ITEM 1. BUSINESS
GENERAL
CFS Bancorp, Inc. (the "Company") was organized in March 1998 at the direction of the Board of Directors of Citizens Financial Services, FSB (the "Bank" or "Citizens Financial") for the purpose of holding all of the capital stock of the Bank and in order to facilitate the conversion of the Bank from a federally-chartered mutual savings bank to a federally-chartered stock savings bank (the "Conversion"). (Unless the context otherwise requires, reference to the Company includes the Bank and the Bank's subsidiaries). In connection with the Conversion, the Office of Thrift Supervision (the "OTS") approved the Company's application to become a savings and loan holding company. The Company now conducts business as a registered unitary savings and loan holding company and is subject to oversight and examination by the OTS. See "Regulation - Regulation of Savings and Loan Holding Companies."
Immediately after the Conversion, on July 24, 1998, SuburbFed Financial Corp., a Delaware corporation with its principal place of business in Illinois ("SFC"), merged with and into the Company (the "Merger"). In connection with the Merger, each outstanding share of SFC common stock, par value $0.01 per share, was converted into the right to receive 3.6 shares of the Company's Common Stock. The Conversion and the Merger were interdependent transactions. The Merger was accounted for on a pooling-of-interests basis and, as such, all financial data in this report includes the assets and the liabilities of the Company and SFC and their subsidiaries on a combined basis.
The Company's assets consist of the outstanding shares of common stock of the Bank, investments made with the portion of the net proceeds from the sale of Company shares in the
Company's July 1998 initial public offering (which was undertaken in conjunction with the Conversion) (the "Offering") retained by the Company, and the Company's loan to the Bank for the employee stock ownership plan (the "ESOP"). The Company has no significant liabilities. The management of the Company and the Bank are substantially identical, and the Company neither owns nor leases any property but instead uses the premises, equipment and furniture of the Bank. The Company does not employ any persons other than officers who are also officers of the Bank. In addition the Company utilizes the support staff of the Bank from time to time. Additional employees may be hired as appropriate to the extent the Company expands or changes its business in the future.
Management believes that the holding company structure provides the Company and the Bank with additional flexibility to diversify its business activities through existing or newly-formed subsidiaries, or through acquisitions of other entities, including potentially other financial institutions and financial services related companies. Such expansion is subject to regulatory limitations and the Company's financial position. The activities of the Company have been funded by the portion of the net proceeds of the Offering which was retained by the Company and earnings thereon, as well as dividends from the Bank.
The Bank is subject to examination and comprehensive regulation by the OTS, which is the Bank's chartering authority and primary federal regulator. The Bank is also regulated by the Federal Deposit Insurance Corporation (the "FDIC"), administrator of the Savings Association Insurance Fund (the "SAIF"). The Bank is also subject to certain reserve requirements established by the Board of Governors of the Federal Reserve System (the "FRB") and is a member of the Federal Home Loan Bank (the "FHLB") of Indianapolis, which is one of the 12 regional banks comprising the FHLB System.
Citizens Financial is a federally-chartered stock savings bank that was originally organized in 1934. The Bank conducts its business from its executive offices and an insurance and investment center, both in Munster, Indiana, as well as 22 banking centers located in Lake and Porter Counties in northwest Indiana and Cook, DuPage and Will Counties in Illinois. At December 31, 2001, the Company had $1.6 billion in total assets, $946.0 million in deposits, $462.7 million in borrowed funds and $171.3 million of stockholders' equity. The Bank is primarily engaged in attracting deposits from the general public and using those funds to originate loans and invest in securities. During 1998 the Bank began leveraging its capital base, using borrowings to provide additional funds to support its lending and investing activities. Historically, the Bank's primary lending emphasis was on loans secured by the first liens on single-family (one-to four-units) residential properties located in northwest Indiana and southeastern Cook County, Illinois. However, the Bank decided not to participate aggressively in the substantial refinancing of home loans that occurred nationally in 2001 due to record low interest rates. Instead the Banks' strategy was to accumulate liquidity in order to take advantage of loans and other investments that would become available as the economy improved and interest rates rose to expected higher levels.
The Bank also originated construction and land development loans, multi-family residential real estate loans, commercial real estate loans, home equity loans and other loans. Since 1998, the Bank has shifted its lending emphasis, increasing its involvement in construction and land development loans and commercial and multi-family real estate loans while concurrently reducing its originations of single-family residential loans.
MARKET AREA AND COMPETITION
Citizens Financial operates out of its headquarters in Munster, Indiana, which is located in Lake County in northwest Indiana. Citizens Financial also maintains an insurance and investment center in Munster and 22 banking centers in Lake and Porter Counties in northwest Indiana and in Cook, DuPage and Will Counties in Illinois. The areas served by Citizens Financial are part of the Chicago Metropolitan Statistical Area.
Citizens Financial has historically concentrated its efforts in the market surrounding its offices. Citizens Financial's market area reflects diverse socioeconomic factors. Traditionally, the market area in northwest Indiana and the suburban areas south of Chicago were dependent on heavy manufacturing. While manufacturing still is an important component of the local economies, service-related industries have become increasingly significant to the region in the last decade. Growth in the local economies can be expected to occur largely as a result of the continued interrelation with Chicago as well as suburban business centers in the area.
The Bank faces significant competition both in making loans and in attracting deposits. The Chicago metropolitan area is one of the largest money centers in the United States, and the market for deposit funds is highly competitive. The Bank's competition for loans comes principally from commercial banks, other savings banks, savings associations and mortgage-banking companies. The Bank's most direct competition for deposits has historically come from savings banks, commercial banks and credit unions. The Bank faces additional competition for deposits from short-term money market funds and other corporate and government securities funds and from other non-depository financial institutions such as brokerage firms and insurance companies.
LENDING ACTIVITIES
GENERAL. At December 31, 2001, the Company's net loans amounted to $883.4 million or 55.1% of the Company's total assets at such date. In addition to loans secured by single-family residential real estate, the Bank's mortgage loan portfolio at December 31, 2001 includes loans secured by multi-family (over four units) residential properties, which amounted to $51.6 million or 5.6% of the total loan portfolio, construction and land development loans, which totaled $119.8 million or 13.1% of the total loan portfolio, loans secured by commercial real estate, which amounted to $142.7 million or 15.6% of the loan portfolio, and home equity loans, which totaled $41.4 million or 4.5% of the total loan portfolio. In addition to mortgage loans, the Bank originates various other loans which, at December 31, 2001, amounted to $26.1 million, or 2.8% of the loan portfolio. Included in this total were $24.0 million of commercial loans and $2.1 million of consumer loans.
The types of loans that the Bank may originate are subject to federal and state law and regulations. Interest rates charged by the Bank on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and the rates offered by its competitors. These factors are, in turn, affected by general and economic conditions, the monetary policy of the federal government, including the Federal Reserve Board, legislative tax policies and governmental budgetary matters.
LOAN PORTFOLIO COMPOSITION. The following table sets forth the composition of the Bank's loans at the dates indicated.
CONTRACTUAL PRINCIPAL REPAYMENTS AND INTEREST RATES. The following table sets forth scheduled contractual amortization of the Bank's loans at December 31, 2001, as well as the dollar amount of such loans which are scheduled to mature after one year which have fixed or adjustable interest rates. Demand loans, loans having no schedule of repayments and no stated maturity and overdraft loans are reported as due in one year or less.
Principal Repayments Contractually Due In Year(s) Ended December 31, -------------------------------------------------- Total at December 31, 2001 2002 2003-2006 Thereafter -------------------------------------------------- (In Thousands)
Mortgage loans:
Single-family residential $535,197 $ 2,256 $ 13,351 $519,590
Multi-family residential 51,635 484 21,980 29,171
Commercial real estate 142,663 5,814 37,277 99,572
Construction and land development 119,819 51,476 30,975 37,368
Home equity 41,416 2,334 22,964 16,118 Other loans: Commercial 23,996 16,188 5,546 2,262 Consumer 2,066 753 1,278 35 -------------------------------------------------- Total (1) $916,792 $ 79,305 $133,371 $704,116 ==================================================
(1) Of the $837.5 million of loan principal repayments contractually due after December 31, 2002, $298.2 million have fixed rates of interest and $539.3 million have adjustable rates of interest.
Scheduled contractual amortization of loans does not reflect the expected term of the Bank's loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current market rates of interest for mortgage loans are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are higher than current market rates as borrowers refinanced adjustable-rate and fixed-rate loans at lower rates. Under the latter circumstance, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates.
ACTIVITY IN LOANS. The following table shows the activity in the Bank's loans during the periods indicated.
The lending activities of Citizens Financial are subject to the credit policy established by the Bank's Board of Directors and management. Applications for mortgage and consumer loans are taken at all of the Bank's branch offices, while commercial loan officers take loan applications at the customers' offices. In addition, the Bank's business development officers call on individuals and businesses in the Bank's market area in order to solicit new loan originations as well as other banking relationships. All loan applications are forwarded to the Bank's credit administration offices for underwriting and approval. The Bank requires that a property
appraisal be obtained in connection with new mortgage loans. Citizens Financial requires that title insurance and hazard insurance be maintained on all security properties (except for home equity loans) and that adequate flood insurance be maintained if the property is within a designated flood plain.
Certain officers of the Bank have been authorized by the Board of Directors to approve loans up to certain designated amounts. The Asset/Liability Management Committee of Citizens Financial meets weekly and reviews all loans. The full Board of Directors of Citizens Financial is provided with a monthly report of all loans made in the period.
A federal savings bank generally may not make loans to one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus (or approximately $20.5 million in the case of the Bank at December 31, 2001), although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable securities. Generally, Citizens Financial's aggregate loans to one borrower and related entities have been well below the regulatory limits. As of December 31, 2001, Citizens Financial's two largest relationships with one borrower and related entities amounted to $21.5 million and $19.1 million, and all of the Bank's loans included in such relationships were performing in accordance with their terms. Both relationships were originated when the Bank's loans to one borrower limitation was greater than the current level of $20.5 million. The Bank currently has a policy of limiting any one loan or multiple loans to the same borrower to 75% of the legal limit.
SINGLE-FAMILY RESIDENTIAL AND HOME EQUITY LOANS. Substantially all of the Bank's single-family residential mortgage loans consist of conventional loans. Conventional loans are loans that are neither insured by the Federal Housing Administration ("FHA") or partially guaranteed by the Department of Veterans Affairs ("VA"). The vast majority of the Bank's single-family residential mortgage loans are secured by properties located in northwest Indiana and DuPage, Will and Cook County, Illinois. Historically, the Bank retained virtually all mortgage loans which it originated and did not engage in sales of residential mortgage loans. Beginning July 1, 1999, the Bank instituted a new policy and began selling its newly originated fixed-rate loans; such sales amounted to $5.9 million in 2001 and included the release of servicing. As of December 31, 2001, $535.2 million, or 58.4%, of the Bank's total loans consisted of single-family residential mortgage loans. Citizens Financial originated $23.5 million, $85.9 million and $164.3 million of single-family residential mortgage loans in 2001, 2000 and 1999, respectively. Although the Bank will continue to originate single-family residential mortgage loans, it anticipates construction and land development, commercial and commercial real estate and multi-family real estate loans will continue to increase as a percentage of total new loan originations as the Bank continues to implement its strategic plan.
Citizens Financial's residential mortgage loans have either fixed rates of interest or interest rates which adjust periodically during the term of the loan. Fixed-rate loans generally have maturities of 10, 15 or 30 years and are fully amortizing with monthly loan payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank's fixed-rate loans are generally originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies ("GSE's"), such as the
Federal Home Loan Mortgage Corporation ("Freddie Mac"), and other investors in the secondary market for mortgages. At December 31, 2001, $153.0 million, or 28.6%, of the Bank's single-family residential mortgage loans were fixed-rate loans. Substantially all of the Bank's single-family residential mortgage loans contain due-on-sale clauses, which permit the Bank to declare the unpaid balance to be due and payable upon the sale or transfer of any interest in the property securing the loan. The Bank enforces such due-on-sale clauses.
The adjustable-rate single-family residential mortgage ("ARM") loans currently offered by the Bank have interest rates which are fixed for the initial three or five years and are thereafter adjusted on an annual basis in accordance with a designated index such as one-year U.S. Treasury obligations adjusted to a constant maturity ("CMT"), plus a stipulated margin. The Bank's adjustable-rate single-family residential real estate loans generally have a cap of 2% on any increase or decrease in the interest rate at any adjustment date, and include a specified cap on the maximum interest rate over the life of the loan, which cap generally is 6% above the initial rate. From time to time, based on prevailing market conditions, the Bank may offer ARM loans with initial rates which are below the fully indexed rate. Such loans generally are underwritten based on the full indexed rate. The Bank's adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not permit any of the increased payment to be added to the principal amount of the loan, or so-called negative amortization. At December 31, 2001, $382.2 million or 71.4% of the Bank's single-family residential mortgage loans were adjustable-rate loans.
Adjustable-rate loans decrease the Bank's risks associated with changes in interest rates but involve other risks, primarily because as interest rates increase, the loan payment by the borrower increases to the extent permitted by the terms of the loan, thereby increasing the potential for default. Moreover, as with fixed-rate loans, as interest rates increase, the marketability of the underlying collateral property may be adversely affected by higher interest rates. Also, when interest rates decline substantially, borrowers tend to refinance into fixed rate loans. The Bank believes that these risks, which have not had a material adverse effect on the Bank to date, generally are less than the risks associated with holding fixed-rate loans in an increasing interest rate environment.
The volume and types of ARMs originated by Citizens Financial are affected by such market factors as the level of interest rates, competition, consumer preferences and availability of funds. Accordingly, although the Bank anticipates that it will continue to offer single-family ARMs, the increased emphasis over the past few years on originating more construction and land development and commercial and multi-family real estate loans has reduced the proportion that single-family residential loans bear to total loans.
The Bank's single-family residential mortgage loans generally do not exceed amounts limited to the maximum amounts contained in GSE guidelines. In addition, the maximum loan-to-value ("LTV") ratio for the Bank's single-family residential mortgage loans generally is 95% of the appraised value of the security property, provided, however, that private mortgage insurance generally is obtained on the portion of the principal amount that exceeds 80% of the appraised value.
At December 31, 2001, Citizens Financial's home equity loans amounted to $41.4 million, or 4.5%, of the Bank's total loans. The preponderance of the Bank's home equity loans are structured as fixed-rate, fixed-term loans, although the Bank also offers floating rate home equity lines of credit. Home equity loans, like single-family residential mortgage loans, are secured by the underlying equity in the borrower's residence. However, the Bank generally obtains a second mortgage position to secure its home equity loans. At December 31, 2001 the Bank was in a first mortgage position on a majority of the properties securing these loans. The Bank's home equity loans generally require LTV ratios of 80% or less after taking into consideration any first mortgage loan. The Bank originated $30.7 million, $19.1 million and $13.2 million of home equity loans in 2001, 2000 and 1999, respectively.
MULTI-FAMILY RESIDENTIAL AND COMMERCIAL REAL ESTATE LOANS. After the completion of the Conversion in July 1998, the Company increased its emphasis on the origination of commercial real estate loans, multi-family residential loans and construction and land development loans. In order to implement the Bank's strategy, the Bank has significantly increased the number of employees dedicated to multi-family residential and commercial real estate lending. Such loans often have interest rates that are adjustable or float based on the prime rate and generally have shorter terms to maturity and higher yields than the Bank's single-family residential mortgage loans. At December 31, 2001, Citizens Financial's multi-family residential mortgage loans and commercial real estate loans amounted to $51.6 million and $142.7 million, or 5.6% and 15.6%, respectively, of the Bank's total loan portfolio, as compared to $21.6 million and $39.0 million, or 2.8% and 5.2%, respectively, of the Bank's total loan portfolio at December 31, 1998.
The Bank's multi-family residential real estate loans are concentrated in northwest Indiana and DuPage, Will and Cook Counties, Illinois. The Bank originated $2.5 million of multi-family residential real estate loans in 2001 compared to $6.2 million and $13.9 million in 2000 and 1999, respectively.
The Bank's commercial real estate loans generally are secured by hotels, medical office facilities, churches, small office buildings, strip shopping centers and other commercial uses primarily located in the Bank's market area. The Bank's commercial real estate loans usually are less than $5.0 million and, as of December 31, 2001, the average size of the Bank's commercial real estate loans was approximately $660,000. The Bank originated $23.2 million of commercial real estate loans during the year ended December 31, 2001 compared to $31.0 million and $52.6 million, respectively, of commercial real estate loan originations in 2000 and 1999. As of December 31, 2001, the Bank's five largest commercial real estate and multi-family residential loan relationships were $21.5 million, $17.8 million, $12.9 million, $9.2 million and $9.1 million, all of which were performing in accordance with their terms.
The Bank's multi-family residential and commercial real estate loans generally are five-year, fixed-rate loans with an amortization period of up to 25 years and loan to value ratios of not more than 80%. Citizens Financial also originates adjustable-rate multi-family residential and commercial real estate loans. Generally, fees of between .5% and 1.0% of the principal loan balance are charged to the borrower upon closing. The Bank generally charges prepayment
penalties on commercial real estate and multi-family residential mortgage loans. The Bank generally obtains personal guarantees of the borrower's principals as additional security for any commercial real estate and multi-family residential loans.
Citizens Financial evaluates various aspects of commercial and multi-family residential real estate loan transactions in an effort to mitigate credit risk to the extent possible. In underwriting these loans, consideration is given to the stability of the property's cash flow history, future operating projections, current and projected occupancy, position in the market, location and physical condition. The Bank has also generally imposed a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of not less than 115% for commercial real estate loans and 110% for multi-family residential loans. The underwriting analysis also includes credit checks and a review of the financial condition of the borrower and guarantor, if applicable. An appraisal report is prepared by an independent appraiser commissioned by the Bank to substantiate property values for every commercial real estate and multi-family loan transaction. All appraisal reports are reviewed by the Bank prior to the closing of the loan.
Commercial real estate and multi-family residential lending entails substantially different risks when compared to single-family residential lending because such loans often involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower's business. These risks can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses, or other commercial space. The Bank attempts to minimize its risk exposure by limiting such lending to proven businesses, only considering properties with existing operating performance which can be analyzed, requiring conservative debt coverage ratios, and periodically monitoring the operation and physical condition of the collateral as well as the business occupying the property.
As of December 31, 2001, multi-family residential real estate loans totaling $36,000 were considered non-performing loans while $1.8 million, or 1.3% of its commercial real estate loans were considered non-performing.
CONSTRUCTION AND LAND DEVELOPMENT LOANS. As previously indicated, the Bank increased its emphasis on construction and land development loans in the second half of 1998. Historically, in the several years prior to the Bank's Conversion, the Bank had concentrated its construction lending efforts primarily on residential construction loans to local real estate builders, generally with whom it had an established relationship. The Bank also originated such loans to individuals for the construction of their residences. Commencing in the second half of 1998, the Bank expanded its efforts to originate construction loans for commercial real estate and multi-family residential properties. At December 31, 2001 the average size of construction loans for commercial real estate and multi-family residential properties was approximately $4.3 million. At December 31, 2001, construction and land development loans amounted to $119.8 million or 13.1% of the Bank's loan portfolio (including $24.5 million of loans in process). Of the Bank's construction and land development loans at December 31, 2001, $17.2 million were construction/permanent, single-family residential loans which loans, by their terms, convert to permanent mortgage loans upon the completion of construction. The Bank originated $63.0
million of construction and land development loans during 2001, compared to $91.5 million and $142.9 million of construction and land development loans in 2000 and 1999, respectively. This decrease resulted from a steady decline in loan approvals as the economy weakened and the Bank's credit standards were tightened. Of the $63.0 million of construction and land development loans originated in 2001, an aggregate of $50.1 million was for commercial real estate and multi-family residential construction loans. Of the Bank's commercial real estate and multi-family residential mortgage loans at December 31, 2001, $61.9 million were construction/permanent loans.
Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property by an independent appraiser approved by the Board of Directors. The Bank's staff, or a third-party contractor retained by Citizens Financial, also reviews and inspects each project at the commencement of construction and prior to every disbursement of funds during the term of the construction loan. Loan proceeds are disbursed after inspections of the project based on a percentage of completion.
The Bank originates land loans to local developers for the purpose of developing the land (i.e., roads, sewer and water) for sale. Such loans are secured by a lien on the property, are generally limited to 75% of the appraised value of the secured property and are typically made for a period of up to two years. The Bank requires monthly interest payments during the term of the loan. The principal of the loan is reduced as lots are sold and released. All of the Bank's land loans are secured by property located in its primary market area. In addition, the Bank generally obtains personal guarantees from the borrowers' principals.
The Bank's loan underwriting and processing procedures require that construction and development loans be reviewed by independent architects and engineers for verification of costs. Disbursements during the construction phase are based on regular on-site inspections and approved certifications. In the case of construction loans on commercial projects where the Bank provides the permanent financing, the Bank usually requires firm lease commitments on some portion of the property under construction from qualified tenants for all leases. In addition, the Bank limits both its residential and commercial construction lending to northwest Indiana and the Chicago-land area. The Bank's five largest construction and land development relationships were $17.2 million, $8.7 million, $6.2 million, $5.8 million and $4.3 million, all of which were performing in accordance with their terms.
Construction and development financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. The Bank's risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost (including interest) of construction. If the estimate of construction cost proves to be inaccurate, the Bank may need to advance funds beyond the amount originally committed to permit completion of the development. Construction and development loans generally are considered to be more difficult to evaluate and monitor than single-family residential mortgage loans. In addition, the Bank's commercial real estate and construction and development loans generally have larger principal balances than its single-family residential mortgage loans.
In evaluating any new originations of construction and development loans, the Bank generally considers evidence of the availability of permanent financing or a takeout commitment to the borrower, the reputation of the borrower and the contractor, the amount of the borrower's equity in the project, independent valuations and reviews of cost estimates, pre-construction sale and leasing information, and cash flow projections of the borrower. To reduce the risk inherent in such lending, on certain occasions the Bank also requires performance bonds in the amount of the construction contract, and it often obtains personal guarantees from the principals of the borrower.
As of December 31, 2001, $1.4 million, or 1.1% of Citizens Financial's construction and land development loans, were considered non-performing.
OTHER LOANS. Citizens Financial's other loans consist primarily of commercial loans, consumer loans and loans secured by deposit accounts. Included in the category of commercial loans are loans secured by business assets other than real estate, unsecured loans, and secured and unsecured operating lines of credit. As of December 31, 2001, Citizens Financial's other loans amounted to $26.1 million compared to $20.2 million and $17.9 million at December 31, 2000 and 1999, respectively. The Bank is not actively marketing its other loans and offers them primarily as a service to its existing customers.
ASSET QUALITY
GENERAL. All of the Bank's assets are subject to review under its classification system. Loans are periodically reviewed, and the classifications are reviewed by the Asset/Liability Management Committee of the Board of Directors on at least a quarterly basis. When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made 30 days after a payment is due. In most cases, deficiencies are cured promptly. If a delinquency continues, late charges are assessed and additional efforts are made to collect the past due payments. While the Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 90 days delinquent, the Bank institutes foreclosure or other proceedings, as necessary, to minimize any potential loss.
Loans are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. As a matter of policy, the Bank does not accrue interest on loans past due 90 days or more.
Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. Foreclosed assets are held for sale and such assets are carried at the lower of fair value minus estimated costs to sell the property, or cost (generally the balance of the loan on the property at the date of acquisition with any resulting losses being charged to the allowance for losses on loans). After the date of acquisition, all costs incurred in maintaining the property are expensed, and costs incurred for the
improvement or development of such property are capitalized up to the extent of their net realizable value.
DELINQUENT LOANS. The following table sets forth information concerning delinquent loans, at the dates indicated, in dollar amounts and as a percentage of each category of the Bank's loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans.
At December 31, ------------------------------------------------------- 2001 2000 1999 ------------------------------------------------------- 60-89 Days 60-89 Days 60-89 Days Delinquent Delinquent Delinquent ------------------------------------------------------- Percent of Percent of Percent of Loan Loan Loan Amount Category Amount Category Amount Category ------------------------------------------------------- (Dollars in Thousands) Residential:
Single-family $ 3,593 0.68% $ 4,905 0.70% $ 5,108 0.77%
Multi-family 1,945 3.77 30 0.07 43 0.13
Commercial real estate 4,842 3.40 163 0.13 45 0.05
Construction and land
development 846 0.71 275 0.19 479 0.36
Home equity 257 0.62 288 1.40 20 0.13
Other:
Commercial 396 1.65 892 5.10 -- --
Consumer 29 1.41 65 2.39 113 2.68 ------------------------------------------------ Total $11,908 1.30% $ 6,618 0.63% $ 5,808 0.61% ================================================
Included in the category of 60-89 days delinquent commercial real estate loans for 2001 are two loans which have not previously been in this category. One loan for $2.5 million is secured by an office building which has been slow to reach the occupancy level necessary to support the cash flow levels as originally projected. Another loan for $2.0 million is secured by a restaurant. The borrower closed the restaurant but has been making partial payments and is pursuing the sale of this property to another restaurant. Included in the 60-89 day delinquent category of multi-family residential real estate for 2001 is an apartment complex with an unpaid balance of $1.8 million. This apartment complex is currently the subject of sale negotiations. Management of the Bank has not established specific reverses for any of these loans as they currently believe these loans to be fully collectible.
NON-PERFORMING AND UNDER-PERFORMING ASSETS. The following table sets forth information with respect to non-performing and certain under-performing assets identified by Citizens Financial, including non-accrual loans and other real estate owned. Citizens Financial had no accruing loans 90 days or more past due as to principal or interest at any of the below-referenced dates.
Included in single-family residential loans at December 31, 2001 are balances of $3.3 million more than were included at December 31, 2000. This increase is mainly attributed to a general slowdown in the economy. The Bank's historical experience with single-family residential real estate loans has been favorable, even in times of economic slowdown. As a result the Bank believes that any losses incurred with respect to these loans will be minimal.
The interest income that would have been recorded during the year ended December 31, 2001, if all of the Bank's non-performing loans at the end of such period had been current in accordance with their terms during such periods, was $879,491. The actual amount of interest recorded as income (on a cash basis) on such loans during the period amounted to $486,480.
CLASSIFIED AND CRITICIZED ASSETS. Federal regulations require that each insured institution classify its assets on a regular basis. Furthermore, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: "substandard," "doubtful" and "loss." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high probability of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Another category designated "special mention" also must be established and maintained for assets which have some identified weaknesses but do not currently expose an insured institution to a sufficient degree of risk to warrant classification as substandard, doubtful or loss. At December 31, 2001, Citizens Financial had an aggregate of $39.3 million of classified assets, 99.5% of which were classified substandard and .5% of which were classified as doubtful, compared to $14.9 million of classified assets as of December 31, 2000. The Bank hired an outside party to provide loan review procedures semi-annually on commercial loans and commercial real estate loans. One of the comments from this review pertained to the ongoing monitoring of commercial loans and commercial real estate loans. Additional personnel have been hired and/or reassigned to perform this monitoring function; however, until such monitoring and ongoing performance by the borrowers are at satisfactory levels, these loans will be classified as substandard or designated special mention as considered appropriate even though they are not delinquent.
ALLOWANCE FOR LOSSES ON LOANS. The Bank's policy is to establish allowances for estimated losses on delinquent loans when it determines that losses are expected to be incurred on such loans. The allowance for losses on loans is maintained at a level believed adequate by management to absorb losses inherent in the portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income. As shown in the table below, at December 31, 2001, the Bank's allowance for losses on loans amounted to $7.7 million or 55.2% and 0.86% of the Bank's non-performing loans and total loans receivable, respectively. The Bank's provision for losses on loans amounted to $1.2 million for the year ended December 31, 2001 and $3.4 million for 2000. While no assurance can be given that future charge-offs and/or additional provisions will not be necessary, management of the Company believes that, as of December 31, 2001, the allowance for losses on loans was adequate.
A savings institution's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Office of Thrift Supervision which can
order the establishment of additional general or specific loss allowances. The Office of Thrift Supervision, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on the allowance for loan and lease losses. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines. Generally, the policy statement recommends that institutions have effective systems and controls to identify, monitor and address asset quality problems; that management has analyzed all significant factors that affect the collectibility of the portfolio in a reasonable manner; and that management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. Our policy for establishing loan losses is consistent with the Office of Thrift Supervision's policy statement. In July 2001, the SEC issued Staff Accounting Bulletin ("SAB") No. 102, "Selected Loan Loss Allowance Methodology and Documentation Issues." The guidance contained in the SAB was effective immediately and focuses on the documentation the SEC staff normally expects registrants to prepare and maintain in support of the allowance for loan and lease losses. Concurrent with the SEC's issuance of SAB No. 102, the federal banking agencies, represented by the Federal Financial Institutions Examination Council ("FFIEC"), issued an interagency policy statement entitled "Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions" (Policy Statement). The SAB and Policy Statement were the result of an agreement between the SEC and the federal banking agencies in March 1999 to provide guidance on allowance for loan and lease losses methodologies and supporting documentation. There is no expected impact on earnings, financial condition, or stockholder's equity upon implementation of the SAB or FFIEC pronouncement.
The following table sets forth the activity in the Bank's allowance for loan losses during the periods indicated.
ALLOCATION OF THE ALLOWANCE FOR LOSSES ON LOANS. Management of the Bank determines the sufficiency of the allowance for losses on loans based upon its periodic assessment of the risk elements in its loan portfolio. Management of Citizens Financial utilizes analytical data as well as anticipated borrower performance in light of general economic conditions existing in the Bank's market area.
The determination of the adequacy of the allowance at December 31, 2001 and 2000 specifically considered various factors, including the increase in the Bank's balance of outstanding loans, in commercial real estate, construction and land development.
Citizens Financial will continue to monitor and modify its allowances for losses on loans as conditions dictate. While management believes that, based on information currently available, the Bank's allowance for loan losses is sufficient to cover losses inherent in its loan portfolio at this time, no assurance will be given that the Bank's level of allowance for losses on loans will be sufficient to absorb future loan losses incurred by the Bank or that future adjustments to the allowance for losses on loans will not be necessary if economic and other conditions differ substantially from the economic and other conditions used by management to determine the current level of the allowance for losses on loans. In addition, the OTS, as an integral part of its examination process, periodically reviews the Bank's allowance for loan losses. Such agency may require the Bank to make additional provisions for estimated loan losses based upon judgments different from those of management.
Commencing in 1998, the Bank began to allocate the allowance for losses on loans by loan category. Various percentages are assigned to the loan categories based on management's analysis of their relative risks. At December 31, 2001, 2000, 1999 and 1998, the allowance for losses on loans was allocated as follows:
INVESTMENT SECURITIES ACTIVITIES
GENERAL. As of December 31, 2001, the Company had an aggregate of $47.2 million of investment securities or 3.0% of its total assets at such date. At such date, the unrealized loss on the Company's investment securities available for sale amounted to $248,000, net of deferred income taxes.
The Company's investment securities consist primarily of callable agency securities, which amounted to $13.8 million, and commercial paper, which amounted to $19.3 million, at December 31, 2001. The Company attempts to maintain a high degree of liquidity in its other securities and generally does not invest in debt securities with estimated average lives in excess of 10 years. In recent years, the Company has purchased substantial amounts of callable agency securities, which are U.S. Government agency debt obligations, generally having a contractual term to maturity of 10 years. These securities may be called for redemption at predetermined dates (generally every three months) throughout their terms. During 1998 and the first half of 1999 virtually all of the Company's callable agency securities were called within one year of purchase. As interest rates rose during the second half of 1999 these agency securities were not called. This trend continued into 2000, with no securities being called until late in the year, when rates again began to decline. The trend to lower interest rates continued throughout 2001 with the Federal Reserve Board reducing rates eleven times. As of December 31, 2001, the contractual weighted average lives of the Company's investment securities was 1.5 years.
At December 31, 2001, $47.2 million of the Company's investment securities was classified as available for sale, and none were classified as held to maturity. Securities classified as available for sale are carried at fair value. Unrealized gains and losses on available for sale securities are recognized as direct increases or decreases in equity, net of applicable deferred income taxes. Securities which are classified as held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a method which approximates a level yield.
The investment policy of the Company, which has been established by the Board of Directors, is designed, among other things, to assist the Company in its asset/liability management policies. The Company's investment policy emphasizes principal preservation, favorable returns on investment, liquidity within designated guidelines, minimal credit risk, and flexibility. The Company's current investment policy permits investments in various types of securities including obligations of the U.S. Treasury and federal agencies, investment grade corporate obligations ("A" rated or better), trust preferred stocks, other equity securities, commercial paper, certificates of deposit, and federal funds sold to financial institutions approved by the Board of Directors.
The Company currently does not participate in hedging programs, interest rate swaps, or other activities involving the use of off-balance sheet derivative instruments.
The following table set forth information regarding the carrying and fair value of the Company's investment securities at the dates indicated.
None of the investment securities held at any of the above dates had adjustable rates.
The following table sets forth certain information regarding the maturities of the Company's callable agency securities, corporate bonds, commercial paper, trust preferred securities and asset- backed notes at December 31, 2001.
MORTGAGE-BACKED SECURITIES
GENERAL. At December 31, 2001, the Company's mortgage-backed securities included $313.2 million of mortgage participation certificates, collateralized mortgage obligations ("CMOs") and securities which qualified as real estate mortgage investment conduits ("REMICs"). At December 31, 2001 the unrealized gain on the Company's mortgage-backed securities available for sale amounted to $2.7 million, net of deferred income taxes. At December 31, 2001, $276.2 million of the Company's mortgage-backed securities were classified as available for sale, and $37.0 million were held to maturity. Securities classified as available for sale are carried at fair value. Unrealized gains and losses on available for sale
securities are recognized as direct increases or decreases in equity, net of applicable deferred income taxes. Securities which are held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a method which approximates a level yield.
The following table sets forth information regarding the carrying and fair value of the Company's mortgage-backed securities at the dates indicated.
At December 31, 2001, $28.7 million, or 9.2%, of the Company's mortgage-backed securities portfolio consisted of adjustable-rate securities, as compared to $26.6 million, or 7.4%, and $24.4 million, or 6.1%, at December 31, 2000 and 1999, respectively.
Participation certificates represent a participation interest in a pool of single-family or multi-family mortgages. The principal and interest payments on mortgage-backed securities are passed from the mortgage originators, as servicers, through intermediaries (generally U.S. Government agencies and government-sponsored enterprises) that pool and repackage the participation interests in the form of securities, to investors such as the Company. Such U.S. Government agencies and government sponsored enterprises, which guarantee the payment of principal and, in some cases, interest to investors, primarily include the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association and the Government National Mortgage Association.
REMICs are a form of CMOs which are also known as mortgage-backed securities. In contrast to pass-through mortgage-backed securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity. CMOs are typically issued by governmental agencies, government sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. At December 31, 2001 $126.5 million of the Company's REMICs were issued by government-related entities while $124.9 million were issued by other issuers.
SOURCE OF FUNDS
GENERAL. Deposits are the primary source of the Bank's funds for lending and other investment purposes. In addition to deposits, the Bank derives funds from loan principal repayments and prepayments and borrowings. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Prior to 1998 Citizens Financial did not utilize borrowings as a source of funds; however, beginning in 1998, given the Bank's asset size and interest rate environment, management began using borrowings to a greater extent.
DEPOSITS. Citizens Financial's deposit products include a broad selection of deposit instruments, including negotiable order of withdrawal ("NOW") accounts, money market accounts, noninterest-bearing checking accounts, passbook accounts and term certificate accounts. Deposit account terms may vary, with the principal differences being the minimum balance required, the time periods the funds must remain on deposit and the interest rate.
Citizens Financial utilizes traditional marketing methods to attract new customers and deposits. The Bank does not advertise for deposits outside of its market area. The Bank does not utilize the services of deposit brokers. The Bank traditionally has relied on customer service and convenience in marketing its deposit products. In addition, Citizens Financial generally has been competitive in the types of accounts and interest rates offered, and often it has been among the leaders in its market area on the rates paid on its deposits. In recent years, many depository institutions have experienced disintermediation of their deposits due, in part, to higher returns provided by competing investment products offered by non-depository institutions. Citizens Financial experienced a net decrease in deposits before interest credited of $24.6 million in 2001 and $29.7 million in 2000.
The following table sets forth the activity in the Bank's deposits during the periods indicated.
The following table sets forth the amount and remaining maturities of the Bank's certificates of deposit at December 31, 2001.
As of December 31, 2001, the aggregate amount of outstanding time certificates of deposit in amounts greater than or equal to $100,000 was $128.2 million. The following table presents the maturity of these time certificates of deposit at such dates.
December 31, 2001 ----------------- (In Thousands) 3 months or less $36,258 Over 3 months through 6 months 34,309 Over 6 months through 12 months 24,473 Over 12 months 33,172 -------- $128,212 ========
The following table sets forth the dollar amount of deposits and the percentage of total deposits in various types of deposits offered by the Bank at the dates indicated.
BORROWINGS
The following table sets forth certain information as to the Bank's FHLB advances and other borrowings at the dates indicated and the weighted average interest rates paid on borrowings for the years ended December 31, 2001, 2000 and 1999.
Refer to Note 9 Borrowed Money in the Consolidated Financial Statements for additional information related to Borrowings.
TRUST ACTIVITIES
The Company also provides fiduciary services through the Bank's Trust Department. Services offered include fiduciary services for trusts and estates and land trusts. As of December 31, 2001, the Trust Department maintained 62 trust/fiduciary accounts, with an aggregate principal balance of $3.2 million at such date. Revenue from the Trust Department for the year ended December 31, 2001 was $28,000.
The accounts maintained by the Trust Department consist of "managed" and "non-managed" accounts. "Managed accounts" are those accounts under custody for which the Bank has responsibility for administration and investment management and/or investment advice. "Non-managed" accounts are those accounts for which the Bank merely acts as a custodian. The Company receives fees dependent upon the level and type of service provided. The Trust Department administers various trust accounts (revocable and irrevocable trusts, and trusts under wills), estates and guardianships. Executive management of the department is provided by the Bank's Vice President and Corporate Counsel, subject to direction by the Trust Committee.
SUBSIDIARIES
The Bank currently has three active, wholly-owned subsidiaries, CFS Holdings, Ltd., CFS Insurance Agency, Inc. and CFS Investment Services, Inc.
CFS Holdings, Ltd. ("CFS Holdings") was approved by the Office of Thrift Supervision in January 2001 and was funded and began operations in June 2001. CFS Holdings is located in Hamilton, Bermuda. It was funded with approximately $140.0 million of the Bank's investments and performs a significant amount of the Bank's investment securities and mortgage-backed
securities investing activities. Certain of these activities are performed by a resident agent in Hamilton in accordance with the operating procedures and investment policy established for CFS Holdings by the Bank. Revenues of CFS Holdings were $4.2 million for the period from inception through December 31, 2001. Operating expenses of this operation for the seven months of 2001 were $34,892.
CFS Insurance Agency, Inc. ("CFS Insurance") is an independent insurance brokerage subsidiary which offers a full line of insurance products to the general public. CFS Insurance operates out of the Bank's Insurance/Investment Center in Munster, Indiana. The Bank has owned CFS Insurance since 1972. At December 31, 2001, CFS Insurance had 12 licensed insurance agents on its staff. CFS Insurance primarily sells property, casualty and life insurance products to individuals in the Bank's market area and has recently increased its efforts with respect to the sale of commercial insurance products (which generally have higher premiums). Revenues of CFS Insurance were $1.1 million, $902,000 and $883,00 in 2001, 2000 and 1999, respectively.
CFS Investments Services, Inc. ("CFS Investments") is primarily involved in the sale of mutual funds and other securities to members of the general public in the Bank's primary market area. CFS Investments commenced full service securities brokerage activities in 1994. At December 31, 2001, CFS Investments had 14 licensed securities brokers on staff. CFS Investments is affiliated with a registered securities broker-dealer which is responsible for supervision of CFS Investments and for execution of securities transactions. CFS Investments also offers fixed and variable annuities. In addition to its presence in the CFS Insurance/Investments Center, CFS Investments maintains offices in eight of the Bank's branches. CFS Investments had total commission revenue of $873,000 in 2001 and $1.4 million in each of the years ended 2000 and 1999.
EMPLOYEES
Citizens Financial had 351 full-time equivalent employees at December 31, 2001. None of these employees is represented by a collective bargaining agent, and the Bank believes that it enjoys good relations with its personnel.
REGULATION
REGULATION OF SAVINGS AND LOAN HOLDING COMPANIES
The Company is a registered savings and loan holding company. The Home Owners' Loan Act, as amended ("HOLA"), and OTS regulations generally prohibit a savings and loan holding company, without prior OTS approval, from acquiring, directly or indirectly, the ownership or control of any other savings association or savings and loan holding company, or all, or substantially all, of the assets or more than 5% of the voting shares thereof. These provisions also prohibit, among other things, any director or officer of a savings and loan holding company, or any individual who owns or controls more than 25% of the voting shares of such holding company, from acquiring control of any savings association not a subsidiary of such
savings and loan holding company, unless the acquisition is approved by the OTS. Certain Federal banking laws were amended in 1999. See "Financial Modernization."
Holding Company Activities. The Company currently operates as a unitary savings and loan holding company. Generally, there are limited restrictions on the activities of a unitary savings and loan holding company and its non-savings association subsidiaries. If the Company ceases to be a unitary savings and loan holding company, the activities of the Company and its non-savings association subsidiaries would thereafter be subject to substantial restrictions.
The HOLA requires every savings association subsidiary of a savings and loan holding company to give the OTS at least 30 days' advance notice of any proposed dividends to be made on its guarantee, permanent or other non-withdrawable stock, or else such dividend will be invalid.
Affiliate Restrictions. Transactions between a savings association and its "affiliates" are subject to quantitative and qualitative restrictions under Sections 23A and 23B of the Federal Reserve Act. Affiliates of a savings association include, among other entities, the savings association's holding company and companies that are under common control with the savings association.
In general, Sections 23A and 23B and OTS regulations issued in connection therewith limit the extent to which a savings association or its subsidiaries may engage in certain "covered transactions" with affiliates to an amount equal to 10% of the association's capital and surplus, in the case of covered transactions with any one affiliate, and to an amount equal to 20% of such capital and surplus, in the case of covered transactions with all affiliates. In addition, a savings association and its subsidiaries may engage in covered transactions and certain other transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the savings association or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A "covered transaction" is defined to include a loan or extension of credit to an affiliate; a purchase of investment securities issued by an affiliate; a purchase of assets from an affiliate, with certain exceptions; the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; or the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
In addition, under OTS regulations, a savings association may not make a loan or extension of credit to an affiliate unless the affiliate is engaged only in activities permissible for bank holding companies; a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary; a savings association and its subsidiaries may not purchase a low-quality asset from an affiliate; and covered transactions and certain other transactions between a savings association or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices. With certain exceptions, each loan or extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130% (depending on the type of collateral) of the amount of the loan or extension of credit.
The OTS regulation generally excludes all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except to the extent that the OTS or the Federal Reserve Board decides to treat such subsidiaries as affiliates. The regulation also requires savings associations to make and retain records that reflect affiliate transactions in reasonable detail and provides that certain classes of savings associations may be required to give the OTS prior notice of transactions with affiliates.
Financial Modernization. Under the Gramm-Leach-Bliley Act enacted into law on November 12, 1999, no company may acquire control of a savings and loan holding company after May 4, 1999, unless the company is engaged only in activities traditionally permitted for a multiple savings and loan holding company or newly permitted for a financial holding company under Section 4(k) of the Bank Holding Company Act. Existing savings and loan holding companies, such as the Company, and those formed pursuant to an application filed with the OTS before May 4, 1999 may engage in any activity including non-financial or commercial activities provided such companies control only one savings and loan association that meets the Qualified Thrift Lender test. Corporate reorganizations are permitted, but the transfer of grandfathered unitary holding company status through acquisition is not permitted.
REGULATION OF FEDERAL SAVINGS BANKS
As a federally insured savings bank, lending activities and other investments of the Bank must comply with various statutory and regulatory requirements. The Bank is regularly examined by the OTS and must file periodic reports concerning its activities and financial condition.
Although the OTS is the Bank's primary regulator, the FDIC has "backup enforcement authority" over the Bank. The Bank's eligible deposit accounts are insured by the FDIC under the SAIF, up to applicable limits.
Federal Home Loan Banks. The Bank is a member of the FHLB System. Among other benefits, FHLB membership provides the Bank with a central credit facility. The Bank is required to own capital stock in a FHLB in an amount equal to at least 1% of its aggregate unpaid residential mortgage loans, home purchase contracts and similar obligations at the beginning of each calendar year or 5% of its advances from the FHLB, whichever is greater.
Regulatory Capital Requirements. OTS capital regulations require savings banks to satisfy minimum capital standards: risk-based capital requirements, a leverage requirement and a tangible capital requirement. Savings banks must meet each of these standards in order to be deemed in compliance with OTS capital requirements. In addition, the OTS may require a savings association to maintain capital above the minimum capital levels.
All savings banks are required to meet a minimum risk-based capital requirement of total capital (core capital plus supplementary capital) equal to 8% of risk-weighted assets (which includes the credit risk equivalents of certain off-balance sheet items). In calculating total capital for purposes of the risk-based requirement, supplementary capital may not exceed 100% of core capital. Under the leverage requirement, a savings bank is required to maintain core capital equal
to a minimum of 3% of adjusted total assets. (In addition, under the prompt corrective action provisions of the OTS regulations, all but the most highly-rated institutions must maintain a minimum leverage ratio of 4% in order to be adequately capitalized.) A savings bank is also required to maintain tangible capital in an amount at least equal to 1.5% of its adjusted total assets.
These capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels well above the minimum. In addition, the OTS regulations provide that minimum capital levels higher than those provided in the regulations may be established by the OTS for individual savings associations, upon a determination that the savings association's capital is or may become inadequate in view of its circumstances. The OTS regulations provide that higher individual minimum regulatory capital requirements may be appropriate in circumstances where, among others: (1) a savings association has a high degree of exposure to interest rate risk, prepayment risk, credit risk, concentration of credit risk, certain risks arising from nontraditional activities, or similar risks of a high proportion of off-balance sheet risk; (2) a savings association is growing, either internally or through acquisitions, at such a rate that supervisory problems are presented that are not dealt with adequately by OTS regulations; and (3) a savings association may be adversely affected by activities or condition of its holding company, affiliates, subsidiaries or other persons or savings associations with which it has significant business relationships. The Bank is not subject to any such individual minimum regulatory capital requirement.
The Bank's tangible and core capital ratios were 8.48%, and its total risk-based capital ratio was 15.4% at December 31, 2001.
Certain Consequences of Failure to Comply with Regulatory Capital Requirements. A savings bank's failure to maintain capital at or above the minimum capital requirements may be deemed an unsafe and unsound practice and may subject the savings bank to enforcement actions and other proceedings. Any savings bank not in compliance with all of its capital requirements is required to submit a capital plan that addresses the bank's need for additional capital and meets certain additional requirements. While the capital plan is being reviewed by the OTS, the savings bank must certify, among other things, that it will not, without the approval of its appropriate OTS Regional Director, grow beyond net interest credited or make capital distributions. If a savings bank's capital plan is not approved, the bank will become subject to additional growth and other restrictions. In addition, the OTS, through a capital directive or otherwise, may restrict the ability of a savings bank not in compliance with the capital requirements to pay dividends and compensation, and may require such a bank to take one or more of certain corrective actions, including, without limitation: (i) increasing its capital to specified levels, (ii) reducing the rate of interest that may be paid on savings accounts, (iii) limiting receipt of deposits to those made to existing accounts, (iv) ceasing issuance of new accounts of any or all classes or categories except in exchange for existing accounts, (v) ceasing or limiting the purchase of loans or the making of other specified investments, and (vi) limiting operational expenditures to specified levels.
The HOLA permits savings banks not in compliance with the OTS capital standards to seek an exemption from certain penalties or sanctions for noncompliance. Such an exemption will be granted only if certain strict requirements are met and must be denied under certain
circumstances. If an exemption is granted by the OTS, the savings bank still may be subject to enforcement actions for other violations of law or unsafe or unsound practices or conditions.
Prompt Corrective Action. The prompt corrective action regulation of the OTS, promulgated under the Federal Deposit Insurance Corporation Improvement Act of 1991, requires certain mandatory actions and authorizes certain other discretionary actions to be taken by the OTS against a savings bank that falls within certain undercapitalized capital categories specified in the regulation. The regulation establishes five categories of capital classification: "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under the regulation, the ratio of total capital to risk-weighted assets, core capital to risk-weighted assets and the leverage ratio are used to determine an institution's capital classification. At December 31, 2001, the Bank met the capital requirements of a "well-capitalized" institution under applicable OTS regulations.
Enforcement Powers. The OTS and, under certain circumstances, the FDIC have substantial enforcement authority with respect to savings associations, including authority to bring various enforcement actions against a savings association and any of its "institution-affiliated parties" (a term defined to include, among other persons, directors, officers, employees, controlling stockholders, agents and stockholders who participate in the conduct of the affairs of the institution). This enforcement authority includes, without limitation, the ability to: (i) terminate a savings association's deposit insurance, (ii) institute cease-and-desist proceedings, (iii) bring suspension, removal, prohibition and criminal proceedings against institution-affiliated parties, and (iv) assess substantial civil money penalties. As part of a cease-and-desist order, the agencies may require a savings association or an institution-affiliated party to take affirmative action to correct conditions resulting from that party's actions, including making restitution or providing reimbursement, indemnification or guarantee against loss, restricting the growth of the institution, and rescinding agreements and contracts.
Capital Distribution Regulation. In January 1999, the OTS amended its capital distribution regulation to bring such regulations into greater conformity with the other bank regulatory agencies. Specifically, savings associations that would be well-capitalized following a capital distribution are not subject to any requirement for notice or application unless the total amount of all capital distributions, including any proposed capital distribution, for the applicable calendar year would exceed an amount equal to the savings bank's net income for that year to date plus the savings bank's retained net income for the preceding two years. However, because the Bank is a subsidiary of a savings and loan holding company, the Bank is required to give the OTS at least 30 days notice prior to any capital distribution to the Company.
Qualified Thrift Lender Test. In general, savings associations are required to maintain at least 65% of their portfolio assets in certain qualified thrift investments (which consist primarily of loans and other investments related to residential real estate and certain other assets). A savings association that fails the qualified thrift lender test is subject to substantial restrictions on activities and to other significant penalties. A savings association may qualify as a qualified thrift lender not only by maintaining 65% of portfolio assets in qualified thrift investments but also, in the alternative, by qualifying under the Internal Revenue Code as a "domestic building
and loan association." The Bank is a domestic building and loan association as defined in the Code.
FDIC Assessments. The deposits of the Bank are insured to the maximum extent permitted by the SAIF, which is administered by the FDIC, and are backed by the full faith and credit of the U.S. Government. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action.
Under FDIC regulations, institutions are assigned to one of three capital groups for insurance premium purposes -- "well-capitalized," "adequately capitalized" and "undercapitalized" -- which are defined in the same manner as the regulations establishing the prompt corrective action system, as discussed above. These three groups are then divided into subgroups which are based on supervisory evaluations by the institution's primary federal regulator, resulting in nine assessment classifications. Effective January 1, 1997, assessment rates for both SAIF-insured institutions and BIF-insured institutions ranged from 0% of insured deposits for well-capitalized institutions with minor supervisory concerns to .27% of insured deposits for undercapitalized institutions with substantial supervisory concerns. The Bank's deposit insurance premiums totaled $183,000 or .019% of its insured deposits for the year ended December 31, 2001.
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.
Community Reinvestment Act and the Fair Lending Laws. Savings institutions have a responsibility under the CRA and related regulations of the OTS to help meet the credit needs of their communities, including low and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act (together, the "Fair Lending Laws") prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution's failure to comply with the provisions of CRA could, at a minimum, result in regulatory restrictions on its activities, and failure to comply with the Fair Lending Laws could result in enforcement actions by the OTS, as well as other federal regulatory agencies and the Department of Justice.
Safety and Soundness Guidelines. The OTS and the other federal banking agencies have established guidelines for safety and soundness, addressing operational and managerial, as well as compensation matters for insured financial institutions. Institutions failing to meet these
standards are required to submit compliance plans to their appropriate federal regulators. The OTS and the other agencies have also established guidelines regarding asset quality and earnings standards for insured institutions.
Change of Control. Subject to certain limited exceptions, no company can acquire control of a savings association without the prior approval of the OTS, and no individual may acquire control of a savings association if the OTS objects. Any company that acquires control of a savings association becomes a savings and loan holding company subject to extensive registration, examination and regulation by the OTS. Conclusive control exists, among other ways, when an acquiring party acquires more than 25% of any class of voting stock of a savings association or savings and loan holding company, or controls in any manner the election of a majority of the directors of the company. In addition, a rebuttable presumption of control exists if, among other things, a person acquires more than 10% of any class of a savings association or savings and loan holding company's voting stock (or 25% of any class of stock) and, in either case, any of certain additional control factors exist.
Companies subject to the Bank Holding Company Act of 1956, as amended, that acquire or own savings associations are no longer defined as savings and loan holding companies under the HOLA and, therefore, are not generally subject to supervision and regulation by the OTS. OTS approval is no longer required for a bank holding company to acquire control of a savings association, although the OTS has a consultative role with the FRB in examination, enforcement and acquisition matters.
TAXATION
FEDERAL TAXATION
GENERAL. The Company and Citizens Financial are subject to federal income taxation in the same general manner as other corporations with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to the Bank. The Bank's federal income tax returns have been closed without audit by the IRS through 1996.
The Company will file consolidated tax returns with Citizens Financial. Accordingly, it is anticipated that any cash distributions made by the Company to its stockholders will be treated as cash dividends and not as a non-taxable return of capital to stockholders for federal and state tax purposes.
METHOD OF ACCOUNTING. For federal income tax purposes, Citizens Financial reports its income and expenses on the accrual method of accounting and uses a tax year ending December 31 for filing its consolidated federal income tax returns. The Small Business Protection Act of 1996 (the "1996 Act") eliminated the use of the reserve method of accounting for bad debts by large savings institutions, effective for taxable years beginning after 1995.
BAD DEBT RESERVES. Prior to the 1996 Act, the Bank was permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions could, within specified formula limits, be deducted in arriving at taxable income. As a result of the 1996 Act, large savings associations must use the specific chargeoff method in computing their bad debt deduction beginning with their 1996 Federal tax return. In addition, the federal legislation requires the recapture (over a six year period with a deferral of one or two years if certain requirements were met) of the excess of tax bad debt reserves at December 31, 1995 over those established as of December 31, 1987. The amount of such reserve subject to recapture as of December 31, 2001 is approximately $1.6 million for Citizens Financial.
TAXABLE DISTRIBUTIONS AND RECAPTURE. Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if the Bank failed to meet certain thrift asset and definitional tests, made certain excess distributions to, or redemption of, shareholders, or changed to a bank charter. Under current law, pre-1988 reserves are subject to recapture only if the Bank makes certain non-dividend distributions or redemptions or ceases to maintain a bank charter.
At December 31, 2001 the total federal pre-1988 reserve was approximately $12.5 million for Citizens Financial. This reserve reflects the cumulative effects of federal tax deductions by the Bank for which no Federal income tax provision has been made.
MINIMUM TAX. The Code imposes a minimum tax at a rate of 20% on a base of regular taxable income plus certain tax adjustments and preferences ("alternative minimum taxable income" or "AMTI"). The minimum tax is payable to the extent such tax is in excess of the regular tax. This excess is the alternative minimum tax ("AMT"). Net operating losses can offset no more than 90% of AMTI. Payments of AMT may be used as credits against regular tax liabilities in future years subject to certain limitations. Citizens Financial has not been subject to the AMT, nor does it have any such amounts available as credits for carryover.
NET OPERATING LOSS CARRYOVERS. A financial institution may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. Losses incurred in tax years beginning before August 6, 1997 and after December 31, 1986 can be carried back three years and forward 15 years. Prior to 1987, various carryback and carryforward provisions apply. At December 31, 1999, Citizens Financial had no net operating loss carryforwards for federal income tax purposes.
CORPORATE DIVIDENDS-RECEIVED DEDUCTION. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is 80% in the case of dividends received from corporations, the stock of which the corporate recipient owns 20% or more, but generally less than 80%, and corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct only 70% of dividends received or accrued on their behalf.
STATE AND LOCAL TAXATION
INDIANA STATE TAXATION. The Company and the Bank are subject to an 8.5% franchise tax, imposed by the State of Indiana, on the net income of financial (including thrift) institutions, exempting them from the current gross income, supplemental net income and intangible taxes. Net income for franchise tax purposes is federal taxable income before net operating loss deductions and special deductions, adjusted for certain items, including Indiana income taxes, property taxes, charitable contributions, tax exempt interest and bad debts. Other applicable Indiana taxes include sales, use and property taxes. Beginning in 1999, the Company and the Bank can apportion income outside of Indiana.
ILLINOIS STATE TAXATION. For Illinois income tax purposes, the Company and the Bank are taxed at a rate of 7.18% of Illinois taxable income. For these purposes, "Illinois Taxable Income" generally means federal taxable income, subject to certain adjustments (including the addition of interest income on state and municipal obligations and the exclusion of interest income on United States Treasury obligations) and apportionment. The exclusion of income on United States Treasury obligations has the effect of reducing the Illinois taxable income of the Bank.
DELAWARE STATE TAXATION. As a Delaware holding company not earning income in Delaware, the Company is exempt from Delaware corporate income tax but is required to file an annual report with and pay an annual franchise tax to the State of Delaware. The tax is imposed as a percentage of the capital base of the Company with an annual maximum of $150,000.
ITEM 2.
ITEM 2. PROPERTIES
OFFICES AND PROPERTIES
The following table sets forth certain information relating to Citizens Financial's offices at December 31, 2001. In addition, the Bank maintains 39 automated teller machines ("ATMs"), with 22 of such ATMs at the Bank's branch offices.
(1) Building donated to the United Way, June 30, 1999, Citizens Financial Services now leases approximately ten percent of building for branch operations. (2) Full service branch facilities located in a local grocery store chain. (3) Insurance and Investment Center. (4) Operations Center. (5) Deposits included with office located at 162nd Street. (6) The current lease on this location expires in December 2002. Should the Bank elect to renew this lease, it must provide notification to the landlord by June 2002. Lease negotiations are currently in progress.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
LEGAL PROCEEDINGS
In 1983, with the assistance of the Federal Savings and Loan Insurance Corporation ("FSLIC") as set forth in an assistance agreement ("Assistance Agreement"), the Bank acquired First Federal Savings and Loan Association of East Chicago, East Chicago, Indiana ("East Chicago Savings"), and Gary Federal Savings and Loan Association, Gary, Indiana ("Gary Federal"). The FSLIC-assisted supervisory acquisitions of East Chicago Savings and Gary Federal were accounted for using the purchase method of accounting which resulted in supervisory goodwill (the excess of cost over the fair value of net assets acquired), an intangible asset, of $52.9 million, compared to $40.2 million of goodwill as reported on a generally accepted accounting principles basis. Such goodwill was included in the Bank's regulatory capital as required by the Assistance Agreement. The Assistance Agreement relating to the Bank's acquisitions of East Chicago Savings and Gary Federal provided for the inclusion of supervisory goodwill as an asset on the Bank's balance sheet, to be amortized over 35 years for regulatory purposes and includable in regulatory capital. Pursuant to the regulations adopted by the OTS to implement the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the regulatory capital requirement for federal savings banks was increased and the amount of supervisory goodwill that could be included in regulatory capital decreased significantly. At September 30, 1989, the Bank had approximately $26.0 million of remaining supervisory goodwill. However, excluding supervisory goodwill, the Bank continued to exceed its capital requirements of FIRREA at such date.
On May 13, 1993, the Bank filed suit against the U.S. government seeking damages and/or other appropriate relief on the grounds, among others, that the government had breached the terms of the Assistance Agreement. The suit is pending in the United States Court of Federal Claims, Judge Sarah L. Wilson presiding, and is entitled Citizens Financial Services, FSB, et al. v. United States (Case No. 93-306-C).
The Bank has filed a motion for summary judgment that is presently pending before the Claims Court. Case-specific discovery, including large-scale document production and numerous depositions has occurred. Expert witness discovery has been completed. It is believed the trial in the matter will be scheduled after the close of discovery and will most likely be held no earlier than 2003.
In its complaint, the Bank did not specify the amount of damages it is seeking from the United States. The Bank has retained experts in order to attempt to quantify the amount of damages. The Bank's primary expert has filed his report detailing the Bank's claim under three alternative methods: lost profits, restitution, and capital replacement. The government's experts have sought to rebut the Bank's claims that it has been damaged. This is consistent with the government's current litigation strategy of denying that there have been any damages suffered and refusing to settle any pending goodwill cases.
The Bank is unable to predict the outcome of its claim against the United States and the amount of damages that may actually be awarded to the Bank, if any, in the event that a judgment is rendered in the Bank's favor. Consequently, no assurance can be given as to the
result of this claim or the timing of any proceedings in relation thereto. The cost, including attorneys' fees, experts' fees, and related expenses of the litigation for fiscal 2001 was approximately $436,000, compared to $550,000 in 2000 and $18,000 in 1999.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The information required herein is incorporated by reference from page 48 of the Registrant's 2001 Annual Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information required herein is incorporated by reference from pages 13 to 14 of the Registrant's 2001 Annual Report.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required herein is incorporated by reference from pages 15 to 23 of the Registrant's 2001 Annual Report.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required herein is incorporated by reference from pages 21 to 22 of the Registrant's 2001 Annual Report.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required herein is incorporated by reference from pages 25 to 47 of the Registrant's 2001 Annual Report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required herein is incorporated by reference from pages 3 to 4 of the Registrant's Proxy Statement dated March 28, 2002 ("Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required herein is incorporated by reference from pages 6 to 13 of the Registrant's Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required herein is incorporated by reference from page 15 to 16 of the Registrant's Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required herein is incorporated by reference from page 13 of the Registrant's Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Document filed as part of this Report.
(1) The following documents are filed as part of this report and are incorporated herein by reference from the Registrant's 2001 Annual Report.
Independent Auditors' Report.
Consolidated Statements of Financial Condition as of December 31, 2001 and 2000.
Consolidated Statements of Income for the Years Ended December 31, 2001, 2000 and 1999.
Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 2001, 2000 and 1999.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2000 and 1999.
Notes to Consolidated Financial Statements.
(2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or notes thereto.
(3)(a) The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index.
3.1 Certificate of Incorporation of CFS Bancorp, Inc.* 3.2 Bylaws of CFS Bancorp, Inc.* 4.0 Form of Stock Certificate of CFS Bancorp, Inc.* 10.1 Form of Employment Agreement entered into between Citizens Financial Services, FSB and each of Thomas F. Prisby, James W. Prisby and John T. Stephens* 10.2 Form of Employment Agreement entered into between CFS Bancorp, Inc. and each of Thomas F. Prisby, James W. Prisby and John T. Stephens* 10.3 CFS Bancorp, Inc. 1998 Stock Option Plan as amended** 10.4 CFS Bancorp, Inc. 1998 Recognition and Retention Plan and Trust Agreement as amended** 10.5 Supplemental ESOP Benefit Plan*** 13.0 2001 Annual Report to Stockholders specified portion (pp. 13 to end) of the Registrant's Annual Report to Stockholders for the year ended December 31, 2001. 21.0 Subsidiaries of the Registrant - Reference is made to Item 1. "Business" for the required information. 23.0 Consent of Independent Auditors - Ernst & Young LLP - ------------- * Incorporated by Reference from the Company's Registration Statement on Form S-1 filed on March 31, 1998, as amended and declared effective on May 14, 1998. ** Incorporated by Reference from the Company's Definitive Proxy Statement for the Meeting of Stockholders filed on March 23, 2001. ***Incorporated by Reference from the Company's December 31, 1999 Annual Report on Form 10-K filed on March 30, 2000.
(3)(b) Reports filed on Form 8-K.
None.
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.
CFS BANCORP, INC.
By: /s/ THOMAS F. PRISBY ------------------------- Thomas F. Prisby Chairman of the Board and Chief Executive Officer
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.
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.
CFS BANCORP, INC.
By: /s/ Thomas F. Prisby ------------------------- Thomas F. Prisby Chairman of the Board and Chief Executive Officer
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.