, its experience, and its evaluation of general economic conditions. If the Company’s assumptions and analysis prove to be incorrect, its current allowance may not be sufficient. In addition, adjustments may be necessary to allow for unexpected volatility or deterioration in the local or national economy or other factors such as changes in interest rates that may be beyond its control. Large additions to the allowance could materially decrease the Company’s net income. In addition, federal regulators periodically review the Company’s allowance for loan losses and may require it to increase its provision for loan losses or recognize further loan charge-offs, based on judgments different than those of the Company’s management. Any increase in the Company’s loan allowance or loan charge-offs as required by these regulatory agencies could have a material adverse effect on its results of operations.
An interruption in or breach in security of the Company’s information systems may result in a loss of customer business.
The Company relies heavily on communications and information systems to conduct its business. Any failure or interruptions or breach in security of these systems could result in failures or disruptions in its customer relationship management, general ledger, deposits, servicing, or loan origination systems. The occurrence of any failures or interruptions or breach in security could result in a loss of customer business, costly remedial actions, or legal liabilities and have a material adverse effect on the Company’s results of operations and financial condition.
The Company’s ability to pay dividends and make payment on its debt securities is dependent on the earnings of its subsidiaries and is subject to other restrictions.
Most of the Company’s ability to pay dividends and make payments on its debt securities come from amounts paid to it by its subsidiary bank. Under applicable banking law, the total dividends declared in any calendar year by a state-chartered bank (the Bank) may not, without the approval of the Federal Reserve, or the FDIC, as the case may be, exceed the aggregate of the bank’s net profits and retained net profits for the preceding two years. The Bank is also subject to limits on dividends under the Illinois Banking Act.
If, in the opinion of the federal bank regulatory agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution, could include the payment of dividends), the agency may require that the bank cease and desist from the practice. The Federal Reserve has similar authority with respect to bank holding companies. In addition, the federal bank regulatory agencies have issued policy statements which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. Finally, these regulatory authorities have established guidelines with respect to the maintenance of appropriate levels of capital by a bank, bank holding company or savings association under their jurisdiction. Compliance with the standards set forth in these guidelines could limit the amount of dividends that the Company and its affiliates may pay in the future.
Under the terms of junior subordinated debentures the Company has issued, it has agreed not to declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of its common stock or preferred stock if, at that time, there is a default under the junior subordinated debentures or a related guarantee or it has delayed interest payments on the securities issued under the junior indenture. The Company also has dividend limitations under its revolving line of credit agreement.
The Company’s business may be adversely affected by the highly regulated environment in which it operates.
The Company is subject to extensive federal and state legislation, regulation and supervision. The burden of regulatory compliance has increased under current legislation and banking regulations and is likely to continue to have a significant impact on the financial services industry. Recent legislative and regulatory changes, as well as changes in regulatory enforcement policies and capital adequacy guidelines, are increasing the Company’s costs of doing business and, as a result, may create an advantage for its competitors who may not be subject to similar legislative and regulatory requirements. In addition, future regulatory changes, including changes to regulatory capital requirements, could have an adverse impact on the Company’s future results. In addition, the federal and state bank regulatory authorities who supervise the Company have broad discretionary powers to take enforcement actions against banks for failure to comply with applicable regulations and laws. If the Company fails to comply with applicable laws or regulations, it could become subject to enforcement actions that have a material adverse effect on its future results.
The Company could encounter difficulties or unexpected developments related to any future acquisitions.
The Company plans to pursue potential acquisitions of other community-oriented banks and branches as well as money managers, mortgage companies, specialty lenders and related financial services businesses which could also present challenges relating to the integration of the acquired operations. Acquiring other banks, branches, or businesses into its organization involves various risks commonly associated with acquisitions, including, among other things:
•
potential exposure to unknown or contingent liabilities or asset quality issues of the target company;
•
difficulty and expense of integrating the operations and personnel of the target company;
•
potential disruption to the Company’s business, including diversion of management’s time and attention;
•
the possible loss of key employees and customers of the target company;
•
difficulty in estimating the value of the target company; and
•
potential changes in banking or tax laws or regulations that may affect the target company.
Acquisitions typically involve the payment of a premium over book and market values; therefore, some dilution of the Company’s tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on the Company’s financial condition and results of operations.
Provisions in the Company’s amended and restated certificate of incorporation and its amended and restated by-laws may delay or prevent an acquisition of the Company by a third party.
The Company’s amended and restated certificate of incorporation and its amended and restated by-laws contain provisions that may make it more difficult for a third party to gain control or acquire the Company without the consent of its board of directors. These provisions also could discourage proxy contests and may make it more difficult for dissident stockholders to elect representatives as directors and take other corporate actions.
These provisions of the Company’s governing documents may have the effect of delaying, deferring or preventing a transaction or a change in control that some or many of its stockholders might believe to be in their best interest.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
The following table sets forth certain information regarding the Company’s principal office and bank branches.
*
Land is leased and building is owned.
Management believes that the facilities are of sound construction, in good operating condition, appropriately insured, and adequately equipped for carrying on the business of the Company.
Item 3.
Item 3.
Legal Proceedings
The Company and its subsidiaries are from time to time parties to various legal actions arising in the normal course of business. Management believes that there is no proceeding pending against the Company or any of its subsidiaries which, if determined adversely, would have a material adverse effect on the financial condition or results of operations of the Company.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity and Related Stockholder Matters
The Company’s common stock is traded over-the-counter and quoted on the Nasdaq National Market under the symbol “MBHI.” As of March 1, 2007, the Company had approximately 3,365 stockholders of record. The table below sets forth the high and low sale prices of the common stock and the cash dividends declared during the periods indicated.
Issuer Purchases of Equity Securities
On May 3, 2006, the Company announced a 5.0% stock repurchase program. During the second half of 2006, the Company repurchased 204,188 shares of its common stock at an average price of $23.37. These shares were acquired in private and public transactions as part of the Company’s stock repurchase program. There are 1.0 million
shares still authorized to be repurchased under this program. The Company did not repurchase common shares in 2005. The following table sets forth the common stock repurchased during 2006.
Information regarding the equity compensation plan is included in Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters and the information included therein is incorporated herein by reference.
Holders of common stock are entitled to receive such dividends that may be declared by the Board of Directors from time to time and paid out of funds legally available therefore. Because the Company’s consolidated net income consists largely of net income of the Bank, the Company’s ability to pay dividends depends upon its receipt of dividends from the Bank. The Bank’s ability to pay dividends is regulated by banking statutes. See “Supervision and Regulation, Financial Institution Regulation - Dividend Limitations.” The declaration of dividends by the Company is discretionary and depends on the Company’s earnings and financial condition, regulatory limitations, tax considerations and other factors including limitations imposed by the terms of the Company’s revolving lines of credit and limitations imposed by the terms of the Company’s outstanding junior subordinated debentures owed to its unconsolidated trusts. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity.” While the Company expects to continue to pay dividends quarterly, there can be no assurance that dividends will be paid in the future.
Performance Graph
The following graph shows a comparison of the cumulative returns for the Company, the S&P 500 Index, and the Nasdaq Market Bank Stocks Index for the period beginning December 31, 2001 and ending December 31, 2006. The information assumes that $100 was invested at the closing price on December 31, 2001 in the common stock of the Company and each index and that all dividends were reinvested.
Item 6.
Item 6.
Selected Consolidated Financial Data
The following table sets forth certain selected consolidated financial data at or for the periods indicated. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the related results of operations and gain for MBWI are reflected in the Company’s statements of income as “discontinued operations.” This information should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto included herein. See “Item 8, Consolidated Financial Statements and Supplementary Data.”
(1)
Net income divided by average assets.
(2)
Net income divided by average equity.
(3)
Net interest income, on a fully tax-equivalent basis, divided by average earning assets.
(4)
The following table reconciles reported net interest income on a fully tax-equivalent basis for the periods presented:
(5)
Reflects continuing operations due to the sale of bank subsidiary on September 30, 2005.
(6)
Noninterest expense less noninterest income, excluding security gains or losses, divided by average assets.
(7)
Noninterest income, excluding security gains or losses, plus net interest income on a fully tax-equivalent basis divided by noninterest expense excluding amortization and other real estate expense.
(8)
Includes total nonaccrual, impaired and all other loans 90 days or more past due.
(9)
Includes total nonaccrual, all other loans 90 days or more past due, and other real estate owned.
(10)
Stockholders’ equity less goodwill, core deposits and other intangible assets. The following table reconciles reported stockholders’ equity to tangible stockholders’ equity for the periods presented:
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The Company’s principal business is conducted by the Bank which provides of a full range of community-based financial services, including commercial and retail banking. The profitability of the Company’s operations depends primarily on its net interest income, provision for loan losses, noninterest income, noninterest expenses, and income taxes. Net interest income is the difference between the income the Company receives on its loan and securities portfolios and its cost of funds, which consists of interest paid on deposits and borrowings. The provision for loan losses reflects the cost of credit risk in the Company’s loan portfolio. Noninterest income consists of service charges on deposit accounts, securities gains or losses, net trading profits or losses, gains on sales of loans, insurance and brokerage commissions, trust income, increase in cash surrender value of life insurance, and other noninterest income. Noninterest expenses include salaries and employee benefits, occupancy and equipment expenses, professional services, and other noninterest expenses. The Company is subject to state and federal income taxes.
Net interest income is dependent on the amounts of and yields on interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities. Net interest income is sensitive to changes in market interest rates and is dependent on the Company’s asset/liability management procedures to react appropriately to such changes. The provision for loan losses is based upon management’s assessment of the collectibility of the loan portfolio under current economic conditions. Noninterest expenses are influenced by the growth of operations, with additional employees necessary to staff and marketing expenses necessary to promote the Bank branches. Growth in the number of account relationships directly affects such expenses as data processing costs, supplies, postage, and other miscellaneous expenses. The provision for income taxes is affected by tax law and regulation, accounting principles and policies, and income tax strategies. See Note 2 to the Notes to the audited consolidated financial statements for more details.
The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto and the Selected Consolidated Financial Data presented herein. In addition to historical information, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed in this report.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the Company’s financial position or results of operations. Actual results could differ from those estimates. Discussed below are those critical accounting policies that are of particular significance to the Company.
Allowance for Loan Losses: The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Company’s methodology for determining the allowance for loan losses represents an estimation pursuant to SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a
Loan.” The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of commercial, commercial real estate, and agricultural loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect the Company’s earnings or financial position in future periods.
A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Evaluation of Securities for Impairment: Securities are classified as held-to-maturity when the Company has the ability and management has the positive intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on the disposition of securities available-for-sale are based on the net proceeds and the adjusted carrying amounts of the securities sold, using the specific identification method. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary losses, management considers (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Income Taxes: The Company recognizes expense for federal and state income taxes currently payable as well as for deferred federal and state taxes for estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the consolidated balance sheets, as well as loss carryforwards and tax credit carryforwards. Realization of deferred tax assets is dependent upon generating sufficient taxable income in either the carryforward or carryback periods to cover a net operating losses generated by the reversal of temporary differences. A valuation allowance is provided by way of a charge to income tax expense if it is determined that it is not more likely than not that some or all of the deferred tax asset will be realized. If different assumptions and conditions were to prevail, the valuation allowance may not be adequate to absorb unrealized deferred taxes and the amount of income taxes payable may need to be adjusted by way of a charge or credit to expense. Furthermore, income tax returns are subject to audit by the IRS and state taxing authorities. Income tax expense for current and prior periods is subject to adjustment based upon the outcome of such audits. The Company believes it has adequately accrued for all probable income taxes payable. Accrual of income taxes payable and valuation allowances against deferred tax assets are estimates subject to change based upon the outcome of future events.
The Company entered into tax allocation agreements with its subsidiary entities included in the consolidated US federal and unitary and combined state income tax returns. These agreements govern the timing and amount of income tax payments required by the various entities.
In December 2004, the Financial Accounting Standards Board (“FASB”) published Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“FAS 123(R)”). FAS 123(R) requires that the compensation cost relating to share-based payment transactions, including grants of employee stock options, be recognized in financial statements. That cost is measured based on the fair value of the equity or liability instruments issued. FAS 123(R) permits entities to use any option-pricing model that meets the fair value objective in FAS 123(R). Modifications of share-based payments are treated as replacement awards with the cost of the incremental value recorded in the financial statements. FAS 123(R) was effective at the beginning of the first quarter of 2006. Adoption and application of this statement did not have a material impact on the Company’s consolidated financial statements. See Note 19 to the Notes to the audited consolidated financial statements for more details.
In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in application of income tax law, providing a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax positions taken or expected to be taken in income tax returns. The Company will adopt FIN 48 in the first quarter of 2007 and has evaluated and concluded that the effect of the adoption of FIN 48 will not have a material impact on its consolidated financial position and results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements when the FASB has previously concluded in those pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption permitted. The Company has not yet determined the effect, if any, that the adoption of SFAS No. 157 will have on its results of operations or financial condition.
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to provide guidance in the process of quantifying financial statement misstatements. SAB No. 108 requires registrants to quantify an error under both the rollover and iron curtain approaches. Consequently, a registrant’s financial statements would require adjustment when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. SAB No. 108 was effective for financial statements issued for fiscal years after November 15, 2006. The adoption of SAB No. 108 did not have any impact on the Company’s results of operations or financial condition.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R),” which reconsiders the guidance in SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” and SFAS No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” SFAS No. 158 requires the recognition of a net liability or asset to report the funded status of defined benefit pension and other postretirement benefit plans on the statement of financial position. The adoption of SAFS No. 158 did not have any impact on the Company’s results of operations or financial condition.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115,” which creates a fair value option allowing an entity to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 also requires an entity to report those financial assets and financial liabilities measured at fair value in a manner that separates those reported fair values from the carrying amounts of assets and liabilities measured using another measurement attribute on the face of the statement of financial position. Lastly, SFAS No. 159 requires an entity to provide information that would allow users to understand the effect on earnings of changes in the fair value on those
instruments selected for the fair value election. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 (January 1, 2008 for the Company), with early adoption permitted. The Company is evaluating SFAS No. 159 to assess the impact on its results of operations or financial condition if an election was made to adopt the standard.
Developments
On July 1, 2006, the Company, as part of its expansion strategy, completed its acquisition of Royal American. At acquisition, Royal American had total assets of $561.2 million. The Company issued 2.9 million common shares, paid $64.6 million in cash, and paid $795,000 in costs that were capitalized for a total purchase price of $129.2 million.
The acquisition of Royal American promotes the Company’s strategic plans by:
•
Expanding the community banking market penetration;
•
Adding experienced key executives;
•
Expanding the size of the loan portfolio and diversifying its risk profile by increasing the percentage of commercial and industrial loans and owner occupied commercial real estate loans, while decreasing the percentage of construction loans;
•
Expanding the deposit base by adding a higher percentage of noninterest-bearing and interest-bearing demand deposit, money market, and savings accounts; and
•
Acquiring approximately $200.0 million in managed trust assets.
During the second half of 2006, the Company repurchased 204,188 shares of its common stock at an average price of $23.37. These shares were acquired in private and public transactions as part of the Company’s 5% stock repurchase program. There are 1.0 million shares still authorized to be repurchased under this program. See Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters for details on the common stock repurchased during 2006.
Earnings for 2006 were reduced by provisions for loan losses recorded to reflect the deterioration of one large lending relationship. Developments in this customer’s operations, relating to uncertainty of the customer’s ability to collect a large account receivable, prompted the Company to record a $5.5 million provision for loan losses and charge off $7.5 million of these loans in the fourth quarter of 2006. The Company recorded a loan loss provision of $5.0 million relating to this problem relationship in the second quarter of 2006.
The Company reduced its loan concentrations in 2006. The balance outstanding for borrowing relationships of $30.0 million or more decreased by $124.0 million, or 56.7% compared to 2005.
Developments
In June 2005, the Company completed its balance sheet repositioning which included the sale of low-yielding, long duration U.S. government-sponsored entity notes, prepayment of long-term high cost FHLB advances, and redemption of 10% trust preferred securities, which resulted in pre-tax charges of $30.8 million from continuing operations.
On August 16, 2005, the Company issued 3,450,000 shares of its common stock at $21.00 per share in a secondary public offering. This offering, which included 450,000 shares to cover over-allotments, increased equity by $67.9 million, after issuance costs.
The Company entered into a Stock Purchase Agreement with Western Illinois Bancshares, Inc. (“WIB”), pursuant to which WIB acquired Midwest Bank of Western Illinois, Monmouth, Illinois (“MBWI”), formerly one of the Company’s bank subsidiaries. The sale of MBWI closed on September 30, 2005. The sale price was $32.0 million. MBWI made a dividend distribution to the Company, prior to the sale closing, in the amount of $3.9 million. The after-tax gain on the sale of MBWI of $6.9 million is reflected in the income statement in discontinued operations for the year ended December 31, 2005.
Consolidated Results of Operations
Compared to 2005
Set forth below are some highlights of 2006 results compared to 2005 for continuing operations. In accordance with SFAS No. 144, the results of operations for MBWI, which was sold in 2005, are reflected in the Company’s statement of income as “discontinued operations” and are not reflected below.
•
Income was $17.7 million for the year ended December 31, 2006 compared to a loss of $1.6 million for the prior year.
•
Core income (defined as income excluding the merger related and balance sheet repositioning charges as reconciled below in Supplemental Information) was $18.7 million for the year ended December 31, 2006, or 7.4% higher compared to core income of $17.4 million for the year ended December 31, 2005.
•
2006 earnings were reduced by provisions for loan losses recorded to reflect the deterioration of a large lending relationship. The Company recorded a loan loss provision of $5.0 million relating to this problem relationship in the second quarter of 2006. In the fourth quarter, the Company recorded a $5.5 million provision for loan losses and charged off $7.5 million of these loans to reflect the deterioration of the relationship with this borrower.
•
The return on average assets was 0.67% for 2006 compared to a negative 0.07% for 2005; core return on average assets was 0.71% for 2006 compared to 0.76% for 2005.
•
The return on average equity was 7.04% in 2006 compared to a negative 0.95% in 2005; core return on average equity was 7.42% for 2006 compared to 10.37% for 2005.
Net Interest Income. Net interest income on a fully tax-equivalent basis increased $15.5 million, or 24.2%, to $79.6 million in 2006 from $64.1 million in 2005. The Royal American acquisition contributed to the increase in the net interest income for the year ended December 31, 2006 along with loan growth and an increase in rates, while interest expense increased to a lesser extent. The Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) slightly increased to 3.32% for 2006 compared to 3.31% for 2005.
Trends in interest income and average earning assets include:
•
Interest income on a fully tax-equivalent basis increased $48.7 million to $163.5 million in 2006 compared to $114.9 million in 2005. Average earning assets increased by $457.7 million (approximately $262.2 million of this increase was attributable to the Royal American acquisition) and average yields increased by 90 basis points.
•
Interest income on loans on a fully tax-equivalent basis increased $43.9 million to $124.1 million in 2006 from $80.2 million in 2005 due to an increase in average rates paid on loans from 6.63% to 7.48% and an increase of $448.0 million in average loans; $261.8 million of the increase in average loans was from the Royal American acquisition.
•
Interest income on securities on a fully tax-equivalent basis increased $4.7 million to $38.1 million in 2006 from $33.4 million in 2005 as a result of an increase in yields on securities from 4.81% in 2005 to 5.39% in 2006 while average securities increased $12.9 million, or 1.9%.
Trends in interest expense and average interest-bearing liabilities include:
•
Interest expense on interest-bearing liabilities increased $33.2 million to $84.0 million in 2006 from $50.8 million in 2005. Average balances on interest-bearing liabilities increased by $360.3 million in 2006 to $2.1 billion compared to $1.8 billion in the prior year while rates paid increased 108 basis points to 3.95% during 2006 compared to 2.87% in 2005.
•
Interest expense on interest-bearing deposits increased by $23.5 million to $57.5 million in 2006 from $34.1 million in 2005. Average interest-bearing deposits increased $237.2 million to $1.6 billion in 2006 compared to $1.3 billion in the prior year; $188.0 million of the increase was attributable to the Royal
American acquisition. Average rates paid on interest-bearing deposits increased by 110 basis points to 3.63% in 2006 compared to 2.53% in the prior year.
•
The migration of demand deposit, interest-bearing demand deposit, money market, and savings accounts into certificates of deposit and the reliance on more expensive wholesale funds contributed to the increase in the cost of funds.
•
Average interest-bearing core deposits (interest-bearing demand deposit, money market, and savings accounts) decreased $26.7 million in 2006 compared to 2005 and rates paid increased 38 basis points.
•
Average certificates of deposits less than $100,000 remained flat while rates paid increased by 101 basis points. Average certificates of deposits greater than $100,000 increased $266.1 million in 2006 and rates paid increased by 176 basis points. Average brokered deposits increased by $136.5 million in 2006 compared to the prior year.
•
Interest expense on borrowings increased by $9.7 million to $26.5 million in 2006 from $16.7 million in 2005. Average borrowings increased by $123.0 million to $545.4 million in 2006 compared to $422.4 million in the prior year mainly due to the increase in FHLB advances; $15.0 million of the increase in borrowings was from the Royal American acquisition. This increase in borrowings was a result of the Company’s difficulty in raising lower cost deposits.
•
Interest expense on Federal funds purchased and securities sold under agreements to repurchase increased by $4.7 million in 2006 as a result of the increases in rates of 155 basis points and average balances of $23.5 million.
•
Interest expense on FHLB advances increased by $4.1 million in 2006 compared to the prior year while average balances increased by $94.6 million during the same period; a $5.0 million FHLB advance was acquired in the Royal American acquisition. Average rates paid on FHLB advances rose by only 4 basis points in 2006 to 4.29% compared to 4.25% in 2005.
•
The Company used $64.6 million of the cash raised through a secondary public offering to pay for the Royal American acquisition. Funding costs increased as a result of replacing these funds with more expensive borrowings, which were offset by the increase in net interest income resulting from the Royal American acquisition.
Provision for Loan Losses. The provision for loan losses increased by $9.5 million to $12.1 million in 2006 from $2.6 million in 2005 due primarily to the deterioration in the credit quality of a large lending relationship. Developments in this customer’s operations, relating to uncertainty of the customer’s ability to collect a large account receivable, prompted the Company to record a $5.5 million provision for loan losses and charge off $7.5 million of these loans in the fourth quarter of 2006. The Company recorded a loan loss provision of $5.0 million relating to this problem relationship in the second quarter of 2006. As of December 31, 2006, the allowance for loan losses totaled $23.2 million, or 1.19% of total loans, and was equal to 54.2% of nonaccrual loans compared to $17.8 million, or 1.32% of total loans, and 224.7% of nonaccrual loans at December 31, 2005.
Noninterest Income. The Company’s total noninterest income was $14.6 million in 2006 compared to the loss of $6.2 million in 2005. The loss in 2005 was primarily due to the losses on securities transactions of $17.4 million, mainly as a result of the balance sheet repositioning. Other changes in noninterest income are noted below:
•
$1.3 million 2006 gain on extinguishment of debt. The Company, as part of its program of repositioning the maturities of its borrowings, recognized a gain on the extinguishment of debt of $625,000 in the first quarter of 2006 as a result of the prepayment of a $28.0 million repurchase agreement and recognized $625,000 gain in the second quarter of 2006 as a result of the assignment of a $50.0 million FHLB advance
•
$629,000 increase in the cash surrender value of life insurance reflecting an additional purchase of bank owned life insurance of $6.0 million in 2006 and $12.5 million of such insurance acquired with Royal American;
•
$616,000 increase in trust income primarily as a result of the trust operations acquired from Royal American;
•
$594,000 increase in service charges on deposits mainly due to the increase in noninterest-bearing demand deposit service charges of $1.1 million which was partially offset by the decrease in overdraft fees of $514,000;
•
$471,000 increase in insurance and brokerage commissions as a result of increased staff and brokerage activity;
•
$403,000 increase in gains on sale of loans due to a 134.5% increase in loans sold as a result of a higher level of mortgage refinancing volume; and
•
$211,000 increase in trading profits.
As part of its strategic plan, the Company is focusing on opportunities to increase noninterest income especially in the areas of corporate cash management, insurance and investment services, trust services, and secondary-market mortgage lending.
Noninterest Expenses. The Company’s total noninterest expenses decreased by $1.9 million, or 3.2%, to $58.6 million in 2006 from $60.5 million in 2005; 2005 reflects approximately $13.6 million in charges taken in connection with the balance sheet repositioning. Noninterest expenses as a percentage of average assets were 2.22% for 2006 compared to 2.63% for 2005. The decrease in total noninterest expenses in 2006 was primarily due to the following factors:
•
The loss on extinguishment of debt of $13.1 million in 2005, which did not occur in 2006;
•
Other real estate expense decreased by $2.2 million in 2006 compared to 2005 as a result of a $2.4 million write down of other real estate owned in the second quarter of 2005;
•
Salaries and employee benefits increased $7.8 million reflecting the additions to management and the 50 full-time equivalent employees from the Royal American acquisition;
•
Non-capitalized merger related expense was $1.6 million in 2006;
•
Occupancy and equipment increased $1.5 million in 2006 compared to the prior year reflecting the additional branches acquired in the Royal American acquisition;
•
Marketing expenses increased by $294,000 in 2006 compared to the prior year due to increased marketing activity; and
•
Professional services increased $248,000 in 2006 due to an increase in consulting expense.
The efficiency ratio was 60.55% for the year ended December 31, 2006 compared to 75.44% in 2005. The core efficiency ratio (which excludes the merger related and balance sheet repositioning charges) was 58.86% for 2006 and 58.00% for 2005.
Federal and State Income Tax. The Company’s consolidated income tax rate varies from statutory rates. The Company recorded income tax expense of $1.4 million in 2006 compared to the income tax benefit of $6.3 million
in 2005. Set forth below is a reconciliation of the effective tax rate from continuing operations for the years ended December 31, 2006 and 2005 to statutory rates.
Compared to 2004
Set forth below are some highlights of 2005 results compared to 2004. In accordance with SFAS 144, the results of operations and gain on sale of MBWI are reflected in the Company’s statements of income as “discontinued operations” and are not included in the discussion below.
•
Total assets increased $70.8 million, or 3.2%, to $2.3 billion as of December 31, 2005 from December 31, 2004 or increased $353.3 million after giving consideration to the sale of MBWI on September 30, 2005 which had assets of $282.5 million.
•
In June 2005, the Company completed its balance sheet repositioning which included the sale of low-yielding, long duration U.S. government-sponsored entity notes, the prepayment of long-term high cost FHLB advances, and the redemption of 10% trust preferred securities, with after-tax charges of $21.0 million.
•
Loans increased $253.9 million, or 23.1%, to $1.4 billion as of December 31, 2005 compared to December 31, 2004.
•
Net loans charged off to average total loans were 0.09% for the year ended December 31, 2005 compared to 0.17% in the prior year.
•
Securities increased by $221.4 million, or 42.1%, in 2005 compared to 2004 as a result of investing federal funds sold and other short-term investments of $169.8 million at December 31, 2004.
•
Allowance to nonaccrual loans coverage increased to 2.25x at December 31, 2005 from 1.74x at December 31, 2004.
•
Loss from continuing operations was $1.6 million for the year ended December 31, 2005 compared to income from continuing operations of $3.1 million for the prior year.
•
Core income from continuing operations (defined as income from continuing operations excluding charges from the balance sheet repositioning and retirement benefit obligation as reconciled below in Supplemental Information) was $17.4 million for the year ended December 31, 2005 or 75.6% higher compared to core income from continuing operations of $9.9 million for the year ended December 31, 2004.
•
The return on average assets from continuing operations was a negative 0.07% for 2005 and a positive 0.13% for 2004; core return on average assets from continuing operations was 0.76% for 2005 and 0.43% for 2004.
•
The return on average equity from continuing operations decreased to a negative 0.95% in 2005 from 2.17% in 2004; core return on average equity from continuing operations was 10.37% for 2005 and 7.01% for 2004.
Net Interest Income. Net interest income on a fully tax-equivalent basis increased $11.5 million, or 21.9%, to $64.1 million in 2005 from $52.6 million in 2004, mainly driven by the repositioning of the securities portfolio and the increase in rates and growth in loans. Average yields on earning assets increased to a greater extent than average rates paid on deposits and borrowings. Evidence of this is the increase in the Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) to 3.31% for 2005 compared to 2.82% for 2004.
Trends in net interest income average earning assets include:
•
Interest income on a fully tax-equivalent basis increased $20.5 million to $114.9 in 2005 compared to $94.4 million in 2004. Average earning assets increased by $74.8 million, and average yields increased by 87 basis points.
•
Interest income on loans on a fully tax-equivalent basis increased $20.6 million to $80.2 million in 2005 from $59.7 million in 2004 due to an increase in average rates paid on loans from 6.06% to 6.63% and an increase of $225.9 million in average loans.
•
Interest income on securities on a fully tax-equivalent basis increased $1.1 million to $33.4 million in 2005 from $32.3 million in 2004 as a result of an increase of yields on securities from 4.33% in 2004 to 4.81% in 2005 despite a $50.3 million decrease in average securities. The duration of the securities portfolio decreased to 3.8 years at December 31, 2005 from 5.0 years a year ago.
•
Consistent with its strategy, the Company changed the mix of its securities portfolio through the sale of U.S. government-sponsored entity notes in the fourth quarter of 2004 and the first half 2005 and the investment in mortgage-backed securities described below.
•
During 2005, the Company invested $342.4 million in 5/1, 7/1, and 10/1 adjustable rate mortgage-backed securities with a weighted average yield of 4.84% as well as $201.4 million in 15-year fixed mortgage-backed securities with a weighted average yield of 4.87%. The Company expects these securities to provide added liquidity to fund future loan growth.
•
Average cash equivalents decreased by $98.4 million compared to 2004 due to more proactive funds management.
Trends in net interest expense average interest-bearing liabilities include:
•
Interest expense on interest-bearing liabilities increased $9.0 million to $50.8 million in 2005 from $41.8 million in 2004, or 21.6%, due primarily to the increase in interest expense on deposits. Average balances on interest-bearing liabilities increased by $44.8 million in 2005 to $1.8 billion.
•
Interest expense on interest-bearing deposits increased by $6.4 million to $34.1 million in 2005 from $27.7 million in 2004, or 23.2%. This is mainly the result of the increase in average rates paid on certificates of deposits and public funds of 58 basis points in 2005 and increase in average balances of $32.8 million. Average interest-bearing core deposits (interest-bearing demand deposit, money market, and savings accounts) increased $9.9 million compared to 2004, while rates paid increased 13 basis points.
•
The Company also experienced a migration of balances in core interest-bearing deposits (interest-bearing demand, money market, and savings accounts) to certificates of deposits as a result of the upward movement in rates.
•
Interest expense on borrowings increased by $2.6 million to $16.7 million in 2005 from $14.1 million in 2004, or 18.4%. Included in 2004’s interest expense is a purchase accounting adjustment of $2.1 million which reduced the interest expense on FHLB advances.
•
Interest expense on Federal funds purchased and securities sold under agreements to repurchase increased by $2.9 million in 2005 as a result of the increase in rates of 40 basis points and average balances of $73.0 million. This increase in Federal funds purchased and securities sold under agreements to repurchase was a result of the Company’s difficulty in raising low cost deposits.
•
The Company prepaid $121.5 million of FHLB advances with an average rate of 5.47%, unwound the interest rate swaps associated with those advances, and replaced them with $150.0 million in new advances with an average rate of 3.48%.
•
The Company also redeemed $20.6 million of its junior subordinated debt at a rate of 10.00% during June 2005 and replaced it with another issuance for the same amount at LIBOR plus 177 basis points adjusting quarterly.
Provision for Loan Losses. The provision for loan losses decreased by $811,000, or 23.9%, to $2.6 million in 2005 from $3.4 million in 2004 due to reduced provisions relating to a lower level of nonaccrual loans, which decreased from $9.3 million at December 31, 2004 to $7.9 million at December 31, 2005 (see Nonaccrual Loans). As of December 31, 2005, the allowance for loan losses totaled $17.8 million, or 1.32% of total loans, and was equal to 224.7% of nonaccrual loans.
Noninterest Income. The Company’s total noninterest income decreased $6.2 million to a loss of $6.2 million in 2005 from a loss of $88,000 in 2004. The decrease in noninterest income in 2005 compared to 2004 was primarily due to the increase in net losses on securities transactions of $13.7 million, as a result of the balance sheet repositioning. Other changes in noninterest income are noted below:
•
$116,000 decrease in service charges on deposits mainly due to the decrease in overdraft and noninterest-bearing demand deposit service charges of $266,000, partially offset by an increase in ATM and debit card fees of $113,000;
•
$204,000 increase in trading profits:
•
covered call options were written to provide incremental revenue enhancement when market conditions provided such opportunities, and
•
compared to 2004, trading activities have been curtailed with reductions in the volume of securities traded and number of transactions;
•
$95,000 increase in insurance and brokerage commissions;
•
$315,000 increase in the cash surrender value of life insurance (reflecting the additional investment of $20.0 million in July of 2004 and the increase in crediting rates);
•
$180,000 decrease in gains on sale of loans (as a result of a lower level of mortgage refinancing volume and the retention of variable rate mortgages in the portfolio); and
•
A life insurance benefit was received in the third quarter of 2005 in the amount of $789,000.
As part of the Company’s strategic plan, the Company is focusing on opportunities to increase noninterest income especially in the areas of corporate cash management, insurance and investment services, trust services, and secondary-market mortgage lending.
Noninterest Expenses. The Company’s total noninterest expenses increased by $14.0 million, or 30.2%, to $60.5 million in 2005 from $46.5 million in 2004, mainly due to the charges taken in connection with the balance sheet repositioning. Noninterest expenses as a percentage of average assets were 2.63% for the year ended 2005 compared to 2.01% for the year ended 2004. Net overhead expenses were 2.14% as a percentage of average assets in 2005 compared to 1.58% in 2004. The increase in total noninterest expenses in 2005 was primarily due to the following factors:
•
Salaries and employee benefits increased $2.4 million reflecting additions of new management personnel;
•
Occupancy and equipment decreased $406,000 in 2005 compared to the prior year mainly due to a decrease in real estate taxes;
•
Professional services increased $51,000 for 2005 compared to 2004 due to an increase in audit and ATM processing fees and a decrease in legal and consulting expenses;
•
A $2.4 million write down of other real estate owned was taken in the second quarter of 2005; and
•
The loss on extinguishment of debt (FHLB advances, as mentioned above) was $13.1 million in 2005.
These increases contributed to a slight deterioration in the efficiency ratio to 75.44% for the year ended December 31, 2005 compared to 72.79% in 2004. The core efficiency ratio (which excludes the balance sheet
repositioning and retirement benefit obligation charges) was 58.00% for 2005 and 64.71% for 2004 which is attributed to an increase in revenues more than offsetting the increase in overhead expenses.
Federal and State Income Tax. The Company’s consolidated income tax rate varies from statutory rates. The Company recorded income tax benefit of $6.3 million in 2005 compared to $2.9 million in 2004. Set forth below is a reconciliation of the effective tax rate from continuing operations for the years ended December 31, 2005 and 2004.
Supplemental Information. Core income from continuing operations is income from continuing operations excluding merger related changes, balance sheet repositioning and retirement benefit obligation charges. Management believes that core income from continuing operations is a more useful measure of operating performance since it excludes items that are not recurring in nature. In addition, management believes core income is more reflective of current trends. The following table reconciles reported income from continuing operations to core income from continuing operations for the years ended December 31, 2006, 2005, and 2004:
The efficiency ratio is noninterest expense less amortization and other real estate expenses divided by the sum of net interest income (tax equivalent) plus noninterest income. Core efficiency ratio excludes charges from the balance sheet repositioning and retirement benefit obligation as well as the merger related charges. Management believes that the core efficiency ratio is a more useful measure since it excludes items that are not recurring in nature and is more reflective of current trends. The following table reconciles reported noninterest expense to core noninterest expenses for the periods presented:
Interest-Earning Assets and Interest-Bearing Liabilities
The following table sets forth the average balances, net interest income and expense and average yields and rates for the Company’s interest-earning assets and interest-bearing liabilities for the indicated periods on a tax-equivalent basis assuming a 35.0% tax rate.
(1)
Adjusted for 35% tax rate and adjusted for the dividends-received deduction where applicable.
(2)
Not adjusted for 35% tax rate or for the dividends-received deduction.
(3)
Nonaccrual loans are included in the average balance; however, these loans are not earning any interest.
(4)
Includes loan fees.
(5)
The following table reconciles reported net interest income on a tax equivalent basis for the periods presented:
(6)
Includes construction loans.
(7)
2004 includes $2.1 million purchase accounting adjustment resulting from the prepayment of the FHLB advances which reduced interest expense.
Changes in Interest Income and Expense
The changes in net interest income from period to period are reflective of changes in the interest rate environment, changes in the composition of assets and liabilities as to type and maturity (and the inherent interest rate differences related thereto), and volume changes. Later sections of this discussion and analysis address the changes in maturity composition of loans and investments and in the asset and liability repricing gaps associated with interest rate risk, all of which contribute to changes in net interest margin.
The following table sets forth an analysis of volume and rate changes in interest income and interest expense of the Company’s average interest-earning assets and average interest-bearing liabilities for the indicated periods on a tax-equivalent basis assuming a 35.0% tax rate. The table distinguishes between the changes related to average outstanding balances (changes in volume holding the interest rate constant) and the changes related to average interest rates (changes in average rate holding the outstanding balance constant). The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Financial Condition
The following table sets forth the changes in the balance sheet at December 31, 2006 compared to December 31, 2005 excluding the Royal American acquisition on July 1, 2006.
(1)
Includes fair value adjustments.
(2)
Royal American Acquisition column includes cash and cash equivalents acquired through Royal American of $24,363 less cash paid for acquisition of $64,612 and capitalized costs of $795.
Set forth below are some balance sheet highlights at December 31, 2006 compared to December 31, 2005 excluding changes from the Royal American acquisition.
•
Total assets increased $55.6 million, or 2.4%.
•
Loans increased $99.0 million, or 7.3% .
•
Securities decreased by $128.0 million, or 17.1%; cash flow from principal payments of $86.0 million received on mortgage-backed securities were used to fund loan growth in 2006.
•
Deposits decreased by $31.6 million, or 2.1%; deposit losses included $7.5 million in noninterest-bearing deposits and. $24.1 million interest-bearing deposits.
Set forth below are some asset quality highlights at December 31, 2006 compared to December 31, 2005.
•
The allowance for loan losses was 1.19% of total loans at December 31, 2006 versus 1.32% at December 31, 2005. The allowance for loan losses increased by $3.2 million due to the Royal American merger.
•
Nonaccrual loans increased to 2.20% of total loans at December 31, 2006 from 0.59% at December 31, 2005 as a result of the large loan relationship previously discussed.
•
Allowance to nonaccrual loans coverage decreased to 0.54x in 2006 from 2.25x in 2005. The decrease was a result of net charge-offs totaling $9.8 million, total loan loss provision expense of $12.1 million, and the nonaccrual loans increase to $42.8 million at December 31, 2006 from $7.9 million at December 31, 2005.
•
Net loans charged off to average total loans were 0.59% at December 31, 2006 compared to 0.09% in the prior year. The increase was the result of the $7.5 million charge off in the fourth quarter of 2006 to reflect the deterioration of a large lending relationship.
The acquisition of Royal American contributed to the Company’s ongoing efforts to reduce risk in its loan portfolio through diversification. Similarly, over two thirds of the acquired commercial real estate loans through Royal are owner occupied.
Loans
The following table sets forth the composition of the Company’s loan portfolio as of the indicated dates.
The following table sets forth the changes in composition of the Company’s loan portfolio as of December 31, 2006 excluding the loans acquired through the Royal American acquisition compared to December 31, 2005.
(1)
Includes fair value adjustments.
Set forth below are other highlights of changes in the loan portfolio excluding changes from the Royal American acquisition.
•
Total loans increased $99.0 million, or 7.3%.
•
Commercial loans increased $18.6 million, or 9.2%.
•
Construction loans increased by $24.9 million or 6.9%.
•
Commercial real estate loans rose by $44.0 million or 8.9%.
•
Consumer loans decreased $12.3 million or 10.3%.
•
Residential mortgage loans increased $23.6 million or 13.6%.
Many consumer residential mortgage loans the Company originates are sold in the secondary market. At any point in time, loans will be at various stages of the mortgage banking process. Loans held for sale were $2.7 million at December 31, 2006 compared to $1.9 million the prior year. The carrying value of these loans approximated their market value at that time. The Company does not hold any sub-prime loans.
The Company attempts to balance the types of loans in its portfolio with the objective of reducing risk. Some of the risks the Company attempts to reduce include:
•
The primary risks associated with commercial loans are the quality of the borrower’s management, financial strength and cash flow resources, and the impact of local economic factors.
•
Risks associated with real estate loans include concentrations of loans in a certain loan type, such as commercial or residential, and fluctuating land and property values.
•
Consumer loans also have risks associated with concentrations of loans in a single type of loan, as well as the risk a borrower may become unemployed as a result of deteriorating economic conditions.
The Company reduced its loan concentrations in 2006. The balance outstanding for borrowing relationships of $30.0 million or more decreased by $124.0 million, or 56.7%. The following is a summary of loan concentrations based on balances as of the indicated dates.
Loan Maturities
The following table sets forth the remaining maturities, based upon contractual dates, for selected loan categories as of December 31, 2006.
(1)
The Company’s data processing system currently limits its ability to break net deferred fees out over the timeframes in the table.
Nonaccrual Loans
The Company’s financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on its loan portfolio. The accrual of interest on loans is discontinued at the time a loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Under SFAS No. 114 and No. 118, the Company currently defines loans that are individually evaluated for impairment to include commercial, commercial real estate and agricultural loans over $300,000 that are in nonaccrual status or were restructured. All other smaller balance loans with similar attributes are evaluated for impairment in total.
The classification of a loan as impaired or nonaccrual does not necessarily indicate that the principal is uncollectible, in whole or in part. The Company makes a determination as to the collectibility on a case-by-case basis based upon the specific facts of each situation. The Company considers both the adequacy of the collateral and
the other resources of the borrower in determining the steps to be taken to collect impaired or nonaccrual loans. Alternatives that are typically considered to collect impaired or nonaccrual loans are foreclosure, collection under guarantees, loan restructuring, or judicial collection actions.
Loans that are considered to be impaired are reduced to the present value of expected future cash flows or to the fair value of the related collateral by allocating a portion of the allowance to such loans. If these allocations require an increase to be made to the allowance for loan losses, such increase is reported as a provision for loan losses charged to expense.
The following table sets forth information on the Company’s nonaccrual loans and nonperforming assets as of the indicated dates.
During 2006, 2005, and 2004, the Company recognized interest income on impaired loans of $2.9 million, $2.4 million, and $2.8 million, respectively.
Nonaccrual loans increased $34.9 million to $42.8 million at December 31, 2006 from $7.9 million at December 31, 2005. The Company previously announced the downgrading of a large loan relationship linked to a single long-standing customer to substandard in the second quarter of 2006. On December 31, 2006, total nonaccrual loans related to this relationship were $25.8 million, representing 60% of total nonaccrual loans. Additional advances may also be provided to this borrower as part of the loan workout strategy.
Other real estate decreased to $2.6 million in 2006 from $11.2 million in 2005; the balance was reduced primarily due to the sale of properties included in a townhouse project. Other real estate is carried at its estimated net realizable value.
Total nonperforming assets increased by $26.4 million from $19.1 million in 2005 to $45.5 million in 2006.
Analysis of Allowance for Loan Losses
The Company recognizes that credit losses will be experienced and the risk of loss will vary with, among other things, general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and in the case of a collateralized loan, the quality of the collateral for such loan. The allowance for loan losses represents the Company’s estimate of the amount deemed necessary to provide for probable incurred losses in the portfolio. In making this determination, the Company analyzes the ultimate collectibility of the loans in its portfolio by incorporating feedback provided by internal loan staff and information provided during examinations performed by regulatory agencies. The Company makes an ongoing evaluation as to the adequacy of the allowance for loan losses.
On a quarterly basis, management of the Bank meets to review the adequacy of the allowance for loan losses. Each loan officer grades his or her individual commercial credits and the Company’s independent loan review personnel review the officers’ grades. In the event that the loan is downgraded during this review, the loan is included in the allowance analysis at the lower grade. The grading system is in compliance with regulatory
classifications, and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are known differences (e.g. collateral value is nominal).
The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Company’s methodology for determining the allowance for loan losses represents an estimation done pursuant to SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of commercial, commercial real estate and agricultural loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which potentially result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect the Company’s earnings or financial position in future periods.
The following table sets forth loans charged off and recovered by type of loan and an analysis of the allowance for loan losses for the indicated periods.
(1)
Adjustment made following the Bank’s receipt of $13.3 million of proceeds from an entity indirectly owned by certain directors and family members of directors relating to the sale of previously classified loans, of which $12.5 million was applied to outstanding principal, $750,000 to fund a letter of credit, and $67,000 applied to accrued interest income and late charges on March 26, 2003. As a consequence, the Bank recognized a $4.0 million after-tax capital contribution as a result of the sale of these loans to the related parties. As of December 31, 2002, $6.3 million of the $12.5 million outstanding principal amount of these loans was considered impaired.
The provision for loan losses increased $9.5 million to $12.1 million for the year ended December 31, 2006 from $2.6 million for the year ended December 31, 2005 primarily reflecting the deterioration of a large lending relationship. The Company also charged off $7.5 million of these loans to reflect the deterioration of the relationship with this borrower. The allowance for loan losses was $23.2 million at December 31, 2006 and $17.8 million at December 31, 2005. Total recoveries on loans previously charged off were $984,000 for the year ended December 31, 2006 and $1.5 million for the year ended December 31, 2005. These recoveries were due primarily to payments from customers’ bankruptcy proceedings or payment plans on charged-off loans.
Net charge-offs increased $8.8 million to $9.8 million, or 0.59% of average loans, in 2006 compared to $1.0 million, or 0.09% of average loans in 2005, reflecting the impact of the $7.5 million charge-off discussed above. Allowance for loan losses to nonaccrual loans ratio was 0.54x and 2.25x at December 31, 2006 and December 31, 2005, respectively.
Excluding the large lending relationship, the allowance for loan losses to nonaccrual loans would be 1.19x and the ratio of nonperforming assets to total assets at December 31, 2006, would be 0.67%. The following table reflects the allowance for loan losses, nonaccrual loan, and nonperforming assets excluding the large lending relationship.
The following table sets forth the Company’s allocation of the allowance for loan losses by types of loans as of the indicated dates.
As of December 31, 2006, approximately 26.5% of the allowance was allocated to commercial loans, while 43.5% was allocated in the prior year. During March 2003, $13.3 million of classified nonperforming loans were sold to an insider group. See footnote (1) to the table on page 53.
The Company had a reserve for losses on unfunded commitments of $233,000 at December 31, 2006 and $258,000 at December 31, 2005.
The Company utilizes an internal asset classification system as a means of reporting problem and potential problem assets. At each scheduled Bank Board of Directors meeting, a watch list is presented, showing significant loan relationships listed as Special Mention, Substandard, and Doubtful. Set forth below is a discussion of each of these classifications.
Special Mention: A special mention extension of credit is defined as having potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date,
result in the deterioration of the repayment prospects for the credit or the institution’s credit position. Special mention credits are not considered as part of the classified extensions of credit category and do not expose an institution to sufficient risk to warrant classification. They are currently protected but are potentially weak. They constitute an undue and unwarranted credit risk.
Loans in this category have some identifiable problem but, in management’s opinion, offer no immediate risk of loss. An extension of credit that is not delinquent also may be identified as special mention. These loans are classified due to Bank management’s actions or the servicing of the loan. The lending officer may be unable to properly supervise the credit because of an inadequate loan or credit agreement. There may be questions regarding the condition of and/or control over collateral. Economic or market conditions may unfavorably affect the obligor in the future. A declining trend in the obligor’s operations or an imbalanced position in the balance sheet may exist, although it is not to the point that repayment is jeopardized. Another example of a special mention credit is one that has other deviations from prudent lending practices.
If the Bank may have to consider relying on a secondary or alternative source of repayment, then collection may not yet be in jeopardy, but the loan may be considered special mention. Other trends that indicate that the loan may deteriorate further include such “red flags” as continuous overdrafts, negative trends on a financial statement, such as a deficit net worth, a delay in the receipt of financial statements, accounts receivable ageings, etc. These loans on a regular basis can be 30 days or more past due. Judgments, tax liens, delinquent real estate taxes, cancellation of insurance policies and exceptions to Bank policies are other “red flags.”
Substandard: A substandard extension of credit is one inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Extensions of credit so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. In other words, there is more than normal risk of loss. Loss potential, while existing in the aggregate amount of substandard credits, does not have to exist in individual extensions of credit classified substandard.
The likelihood that a substandard loan will be paid from the primary source of repayment may also be uncertain. Financial deterioration is underway and very close attention is warranted to insure that the loan is collected without a loss. The Bank may be relying on a secondary source of repayment, such as liquidating collateral, or collecting on guarantees. The borrower cannot keep up with either the interest or principal payments. If the Bank is forced into a subordinated or unsecured position due to flaws in documentation, the loan may also be substandard. If the loan must be restructured, or interest rate concessions made, it should be classified as such. If the bank is contemplating foreclosure or legal action, the credit is likely substandard.
Doubtful: An extension of credit classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high; however, because of certain important and reasonably specific pending factors that may work to the advantage of and strengthen the credit, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceedings, capital injection, perfecting liens on additional collateral, or refinancing plans.
If the primary source of repayment is gone, and there is doubt as to the quality of the secondary source, then the loan will be considered doubtful. If a court suit is pending, and is the only means of collection, a loan is generally doubtful. As stated above, the loss amount in this category is often undeterminable, and the loan is classified doubtful until said loss can be determined.
The Company’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Bank’s primary regulators in the course of its regulatory examinations, which can order the establishment of additional general or specific loss allowances. There can be no assurance that regulators, in reviewing the Company’s loan portfolio, will not request the Company to materially increase its allowance for loan losses. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific
and general loan loss allowances may become necessary. The Company’s allowance for loan losses at December 31, 2006 is considered by management to be adequate.
Securities
The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Company has an asset/liability committee which develops current investment policies based upon its operating needs and market circumstances. The investment policy of the Bank is reviewed by senior financial management of the Company in terms of its objectives, investment guidelines and consistency with overall Company performance and risk management goals. The Bank’s investment policy is formally reviewed and approved annually by its Board of Directors. The asset/liability committee of the Bank is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to the Bank’s Board of Directors and the Board of Directors of the Company on a regular basis.
The following tables set forth the composition of the Company’s securities portfolio by major category as of the indicated dates. The securities portfolio as of December 31, 2006, 2005, and 2004 has been categorized as either available-for-sale or held-to-maturity in accordance with SFAS No. 115.
As of December 31, 2006, the Company held no securities of a single issuer with a book value exceeding 10% of stockholders’ equity other than those of the U.S. Treasury or other U.S. government or government-sponsored entities.
The total fair value of the securities portfolio was $634.7 million as of December 31, 2006, or 98.2% of amortized cost. The total fair value of the securities portfolio was $746.3 million and $526.1 million as of December 31, 2005 and 2004, respectively.
The Company has implemented strategies to reduce its securities as a percentage of earning assets and provide funding for higher yielding loans. The proceeds of the principal paydowns from mortgage-backed securities of $86.0 million during 2006 were used to fund loan growth. This strategy will continue as long as yields on average loans are 200 basis points or more than yields on average securities.
The Company’s securities available-for-sale portfolio decreased $98.0 million, or 14.2%, in 2006 compared to 2005. Set forth below is a summary of the change in the available-for-sale securities:
•
Cash flow from principal payments of $86.0 million received on mortgage-backed securities in the available-for-sale and held-to-maturity portfolios were used to fund loan growth during 2006.
•
U.S. government agency and government-sponsored entity mortgage-backed securities decreased 15.1%, or $77.2 million, from $511.3 million at December 31, 2005 to $434.1 million at December 31, 2006.
•
Equity securities decreased $21.4 million to $41.5 million at December 31, 2006 from December 31, 2005. Equity securities included capital securities of U.S. government-sponsored entities.
•
Obligations of state and political subdivisions increased $18.6 million to $97.0 million at December 31, 2006 from December 31, 2005. As part of its tax strategy, the Company continued to build its tax-exempt municipal bond position in the securities portfolio in 2006.
•
Other bonds decreased $219,000 to $10.4 million at December 31, 2006 compared to $10.6 million at December 31, 2005. Other bonds include high grade corporate bonds primarily issued by financial institutions.
Securities held-to-maturity decreased $13.5 million, or 22.7%, from $59.5 million at December 31, 2005 to $45.9 million at December 31, 2006, mainly due to paydowns on mortgage-backed securities.
There were no trading securities held at December 31, 2006 or December 31, 2005. When acquired, the Company holds trading securities and derivatives on a short-term basis based on market and liquidity conditions.
Investment Maturities and Yields
The following tables set forth the contractual or estimated maturities of the components of the Company’s securities portfolio as of December 31, 2006 and the weighted average yields. The table assumes estimated fair values for available-for-sale securities and amortized cost for held-to-maturity securities:
(1)
Equity securities, although they do not have a maturity date, are included in the after ten years column.
Deposits
The Company competes for core deposits in the heavily-banked Chicago Metropolitan Statistical Area. Competitive pricing has made it difficult to maintain and grow these types of deposits. The level of pressure for core deposits is not expected to ease in the near term. To overcome this challenge, the Company has changed and expanded staffing and management at its banking centers and initiated a number of customer outreach initiatives to expand deposits. In addition, the Company is in the process of creating a performance-driven sales environment and increasing activity in its branches. Deposit growth is expected in the future as new customers are added due to the addition of new small business and commercial and industrial loans and a commitment to relationship banking.
The following table sets forth the changes in deposits as of December 31, 2006 compared to December 31, 2005 excluding the deposits acquired through the Royal American acquisition.
(1)
Includes fair value adjustments.
Set forth below is a summary of the change in the Company’s deposits excluding those acquired through Royal American:
•
Deposits decreased by $31.6 million, or 2.1%; deposit losses included $7.5 million in noninterest-bearing deposits and. $24.1 million interest-bearing deposits.
•
Core deposits, which include demand, interest-bearing demand, money market, and savings deposits, decreased $107.7 million. The majority of this decrease was the migration of demand deposit, interest-bearing demand deposit, money market, and savings accounts into certificates of deposit and the reliance on more expensive wholesale funds.
•
Certificates of deposits less than $100,000 decreased 5.2% or $38.8 million.
•
Certificates of deposit over $100,000 increased $144.2 million and public funds certificates of deposits decreased by $29.3 million. Brokered certificates of deposit, included in certificates of deposit over $100,000, increased by $70.8 million.
The following table sets forth the average amount of and the average rate paid on deposits by category for the indicated periods.
(1)
Certificates of deposit exclusive of public funds.
The following table summarizes the maturity distribution of certificates of deposit in amounts of $100,000 or more as of the dates indicated. These deposits have been made by individuals, businesses, and public and other not-for-profit entities, most of which are located within the Company’s market area.
Borrowings
The following table summarizes the Company’s borrowings as of the dates indicated.
The increase in borrowings at December 31, 2006 reflects the funding needs the Company experienced during the year to fund loan growth due to the lack of deposit growth. The increase in FHLB advances was a result of the Company’s difficulty in raising low cost deposits. For the year ended December 31, 2006, the average rate paid on FHLB advances was approximately 66 basis points more than interest-bearing deposits.
The Company’s borrowings include overnight funds purchased, securities sold under agreements to repurchase, FHLB advances, junior subordinated debt, and commercial bank lines of credit. The following tables set forth categories and the balances of the Company’s short-term or revolving lines of credit borrowings (notes payable) for the periods indicated.
(1)
Based on amounts outstanding at each month end during the year.
(2)
During 2006 and 2005, there were four and eight increases, respectively, in the federal funds target rate.
(1)
Based on amount outstanding at month end during each year.
The Bank is a member of the FHLB. Membership requirements include common stock ownership in the FHLB. At December 31, 2006, the FHLB advances have various call provisions ranging from nine months to two years. The Company acquired $5.0 million in FHLB advances in the Royal American merger. These advances are used as a supplemental source of funds. The Bank is currently in compliance with the FHLB’s membership requirements.
The following table sets forth categories and the balances of the Company’s FHLB advances as of the indicated dates or for the indicated periods.
(1)
Based on amount outstanding at month end during each year.
(2)
Includes the impact of the interest rate swaps and purchase accounting adjustment for 2004. The purchase accounting adjustment of $2.1 million reduced the weighted average interest rate from 4.08% to 3.05%.
The following table sets forth categories and balances of the Company’s short-term or revolving lines of credit borrowings from correspondent banks as of the indicated dates or for the indicated periods.
(1)
Based on amount outstanding at month end during each year.
The Company has a credit agreement with a correspondent bank, which provides the Company with a revolving line of credit with a maximum of $50.0 million. This revolving line of credit matures on March 23, 2007.
The Company had $65.8 million in junior subordinated debentures owed to unconsolidated trusts that were formed to issue trust preferred securities. The Company acquired $10.3 million in junior subordinated debt owed to unconsolidated trust through Royal American. The following table details the five unconsolidated trusts and their common and trust preferred securities:
Capital Resources
The Company monitors compliance with bank and bank-holding company regulatory capital requirements, focusing primarily on risk-based capital guidelines. Under the risk-based capital method of capital measurement, the ratio computed is dependent upon the amount and composition of assets recorded on the balance sheet and the amount and composition of off-balance-sheet items, in addition to the level of capital. Included in the risk-based capital method are two measures of capital adequacy: Tier 1, or core capital, and total capital, which consists of Tier 1 plus Tier 2 capital. See “Business - Supervision and Regulation - Bank Holding Company Regulation” for definitions of Tier 1 and Tier 2 capital.
The following tables set forth the Company’s capital ratios as of the indicated dates.
In July 2006, the Company issued 2,865,933 of common shares as a result of the Royal American merger increasing capital by $63.8 million. In August 2005, the Company issued 3,450,000 new common shares through a public offering raising a net amount of new capital of $67.9 million. The Company includes $64.0 million for 2006, $54.0 million for 2005, and $51.3 million for 2004 of trust preferred securities in Tier I capital based on regulatory limitations.
Liquidity
The Company manages its liquidity position with the objective of maintaining sufficient funds to respond to the needs of depositors and borrowers and to take advantage of earnings enhancement opportunities. At December 31, 2006, the Company had cash and cash equivalents of $100.5 million. In addition to the normal inflow of funds from its securities portfolio, and repayments and maturities of loans and securities, the Company utilizes other short-term, intermediate-term and long-term funding sources such as securities sold under agreements to repurchase, overnight funds purchased from correspondent banks and the acceptance of short-term deposits from public entities.
The FHLB provides an additional source of liquidity which has been used by the Bank extensively since 1999. The Bank also has various funding arrangements with commercial and investment banks in the form of Federal funds lines, repurchase agreements, and brokered and public funds certificate of deposit programs. The Bank maintains these funding arrangements to achieve favorable costs of funds, manage interest rate risk, and enhance liquidity in the event of deposit withdrawals. The repurchase agreements and public funds certificate of deposit are subject to the availability of collateral. The Company believes it has sufficient liquidity to meet its current and future liquidity needs.
The Company monitors and manages its liquidity position on several levels, which vary depending upon the time period. As the time period is expanded, other data is factored in, including estimated loan funding requirements, estimated loan payoffs, securities portfolio maturities or calls, and anticipated depository buildups or runoffs.
The Company classifies the majority of its securities as available-for-sale, thereby maintaining significant liquidity. Certain available-for-sale securities were temporarily impaired at December 31, 2006, primarily due to changes in interest rates. The Company has both the intent and ability to hold each of the temporarily impaired securities for the time necessary to recover its amortized cost. See Note 5 to the Notes to the audited consolidated financial statements for more details. The Company’s liquidity position is further enhanced by the structuring of a majority of its loan portfolio interest payments as monthly and also by the representation of residential mortgage loans in the Company’s loan portfolio.
The Company’s cash flows are composed of three classifications: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. See Statement of Cash Flows in the Consolidated Financial Statements.
Contractual Obligations, Commitments, and Off-Balance Sheet Arrangements
The following table details the amounts and expected maturities of significant commitments as of December 31, 2006.
Asset/Liability Management
The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and other securities) that are primarily funded by interest-bearing liabilities (deposits and borrowings). All of the financial instruments of the Company as of December 31, 2006 were held for other-than-trading purposes. Such financial instruments have varying levels of sensitivity to changes in market rates of interest. The Company’s net interest income is dependent on the amounts of and yields on its interest-earning assets as compared to the amounts of and rates on its interest-bearing liabilities. Net interest income is therefore sensitive to changes in market rates of interest.
The Company’s asset/liability management strategy is to maximize net interest income while limiting exposure to risks associated to changes in interest rates. This strategy is implemented by the Company’s ongoing analysis and management of its interest rate risk. A principal function of asset/liability management is to coordinate the levels of interest-sensitive assets and liabilities to manage net interest income fluctuations within limits in times of fluctuating market interest rates.
Interest rate risk results when the maturity or repricing intervals and interest rate indices of the interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments are different, thus creating a risk that will result in disproportionate changes in the value of and the net earnings generated from the Company’s interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments. The Company’s exposure to interest rate risk is managed primarily through the Company’s strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. Because the Company’s primary source of interest-bearing liabilities is customer deposits, the Company’s ability to manage the types and terms of such deposits may be somewhat limited by customer maturity preferences in the market areas in which the Company operates. Over the past few years, several hundred new bank branches have opened in the Company’s marketplace. Deposit pricing is competitive with promotional rates frequently offered by competitors. Ongoing competition for core and time deposits are driving up yields paid. Borrowings, which include FHLB advances, short-term borrowings, and long-term borrowings, are generally structured with specific terms which, in management’s judgment, when aggregated with the terms for outstanding deposits and matched with interest-earning assets, reduce the Company’s exposure to interest rate risk. The rates, terms, and interest rate indices of the Company’s interest-earning assets result primarily from the Company’s strategy of investing in securities and loans (a substantial portion of which have adjustable rate terms). This permits the Company to limit its exposure to interest rate risk, together with credit risk, while at the same time achieving a positive interest rate spread from the difference between the income earned on interest-earning assets and the cost of interest-bearing liabilities.
Management uses a duration model for the Bank’s internal asset/liability management. The model uses cash flows and repricing information from loans and certificate of deposits, plus repricing assumptions on products without specific repricing dates (e.g., savings and interest-bearing demand deposits), to calculate the durations of the Bank’s assets and liabilities. Securities are stress tested, and the theoretical changes in cash flow are key elements of the Company’s model. The model also projects the effect on the Company’s earnings and theoretical value for a change in interest rates. The model computes the duration of the Bank’s rate sensitive assets and liabilities, a theoretical market value of the Bank’s rate sensitive assets and liabilities and the effects of rate changes on the Bank’s earnings and market value. The Bank’s exposure to interest rates is reviewed on a monthly basis by senior management and the Company’s Board of Directors.
Effects of Inflation
Interest rates are significantly affected by inflation, but it is difficult to assess the impact, since neither the timing nor the magnitude of the changes in the various inflation indices coincide with changes in interest rates. Inflation does impact the economic value of longer term, interest-earning assets and interest-bearing liabilities, but the Company attempts to limit its long-term assets and liabilities, as indicated in the tables set forth under “Financial Condition” and “Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
The Company performs a net interest income analysis as part of its asset/liability management practices. Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% and 2.0% increases and 1.0% and 2.0% decreases in market interest rates. The tables below present the Company’s projected changes in net interest income for the various rate shock levels at December 31, 2006 and 2005, respectively.
For instance, as shown above at December 31, 2006, the effect of an immediate 200 basis point increase in interest rates would decrease the Company’s net interest income by 4.00%, or approximately $3.2 million. At December 31, 2005, the effect of an immediate 200 basis point increase in interest rates would increase the Company’s net interest income by 0.26%, or approximately $167,000. Overall net interest income sensitivity remains within the Company’s and recommended regulatory guidelines.
The changes in the Company’s net interest income sensitivity was due, in large part, to the addition of variable rate wholesale borrowings which will increase in the event interest rates rise, thereby increasing funding costs.
The change in net interest income over the one year horizon from December 31, 2006 compared to December 31, 2005 can be attributed, in large part, to increases in loans (which are primarily variable rate) and to changes in the composition of liabilities. During much of 2006, the competitive landscape of banking in Chicago resulted in certificate of deposit pricing that management believed to be significantly above-market. Rather than compete for higher-cost retail certificates of deposit, management chose to pursue funding options in the wholesale markets. These options were not only lower in cost, but allowed the Company to more precisely manage the rate and term structure of its funding liabilities. Throughout 2006, the Company continued to selectively offer special promotions to attract retail deposits as needed.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments, and deposit decay rates and repricing sensitivities, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from assumptions used in preparing the analyses. Interest bearing assets and liabilities are shocked +/− 100 and +/− 200 basis points instantaneously, except interest bearing core deposits, where they are modeled to increase 25 basis points in a +100 basis points shock and +50 basis points in a +200 basis point shock. Under a declining rate shock, they have a 25 basis point floor. Core deposits are priced off various internal indices set by management. Management will adjust the indices accordingly, depending on rate movement and market conditions. The master money market was de-coupled form the 91-day U.S. Treasury bill rate and is now priced off an internal index. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates.
“Gap” analysis is used to determine the repricing characteristics of the Company’s assets and liabilities. The following table sets forth the interest rate sensitivity of the Company’s assets and liabilities as of December 31, 2006, and provides the repricing dates of the Company’s interest-earning assets and interest-bearing liabilities as of that date, as well as the Company’s interest rate sensitivity gap percentages for the periods presented.
This chart shows that the Company is mismatched over the zero-to-12 month time horizon. That is, there were more liabilities repricing or maturing within these periods than assets repricing or maturing. The “Gap” position does not necessarily indicate the Company’s interest rate sensitivity or the impact to net interest income because interest-earning assets and interest-bearing liabilities are repricing off of different indices.
Mortgage-backed securities, including adjustable rate mortgage pools, are included in the above table based on their estimated principal paydowns obtained from outside analytical sources. Loans are included in the above table based on contractual maturity or contractual repricing dates. Deposits are based on management’s retention analysis of deposit balances.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates. These computations should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from assumptions used in preparing the analyses.
Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. The “Gap” analysis is based upon assumptions as to when assets and liabilities will reprice in a changing interest rate environment. Because such assumptions can be no more than estimates, certain assets and liabilities indicated as maturing or otherwise repricing within a stated period may, in fact, mature or reprice at different times and at different volumes than those estimated. Also, the renewal or repricing of certain assets and liabilities can be discretionary and subject to competitive and other pressures. Therefore, the gap table included above does not and cannot necessarily indicate the actual future impact of general interest rate movements on the Company’s net interest income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management.”
Item 8.
Item 8.
Consolidated Financial Statements and Supplementary Data
See “Consolidated Financial Statements” beginning on page.
Item 9.
Item 9.
Changes in and Disagreements With Independent Accountants On Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer of the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Company’s disclosure controls and procedures as of December 31, 2006 are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and such information is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). The Company’s internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. There are inherent limitations to the effectiveness of any control system. 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.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on management’s assessment, it determined that, as of December 31, 2006, the Company’s internal control over financial reporting is effective based on those criteria.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, has been audited by PricewaterhouseCoopers LLP, the independent registered public accounting firm who also audited the Company’s consolidated financial statements, as stated in their report included under Item 8.
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
Information regarding directors of the Company is included in the Company’s Proxy Statement for its 2007 Annual Meeting of Stockholders (the “Proxy Statement”) under the heading “Election of Directors” and the information included therein is incorporated herein by reference. Information regarding the executive officers of the Company is included in Item 1. Business of this report.
Information regarding compliance with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 by the Company’s directors and certain officers, and certain other owners of the Company’s common stock is included in the Company’s Proxy Statement under the heading “Section 16(a) Beneficial Ownership Compliance” and the information included therein is incorporated herein by reference.
Information regarding the Company’s director nomination procedures is included in the Company’s Proxy Statement under the heading “Director Nomination Procedures” and the information included therein is incorporated herein by reference.
Information regarding the Company’s audit committee is included in the Company’s Proxy Statement under the heading “Audit Committee” and the information included therein is incorporated herein by reference.
Information regarding the Company’s Code of Business and Conduct and Ethics is included in the Company’s Proxy Statement under the heading “Code of Business and Conduct and Ethics” and the information included therein is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation
Information regarding compensation of executive officers and directors is included in the Company’s Proxy Statement under the headings “Directors’ Compensation” and “Executive Compensation,” and the information included therein is incorporated herein by reference.
Information regarding the Company’s compensation committee interlocks is included in the Company’s Proxy Statement under the heading “Compensation Committee Interlocks and Insider Participation” and the information included therein is incorporated herein by reference.
Information regarding the report of the Company’s compensation committee is included in the Company’s Proxy Statement under the heading “Compensation Committee Report” and the information included therein is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information regarding equity compensation plan is included in the Company’s Proxy Statement under the heading “Equity Compensation Plan Information,” and the information included therein is incorporated herein by reference.
Information regarding security ownership of certain beneficial owners and management is included in the Company’s Proxy Statement under the headings “Security Ownership of Certain Beneficial Owners,” and the information included therein is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions
Information regarding certain relationships and related transactions is included in the Company’s Proxy Statement under the heading “Transactions with Certain Related Persons,” and the information included therein is incorporated herein by reference.
Information regarding the independence of the Company’s under its director independence standards is set forth in the Company’s proxy statement under the heading “Director Independence,” and the information included therein is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
Information regarding principal accountant fees and services is included in the Company’s Proxy Statement under the heading “Independent Accountant,” and the information included therein is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) (1) Index to Financial Statements
The consolidated financial statements of the Company and its subsidiaries as required by Item 8 of Form 10-K are filed as a part of this document. See “Contents of Consolidated Financial Statements” on page.
(a) (2) Financial Statement Schedules
All financial statement schedules as required by Item 8 and Item 15 of Form 10-K have been omitted because the information requested is either not applicable or has been included in the consolidated financial statements or notes thereto.
(a) (3) Exhibits
The following exhibits are either filed as part of this report or are incorporated herein by reference:
*
Indicates management contracts or compensatory plans or arrangements required to be filed as an exhibit.
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.
Midwest Banc Holdings, Inc.
By:
/s/ James J. Giancola
James J. Giancola
President and Chief Executive Officer
Date: March 15, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Each person whose signature appears below constitutes and appoints James J. Giancola and Daniel R. Kadolph his true and law attorneys-in-fact and agents, each acting alone, with full powers of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in order to effectuate the filing of such report, as fully for all intents and purposes as he might or could do in person, thereby ratifying and confirming all that said attorneys-in-fact and agents, and each of them, or his substitutes, may lawfully do or cause to be done by virtue hereof.
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED FINANCIAL STATEMENTS
CONTENTS
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
See accompanying notes to consolidated financial statements.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 -
Nature of Operations
Midwest Banc Holdings, Inc. (the “Company”) is a bank holding company organized under the laws of the State of Delaware. Through its commercial bank and non-bank subsidiaries, the Company provides a full line of financial services to corporate and individual customers located in the greater Chicago metropolitan area. These services include demand, time, and savings deposits; lending; mortgage banking; insurance products; and trust services. While the Company’s management monitors the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. The Company operates in one business segment, community banking, providing a full range of services to individual and corporate customers. The following disclosures are all related to continuing operations. The Company acquired Royal American Corporation effective July 1, 2006. See Note 3 - Business Combination for more details. The Company sold Midwest Bank of Western Illinois, one of its wholly owned subsidiaries, on September 30, 2005. This divestiture is accounted for in the accompanying financial statements as discontinued operations. See Note 4 - Discontinued Operations for more details.
Note 2 -
Summary of Significant Accounting Policies
Basis of Presentation: The consolidated financial statements of the Company include the accounts of the Company and its wholly owned subsidiaries, Midwest Bank and Trust Company (the “Bank”) and Midwest Financial and Investment Services, Inc.. Included in the Bank are its wholly owned subsidiaries Midwest Bank Insurance Services, L.L.C., MBTC Investment Company, Midwest Funding, L.L.C., and Royal American Investment Services, Inc. Significant intercompany balances and transactions have been eliminated.
Use of Estimates: The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change are the allowance for loan losses and the fair value of financial instruments and derivatives.
Cash and Cash Equivalents: Cash and cash equivalents includes cash, deposits with other financial institutions under 90 days, and federal funds sold. The Bank is required to maintain reserve balances in cash or on deposit with the Federal Reserve Bank, based on a percentage of deposits. The total of those reserve balances was approximately $24.0 million at December 31, 2006.
Securities: Securities are classified as held-to-maturity when the Company has the ability and the positive intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on disposition of securities available-for-sale are based on the net proceeds and the adjusted carrying amounts of the securities sold, using the specific identification method. Trading securities are carried at fair value. Realized and unrealized gains and losses on trading securities are recognized in the statement of income as they occur. No trading securities were held at December 31, 2006 or 2005. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Derivatives: The Company was involved in certain derivative transactions that are intended to protect the fair value of certain asset values and to improve the predictability of certain future transactions. If derivative instruments are designated as hedges of fair values, both the change in the fair value of the hedge and the hedged item are included in current earnings. Fair value adjustments related to cash flow hedges are recorded in other comprehensive income and reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of hedges are reflected in earnings as they occur.
Loans: Loans are reported net of the allowance for loan losses and deferred fees. Impaired loans are carried at the present value of expected future cash flows or the fair value of the related collateral, if the loan is considered to be collateral dependent. Interest on loans is included in interest income over the term of the loan based upon the principal balance outstanding. The accrual of interest on loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost, net of deferred loan fees, or estimated fair value in the aggregate.
Deferred Loan Fees and Costs: Loan origination fees and origination costs are deferred and amortized over the life of the loan as a yield adjustment.
Allowance for Loan Losses: The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Company’s methodology for determining the allowance for loan losses represents an estimation pursuant to SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of commercial, commercial real estate and agricultural loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect earnings or financial position in future periods.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization. Provisions for depreciation and amortization, included in operating expenses, are computed on the straight-line method over the estimated useful lives of the assets. The cost of maintenance and repairs is charged to income as incurred; significant improvements are capitalized.
Other Real Estate: Real estate acquired in settlement of loans is recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Expenditures that increase the fair value of properties are capitalized.
Cash Surrender Value of Life Insurance: The Company has purchased life insurance policies on certain executive and senior officers. Life insurance is recorded at its cash surrender value or the amount that can be realized.
Goodwill: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired net tangible assets and identifiable intangible assets. Goodwill is not amortized but assessed at least annually for impairment, and any such impairment is recognized in the period it is identified. There was no goodwill impairment as of December 31, 2006.
Other Intangibles: Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank, branch, and non-bank acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives.
Income Taxes: Deferred tax assets and liabilities are recognized for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities. Deferred taxes are recognized for the estimated taxes ultimately payable or recoverable based on enacted tax laws. Changes in enacted tax rates and laws are reflected in the financial statements in the periods they occur. Deferred tax assets are reduced by a valuation allowance when, in the judgment of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
Securities Sold Under Agreements to Repurchase: All securities sold under agreements to repurchase represent amounts advanced by various primary dealers. Securities are pledged to secure these liabilities.
Transfers of Financial Assets: Transfers of financial assets are accounted for as sales only when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Fair Value of Financial Instruments and Derivatives: Fair values of financial instruments, including derivatives, are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for the particular items. There is no ready market for a significant portion of the Company’s financial instruments. Accordingly, fair values are based on various factors relative to expected loss experience, current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment. As a consequence, fair values cannot be determined with precision. Changes in assumptions or in market conditions could significantly affect these estimates.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock Compensation: Employee compensation cost relating to share-based payment transactions, including grants of employee stock options, are measured at fair value and recognized in the financial statements as prescribed by SFAS No. 123(R), “Share-Based Payment.” The Company adopted SFAS No. 123(R) in 2006 using the modified prospective method. Employee compensation expense for stock options granted prior to adoption was recorded in the consolidated income statement based on the grant’s vesting schedule. Forfeitures of stock option grants are estimated for those stock options where the requisite service is not expected to be rendered. The grant-date fair value for each grant was calculated using the Black-Scholes option pricing model.
Comprehensive Income: Comprehensive income includes both net income and other comprehensive income elements, including the change in unrealized gains and losses on securities available-for-sale, net of tax.
Earnings Per Common Share: Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the year. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options and restricted stock awards. Earnings and dividends per share are restated for all stock splits and dividends through the date of issue of the financial statements.
Dividend Restriction: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to stockholders.
Reclassifications: Certain items in the prior year financial statements were reclassified to conform to the current year’s presentation. Such reclassifications had no effect on net income.
Accounting Pronouncements:
In December 2004, the Financial Accounting Standards Board (“FASB”) published Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“FAS 123(R)”). FAS 123(R) requires that the compensation cost relating to share-based payment transactions, including grants of employee stock options, be recognized in financial statements. That cost is measured based on the fair value of the equity or liability instruments issued. FAS 123(R) permits entities to use any option-pricing model that meets the fair value objective in FAS 123(R). Modifications of share-based payments are treated as replacement awards with the cost of the incremental value recorded in the financial statements. FAS 123(R) was effective at the beginning of the first quarter of 2006. Adoption and application of this statement did not have a material impact on the Company’s consolidated financial statements. See Note 19 - Stock Compensation and Restricted Stock Awards for more details.
In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in application of income tax law, providing a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax positions taken or expected to be taken in income tax returns. The Company will adopt FIN 48 in the first quarter of 2007 and has evaluated and concluded that the effect of the adoption of FIN 48 will not have a material impact on its consolidated financial position and results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements when the FASB has previously concluded in those pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption permitted. The Company has not yet determined the effect, if any, that the adoption of SFAS No. 157 will have on its results of operations or financial condition.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to provide guidance in the process of quantifying financial statement misstatements. SAB No. 108 requires registrants to quantify an error under both the rollover and iron curtain approaches. Consequently, a registrant’s financial statements would require adjustment when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. SAB No. 108 was effective for financial statements issued for fiscal years after November 15, 2006,. The adoption of SAB No. 108 did not have any impact on the Company’s results of operations or financial condition.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R),” which reconsiders the guidance in SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” and SFAS No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” SFAS No. 158 requires the recognition of a net liability or asset to report the funded status of defined benefit pension and other postretirement benefit plans on the statement of financial position. The adoption of SFAS No. 158 did not have any impact on the Company’s results of operations or financial condition.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115,” which creates a fair value option allowing an entity to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities, with changes in fair value recognized in earnings as they occur. SFAS No. 159 also requires an entity to report those financial assets and financial liabilities measured at fair value in a manner that separates those reported fair values from the carrying amounts of assets and liabilities measured using another measurement attribute on the face of the statement of financial position. Lastly, SFAS No. 159 requires an entity to provide information that would allow users to understand the effect on earnings of changes in the fair value on those instruments selected for the fair value election. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 (January 1, 2008 for the Company), with early adoption permitted. The Company is evaluating SFAS No. 159 to assess the impact on its results of operations or financial condition if an election was made to adopt the standard.
Note 3 -
Business Combination
On February 8, 2006, the Company, as part of its expansion strategy, entered into an agreement to acquire Royal American Corporation (“Royal American”), a bank holding company, in a cash and stock merger transaction. This transaction closed on June 30, 2006 with an effective date of July 1, 2006. At acquisition, Royal American had total assets of $561.2 million. The Company’s stock comprised approximately 50% of the purchase price, at an exchange ratio of 3.58429 shares of Company common stock for each Royal American common share, and the remainder was paid in cash at the rate of $80 for each share of Royal American common shares. The Company issued 2.9 million common shares, paid $64.6 million in cash, and incurred $795,000 in costs that were capitalized for a total purchase price of $129.2 million. Royal American was merged into the Company, thus canceling 100% of Royal American’s voting shares outstanding.
The acquisition of Royal American constitutes a business combination under SFAS No. 141, “Business Combinations,” and was accounted for using the purchase method. Accordingly, the purchase price was allocated to the respective assets acquired and liabilities assumed, based on their estimated fair values on the date of acquisition. The excess of purchase price over the fair value of net assets acquired was recorded as goodwill. The purchase price allocation has not been finalized and is subject to revision in future periods pending the filing of final tax returns for Royal American. The results of operations of Royal American have been included in the Company’s results of operations since July 1, 2006, the date of acquisition.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following are the adjustments made to record the transaction and to adjust Royal American’s assets and liabilities to their estimated fair values at July 1, 2006.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following are the assets acquired and liabilities assumed from Royal American at July 1, 2006 including the adjustments made to record the transaction and to adjust the assets and liabilities to their estimated fair values.
The following are the unaudited pro forma consolidated results of operations of the Company for the years ended December 31, 2006, 2005, and 2004 as though Royal American had been acquired as of January 1, 2004.
Included in the pro forma results of operations for the year ended December 31, 2006 were merger costs net of tax of $6.8 million.
Note 4 -
Discontinued Operations
The Company sold Midwest Bank of Western Illinois (“MBWI”), formerly one of its wholly owned subsidiaries, on September 30, 2005 for $32.0 million cash. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the results of operations of MBWI are shown in the
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Company’s consolidated statements of income for the years ended December 31, 2005 and 2004 as “discontinued operations.”
The results of discontinued operations were as follows (in thousands):
Note 5 -
Securities
The amortized cost and fair value of securities available-for-sale and held-to-maturity are as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following is a summary of the fair value of securities held-to-maturity and available-for-sale with unrealized losses and an aging of those unrealized losses:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(1)
Includes obligations of the Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA).
(2)
Includes obligations of the Government National Mortgage Association (GNMA).
(3)
Includes issues from government-sponsored entities (FNMA and FHLMC).
(1)
Includes obligations of the Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA).
(2)
Includes obligations of the Government National Mortgage Association (GNMA).
(3)
Includes issues from government-sponsored entities (FNMA and FHLMC).
Management does not believe any individual unrealized loss as of December 31, 2006, identified in the preceding table, represents other-than-temporary impairment. These unrealized losses are primarily attributable to changes in interest rates. The Company has both the intent and ability to hold each of the securities shown in the table for the time necessary to recover its amortized cost. The unrealized loss on available-for-sale securities is included, net of tax, in other comprehensive income.
•
The unrealized loss for U.S. government-sponsored entities mortgage-backed securities relate primarily to debt securities issued by FNMA and FHLMC; each security has a stated maturity date. FNMA is rated Aa3, AA- and A+ by Moody’s, S&P and Fitch, respectively. FHLMC is rated Aa3 and AA- by Moody’s and Fitch, respectively. The mortgage-backed securities are notes with a weighted average maturity of approximately 23 years and a weighted average interest rate of 4.99%.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
The unrealized losses on corporate and other debt securities relate to securities which were rated A- or better by either Moody’s or S&P. These debt securities have a weighted average maturity of approximately 7 years and a weighted average interest rate of 4.73%.
Securities with an approximate carrying value of $489.5 million and $385.9 million at December 31, 2006 and 2005 were pledged to secure public deposits, borrowings, and for other purposes as required or permitted by law. Included in securities pledged at December 31, 2006 and 2005 are $213.4 million and $37.8 million, respectively, which have been pledged for FHLB borrowings.
The amortized cost and fair value of securities by contractual maturity at December 31, 2006 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of securities available-for-sale and the realized gross gains and losses are as follows:
See Note 20 - Derivative Instruments for further discussion of the fair value hedge and hedge ineffectiveness.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 6 -
Loans
Major classifications of loans are summarized as follows:
Note 7 -
Allowance for Loan Losses
The following is a summary of changes in the allowance for loan losses:
A portion of the allowance for loan losses is allocated to impaired loans. Information with respect to impaired loans and the related allowance for loan losses is as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Interest payments on impaired loans are generally applied to principal, unless the loan principal is considered to be fully collectible, in which case interest is recognized on a cash basis.
Nonaccrual loans were $42.8 million and $7.9 million as of December 31, 2006 and 2005, respectively. Loans past due 90 days but still accruing were $34,000 and $4,000 as of December 31, 2006 and 2005, respectively.
Note 8 -
Premises and Equipment
Premises and equipment are summarized as follows:
Note 9 -
Goodwill and Intangibles
The following table presents the carrying amount and accumulated amortization of intangible assets (in thousands):
Core deposit and other intangibles increased by $10.5 million as of July 1, 2006 due to the Royal American acquisition. The amortization of intangible assets was $1.0 million for the year ended December 31, 2006. At December 31, 2006, the projected amortization of intangible assets is $1.6 million for the years ending December 31, 2007 and 2008, $1.5 million for the years ending December 31, 2009 and 2010, $1.0 million for the year ending December 31, 2011, and $4.1 million in total for the subsequent years.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents the changes in the carrying amount of goodwill and other intangibles during the years ended December 31, 2006 and 2005 (in thousands):
Note 10 -
Income Taxes
The provision for income taxes from continuing operations consists of the following:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The difference between the provision for income taxes in the consolidated financial statements and amounts computed by applying the current federal statutory income tax rate of 35% to income before income taxes is reconciled as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The net deferred tax asset, included in other assets in the accompanying consolidated balance sheets, consisted of the following components:
As of December 31, 2006 and 2005, the Company believes it is more likely than not that deferred tax assets will be realized and, therefore, no allowance was considered necessary.
Note 11 -
Securities Sold Under Agreements to Repurchase
The Company has repurchase agreements with brokerage firms, which are in possession of the underlying securities. The same securities are returned to the Company at the maturity of the agreements. The following summarizes certain information relative to these borrowings:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2006, securities sold under agreements to repurchase are summarized below:
Note 12 -
Advances from the FHLB
Advances from the FHLB are summarized as follows:
At December 31, 2006, the FHLB advances have various call provisions ranging from nine months to two years. Various securities are pledged as collateral as discussed in Note 5 - Securities. In addition, the Company has collateralized the advances with a blanket lien arrangement at December 31, 2006 and 2005.
Note 13 -
Junior Subordinated Debentures Owed
The Company had $66.0 million in junior subordinated debentures owed to unconsolidated trusts that were formed to issue trust preferred securities. The five trust preferred securities offerings were pooled private placements exempt from registration under the Securities Act pursuant to Section 4(2) thereunder. The Company has provided a full, irrevocable, and unconditional subordinated guarantee of the obligations of these trusts under the preferred securities. The Company is obligated to fund dividends on these securities before it can pay dividends on shares of its common stock.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table details the five unconsolidated trusts and their common and trust preferred securities:
Note 14 -
Employee Benefit Plans
The Company maintains a 401(k) salary reduction plan covering substantially all employees. Eligible employees may elect to make tax deferred contributions within a specified range of their compensation as defined in the plan. The Company contributes 1% more than the employee’s contribution up to a maximum 5% employer contribution. Contributions to the plan are expensed currently and were $812,000, $635,000, and $565,000 for the years ended December 31, 2006, 2005, and 2004, respectively.
The Company and various members of senior management have entered into a Supplemental Executive Retirement Plan (“SERP”). The SERP provides for guaranteed payments, based on a percentage of the individual’s final salary, for 15 years after age 65. The benefit amount is reduced if the individual retires prior to age 65. The liability is being accrued over the vesting period. Expense of $451,000, $343,000, and $1.5 million was recorded for the years ended December 31, 2006, 2005, and 2004 and has been included in salaries and employee benefits expense in the statements of income. Included in the $1.5 million for the year ended December 31, 2004 was $967,000 in expense for the Company’s former president and chief executive officer and $86,000 in accelerated benefit expense. Also included in the retirement benefit obligation for the former president and chief executive officer was severance and welfare benefits of $519,000 which was paid over 12 to 18 months commencing October 2004. These expenses were recognized in the year ended December 31, 2004.
The Company has purchased life insurance policies on various members of executive and senior management. The Company is the beneficiary of these life insurance policies, which have an aggregate death benefit of approximately $174.8 million at December 31, 2006. In addition, the policies had aggregate cash surrender values of approximately $65.2 million at December 31, 2006 and $44.4 million at December 31, 2005.
Note 15 -
Time Deposits
Interest-bearing deposits in denominations of $100,000 and over were $553.7 million as of December 31, 2006 and $246.8 million as of December 31, 2005. Interest expense related to deposits in denominations of $100,000 and over was $16.8 million for 2006, $2.4 million for 2005, and $1.5 million for 2004.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Certificates of deposit have scheduled maturities for the years 2007 through 2011 and thereafter as follows:
Note 16 -
Related Party Transactions
Certain executive officers, directors, and their related interests are loan customers of the Bank. These loans were made under comparable terms as for non-related parties and were determined to be arms-length transactions. A summary of loans made by the Bank to or for the benefit of directors and executive officers is as follows:
Note 17 -
Capital Requirements
The Company and the Bank are subject to regulatory capital requirements administered by the federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, banks must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require banks and bank holding companies to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and Tier 1 capital to average assets. If a bank does not meet these minimum capital requirements, as defined, bank regulators can initiate certain actions that could have a direct material effect on the bank’s financial statements. Management believes that, as of December 31, 2006 and 2005, the Company and the Bank met all capital adequacy requirements to which they were subject.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2006, the most recent Federal Deposit Insurance Corporation 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 institution’s categories. To be categorized as well capitalized, banks must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios. The actual capital amounts and ratios for the Company and the Bank are presented in the following table:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 18 -
Off-Balance-Sheet Risk and Concentrations of Credit Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet financing needs of customers. Since many commitments to extend credit expire without being used, the amounts below do not necessarily represent future cash commitments. These financial instruments include lines of credit, letters of credit, and commitments to extend credit. These are summarized as of December 31, 2006 as follows:
At December 31, 2006, commitments to extend credit included $9.2 million of fixed rate loan commitments. These commitments are due to expire within 30 to 90 days of issuance and have rates ranging generally from 6.50% to 8.25%. Substantially all of the unused lines of credit are at adjustable rates of interest.
In the normal course of business, the Company is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings as of December 31, 2006 would not have a material adverse effect on the Company’s financial position or results of operations.
Note 19 -
Stock Compensation and Restricted Stock Awards
Under the Company’s Stock and Incentive Plan (the “Plan”), officers, directors, and key employees may be granted incentive stock options to purchase the Company’s common stock at no less than 100% of the market price on the date the option is granted. Options can be granted to become exercisable immediately or in installments of 25% a year on each of the first through the fourth anniversaries of the grant date or may be issued subject to performance targets. In all cases, the options have a maximum term of ten years. The Plan also permits the issuance of nonqualified stock options, stock appreciation rights, restricted stock, and restricted stock units. The Plan authorizes a total of 3,900,000 shares for issuance. There are 2,053,750 shares remaining for issuance under the Plan at December 31, 2006. In the past, the Company has issued treasury shares in conjunction with the exercise of stock options or grants of restricted stock. Beginning in 2006, it became the Company’s policy to issue new shares of its common stock in conjunction with the exercise of stock options or grants of restricted stock.
During 2006, 151,894 employee stock options were exercised, of which 136,210 were exercised by individuals who were no longer employed with the Company. As a result of the exercises of employee stock options, the Company received $2.0 million in cash and realized a tax benefit of $571,000. Total employee stock options outstanding at December 31, 2006 were 517,048 with exercise prices ranging between $8.50 and $22.03 and expiration dates between 2007 and 2015. All options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. No stock options were granted during 2006.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Information about option grants follows:
Options exercisable at year end are as follows:
Options outstanding at December 31, 2006 were as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company adopted SFAS No. 123(R), “Share-Based Payment,” in the first quarter of 2006 using the modified prospective method. Employee compensation expense for stock options previously granted was recorded in the consolidated income statement based on the grant’s vesting schedule. Forfeitures of stock option grants are estimated for those stock options where the requisite service is not expected to be rendered. The grant-date fair value for each grant was calculated using the Black-Scholes option pricing model, using the following weighted-average assumptions as of grant date. The following table reflects the only two grants (those options granted in 2005 and 2003) included in employee compensation expense.
For the year ended December 31, 2006, employee compensation expense related to stock options was $264,000. The total compensation cost related to nonvested stock options not yet recognized was $76,000 at December 31, 2006 and the weighted average period over which this cost is expected to be recognized is 18 months.
No stock-based compensation cost is reflected in net income of periods prior to 2006. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.”
The pro forma compensation costs presented in this and prior filings for the Company have been calculated using a Black-Scholes option pricing model.
During the fourth quarter of 2005, the Compensation Committee of the Company’s Board of Directors approved the acceleration of vesting of certain unvested out-of-the-money stock options previously awarded to current employees, including executive officers, effective as of December 19, 2005. A stock option is considered out-of-the-money if the option exercise price is greater than the price per share of common stock traded on the NASDAQ National Market. Such actions were taken in accordance with the provisions of the Company’s Stock and Incentive Plan approved by the stockholders on May 18, 2005. Options relating to 93,875 shares, which were issued in July 2004, vested as a result of the acceleration on December 19, 2005. The primary purpose of accelerating the vesting of these options was to eliminate future compensation expense the Company otherwise would recognize in its consolidated income statement under the requirements of SFAS No. 123(R). The pro forma amount for 2005 in the table above includes $226,000, after-tax, relating to these options.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Under the Plan, officers, directors, and key employees may also be granted restricted shares of the Company’s common stock. Holders of restricted shares are entitled to receive cash dividends paid to the Company’s common stockholders and have the right to vote the restricted shares prior to vesting. The existing restricted share grants vest over a time period not exceeding five years and/or are subject to performance targets, which if achieved permit vesting after three years. Compensation expense for the restricted shares equals the market price of the related stock at the date of grant and is amortized on a straight-line basis over the vesting period assuming certain performance targets are met when applicable.
Information about restricted share grants follows:
For the year ended December 31, 2006, the Company recognized $2.2 million in compensation expense related to the restricted stock grants compared to $873,000 for the year ended December 31, 2005. The total compensation cost related to nonvested restricted shares not yet recognized was $7.7 million at December 31, 2006 and the weighted average period over which this cost is expected to be recognized is 27 months.
Note 20 - Derivative Instruments
As of December 31, 2006, the Company does not have any outstanding derivatives. In January 2005, the Company terminated U.S. Treasury 10-year note futures contracts with a notional value of $290.0 million at a gain of $336,000. The Company also terminated spread lock swap agreements with a notional value of $247.0 million in January 2005 at a loss of $425,000. The respective gain and loss on the futures contracts and spread lock swap agreements, all of which were stand-alone derivatives, were reflected in net trading profits. In the second quarter of 2005, the Company terminated interest rate swaps with a notional value of $121.5 million used to convert its FHLB advance fixed rate debt to floating rate debt. The resulting loss of $3.6 million was reflected in the loss on extinguishment of debt.
The Company has from time to time bought and sold various put and call options with terms less than 90 days on U.S. Treasury and government-sponsored entities obligations, mortgage-backed securities, and futures contracts during 2005 and 2004. These were stand-alone derivatives that were carried at their estimated fair value with the corresponding gain or loss recorded in net trading profits or losses.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 21 - Parent Company Financial Statements
The following are condensed balance sheets and statements of income and cash flows for the Company, without subsidiaries:
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF INCOME
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 22 - Earnings Per Share
(1)
No dilutive shares from stock options or restricted stock were included in the computation of diluted earnings per share for any period there was a loss from continuing or discontinued operations.
Options to purchase 92,500 shares at $22.03 and 120,000 shares at $22.03 were not included in the computation of diluted earnings per share for the years ended December 31, 2005 and 2004, respectively, because the options’ exercise price was greater than the average market price of the common stock and the options were, therefore, antidilutive.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 23 - Other Comprehensive Income
Changes in other comprehensive income or loss components and related taxes are as follows:
Note 24 - Quarterly Results of Operations (Unaudited)
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(a)
Earnings per share for the quarters and fiscal years have been calculated separately. Accordingly, quarterly amounts may not add to the annual amounts because of differences in the average common shares outstanding during each period.
Note 25 - Fair Value of Financial Instruments
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The methods and assumptions used to determine fair values for each class of financial instrument are presented below.
The carrying amount is equivalent to the estimated fair value for cash and cash equivalents, federal funds purchased, FHLB stock, accrued interest receivable and payable, due from and to broker, demand deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully. The fair value of securities and derivatives, including swaps, are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the item or information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, and securities sold under agreements to repurchase, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. The fair value of fixed rate debt is based on current rates for similar financing. The fair value of off-balance-sheet items, loan commitments, is not material.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The estimated fair values of the Company’s financial instruments were as follows:
The remaining other assets and liabilities of the Company are not considered financial instruments and are not included in the above disclosures.
There is no ready market for a significant portion of the Company’s financial instruments. Accordingly, fair values are based on various factors relative to expected loss experience, current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment and, therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect these estimated values.
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors of Midwest Banc Holdings, Inc:
We have completed an integrated audit of Midwest Banc Holdings, Inc.’s 2006 and 2005 consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Midwest Banc Holdings, Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements 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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting under Item 9A, that the Company maintained effective 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 (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’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 opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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. An audit of internal control over financial reporting includes 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 consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
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 (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) 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 (iii) 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.
PRICEWATERHOUSECOOPERS LLP
Chicago, Illinois
March 15, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON THE FINANCIAL STATEMENTS
To the Stockholders and Board of Directors
Midwest Banc Holdings, Inc.
Melrose Park, Illinois
We have audited the accompanying consolidated statement of income, stockholders’ equity, and cash flow of Midwest Banc Holdings, Inc. the for the year ended December 31, 2004. 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 consolidated financial statements referred to above present fairly, in all material respects, the results of its operations and its cash flows of Midwest Banc Holdings, Inc. for the year ended December 31, 2004 in conformity with U.S. generally accepted accounting principles.
MCGLADREY & PULLEN, LLP
Schaumburg, Illinois
February 25, 2005, except as to the discontinued operations referred to in
Note 4, as to which the date is March 15, 2006.