Item 1. Business
General
From November 1, 2000 until October 29, 2003, Bank Mutual Corporation was an OTS chartered United States corporation which became the mid-tier holding company in the regulatory restructuring of Mutual Savings Bank, into mutual holding company form. Until October 29, 2003, Bank Mutual Bancorp, MHC (the “MHC”), a U.S.-chartered mutual holding company of which Mutual Savings Bank’s depositors held all of the voting and membership rights, owned a majority of Bank Mutual Corporation’s outstanding common stock.
On November 1, 2000, Bank Mutual Corporation acquired First Northern Capital Corp., the parent of First Northern Savings Bank. On March 16, 2003, Mutual Savings Bank and First Northern Savings Bank combined to form a single OTS chartered savings bank subsidiary of Bank Mutual Corporation named “Bank Mutual” (“Bank Mutual” or the “Bank”).
On October 29, 2003, Bank Mutual Corporation completed a conversion and reorganization from a mutual holding company form, established a new Wisconsin chartered Bank Mutual Corporation and, in effect, sold the MHC’s interest in Bank Mutual Corporation to the public. Existing Bank Mutual Corporation shareholders exchanged each existing share for 3.6686 shares of the new Bank Mutual Corporation (the “Company”). The total number of shares issued or exchanged in the offering was 78,707,669 shares.
All share and per share numbers in this report on form 10-K have been adjusted to reflect the full conversion transaction and related share exchange. As used herein, the “Company” and “Bank Mutual Corporation” refer to Bank Mutual Corporation both before and after the full conversion transaction, unless the context requires otherwise.
The Bank is a community oriented financial institution, which emphasizes traditional financial services to individuals and businesses within our market areas. Our principal business is originating mortgage loans, consumer loans, commercial real estate loans, and commercial business loans and attracting retail deposits from the general public. We also invest in various mortgage-related securities and investment securities. The principal lending is on one-to four-family, owner-occupied homes, home equity loans and lines of credit, automobile loans, multi-family and commercial real estate loans, and commercial business loans.
The Bank’s revenues are derived principally from interest on our loans and mortgage-related securities, interest and dividends on our investment securities, and noninterest income (including loan servicing fees, deposit servicing fees, gains on sales of loans and commissions on insurance, security and annuity sales). Our primary sources of funds are deposits, borrowings, scheduled amortization and prepayments of loan principal and mortgage-related securities, and maturities of investment securities and funds provided by operations.
The Company maintains a website at bankmutualcorp.com. We make available through that website, free of charge, copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, as soon as reasonably practical after the Company electronically files those materials with, or furnishes them to, the Securities and Exchange Commission. You may access those reports by following the links under “Financial Reports” at the Company’s website.
Cautionary Factors
This Form 10-K contains or incorporates by reference various forward-looking statements concerning the Bank’s prospects that are based on the current expectations and beliefs of management. Forward-looking statements may also be made by the Company from time to time in other reports and documents as well as oral presentations. When used in written documents or oral statements, the words “anticipate,” “believe,” “estimate,” “expect,” “objective” and similar expressions and verbs in the future tense, are intended to identify forward-looking statements. The statements contained herein and such future statements involve or may involve certain assumptions, risks and
uncertainties, many of which are beyond the Company’s control, that could cause the Bank’s actual results and performance to differ materially from what is expected. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company: general economic conditions; legislative and regulatory initiatives; increased competition and other effects of the deregulation and consolidation of the financial services industry; monetary and fiscal policies of the federal government; deposit flows; disintermediation; the cost of funds; general market rates of interest; interest rates or investment returns on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; general economic developments; acts of terrorism and developments in the war on terrorism; and changes in the quality or composition of loan and investment portfolios. See also the factors regarding future operations discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below, particularly those under the caption “Risk Factors.”
Market Area
At February 25, 2005, the Bank has 70 banking offices located in 28 counties in Wisconsin, in addition to a Minnesota bank office. At June 30, 2004, The Bank had approximately a 2.32% share of all Wisconsin bank, savings bank, and savings association deposits. Counties in which the Bank operates include 67% of the population of the state. The Bank is the fourth largest financial institution holding company headquartered in the state of Wisconsin, based on asset size.
The largest concentration of our offices is in the Milwaukee metropolitan area, which includes Milwaukee, Waukesha, Racine, Ozaukee, and Washington counties. There are 19 offices in this area, and we are opening a 20th office in spring 2005. The Milwaukee metro area is the largest population and commercial base in Wisconsin, representing approximately 28% of Wisconsin’s population. The Milwaukee area has traditionally had an extensive manufacturing economic base, which is diversifying into service and technology based businesses.
We have four offices in the Madison area. Madison is the state capital of Wisconsin and is the second largest metropolitan area in Wisconsin representing approximately 8% of the state’s population. Our eight other south central and southeastern Wisconsin offices are located in smaller cities that have economic concentrations ranging from manufacturing to agriculture.
We operate 21 banking offices in nine northeastern counties that make up approximately 16% of the state’s population including the city of Green Bay. The greater Green Bay area has an economic base of paper and other manufacturing, health care, insurance and gaming, and is diversifying into technology based businesses. Two of our offices in this region are near the Michigan border; we are also developing customers in northern Michigan.
We also have 19 offices in the northwestern part of the state. This part of the state has medium sized to smaller cities and towns. Industry includes medium sized and small business, with a significant agricultural component. The counties in which the northwest region offices are located hold 8% of the state’s population. Our Minnesota office is located near the Wisconsin state border on the eastern edge of the Minneapolis-St. Paul metropolitan area.
Competition
We face significant competition in making loans and attracting deposits. Wisconsin has many banks, savings banks, and savings and loan associations, which offer the same types of banking products as the Company. Wisconsin also has an extensive tax-exempt credit union industry, whose expanded powers have resulted in increased competition to financial institutions.
Many of our competitors have greater resources than we do. Similarly, many competitors offer services that we do not provide. For example, the Bank does not provide trust or money management services. However, the Bank’s subsidiary, Lake Financial and Insurance Services, Inc. offers mutual funds and engages in the sale of tax deferred annuities, credit life and disability insurance, and property and casualty insurance and brokerage services. In addition, the banking business in the Milwaukee area, our largest market, tends to be dominated by the two largest commercial banks in the state, which together held 51.44% of the Milwaukee area’s deposits at June 30, 2004.
Most of our competition for loans traditionally has come from commercial banks, savings banks, savings and loan associations and credit unions. Increasingly, other types of companies, such as mortgage banking firms, finance companies, insurance companies, and other providers of financial services also compete for these products. For deposits, we also compete with traditional financial institutions. However, competition for deposits now also includes mutual funds, particularly short-term money market funds, and brokerage firms and insurance companies. The recent increase in electronic commerce also increases competition from institutions and other entities outside of Wisconsin.
Lending Activities
Loan Portfolio Composition. The Company’s loan portfolio primarily consists of mortgage loans. To a lesser degree, the loan portfolio includes consumer loans, including home equity lines of credit and fixed and adjustable rate home equity loans, automobile loans, as well as commercial business loans.
At December 31, 2004, our total loans receivable was $1.9 billion, of which $1.4 billion, or 71.9%, consisted of one to four family ($903.5 million or 46.3%) and other mortgage loans ($498.7 million or 25.6%). The remainder of our loans at December 31, 2004, amounting to $547.4 million, or 28.1% of total loans, consisted of consumer loans ($477.3 million or 24.5%) and commercial business loans ($70.2 million or 3.6%).
We originate adjustable rate mortgage (“ARM”) loans primarily for our own portfolio. We also originate fixed rate mortgage loans with terms of 10 to 30 years. Most of the 20 year and longer fixed rate mortgage loans are immediately sold into the secondary market. At times, we may also sell 15 year fixed rate mortgage loans depending on the percentage of fixed interest rate loans in our portfolio and our tolerance for fixed interest rates in view of the interest rate environment we are anticipating. We sold approximately $5.8 million of our 15 year fixed rate mortgage loan originations in 2004.
The loans that we originate and purchase are subject to federal and state laws and regulations. The interest rates we charge on loans are affected principally by the demand for loans, the cost and supply of money available for lending purposes and the interest rates offered by our competitors. These factors are in turn affected by, among other things, economic conditions, monetary policies of the federal government, including the Federal Reserve Board, legislative tax policies and governmental budgetary matters.
The following table presents the composition of our loan portfolio in dollar amounts and in percentages of the total portfolio at the dates indicated.
At December 31, 2004, our one- to four-family first mortgage loans were pledged as collateral under a blanket pledge to the Federal Home Loan Bank (“FHLB”) of Chicago. As of December 31, 2004, there were no other significant concentrations of loans such as loans to a number of borrowers engaged in similar activities. The Company’s mortgage loans, fixed equity, home equity lines of credit and home improvement loans are primarily secured by properties housing one- to four-families which are generally located in our local lending areas in Wisconsin.
Loan Maturity. The following table presents the contractual maturity of our loans at December 31, 2004. The table does not include the effect of prepayments or scheduled principal amortization.
The following table presents, as of December 31, 2004, the dollar amount of all loans due after December 31, 2005, and whether these loans have fixed interest rates or adjustable interest rates.
The following table presents a summary of our lending activity.
Residential Mortgage Lending. Our primary lending activity has been the origination and purchases of first mortgage loans secured by one- to four-family properties, within our primary lending area. Most of these loans are owner-occupied; however, we do originate first mortgage loans on second homes, seasonal homes, and investment properties. In addition to our loan originations, we have purchased one- to four-family first mortgage loans of $149.0 million in 2004, $41.2 million in 2003, and $4.0 million in 2002. We review each purchased loan for compliance with our underwriting standards, and generally only invest in loans which are located in the midwestern United States.
We offer conventional fixed rate mortgage loans and ARM loans with maturity dates up to 30 years. Residential mortgage loans generally are underwritten to Federal National Mortgage Association (“Fannie Mae”) standards. All ARM mortgage loans and some fixed rate mortgage loans with maturities of up to 20 years are held in our portfolio. Fixed rate mortgage loans with maturities greater than 15 years typically are sold without recourse, servicing retained, into the secondary market. As a result of market competition, during the past few years, we have generally not charged loan origination fees. The interest rates charged on mortgage loan originations at any given date will vary, depending upon conditions in the local and secondary markets.
We also originate “jumbo single family mortgage loans” in excess of the Fannie Mae maximum loan amount, which was $333,700 for single family homes in 2004. Effective for 2005, the maximum loan amount increased to $359,650. Fannie Mae has higher limits for two-, three- and four-family homes. Fixed rate jumbo mortgage loans generally are sold servicing released without recourse to secondary market purchasers of such loans. ARM jumbo mortgage loans are underwritten in accordance with our underwriting guidelines and are retained in our loan portfolio. All jumbo mortgage loans originated in 2004 were ARMs.
Mortgage loan originations are solicited from real estate brokers, builders, existing customers, community groups, other referral sources, and residents of the local communities located in our primary market area through our loan origination staff. We also advertise our mortgage loan products through local newspapers, periodicals, internal customer communications and our website.
In addition to offering loans that conform to underwriting standards that are based on standards specified by Fannie Mae (“conforming loans”), we also originate a limited amount of non-conforming loans, due to size or underwriting considerations, for our own portfolio or for sale. Loans may be fixed rate one- to four-family mortgage loans or adjustable rate one- to four-family mortgage loans with maturities of up to 30 years. The average size of our one- to four-family mortgage loans originated in 2004 was $135,965, and in 2003 and 2002 was approximately $113,723 and $114,000, respectively. We are an approved seller/servicer for Fannie Mae, Freddie Mac, the FHLB of Chicago’s Mortgage Partnership Finance Program, Wisconsin Housing and Economic Development Authority (“WHEDA”) and Wisconsin Department of Veterans Affairs (“WDVA”).
The focus of our residential mortgage loan portfolio is the origination of 30 year ARM loans with interest rates adjustable in one, two, three, or five years. ARM loans typically are adjusted by a maximum of 200 basis points per adjustment period. The adjustments are usually annual, after the initial interest rate lock period. Prior to the merger of the subsidiary banks, there was a lifetime cap of 6% above the origination rate for First Northern Savings Bank and a lifetime interest rate cap of 12.9% for Mutual Savings Bank. Since March 2003, the Bank is originating ARM loans with a lifetime cap of 6% above the origination rate. Monthly payments of principal and interest are adjusted when the interest rate adjusts. We do not offer ARM loans which provide for negative amortization. The initial rates offered on ARM loans fluctuate with general interest rate changes and are determined by competitive conditions and our yield requirements. We currently utilize the monthly average yield on United States treasury securities, adjusted to a constant maturity of one year (“constant treasury maturity index”) as the index to determine the interest rate payable upon the adjustment date of our ARM loans. Some of the ARM loans are granted with conversion options which provide terms under which the borrower may convert the mortgage loan to a fixed rate mortgage loan for a limited period early in the term (normally in the first five years) of the ARM loan. The terms at which the ARM loan may be converted to a fixed rate loan are established at the date of loan origination and are set at a level allowing us to sell the loan into the secondary market upon conversion.
ARM loans may pose credit risks different from the risks inherent in fixed rate loans, primarily because as interest rates rise, the underlying payments from the borrowers rise, thereby increasing the potential for payment default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates.
The volume and types of ARM loans we originate have been affected by the level of market interest rates, competition, consumer preferences and the availability of funds. Although we will continue to offer ARM loans, we cannot guarantee that we will be able to originate a sufficient volume of ARM loans to increase or maintain the proportion that these loans bear to our total loans.
In addition to conventional fixed rate and ARM loans, we are authorized to originate mortgages utilizing various government programs, primarily the Guaranteed Rural Housing Program. We also participate in two state-sponsored mortgage programs operated by WHEDA and WDVA. We originate these state-sponsored loans as an agent and assign them to the agency immediately after closing. Servicing is retained by us on both WHEDA and WDVA loans.
Most residential mortgage loans are processed under the Fannie Mae alternative documentation programs. For reduced documentation loans, we require applicants to complete a Fannie Mae loan application and request income, asset and debt information from the borrower. In addition to obtaining outside vendor credit reports on all borrowers, we also look at other information to ascertain the creditworthiness of the borrower. In most instances, we utilize Fannie Mae’s “Desktop Underwriter” automated underwriting process to further reduce the necessary documentation. For example, a simplified appraisal or inspection may be used to verify the value of the property. Loans that are processed with reduced documentation conform to secondary market standards and generally may be sold on the secondary market.
Normally, an appraisal of the real estate to secure the loan is required, which must be performed by a certified appraiser approved by the board of directors; however, we utilize a streamline process on certain existing mortgage loans which will be refinanced. On such loans we do not require an appraisal and in essence the only items that are modified are the rate and term. A title insurance policy is required on all real estate first mortgage loans. Evidence of adequate hazard insurance and flood insurance, if applicable, is required prior to closing. Borrowers are required to make monthly payments to fund principal and interest (except on a few interest only mortgage loans) as well as private mortgage insurance and flood insurance, if applicable. With some exceptions for lower loan-to-value ratio loans, borrowers also generally are required to escrow in advance for real estate taxes. We make disbursements for these items from the escrow account as the obligations become due.
Our Underwriting Department reviews all pertinent information prior to making a credit decision to approve or deny an application. All recommendations to deny are reviewed by a designated senior officer of the Bank, in addition to the Underwriting Department, prior to the final disposition of the loan application. Our lending policies generally limit the maximum loan-to-value ratio on one- to four-family mortgage loans secured by owner-occupied properties to 100% of the lesser of the appraised value or purchase price of the property. Loans above 80% loan-to-value ratios are subject to the availability of private mortgage insurance. Coverage is required to reduce our exposure to less than 80% of value.
Our originations of residential mortgage loans amounted to $326.8 million in 2004, $790.7 million in 2003, and $695.0 million in 2002. A number of our mortgage loan originations have been the result of refinancing of our existing loans due to the relatively low interest rate levels over the past three years. Total refinancings of our existing mortgage loans were as follows:
In addition to our standard mortgage products, we have developed mortgage programs designed to specifically address the credit needs of low- to moderate-income home mortgage applicants and first-time home buyers. Among the features of the low- to moderate-income home mortgage and first-time home buyer’s programs are lower down payments, no mortgage insurance, and generally less restrictive requirements for qualification compared to our traditional one- to four-family mortgage loans. For instance, certain of these programs currently provide for loans with up to 97% loan-to-value ratios without private mortgage insurance.
Consumer Loans. We have been expanding our consumer loan originations because higher yields can be obtained, there is strong consumer demand for such products, and we have experienced relatively low delinquency and few losses on such products. In addition, we believe that offering consumer loan products helps to expand and create stronger ties to our existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities. At December 31, 2004, $477.3 million, or 24.5%, of our gross loan portfolio was in consumer loans. Consumer loan products offered within our market areas include home equity loans, home equity lines of credit, home improvement loans, automobile loans, recreational vehicle loans, marine loans, deposit account loans, overdraft protection lines of credit, unsecured consumer loans and also to a lesser extent, unsecured consumer loans through the Visa credit card programs (offered through Elan Financial Services) and federally guaranteed student loans.
Our focus in consumer lending has been the origination of home equity loans, home improvement loans, home equity lines of credit and automobile loans. At December 31, 2004, we had $440.8 million or 92.4% of the consumer loan portfolio in such loans. Underwriting procedures for the home equity and home equity lines of credit loans include a comprehensive review of the loan application, an acceptable credit rating, verification of the value of the equity in the home and verification of the borrower’s income. The loan-to-value ratio and the total debt-to-income ratio are two of the determining factors in the underwriting process. Home equity loan and home improvement loan originations are developed through the use of direct mail, cross-sales to existing customers, radio advertisement, and advertisements in local newspapers.
We make indirect automobile, boat and recreational vehicle loans through applications taken by selected dealers on application forms approved by us. The applications are delivered to Savings Financial Corporation (“SFC”), a 50% owned subsidiary of the Bank, for underwriting. If an application is approved, money is funded to the dealer and the loan becomes a part of the SFC portfolio. The SFC paper is then sold to either of the parent companies of SFC or to the Bank’s subsidiary First Northern Investments Inc.
We originate both fixed rate and variable rate home equity loans and home improvement loans with combined loan-to-value ratios to 100%. Pricing on fixed rate home equity and home improvement loans is reviewed by management, and generally terms are in the three to fifteen year range in order to minimize interest rate risk. During 2004, we originated $121.4 million of fixed rate home equity or home improvement loans; these loans carry a
weighted average written term of approximately 9.8 years and a fixed rate ranging from 3.99% to 9.99%. During 2003 we originated approximately $163.3 million of fixed rate home equity or home improvement loans, carrying a weighted average written term of approximately 9.8 years and a fixed rate ranging from 3.25% to 10.25%. We also offer adjustable rate home equity and home improvement loans. At December 31, 2004, $37.6 million or 12.9% of our fixed term home equity and home improvement loan portfolio carried an adjustable rate. The adjustable rate loans have an initial fixed rate for one to three years then adjust annually or monthly depending upon the offering, with terms of up to twenty years.
Our home equity credit line loans, which totaled $88.4 million, or 18.5% of total consumer loans at December 31, 2004, are adjustable rate loans secured by a first or second mortgage on owner-occupied one- to four-family residences primarily located in the state of Wisconsin. Current interest rates on home equity credit lines are tied to the prime rate, adjust monthly after an initial interest rate lock period, and range from prime rate to 300 basis points over the prime rate, depending on the loan-to-value ratio. Home equity line of credit loans are made for terms up to 10 years and require a minimum monthly payment of interest only with a minimum payment of $50 and on home equity line of credit loans with loan-to-value of 90% or greater require a minimum payment of $50 or 11/2% of the month end balance. An annual fee is charged on home equity lines of credit.
At December 31, 2004, student loans amounted to $20.5 million, or 4.3% of our consumer loan portfolio. These loans are serviced by Great Lakes Higher Education Servicing Corporation.
Multi-family and Commercial Real Estate Loans. At December 31, 2004, our multi-family and commercial real estate loan portfolio was $357.3 million or 18.3% of our total loans receivable. The multi-family and commercial real estate loan portfolios consist of fixed rate, ARM and balloon loans originated at prevailing market rates. This portfolio generally consists of loans secured by apartment buildings, office buildings, warehouses, industrial buildings and retail centers. These loans typically do not exceed 80% of the lesser of the purchase price or an appraisal by an appraiser designated by us. Balloon loans generally are amortized on a 15 to 30 year basis with a typical loan term of 3 to 10 years.
Loans secured by multi-family and commercial real estate are granted based on the income producing potential of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property or from the business in an owner-occupied property, must be sufficient to cover the payments relating to the outstanding debt. In most cases, we obtain joint and several personal guarantees from the principals involved. We generally require an assignment of rents or leases in order to be assured that the cash flow from the property will be used to repay the debt. Appraisals on properties securing multi-family and larger commercial real estate loans are performed by independent state certified fee appraisers approved by the board of directors. Title and hazard insurance are required as well as flood insurance, if applicable. Environmental assessments are performed on certain multi-family and commercial real estate loans in excess of $1.0 million. In addition, an annual review is performed by us on non-owner-occupied multi-family and commercial real estate loans over $1.0 million.
At December 31, 2004, the largest outstanding loan on a multi-family property was $14.2 million on a 113 unit apartment project (including 12,000 feet of retail space) located in Madison, Wisconsin. At the same date, the largest outstanding loan on a commercial real estate property was $6.7 million on a retail building located in Kenosha, Wisconsin. At December 31, 2004, these loans were current and performing in accordance with their terms. These loans are substantially below the legal lending limit to a single borrower, which was approximately $77.9 million at December 31, 2004.
Loans secured by multi-family and commercial real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans. Such loans typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project decreases, or if leases are not obtained or renewed, the borrower’s ability to repay the loan may be impaired.
Construction and Development Loans. At December 31, 2004, our construction and development mortgage loan portfolio was $141.4 million, or 7.3% of our total loans receivable. At that date, commercial real estate loans were $94.3 million or 66.7% and multi-family mortgage loans were $47.1 million or 33.3% of the total construction and development loans. As a general matter, construction and development loans convert to permanent loans on our
books. These types of credits carry special repayment risk because if a borrower defaults the construction project needs to be completed before the full value of the collateral can be realized.
Commercial Business Loans. At December 31, 2004, our commercial business loan portfolio consisted of loans totaling $70.2 million or 3.6% of our total loans receivable. The commercial loan portfolio consists of loans to businesses for equipment purchases, working capital lines of credit, debt refinancing, SBA loans and domestic stand-by letters of credit. Typically, these loans are secured by business assets and personal guarantees. We offer variable, adjustable and fixed rate loans. Approximately 29.1% of the commercial business loans have an interest rate adjusted monthly or immediately, with the majority based on the prevailing prime rate. We also have commercial business loans that have an initial period where interest rates are fixed, generally one to five years, and thereafter are adjustable based on various indexes. Fixed rate loans are priced at either a margin over the yield on US Treasury issues with maturities that correspond to the maturities of the notes or to match competitive conditions and yield requirements. Term loans are generally amortized over a three to seven year period and line-of-credit commercial business loans generally have a term of one year, at which point they mature. All borrowers having an exposure to the Bank of $500,000 or more are reviewed annually. The largest commercial business loan at December 31, 2004 had an outstanding balance of $25.5 million and was secured by equipment and chattel paper.
Loan Approval Authority
For one- to four-family residential loans intended for sale into the secondary market, the underwriters are authorized by the board of directors to approve loans processed through the Fannie Mae “Desktop Underwriter” automated underwriting system up to the Fannie Mae conforming loan limits loan limits ($359,650 for a single family residential units; higher limits for two-, three-, and four-family units). For one- to eight-family residential loans intended to be held in the Bank’s portfolio, the underwriters are authorized to approve loans processed through the Fannie Mae “Desktop Underwriter” automated underwriting system up to $359,650, provided the loan-to-value is 80% or less and the loan meets other specific underwriting criteria. All portfolio loans in excess of $359,650, with a loan-to-value greater than 80%, or failing to meet other specific underwriting criteria must be approved by a senior officer.
Consumer loan underwriters have individual approval authority for secured loans ranging from $20,000 to $100,000 provided the loan-to-value on real estate does not exceed 80% or 90% on personal property and that the loan meets other specific underwriting criteria. All consumer loans in excess of $100,000, with a loan-to-value greater than 80% on real estate, 90% on personal property, or failing to meet other specific underwriting criteria must be approved by a senior officer. Consumer loan underwriters have individual approval authority for unsecured loans ranging from $2,000 to $15,000 provided the loan meets other specific underwriting criteria. All unsecured consumer loans in excess of $15,000, or not meeting specific underwriting criteria, must be approved by a senior officer.
Individual lenders and senior officers in the investment real estate department have lending authority of $250,000 for multi-family and commercial loan proposals for both existing and proposed construction of investment real estate properties. Two senior officers together have lending authority of $500,000 for investment real estate loans. All investment real estate loans over $500,000 require approval of the executive committee of the board of directors.
Individual lenders in the commercial banking department have individual lending authority ranging from $50,000 to $150,000 for secured commercial business loans. Senior officers have individual lending authority of $250,000 and two senior officers together have lending authority of $500,000 for secured commercial business loans. All secured business loans over $500,000 require approval of the executive committee of the board of directors. Individual lenders in the commercial banking department have individual lending authority ranging from $10,000 to $25,000 for unsecured commercial business loans. Senior officers have individual lending authority of $50,000 and two senior officers together have lending authority of $150,000 for unsecured commercial business loans. All unsecured business loans over $150,000 require approval of the executive committee of the board of directors.
All loans approved by individuals and senior officers must be ratified by the board of directors at the next meeting following the approval.
Asset Quality
One of our key operating objectives has been and continues to be to maintain a high level of asset quality. Through a variety of strategies, including, but not limited to, borrower workout arrangements and aggressive marketing of foreclosed properties and repossessed assets, we have been proactive in addressing problem and non-performing assets. These strategies, as well as our emphasis on quality loan underwriting, our maintenance of sound credit standards for new loan originations, annual evaluation of large credits and relatively favorable economic and real estate market conditions have resulted in historically low delinquency ratios.
Delinquent Loans and Foreclosed Assets. When a borrower fails to make required payments on a loan, we take a number of steps to induce the borrower to cure the delinquency and restore the loan to a current status. In the case of one- to four-family mortgage loans, our loan servicing department is responsible for collection procedures from the 15th day of delinquency through the completion of foreclosure. Specific procedures include a late charge notice being sent at the time a payment is over 15 days past due with a second notice (in the form of a billing coupon) being sent before the payment becomes 30 days past due. Once the account is 30 days past due, we attempt telephone contact with the borrower. Letters are sent if contact has not been established by the 45th day of delinquency. On the 60th day of delinquency, attempts at telephone contact continue and stronger letters, including foreclosure notices, are sent. If telephone contact cannot be made, we send either our property inspector, a qualified third party inspector, or a loan officer to the property in an effort to contact the borrower.
When contact is made with the borrower, we attempt to obtain full payment or work out a repayment schedule to avoid foreclosure. All properties are inspected prior to foreclosure approval. Most borrowers pay before the deadline given and it is not necessary to start a foreclosure action. If it is, action starts when the loan is between the 90th and 120th day of delinquency following review by a senior officer. In conjunction with commencing a foreclosure action, we perform a property evaluation or in some cases, we do a loan file analysis to determine any potential loss. If there is a potential loss, an appropriate charge-off is taken to bring the loan balance in line with the value of the liquidated real estate. Charge-offs are reported to the board of directors. If the loan is deemed to be uncollectible, we seek the shortest redemption period possible thus waiving our right to collect any deficiency from the borrower. If we obtain the property at the foreclosure sale, we hold the property as real estate owned. We obtain a market evaluation of the property to determine that the carrying balance of the owned real estate is consistent with the market value of the property. Marketing of the property begins immediately following the Bank taking title to the property. The marketing is usually undertaken by a realtor knowledgeable of the particular market. Mortgage insurance claims are filed if the loan had mortgage insurance coverage. It is marketed after a market evaluation is obtained and any mortgage insurance claims are filed. The collection procedures and guidelines as outlined by Fannie Mae, Freddie Mac, Veterans Administration (VA), WHEDA, and Guaranteed Rural Housing are followed.
The collection procedures for consumer loans, excluding student loans, indirect consumer loans and credit card loans, include sending periodic late notices to a borrower once a loan is 5 to 15 days past due depending upon the grace period associated with a loan. We attempt to make direct contact with a borrower once a loan becomes 30 days past due. Supervisory personnel review loans 90 days or more delinquent on a regular basis. If collection activity is unsuccessful after 90 days, we may pursue legal remedies ourselves or refer the matter to our legal counsel for further collection effort or charge-off a loan. Loans we deem to be uncollectible, or partially uncollectible are charged off so that the carrying balance approximates the value of the collateral. Charge-offs of consumer loans require the approval of a senior officer and are reported to the board of directors. All student loans are serviced by the Great Lakes Higher Education Servicing Corporation which guarantees their servicing to comply with all Department of Education Guidelines. Our student loan portfolio is guaranteed by the Great Lakes Higher Education Guaranty Corporation, which is reinsured by the U.S. Department of Education. Credit card loans are serviced by Elan Financial Services.
The collection procedures for multi-family, commercial real estate and commercial business loans include sending periodic late notices to a borrower once a loan is past due. We attempt to make direct contact with a borrower once a loan becomes 15 days past due. Our managers of the multi-family and commercial real estate loan areas review loans 10 days or more delinquent on a regular basis. If collection activity is unsuccessful, we may refer the matter to our legal counsel for further collection effort. Within 90 days, loans we deem to be uncollectible are proposed for repossession or foreclosure and partial or full charge-offs are taken to bring the loan balance in line with the expected collectibility of the loans. This legal action requires the approval of our board of directors, and charge offs are reported to the board.
Our policies require that management continuously monitor the status of the loan portfolio and report to the board of directors on a monthly basis. These reports include information on delinquent loans and foreclosed real estate.
The following table presents information regarding non-accrual mortgage, consumer loans, commercial business loans, accruing loans delinquent 90 days or more, and foreclosed properties and repossessed assets as of the dates indicated.
There were no significant loans, which were considered to be impaired as defined in Statement of Financial Accounting Standards (“SFAS”) No. 114 at December 31, 2002, 2001 or 2000. At December 31, 2004, there were loans totaling $8.7 million that are considered to be impaired as compared to $17.0 million at December 31, 2003. The average impaired loans for the year ended December 31, 2004 was $8.7 million and the interest received and recognized on the impaired loans was $29,073.
There are no restructured loans at the dates presented.
Total non-performing loans decreased as of December 31, 2004, as compared to December 31, 2003, primarily as a result of a decrease in non-accrual mortgage and commercial business loans. The decrease resulted primarily from the transfer of $3.1 million of commercial non-performing loans to real estate owned and $1.3 million of mortgage loans to foreclosure. Total non-performing loans increased as of December 31, 2003, as compared to December 31, 2002, primarily as a result of an increase in non-accrual business loans. Of the increase during 2002, $3.2 million related to a single commercial business borrower with the remaining portion of the increase a result of the general decline in economic conditions affecting the borrower’s cash flow. We believe non-performing loans and assets, expressed as a percentage of total loans and assets, are below national averages for financial institutions, due in part to our loan underwriting standards.
The ultimate results with these and other commercial loans will depend on the success of the related business or projects, economic performance and other factors affecting loans and borrowers.
With the exception of mortgage loans insured or guaranteed by the FHA, VA, Guaranteed Rural Housing and student loans, we stop accruing income on loans when interest or principal payments are greater than 90 days in arrears or earlier when the timely collectibility of such interest or principal is doubtful. We designate loans on which we stop accruing income as non-accrual loans and generally, we reverse outstanding interest that we previously credited to income. We may recognize income in the period that we collect it when the ultimate collectibility of principal is no longer in doubt. We return a non-accrual loan to accrual status when factors indicating doubtful collection no longer exist. We had $5.7 million, $9.3 million and $7.3 million of non-accrual loans at December 31, 2004, 2003 and 2002, respectively. Interest income that would have been recognized had such loans been performing in accordance with their contractual terms totaled approximately $831,000, $384,000 and $375,000 for the years ended December 31, 2004, 2003 and 2002, respectively. A total of approximately $83,000, $381,000 and $499,000 of interest income was actually recorded on such loans in 2004, 2003 and 2002, respectively.
All commercial business and commercial real estate loans which are greater than 90 days past due are considered to be potentially impaired. In addition, we may declare a loan impaired prior to a loan being 90 days past due, if we determine there is a question as to the collectibility of principal. Impaired loans are individually assessed to
determine whether a loan’s carrying value is in excess of the fair value of the collateral or the present value of the loan’s cash flows discounted at the loan’s effective interest rate and if the carrying value is in excess, a loan loss allowance will be established.
Foreclosed real estate consists of property we acquired through foreclosure or deed in lieu of foreclosure. Foreclosed properties increased in 2004 as compared to 2003 primarily as a result of the transfer of non-performing commercial loans and mortgage loans to foreclosed properties, real estate owned or repossessed assets. During the year, we transferred $4.4 million of these loans. Foreclosed real estate properties are initially recorded at the lower of the recorded investment in the loan or fair value. Thereafter, we carry foreclosed real estate at fair value less estimated selling costs. Foreclosed real estate is inspected periodically. Additional outside appraisals are obtained as deemed necessary. Additional write-downs may occur if the property value deteriorates. These additional write-downs are charged directly to current operations.
Charge-offs. The Company will charge off a loan when the fair market value of the underlying collateral or anticipated cash flow discounted at the contract rate, is less than the loan amount. Charge-offs of commercial loans increased in 2004 as compared to 2003 primarily as a result of one large commercial loan.
Allowance for Loan Losses. The following table presents the activity in our allowance for loan losses at or for the periods indicated.
The allowance for loan losses has been determined in accordance with generally accepted accounting principles. We are responsible for the timely and periodic determination of the amount of the allowance required. We believe that our allowance for loan losses is adequate to cover specifically identifiable loan losses, as well as estimated losses inherent in our portfolio for which certain losses are probable but not specifically identifiable.
Loan loss allowances are reviewed monthly. General allowances are maintained by the following categories for performing loans to provide for unidentified inherent losses in the portfolios:
• Commercial business
Various factors are taken into consideration in establishing the loan loss allowance including: historical loss experience, economic factors, loans without escrow accounts and other factors, that, in management’s judgment would affect the collectibility of the portfolio as of the evaluation date. Adjustments to the allowance for loan losses are charged against operations as provision for loan losses.
The appropriateness of the allowance is reviewed by senior management based upon its evaluation of then-existing economic and business conditions affecting the key lending areas of the Bank. Other outside factors such as credit quality trends, collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments and recent loss experience in particular segments of the portfolio that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectibility of the loan are also considered.
Non-performing and Delinquent Loans. One- to four-family loans delinquent more than 90 days, multi-family and commercial real estate loans delinquent more than 30 days, consumer loans delinquent more than 90 days and commercial business loans delinquent more than 30 days are reviewed and analyzed by senior officers on an individual basis. Any loss is charged against the allowance by establishing a corresponding specific allowance for that loan from the general allowance. In such an event, the loan is then reduced by the amount of the specific allowance and a corresponding amount is charged off to the allowance for losses on loans.
By following careful underwriting guidelines, we have historically maintained low levels of non-performing loans to total loans. Our ratio of non-performing loans to total loans at December 31, 2000 was 0.16%, after which it increased somewhat. At December 31, 2004, the ratio was 0.33%. This recent decrease as compared to December 31, 2003 and 2002 was the result of decreased delinquencies on the entire loan portfolio and the foreclosure or acquisition of the collateral by the Bank and subsequent liquidation of a large commercial loan. At December 31, 2004, the recorded investment in loans that are considered to be impaired under SFAS No. 114 was $8.7 million.
We believe the primary risks inherent in our portfolio are possible increases in interest rates, a possible weak economy, generally, and a possible decline in real estate market values. Any one or a combination of these events may adversely affect our loan portfolio resulting in increased delinquencies and loan losses. Accordingly, and because of the increased dollar amount of consumer loans and composition of the loan portfolio, we have taken steps to increase our level of loan loss allowances over the last 5 years. At December 31, 2004, the allowance for loan losses as a percentage of total loans was 0.74% compared with 0.62% at December 31, 2000. Furthermore, the increase in the allowance for loan losses each year from 2000 to 2004 reflects our strategy of providing allowances for inherent losses in the portfolio, identifying potential losses in a timely manner, and providing an allowance to reflect changes in the components of the portfolio during that period.
Although we have established and maintained the allowance for loan losses at an amount that reflects management’s best estimate of the amount necessary to provide for probable and estimable losses on loans, future additions may be necessary if economic and other conditions in the future differ substantially from the current operating environment and as the loan portfolio grows and its composition changes. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our loan and foreclosed real estate portfolios and the related allowance for loan losses and valuation allowance for foreclosed real estate. One or more of these agencies, specifically the OTS or the Federal Deposit Insurance Corporation (“FDIC”), may require us to increase the allowance for loan losses or the valuation allowance for foreclosed real estate based on their judgments of information available to them at the time of their examination, thereby adversely affecting our results of operations.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Comparison of Operating Results for the Years Ended December 31, 2004 and 2003-Provision for Loan Losses.” The following table represents our allocation of allowance for loan losses by loan category on the dates indicated:
Investment Activities
Investment Securities. The Bank’s board of directors reviews and approves its investment policy on an annual basis. Senior officers, as authorized by the board of directors, implement this policy. The board of directors reviews investment activity on a monthly basis.
Our investment objectives are to meet liquidity requirements, generate a favorable return on investments without undue compromise to our other business objectives and our levels of interest rate risk, credit risk and investment portfolio concentrations. Federally chartered savings banks have authority to invest in various types of assets, including U.S. Treasury obligations, securities of various federal agencies, state and municipal obligations, mortgage-related securities, mortgage derivative securities, certain time deposits of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements, loans of federal funds, and, subject to certain limits, corporate debt and equity securities, commercial paper and mutual funds.
The Bank’s investment policy allows participation in hedging strategies such as the use of financial futures, options or forward commitments or interest rate swaps but only with prior approval of the board of directors. We did not have any investment hedging transactions in place at December 31, 2004. Our investment policy prohibits the purchase of non-investment grade bonds. Our investment policy also provides that we will not engage in any practice that the Federal Financial Institutions Examination Council considers to be an unsuitable investment practice. For information regarding the carrying values, yields and maturities of our investment securities and mortgage-related securities, see “-Carrying Values, Yields and Maturities.”
At December 31, 2004, we had not invested funds in any single mutual fund in excess of 10% of our capital. All of our mutual fund investments are permissible investments under our investment policy and applicable laws and regulations. We carry our mutual fund investments at market value. At December 31, 2004, our mutual fund investments were in funds which invested primarily in mortgage-related securities.
We classify securities as trading, held-to-maturity, or available-for-sale at the date of purchase. At December 31, 2004, all investment securities are classified as available-for-sale. These securities are carried at fair value with the change in fair value recorded as a component of
shareholders’ equity.
Mortgage-related Securities. Most of our mortgage-related securities are directly or indirectly insured or guaranteed by the Government National Mortgage Association (“GNMA”), Freddie Mac or Fannie Mae. The rest of the securities are investment-grade private placement collateralized mortgage obligations (“CMOs”). Private placement CMOs carry higher credit risks and higher yields than mortgage-related securities insured or guaranteed by agencies of the U.S. Government. We classify our entire mortgage-related securities portfolio as available-for-sale.
At December 31, 2004, mortgage-related securities available-for-sale totaled $1.3 billion, or 36.8% of total assets. At December 31, 2004, the mortgage-related securities portfolio had a weighted average yield of 4.31%. Of the mortgage-related securities we held at December 31, 2004, $1.2 billion, or 95.5%, had fixed rates and $57.4 million, or 4.5%, had adjustable-rates. Mortgage-related securities at December 31, 2004 included real estate mortgage investment conduits (“REMICs”), which are securities derived by reallocating cash flows from mortgage pass-through securities or from pools of mortgage loans held by a trust. REMICs are a form of, and are often referred to as CMOs.
Our CMOs have fixed and variable coupon rates ranging from 2.25% to 6.00% and a weighted average yield of 4.24% at December 31, 2004. At December 31, 2004, CMOs totaled $1.1 billion, which constituted 89.9% of the mortgage-related securities portfolio, or 33.0% of total assets. Our CMOs had an expected average life of 3.1 years at December 31, 2004. For a further discussion of our investment policies, including those for mortgage-related securities, see “-Investment Securities.” Purchases of mortgage-related securities may decline in the future to offset any significant increase in demand for one- to four-family mortgage loans and other loans.
Mortgage-related securities generally yield less than the loans that underlie such securities because of the cost of payment guarantees or credit enhancements that reduce credit risk. However, mortgage-related securities are more liquid than individual mortgage loans.
In general, mortgage-related securities issued or guaranteed by GNMA, Freddie Mac and Fannie Mae are weighted at no more than 20% for risk-based capital purposes, compared to the 50% risk weighting assigned to most non-securitized residential mortgage loans.
While mortgage-related securities carry a reduced credit risk as compared to whole loans, they remain subject to the risk of a fluctuating interest rate environment. Along with other factors, such as the geographic distribution of the underlying mortgage loans, changes in interest rates may alter the prepayment rate of those mortgage loans and affect the value of mortgage-related securities.
The following table presents our investment securities and mortgage-related securities activities for the periods indicated.
The following table presents the fair value of our money market investments, investment securities and mortgage-related securities portfolios at the dates indicated. It also presents the coupon type for the mortgage-related securities portfolio. For all securities and for all periods presented, the carrying value is equal to fair value.
Carrying Values, Yields and Maturities. The table below presents information regarding the carrying values, weighted average yields and contractual maturities of our investment securities and mortgage-related securities at December 31, 2004. Mortgage-related securities are presented by issuer and by coupon type.
Deposits
We offer a variety of deposit accounts having a range of interest rates and terms. We currently offer regular savings accounts (consisting of passbook and statement savings accounts), interest-bearing demand accounts, non-interest-bearing demand accounts, money market accounts, and time deposits. We also offer IRA time deposit accounts.
Deposit flows are influenced significantly by general and local economic conditions, changes in prevailing interest rates, pricing of deposits and competition. Our deposits are primarily obtained from areas surrounding our bank offices and we rely primarily on paying competitive rates, service, and long-standing relationships with customers to attract and retain these deposits. We have, from time to time, used brokers to obtain wholesale deposits to a limited extent. Early in 2005, we joined a wholesale deposit program called “CDARs” which could increase the amount of wholesale deposits. At December 31, 2004, we had approximately $14.6 million of brokered wholesale deposits.
When we determine our deposit rates, we consider local competition, U.S. Treasury securities offerings and the rates charged on other sources of funds. Core deposits (defined as regular savings accounts, money market accounts and demand accounts) represented 42.4% of total deposits on December 31, 2004. At December 31, 2004, time deposits with remaining terms to maturity of one year or less amounted to $584.2 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Gap Analysis.”
The following table presents our deposit activity for the periods indicated:
At December 31, 2004, we had $155.1 million in time deposits with balances of $100,000 and over maturing as follows:
The following table presents the distribution of our deposit accounts at the dates indicated by dollar amount and percent of portfolio, and the weighted average rate.
Borrowings
We borrow funds to finance our lending and investing activities. Substantially all of our borrowings take the form of advances from the FHLB of Chicago, on terms and conditions generally available to member institutions. At December 31, 2004, we had borrowings totaling $305.6 million with maturities of less than one year; of the notes payable to the FHLB at year end, $150.0 million were fixed rate short term borrowings due within 30 days and the balance were overnight borrowings. We have pledged all of our residential mortgage loans and some investment securities as blanket collateral for these advances and future advances. The FHLB of Chicago offers a variety of borrowing options with fixed or variable rates, flexible repayment options, and fixed or callable terms. We choose the rate, repayment option, and term to fit the purpose of the borrowing. See “Notes to Consolidated Financial Statements-Note 7. Borrowings.”
The following table sets forth certain information regarding our borrowings at the end of and during the periods indicated:
Borrowings increased to $761.5 million at December 31, 2004, as compared to $299.5 million at December 31, 2003, primarily to fund the growth in the loan and mortgage-related securities portfolios, a decrease in the deposit portfolio and the repurchase of shares. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Comparisons of Financial Condition at December 31, 2004 and 2003.”
Average Balance Sheet and Rate Yield Analysis
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Average Balance Sheet and Yield/Rate Analysis.”
Average Equity to Average Assets
The ratio of average equity to average assets measures a financial institution’s financial strength. At December 31, 2004, 2003, 2002, 2001, and 2000 our average equity to average assets ratio was 22.6%, 14.0%, 10.9%, 10.4%, and 9.7%, respectively.
Cash Dividends
We paid cash dividends of $0.18 per share in 2004, $0.12 per share in 2003, $0.093 per share in 2002, and $0.076 per share in 2001. We did not pay any cash dividends in 2000 because our initial conversion was not completed until late in the year. We increased our quarterly dividend to $0.06 per share in the first quarter of 2005, from $0.05 in the fourth quarter of 2004.
Subsidiaries
Lake Financial and Insurance Services, Inc., a wholly owned subsidiary of the Bank, provides investment, brokerage and insurance services to the Bank’s customers and the general public. Investment services include tax deferred and tax free investments, mutual funds, and government securities. Personal insurance, business insurance, life and disability insurance and mortgage protection products are also offered by Lake Financial.
Mutual Investment Corporation, a wholly owned subsidiary of the Bank, owns and manages part of the investment portfolio. First Northern Investment Inc. (“FNII”), a wholly owned subsidiary of the Bank, also owns and manages investments and purchases indirect automobile, recreational vehicle and boat loans from our SFC subsidiary.
MC Development LTD, a wholly owned subsidiary of the Bank, is involved in land development and sales. It owns one parcel of undeveloped land consisting of 15 acres in Brown Deer, Wisconsin. In addition, in the third quarter of 2004, MC Development LTD established Arrowood Development, LLC with an independent third party to develop 318 acres in Oconomowoc, Wisconsin. In the initial transaction, the third party purchased approximately one-half interest in that land, all of which previously had been owned by MC Development. It is anticipated that development of the land will begin in the spring of 2005 and that sales of the developed lots will begin in late 2005 or early 2006. See “-Properties.”
SFC, 50% owned by the Bank and 50% owned by another financial institution, originates, sells, and services the indirect automobile, recreational vehicles and boat loans. SFC sells the loans on a regular basis to FNII or the Bank, but retains the servicing rights in the loans.
In addition, the Bank has five wholly owned subsidiaries that are inactive but will continue to be wholly owned subsidiaries for possible future use in a related or other area.
Employees
At December 31, 2004, we employed 702 full time and 98 part time associates. Management considers its relations with its associates to be good.
Regulation
Set forth below is a brief description of certain laws and regulations that relate to the regulation of the Bank and the Company.
General
The Bank is a federally chartered stock savings association, chartered as a savings bank, whose primary regulator is the OTS. The FDIC, under the Savings Association Insurance Fund (“SAIF”), insures its deposit accounts up to applicable limits. The Bank is currently subject to extensive regulation, examination and supervision by the OTS as its chartering agency, and by the FDIC as its deposit insurer. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, and must obtain regulatory approval prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions and acquiring branch offices. In addition, the Bank’s relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in such matters as the ownership of deposit accounts and the form and content of the Bank’s mortgage documents.
The OTS currently conducts periodic examinations to assess the Bank’s compliance with various regulatory requirements. In addition, the FDIC has the right to perform examinations of the Bank should the OTS or the FDIC determine the Bank is in a weakened financial condition or a failure is foreseeable. This regulation and supervision establishes a comprehensive framework of activities in which a savings bank can engage and is intended primarily for the protection of the deposit insurance fund and depositors rather than the shareholders of the Company. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes.
The Company is a Wisconsin corporation registered with the OTS as a unitary savings and loan holding company. It files reports with the OTS and is subject to regulation and examination by the OTS. The Company also is required to file certain reports with, and otherwise comply with, the rules and regulations of the Securities and Exchange Commission under the federal securities laws.
Any change in these laws and regulations, whether by the OTS, the FDIC, the SEC, or through legislation, could have a material adverse impact on the Bank and the Company, and their operations and shareholders.
Certain of the laws and regulations applicable to the Bank and the Company are summarized below. These summaries do not purport to be complete and are qualified in their entirety by reference to such laws and regulations.
Federal Regulation of the Bank
General. As a federally chartered, FDIC-insured savings bank, the Bank is subject to extensive regulation by the OTS and the FDIC. Lending activities and other investments must comply with federal statutory and regulatory requirements. This federal regulation and supervision establishes a comprehensive framework of activities in which a savings bank can engage and is intended primarily for the protection of the FDIC and depositors rather than the shareholders of the Company. This regulatory structure gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies regarding the classification of assets and the establishment of adequate loan loss reserves.
The OTS regularly examines the Bank and issues a report on its examination findings to the Bank’s board of directors. The Bank’s relationships with its depositors and borrowers is also regulated by federal law, especially in such matters as the ownership of savings accounts and the form and content of the Bank’s mortgage documents.
The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition, and must obtain regulatory approvals prior to entering into transactions such as mergers with or acquisitions of other financial institutions.
Regulatory Capital Requirements. OTS capital regulations require savings associations such as the Bank to meet three capital standards. The minimum standards are tangible capital equal to at least 1.5% of adjusted total assets, core capital equal to at least 3% of adjusted total assets, and risk-based capital equal to at least 8% of total risk-
weighted assets. These capital standards are in addition to the capital standards promulgated by the OTS under its prompt corrective action regulations, as described below under the heading “Prompt Corrective Action.”
Tangible capital is defined as core capital less all intangible assets and certain mortgage servicing rights. Core capital is defined as common shareholders’ equity, noncumulative perpetual preferred stock, related surplus and minority interests in the equity accounts of fully consolidated subsidiaries, nonwithdrawable accounts and pledged deposits of mutual savings associations and qualifying supervisory goodwill, less nonqualifying intangible assets, mortgage servicing rights and investments in certain non-includable subsidiaries.
The risk-based capital standard for savings institutions requires the maintenance of total risk-based capital of at least 8% of risk-weighted assets. Risk-based capital is comprised of core and supplementary capital. The components of supplementary capital include, among other items, cumulative perpetual preferred stock, perpetual subordinated debt, mandatory convertible subordinated debt, intermediate-term preferred stock, up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair values, and the portion of the allowance for loan losses not designated for specific loan losses. The portion of the allowance for loan and lease losses includible in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, supplementary capital is limited to 100% of core capital. A savings association must calculate its risk-weighted assets by multiplying each asset and off-balance sheet item by various risk factors as determined by the OTS, which range from 0% for cash to 100% for delinquent loans, property acquired through foreclosure, commercial loans, and other assets.
OTS rules require a deduction from capital for institutions that have unacceptable levels of interest rate risk. The OTS calculates the sensitivity of an institution’s net portfolio value based on data submitted by the institution in a schedule to its quarterly Thrift Financial Report and using the interest rate risk measurement model adopted by the OTS. The amount of the interest rate risk component, if any, is deducted from an institution’s total capital in order to determine if it meets its risk-based capital requirement.
Dividend and Other Capital Distribution Limitations. The OTS imposes various restrictions or requirements on the ability of savings associations to make capital distributions, including dividend payments.
OTS regulations require the Bank to give the OTS 30 days’ advance notice of any proposed declaration of dividends, and the OTS has the authority under its supervisory powers to prohibit the payment of dividends.
OTS regulations impose uniform limitations on the ability of all savings banks and associations to engage in various distributions of capital such as dividends, stock repurchases and cash-out mergers. In addition, the regulation utilizes a three-tiered approach permitting various levels of distributions based primarily upon a savings bank’s capital level.
The Bank currently meets the criteria to be designated a Tier 1 association and, consequently, could at its option (after prior notice to, and no objection made by, the OTS) distribute up to 100% of its net income during the calendar year plus its retained net income for the preceding two years, less any distributions previously paid during the year. Additional dividends or distributions would require further OTS approval.
Qualified Thrift Lender Test. Federal savings associations must meet a qualified thrift lender (“QTL”) test or they become subject to operating restrictions. The Bank met the QTL test as of December 31, 2004 and anticipates that it will maintain an appropriate level of investments consisting primarily of residential mortgages, mortgage-backed securities and other mortgage-related investments, and otherwise qualify as a qualified thrift lender. The required percentage of these mortgage-related investments is 65% of portfolio assets. Portfolio assets are all assets minus goodwill and other intangible assets, property used by the institution in conducting its business and liquid assets equal to 20% of total assets. Compliance with the qualified thrift lender test is determined on a monthly basis in nine out of every twelve months.
Liquidity Standard. Each federal savings association is required to maintain sufficient liquidity to ensure its safe and sound operations.
Federal Home Loan Bank System. The Bank is a member of the FHLB of Chicago, which is one of 12 regional Federal Home Loan Banks. Each Federal Home Loan Bank serves as a reserve or central bank for its members within its assigned region. It is funded primarily from funds deposited by member financial institutions and proceeds derived from the sale of consolidated obligations of the Federal Home Loan Bank System. It makes loans to members pursuant to policies and procedures established by the board of directors of the FHLB of Chicago.
As a member, the Bank is required to purchase and maintain stock in the FHLB of Chicago in an amount equal to the greatest of $500, 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year, or 5% of its outstanding advances. The Bank is currently in compliance with this requirement. The FHLB of Chicago also imposes various limitations on advances made to member banks, which limitations relate to the amount and type of collateral, the amounts of advances, and other items.
Under the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (the “GLB Act”), the Bank is a voluntary member of the FHLB of Chicago. The Bank could withdraw or reduce its stock ownership in the FHLB of Chicago, although it has no current intention to do so. The FHLB of Chicago contributes to affordable housing programs through direct loans, interest subsidies on advances, and grants targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of dividends paid by the FHLB of Chicago and could continue to do so in the future.
Federal Reserve System. The Federal Reserve System requires all depository institutions to maintain non-interest-bearing reserves at specified levels against their checking, NOW, and Super NOW checking accounts and non-personal time deposits. Savings institutions have authority to borrow from the Federal Reserve System “discount window,” but Federal Reserve System policy generally requires savings institutions to exhaust all other sources before borrowing from the Federal Reserve System.
Deposit Insurance. The deposit accounts held by customers of the Bank are insured by the SAIF to a maximum of $100,000 as permitted by law. Insurance on deposits may be terminated by the FDIC if it finds that the Bank has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS as the Bank’s primary regulator. The management of the Bank does not know of any practice, condition, or violation that might lead to termination of the Bank’s deposit insurance.
The FDIC sets deposit insurance premiums based upon the risks a particular bank or savings association posed to its deposit insurance funds. Under the risk-based deposit insurance assessment system, the FDIC assigns an institution to one of three capital categories based on the institution’s financial information, as of the reporting period ending six months before the assessment period. The three capital categories are (1) well capitalized, (2) adequately capitalized and (3) undercapitalized. The FDIC also assigns an institution to one of three supervisory subcategories within each capital group. With respect to the capital ratios, institutions are classified as well capitalized, adequately capitalized or undercapitalized using ratios that are substantially similar to the prompt corrective action capital ratios discussed below. The FDIC also assigns an institution to a supervisory subgroup based on a supervisory evaluation provided to the FDIC by the institution’s primary federal regulator and information that the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds (which may include, if applicable, information provided by the institution’s state supervisor).
An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned. Under the final risk-based assessment system, there are nine assessment risk classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates are applied. Assessment rates for deposit insurance currently range from 0 basis points to 27 basis points. The capital and supervisory subgroup to which an institution is assigned by the FDIC is confidential and may not be disclosed. A bank’s rate of deposit insurance assessments will depend upon the category and subcategory to which the bank is assigned by the FDIC. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.
Transactions with Affiliates. Sections 23A and 23B of the Federal Reserve Act govern transactions between an insured federal savings association, such as the Bank, and any of its affiliates, such as the Company. The Federal Reserve Board has adopted Regulation W, which comprehensively implements and interprets Sections 23A and 23B, in part by codifying prior Federal Reserve Board interpretations under Sections 23A and 23B.
An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. A subsidiary of a bank that is not also a depository institution or a “financial subsidiary” under the GLB Act is not treated as an affiliate of the bank for the purposes of Sections 23A and 23B; however, the OTS has the discretion to treat subsidiaries of a savings association as affiliates on a case-by-case basis. Sections 23A and 23B limit the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such bank’s capital stock and surplus, and limit all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus. The statutory sections also require that all such transactions be on
terms that are consistent with safe and sound banking practices. The term “covered transaction” includes the making of loans, purchase of assets, issuance of guarantees and other similar types of transactions. Further, most loans by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100 to 130 percent of the loan amounts. In addition, any covered transaction by an association with an affiliate and any purchase of assets or services by an association from an affiliate must be on terms that are substantially the same, or at least as favorable, to the bank as those that would be provided to a non-affiliate.
Acquisitions and Mergers. Under the federal Bank Merger Act, any merger of the Bank with or into another institution would require the approval of the OTS, or the primary federal regulator of the resulting entity if it is not an OTS-regulated institution. See also “Acquisition of Bank Mutual Corporation” below for a discussion of factors relating to acquisitions of the Company.
Prohibitions Against Tying Arrangements. Savings associations such as the Bank are subject to the prohibitions of 12 U.S.C. Section 1972 on certain tying arrangements. A savings association is prohibited, subject to certain exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or certain of its affiliates or not obtain services of a competitor of the institution.
Customer Privacy. Savings associations such as the Bank are required to develop and maintain privacy policies relating to information on the customers and establish procedures to protect customer data. Applicable privacy regulations further restrict the sharing of non-public customer data with non-affiliated parties if the customer requests.
Uniform Real Estate Lending Standards. The federal banking agencies adopted uniform regulations prescribing standards for extensions of credit that are secured by liens on interests in real estate or made for the purpose of financing the construction of a building or other improvements to real estate. Under the joint regulations adopted by the federal banking agencies, all insured depository institutions must adopt and maintain written policies that establish appropriate limits and standards for extensions of credit that are secured by liens or interests in real estate or are made for the purpose of financing permanent improvements to real estate. These policies must establish loan portfolio diversification standards, prudent underwriting standards (including loan-to-value limits) that are clear and measurable, loan administration procedures, and documentation, approval and reporting requirements. The real estate lending policies must reflect consideration of the Interagency Guidelines for Real Estate Lending Policies that have been adopted by the federal bank regulators.
The Interagency Guidelines, among other things, require a depository institution to establish internal loan-to-value limits for real estate loans that are not in excess of the following supervisory limits:
• for loans secured by raw land, the supervisory loan-to-value limit is 65% of the value of the collateral;
• for land development loans (i.e., loans for the purpose of improving unimproved property prior to the erection of structures), the supervisory limit is 75%;
• for loans for the construction of commercial, multi-family or other non-residential property, the supervisory limit is 80%;
• for loans for the construction of one- to four-family properties, the supervisory limit is 85%; and
• for loans secured by other improved property (e.g., farmland, completed commercial property and other income-producing property, including non-owner occupied, one- to four-family property), the limit is 85%.
Although no supervisory loan-to-value limit has been established for owner-occupied, one- to four-family and home equity loans, the Interagency Guidelines state that for any such loan with a loan-to-value ratio that equals or exceeds 90% at origination, an institution should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral.
Community Reinvestment Act. Under the Community Reinvestment Act (“CRA”), any insured depository institution, including the Bank, has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an
institution’s discretion to develop the types of products and services that it believes are best suited to its particular community. The CRA requires the OTS, in connection with its examination of a savings association, to assess the savings association’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such association, including applications for additional branches and acquisitions.
Among other things, the CRA regulations contain an evaluation system that would rate an institution based on its actual performance in meeting community needs. In particular, the evaluation system focuses on three tests:
• a lending test, to evaluate the institution’s record of making loans in its service areas;
• affordable housing, and programs benefiting low or moderate income individuals and businesses; and
• a service test, to evaluate the institution’s delivery of services through its branches, ATMs and other offices.
The CRA requires the OTS, in the case of the Bank, to provide a written evaluation of a savings association’s CRA performance utilizing a four-tiered descriptive rating system and requires public disclosure of an association’s CRA rating. The Bank received a “satisfactory” overall rating in its most recent CRA examination.
Safety and Soundness Standards. Each federal banking agency, including the OTS, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal shareholder.
Prompt Corrective Action. FDICIA also established a system of prompt corrective action to resolve the problems of undercapitalized insured institutions. The OTS, as well as the other federal banking regulators, adopted the FDIC’s regulations governing the supervisory actions that may be taken against undercapitalized institutions. These regulations establish and define five capital categories, in the absence of a specific capital directive, as follows:
*
3% if the bank receives the highest rating under the uniform system
The severity of the action authorized or required to be taken under the prompt corrective action regulations increases as a bank’s capital decreases within the three undercapitalized categories. All savings associations are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the association would be undercapitalized. The FDIC or the OTS, in the case of the Bank, is required to monitor closely the condition of an undercapitalized bank and to restrict the growth of its assets. An undercapitalized savings association is required to file a capital restoration plan within 45 days of the date the association receives notice that it is within any of the three undercapitalized categories, and the plan must be guaranteed by any parent holding company. The aggregate liability of a parent holding company is limited to the lesser of:
• an amount equal to five percent of the bank’s total assets at the time it became “undercapitalized”; and
• the amount that is necessary (or would have been necessary) to bring the bank into compliance with all capital standards applicable with respect to such bank as of the time it fails to comply with the plan.
If a savings association fails to submit an acceptable plan, it is treated as if it were “significantly undercapitalized.” Banks that are significantly or critically undercapitalized are subject to a wider range of regulatory requirements and restrictions.
The FDIC has a broad range of grounds under which it may appoint a receiver or conservator for an insured savings association. If one or more grounds exist for appointing a conservator or receiver for a savings association, the FDIC may require the association to issue additional debt or stock, sell assets, be acquired by a depository bank or savings association holding company or combine with another depository savings association. Under FDICIA, the FDIC is required to appoint a receiver or a conservator for a critically undercapitalized savings association within 90 days after the association becomes critically undercapitalized or to take such other action that would better achieve the purposes of the prompt corrective action provisions. Such alternative action can be renewed for successive 90-day periods. However, if the savings association continues to be critically undercapitalized on average during the quarter that begins 270 days after it first became critically undercapitalized, a receiver must be appointed, unless the FDIC makes certain findings that the association is viable.
Loans to Insiders. A savings association’s loans to its executive officers, directors, any owner of more than 10% of its stock (each, an insider) and any of certain entities affiliated with any such person (an insider’s related interest) are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the Federal Reserve Board’s Regulation O thereunder. Under these restrictions, the aggregate amount of the loans to any insider and the insider’s related interests may not exceed the loans-to-one-borrower limit applicable to national banks, which is comparable to the loans-to-one-borrower limit applicable to the Bank’s loans. All loans by a savings association to all insiders and insiders’ related interests in the aggregate may not exceed the bank’s unimpaired capital and unimpaired surplus. With certain exceptions, loans to an executive officer, other than loans for the education of the officer’s children and certain loans secured by the officer’s residence, may not exceed the greater of $25,000 or 2.5% of the savings association’s unimpaired capital and unimpaired surplus, but in no event more than $100,000. Regulation O also requires that any proposed loan to an insider or a related interest of that insider be approved in advance by a majority of the board of directors of the savings association, with any interested director not participating in the voting, if such loan, when aggregated with any existing loans to that insider and the insider’s related interests, would exceed either $500,000 or the greater of $25,000 or 5% of the savings association’s unimpaired capital and surplus. Generally, such loans must be made on substantially the same terms as, and follow credit underwriting procedures that are no less stringent than, those that are prevailing at the time for comparable transactions with other persons and must not present more than a normal risk of collectibility.
An exception is made for extensions of credit made pursuant to a benefit or compensation plan of a bank that is widely available to employees of the savings association and that does not give any preference to insiders of the association over other employees of the association.
The USA PATRIOT Act. In response to the terrorist attacks of September 11, 2001, Congress adopted the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By means of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks and savings associations.
Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:
• All financial institutions must establish anti-money laundering programs that include, at minimum; (a) internal policies, procedures, and controls; (b) specific designation of an anti-money laundering compliance officer; (c) ongoing employee training programs, and (d) an independent audit function to test the anti-money laundering program.
• The Secretary of the Treasury, in conjunction with other bank regulators, may issue regulations that provide for minimum standards with respect to customer identification at the time new accounts are opened.
• Financial institutions that establish, maintain, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) must establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.
• Financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and will be subject to certain recordkeeping obligations with respect to correspondent accounts of foreign banks.
• Bank regulators are directed to consider a holding company’s effectiveness in combating money laundering when ruling on Federal Reserve Act and bank merger applications.
Bank Mutual Corporation Regulation
Holding Company Regulation
Bank Mutual Corporation is registered with the Office of Thrift Supervision as a savings and loan holding company and therefore, is subject to regulation and supervision by the OTS. The OTS has enforcement authority over the Company and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a risk to the Bank.
Non-grandfathered unitary savings and loan holding companies are limited to those activities permissible for financial holding companies or for multiple savings and loan holding companies. The Company is not a grandfathered unitary savings and loan holding company and, therefore, is limited to the activities permissible for financial holding companies or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance, incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the Office of Thrift Supervision, and certain additional activities authorized by OTS regulations.
Federal law prohibits a savings and loan holding company, directly or indirectly, from acquiring control of another savings institution or holding company thereof, without prior written approval of the Office of Thrift Supervision. It also prohibits the acquisition or retention of, with specified exceptions, more than 5% of the equity securities of a company engaged in activities that are not closely related to banking or financial in nature or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources, future prospects of the savings institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors.
Federal Securities Laws
Bank Mutual Corporation common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. The Company is therefore subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 was adopted in response to public concerns regarding corporate accountability in connection with the accounting and corporate governance scandals at several prominent companies. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.
The Sarbanes-Oxley Act is the most far-reaching U.S. securities legislation enacted in some time. It applies to all public companies, including the Company, that file periodic reports with the SEC, under the Securities Exchange Act.
The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and national securities exchanges and associations to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC, and increases penalties for violation. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
The Sarbanes-Oxley Act addresses, among other matters:
• audit committees and auditor independence;
• certification of financial statements by the chief executive officer and the chief financial officer;
• management reporting, and auditor attestation, of internal control over financial reporting;
• the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities if the issuer’s financial statements later require restatement;
• a prohibition on insider trading during retirement plan black out periods;
• further disclosure of off-balance sheet transactions;
• a prohibition on many personal loans to directors and officers (with exceptions for financial institutions);
• expedited filing requirements for reporting of insiders’ transactions; and
• disclosure of a code of ethics and disclosure of a change or waiver of such code.
Because some OTS accounting and governance regulations also refer to the SEC’s regulations, the Sarbanes-Oxley Act also may affect the Bank.
The Securities and Exchange Commission has been delegated the task of enacting rules to implement various of the provisions with respect to, among other matters, disclosure in filings pursuant to the Exchange Act, which rulemaking is substantially complete.
Acquisition of Bank Mutual Corporation
Under federal law, no person may acquire control of Bank Mutual Corporation or the Bank without first obtaining, as summarized below, the approval of such acquisition of control by the Office of Thrift Supervision. Under the federal Change in Bank Control Act and the Savings and Loan Holding Company Act, any person, including a company, or group acting in concert, seeking to acquire 10% or more of the outstanding shares of the Company must file a notice with the OTS. In addition, any person or group acting in concert seeking to acquire more than 25% of the outstanding shares of the Company’s common stock will be required to obtain the prior approval of the OTS. Under regulations, the OTS generally has 60 days within which to act on such applications, taking into consideration certain factors, including the financial and managerial resources of the acquiror, the convenience and needs of the communities served by the Company and the Bank, and the antitrust effects of the acquisition.
Office of Thrift Supervision conversion regulations prohibit, without the prior written approval of the OTS, any person from making an offer, announcing an intent to make an offer or participating in any other arrangement to purchase stock or acquiring stock in an institution or its holding company from another person, or actually acquiring shares in the converting institution or its holding company, for a period of three years from the date of the completion of the conversion if, upon the completion of such offer, announcement or acquisition, that person would become the beneficial owner of more than 10% of the outstanding stock of the institution or its holding company. The OTS has defined “person” to include any individual, group acting in concert, corporation, partnership,
association, joint stock company, trust, unincorporated organization or similar company, a syndicate or any other group formed for the purpose of acquiring, holding or disposing of securities of an insured institution. However, offers made exclusively to a bank or its holding company, or an underwriter or member of a selling group acting on the converting institution’s or its holding company’s behalf for resale to the general public are excepted. The Company’s conversion was completed on October 29, 2003. The regulation also provides civil penalties for willful violation or assistance in any such violation of the regulation by any person connected with the management of the converting institution or its holding company or who controls more than 10% of the outstanding shares or voting rights of a converted institution or its holding company.
Federal and State Taxation
Federal Taxation. The Company and its subsidiaries file a calendar year consolidated federal income tax return, reporting income and expenses using the accrual method of accounting.
Bad Debt Reserves. The Small Business Job Protection Act of 1996 (the “Job Protection Act”) repealed the “reserve method” of accounting for bad debts by most thrift institutions effective for the taxable years beginning after 1995. Larger thrift institutions such as the Bank are now required to use the “specific charge-off method.” The Job Protection Act also granted partial relief from reserve recapture provisions, which are triggered by the change in method. This legislation did not have a material impact on our financial condition or results of operations.
The federal income tax returns for the Company’s subsidiaries have been examined and audited or closed without audit by the IRS for tax years through 1999.
Depending on the composition of its items of income and expense, the Company may be subject to alternative minimum tax (“AMT”) to the extent AMT exceeds the regular tax liability. AMT is calculated at 20% of alternative minimum taxable income (“AMTI”). AMTI equals regular taxable income increased by certain tax preferences, including depreciation deductions in excess of allowable AMT amounts, certain tax-exempt interest income and 75% of the excess of adjusted current earnings (“ACE”) over AMTI. ACE equals AMTI adjusted for certain items, primarily accelerated depreciation and tax-exempt interest. The payment of AMT would create a tax credit, which can be carried forward indefinitely to reduce the regular tax liability in future years.
State Taxation. Under current law, the state of Wisconsin imposes a corporate franchise tax of 7.9% on the separate taxable incomes of the members of our consolidated income tax group except our Nevada subsidiaries. Presently, the income of the Nevada subsidiaries is only subject to taxation in Nevada, which currently does not impose a corporate income or franchise tax. However, see “Management’s Discussion and Analysis of Financial Condition-Comparisons of Operating Results for the Years Ended December 31, 2004 and 2003-Income Taxes” for a discussion of Wisconsin tax developments relating to these subsidiaries.
Item 2.
Item 2. Properties
The Company and its subsidiaries conducts its business through its executive office, an operations center and 71 banking offices, which had an aggregate net book value of $39.9 million as of December 31, 2004. The following table shows the location of our offices, whether they are owned or leased, and the expiration date of the leases for the leased offices.
*
If a leased property, the chart also shows year of lease expiration.
**
Date originally opened by an institution which was acquired by the Bank.
In addition, the Bank owns one parcel of undeveloped land in Brown Deer, Wisconsin through its MC Development subsidiary and one parcel of undeveloped land in Oconomowoc, Wisconsin. The 15 acre Brown Deer parcel is comprised of four lots consisting of 2.9 to 4.3 acres and was part of a larger property that was acquired in 1988 to accommodate the construction of a new corporate headquarters building. Each of the lots is available for sale and is designed to accommodate 60,000 to 75,000 square foot office buildings. The net book value of the four lots is $1.6 million.
MC Development’s owned Oconomowoc property consists of 318 acres of undeveloped land of which a one-half interest was sold in 2004 to a third party. Simultaneously in 2004, MC Development and that third party formed a joint venture, Arrowhead Development, LLC, to develop the entire 318 acre site. We anticipate that Arrowhead Development will begin to develop this land in 2005, and that residential lot sales will begin by late 2005 or in 2006.
Item 3.
Item 3. Legal Proceedings
The Bank is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. We believe that these routine legal proceedings, in the aggregate, are immaterial to our financial condition and results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Executive Officers of the Registrant
The table below sets forth certain information regarding the persons who have been determined, by our board of directors, to be executive officers of the Company. These persons will continue in the same positions with the successor the Company.
*
Excluding directorships and excluding positions with Bank subsidiaries. Those positions do not constitute a substantial part of the officers’ duties.
(1)
Indicates date when individual first held an executive officer position with the Bank or First Northern Savings. Each of these persons, other than Mr. Anderegg and Mr. Callen, became a Bank Mutual Corporation executive officer in 2000.
(2)
Michael Crowley, Jr. became president of Bank Mutual Corporation in 2003.
(3)
Rick Colberg is the chief financial officer of Bank Mutual Corporation. He is also Vice President of the Bank since 2003, when First Northern Savings merged into it. Previously he was senior vice president, chief financial officer, and treasurer of First Northern Savings.
(4)
This position has been considered to be an executive officer position of Bank Mutual Corporation since May 2003, as a result of the merger of the subsidiary banks.
Part II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchase of Equity Securities
The common stock of the Company is traded on The Nasdaq Stock Market® under the symbol “BKMU.”
As of February 28, 2005, there were 68,964,713 shares of common stock outstanding and approximately 6,423 shareholders of record. Bank Mutual Corporation became a publicly held corporation on November 1, 2000 and we did not pay a cash dividend in 2000. We paid a cash dividend of $0.18 per share in 2004. We increased our cash dividend to $0.06 per share to shareholders of record on February 17, 2005 which was paid March 1, 2005.
We anticipate that we will continue to pay quarterly cash dividends on our common stock, although there can be no assurance that payment of such dividends will continue or that they will not be reduced. The payment of dividends in the future is discretionary with our board of directors and will depend on our operating results and financial condition, regulatory limitations, tax considerations and other factors.
Interest on deposits will be paid prior to payment of dividends on Bank Mutual Corporation’s common stock. Earnings appropriated to bad debt reserves and deducted for federal income tax purposes cannot be used to pay cash dividends without the payment of federal income taxes on the amounts removed from the reserves for such purpose at the then current income tax rate.
Our common stock trades on The Nasdaq Stock Market®. The high and low trading prices from January 1, 2002 through December 31, 2004, by quarter, and the dividends paid in each quarter, were as follows:
COMMON STOCK TRADING PRICE RANGE
(High and Low Sales Price)
CASH DIVIDENDS PAID
A cash dividend of $0.06 per share, a 20.0% increase over the fourth quarter of 2004 cash dividend of $0.05 per share, was paid on March 1, 2005 to shareholders of record on February 17, 2005.
During the first two months of 2005, Bank Mutual’s common stock sales price ranged between $12.30 to $11.50 per share, and closed on February 28, 2005 at $12.09 per share
During 2004, Bank Mutual Corporation repurchased 6,642,521 shares at an average price of $11.87 per share. In addition, in December 2004, we announced another stock repurchase program, for 5.0 million shares; we did not begin purchases under this program until January 2005. In February 2005, we announced an amendment to this plan to increase the total number of shares to be repurchased under it to 10.0 million. As of February 28, 2005 Bank Mutual Corporation has repurchased 4.5 million shares at an average price of $12.17 per share.
The following table provides the specified information about the repurchases of shares by the Company during the fourth quarter of 2004.
The above table does not reflect the February 2005 amendment of the previously-announced stock repurchase plan to permit repurchase of an additional 5.0 million shares. The shares not purchased as part of the publicly announced program were existing owned Company shares used by option holders in payment of the purchase price and/or tax withholding obligations in connection with their exercise of stock options under the Company’s 2001 Stock Incentive Plan. The “price” used for these purposes is the deemed value of those shares under the 2001 Plan.
Item 6.
Item 6. Selected Financial Data
Selected Financial Highlights
The following table provides selected financial data for Bank Mutual Corporation for its past five fiscal years. The data is derived from the Company’s audited financial statements, although the table itself is not audited. The following data should be read together with the Company’s consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” later in this report.
On November 1, 2000, Mutual Savings Bank converted from a mutual to stock form of organization, completing a restructuring that resulted in the creation of Bank Mutual Corporation as its publicly-held holding company. The transactions included the Company’s stock offering and the Company’s related acquisition of First Northern. Under the purchase accounting method, First Northern’s results are included from the date of acquisition, and results prior to those dates are those of Mutual Savings Bank.
On October 29, 2003, the Company completed a conversion and reorganization from a mutual holding company form, established a new Wisconsin chartered company and in effect sold the MHC’s investment in the Company to the public. Approximately $404.8 million of net new capital was obtained in the October 29, 2003 conversion.
(4) In 2002, accounting rules concerning the amortization of goodwill changed. These ratios are being presented “excluding goodwill” so as to make them comparable among the years presented.
(5) Efficiency ratio is calculated by dividing noninterest expense by the sum of net interest income and noninterest income.
(6) The ratio is calculated by dividing total shareholders’ equity minus goodwill, other intangible assets net of deferred taxes and mortgage servicing rights by the sum of total assets minus goodwill, other intangible assets net of deferred taxes and mortgage servicing rights.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
From November 1, 2000 until October 29, 2003, Bank Mutual Corporation was an OTS chartered United States corporation which became the mid-tier holding company in the regulatory restructuring of Mutual Savings Bank into mutual holding company form. Until October 29, 2003, Bank Mutual Bancorp, MHC (the “MHC”), a U.S.-chartered mutual holding company of which Mutual Savings Bank’s depositors held all of the voting and membership rights, owned 52.2% of Bank Mutual Corporation’s outstanding common stock.
On November 1, 2000, Bank Mutual Corporation also acquired First Northern Capital Corp., the parent of First Northern Savings Bank. On March 16, 2003, Mutual Savings Bank and First Northern Savings Bank combined to form a single OTS chartered savings bank subsidiary of Bank Mutual Corporation called “Bank Mutual” herein called (the “Bank”).
On October 29, 2003, Bank Mutual Corporation completed a conversion and reorganization from a mutual holding company form, established a new Wisconsin chartered Bank Mutual Corporation and, in effect, sold the MHC’s interest in Bank Mutual Corporation to the public. Existing Bank Mutual Corporation shareholders exchanged each existing share for 3.6686 shares of the new Bank Mutual Corporation shares. The total number of shares issued or exchanged in the offering was approximately 78,707,669 shares.
All share and per share numbers in this discussion have been adjusted to reflect the full conversion transaction and related share exchange. As used herein, the “Company” and “Bank Mutual Corporation” refer to Bank Mutual Corporation both before and after the full conversion transaction, unless the context requires otherwise.
Significant Accounting Policies
There are a number of accounting policies that we established which require us to use our judgment. Some of the more significant policies are as follows:
- Establishing the amount of the allowance for loan losses requires the use of our judgment. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans and actual loss experience, current economic events in specific industries and geographical areas, including unemployment levels, and other pertinent factors, including regulatory guidance and general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends, all of which may be susceptible to significant change. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary. If we misjudge a major component and experience a loss, it will likely affect our earnings. Developments affecting loans can also cause the allowance to vary significantly between quarters. We consistently challenge ourselves in the review of the risk components to identify any changes in trends and their cause.
- Another valuation that requires our judgment relates to mortgage servicing rights. Mortgage servicing rights are recorded as an asset when loans are sold with servicing rights retained. The total cost of loans sold is allocated between the loan balance and the servicing asset based on their relative fair values. The capitalized value of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net future servicing revenue. Mortgage servicing rights are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. The carrying values are periodically evaluated for impairment. For purposes of measuring impairment, the servicing rights are stratified into pools based on term and interest rate. Impairment represents the excess of the remaining capitalized cost of a stratified pool over its fair value, and is recorded through a valuation allowance. The fair value of each servicing rights pool is calculated based on the present value of estimated future cash flows using a discount rate, given current market conditions. Estimates of fair value include assumptions about prepayment speeds, interest rates and other factors which are subject to change over time. Changes in these underlying assumptions could cause
the fair value of mortgage servicing rights, and the related valuation allowance, if any, to change significantly in the future.
- We also use our judgment in the valuation of other intangible assets (core deposit base
intangibles). Core deposit base intangible assets have been recorded for core deposits (defined as checking, money market and savings deposits) that have been acquired in acquisitions that were accounted for as purchase business combinations. The core deposit base intangible assets have been recorded using the assumption that they provide a more favorable source of funding than more expensive wholesale borrowings. An intangible asset has been recorded for the present value of the difference between the expected interest to be incurred on these deposits and interest expense that would be expected if these deposits were replaced by wholesale borrowings, over the expected lives of the core deposits. We currently estimate the underlying core deposits have lives of seven to fifteen years. If we find these deposits have a shorter life, we will have to write down the asset by expensing the amount that is impaired.
- We review goodwill at least annually for impairment, which requires the use of our judgment. Goodwill has been recorded as a result of two acquisitions in which the purchase price exceeded the fair value of tangible net assets acquired. If goodwill is determined to be impaired, it would be expensed in the period in which it became impaired.
- The assessment of our tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions, regulatory actions or interpretations, or changes in positions of federal and state taxing authorities will not differ from management’s current assessment. The impact of these matters could be significant to the consolidated results of operations and reported earnings.
Comparisons of Financial Condition at December 31, 2004 and 2003
Bank Mutual Corporation’s total assets at December 31, 2004, were $3.45 billion as compared to $3.11 billion at December 31, 2003. Total assets increased $336.8 million or 10.8% primarily as a result of investment of $200.0 million into mortgage-related securities funded by borrowing.
Cash and cash equivalents decreased $48.9 million in 2004 primarily as a result of using federal funds sold and interest-earning deposits to purchase mortgage-related securities, fund loans and deposit outflows.
Investment securities available-for-sale increased $899,000 during 2004 as a result of the increased fair market value in 2004.
Mortgage-related securities available-for-sale increased $212.9 million in 2004 primarily as a result of the reinvestment of principle and interest payments received from the mortgage-related securities portfolio and $200.0 million of mortgage-related securities purchased as a result of the additional borrowings. We intend to use the repayments and prepayments on these securities to fund loans and, therefore, reduce the dollar amount of the mortgage-related securities portfolio over time. The current portfolio has a weighted average yield of approximately 4.31% at December 31, 2004; however, the average yield earned for the year on the average portfolio was 4.35% as compared to 4.38% for the year of 2003. At December 31, 2004, we had $9.9 million of private placement collateralized mortgage obligations (“CMOs”) in our investment portfolio. Private placement CMOs have more credit risk than government agency CMOs and therefore, have a higher risk of impairment. If permanent impairment would occur, a related impairment would reduce earnings. See “Item 1. Business - Investment Activities.”
The following table sets forth our mortgage, consumer and commercial loan originations and purchases:
Loan originations decreased $461.7 million in 2004 as compared to originations in 2003, primarily as a result of relatively stable interest rates which prompted consumers to reduce the refinancing of their existing loans. Mortgage loan originations decreased $420.0 million or 46.7% and consumer loans decreased $33.1 million or 11.0% in 2004 as a result of the reduced refinancing of existing loans. A majority of the consumer loan originations continued to be first and second mortgage loans. We significantly increased our purchases of mortgage loans during 2004 to augment our loan originations. Each mortgage loan that is purchased is underwritten by us and conforms to our underwriting standards. Most of these purchased mortgage loans are in Wisconsin or in states adjacent to Wisconsin.
Commercial business loan originations decreased $8.6 million or 17.4 % in 2004 primarily as a result of reduced demand for commercial loans in our market area. In 2004, we hired an additional four experienced commercial loan originators in our continued efforts to emphasize commercial loan originations. Most of the new commercial loan originators were hired in the last six months of 2004. We anticipate that we will continue our emphasis not only on commercial loans but also on consumer loan originations to aid our asset and liability management and to aid in our overall profitability, although at somewhat more risk than traditional mortgage products.
Loans held for sale at December 31, 2004 as compared to December 31, 2003 increased $931,000 as a result of a temporary decrease in market interest rates in the fourth quarter of 2004, which resulted in more fixed rate mortgage loan originations and ultimately sales of fixed rate mortgage loans. Currently, we sell all of our 30 year fixed rate mortgage loan originations and some of our 20 and 15 year fixed rate mortgage loan originations in the secondary mortgage market.
Loans receivable increased $163.6 million in 2004 as a result of growth in all loan products except commercial real estate and commercial business loans. The one-to four-family mortgage loan portfolio increased $110.3 million or 13.9% primarily as a result of reduced fixed rate mortgage loan sales, reduced refinancing of existing loans, increased mortgage loans purchases from third parties and increased adjustable interest rate mortgage loan originations which are retained in the portfolio. The multi-family portfolio increased $37.1 million or 29.8% and the consumer loan portfolio increased $26.8 million or 5.9% both primarily as a result of reduced payoffs of existing loans.
The commercial real estate portfolio decreased $13.6 million or 6.5% primarily as a result of payoffs of related loans made to finance large apartment complexes. These loans were refinanced by the borrower with another company. The commercial business loan portfolio decreased $4.9 million or 6.5% primarily as a result of reduced originations and the transfer of $3.1 million of commercial non-performing loans to real estate owned and repossessed assets and ultimate disposal of the collateral or write-off of the loans.
Management expects to continue to emphasize consumer, non-residential mortgage loan and commercial business loan originations, as we believe they will continue to add to the overall profitability and aid in the management of interest rate risk. However, these loans can present higher credit risks than residential mortgage loans.
Goodwill resulted from the acquisitions of First Northern in 2000 and First Federal Bancshares of Eau Claire (“First Federal”) in 1997. Under the Financial Accounting Standards Board (“FASB”) Statement No. 142 “Goodwill and Other Intangible Assets” goodwill is tested at least annually for impairment. If goodwill is determined to be impaired, it will be expensed in the period in which it became impaired. No impairment of goodwill occurred in 2004, 2003 or 2002.
Other intangible assets are composed of core deposit base intangibles which were also the result of the First Northern and First Federal Eau Claire acquisitions. Other intangible assets are amortized over their expected life and tested for impairment at least annually.
Mortgage servicing rights are established on mortgage loans that we originate and sell. See “-Significant Accounting Policies” above and “-Comparisons of Operating Results for Years Ended December 31, 2004 and 2003-Noninterest Income” below for a further discussion of mortgage servicing rights.
Other assets are comprised of the following:
Our foreclosed properties and repossessed assets increased $991,000 to $1.6 million at December 31, 2004 as a result of foreclosures on commercial business loans. We believe that we continue to have good asset quality, particularly in our residential portfolio, and the homes, boats, recreational vehicles and other items that have been repossessed, are small in dollar amount in comparison to the size of our loan portfolio.
Premises and equipment decreased $1.2 million in 2004 primarily as a result of normal depreciation of these assets. We anticipate that two or three new bank office buildings will be established in 2005. The effect of these new bank offices will be an increase to our premises and equipment depreciation expense.
Federal Home Loan Bank (“FHLB”) of Chicago stock increased $2.7 million primarily as a result of stock dividends paid by the FHLB of Chicago. The FHLB of Chicago requires that its members own FHLB of Chicago stock as a condition for borrowing. The FHLB of Chicago generally pays dividends and had targeted a rate of return for their stock of 1% over the 1 year constant maturity Treasury note yield. Recently, the FHLB of Chicago modified its dividend payout policy to a dividend payout ratio not to exceed 90% of its adjusted core income, which is net income excluding gains or losses from non-recurring events. Historically, the FHLB of Chicago stock has met or exceeded its targeted returns but we cannot assure that will continue. See “Notes to Consolidated Financial Statements-Note 7. Borrowings.”
Bank owned life insurance (“BOLI”) is an asset that is used to partially offset the future cost of employee benefits. BOLI is long-term life insurance on the lives of certain current and past employees where the insurance policy benefits and ownership are retained by us. We value BOLI at the amount which we could obtain if we cashed in the policies at the current time. The cash value accumulation on BOLI is permanently tax deferred if the policy is held to the insured person’s death.
Deposits decreased $69.4 million in 2004 primarily as a result of our decision to offer interest rates on longer-term deposits at interest rates that approximate market average interest rates rather than offering higher promotional deposit rates. We believe that deposit growth (or shrinkage) for future periods will continue to depend, in a significant part, on the performance of other investment alternatives and world events. Early in 2005, we contracted with a wholesale deposit program which has the potential to increase the amount of our wholesale deposits.
Our borrowings increased $462.0 million in 2004, as a result of the increase in the securities and loan portfolio, the decrease in the deposit portfolio and the repurchase of our shares. In 2004, we refinanced two Federal Home Loan Bank of Chicago borrowings totaling $200.0 million that had maturities in November and December of 2004. The refinanced borrowings are due in September 2006. Prior to refinancing, the interest rates on the borrowings were 5.62% and 5.77% while, the new two year FHLB borrowing has a fixed interest rate of 2.75%. As a result of this transaction, we paid a $1.7 million prepayment penalty. In addition, in the fourth quarter of 2004, we borrowed an additional $200.0 million from the FHLB, on customary terms offered by the FHLB to member institutions. In addition to the foregoing borrowings, we also had outstanding overnight borrowings of $137.6 million at December 31, 2004 and $150.0 million of short-term fixed rate borrowing which matured early in January 2005 and was refinanced on similar short-term basis; these additional borrowings also were on terms and conditions which the FHLB generally makes available to member institutions. We use overnight and short-term borrowings to fund loan originations and decreases in deposits on a shorter-term basis.
Shareholders equity decreased $60.6 million in 2004 primarily as a result of the repurchase of shares, dividends paid in 2004, a decrease in our accumulated other comprehensive income and an increase in unearned deferred compensation offset by our net earnings.
We repurchased 6,642,521 shares in 2004 at an average price of $11.87. In addition, on December 19, 2004, we announced another 5.0 million Share Repurchase Plan that began January 21, 2005. On February 21, 2005, our existing repurchase plan was modified by authorizing an additional 5.0 million shares (a total of 10.0 million shares) to be repurchased. In 2005, through February 28th, we have repurchased an additional 4,524,000 shares, at an average price of $12.17 per share.
We increased our quarterly cash dividend to $0.04 per share for the first and second quarter of 2004, and again increased our cash dividend to $0.05 per share for the third and fourth quarter of 2004. The dividend payout ratio for 2004 was 45.3%, and total dividends paid during the year were $13.4 million. In February 2005, we further increased our dividend to $0.06 per share; our total dividends paid will not increase proportionately, however, as a result of our share repurchases.
Accumulated other comprehensive income decreased $5.0 million in 2004 primarily as a result of unfunded supplemental non-qualified benefit plan obligation and reduced fair market value on the mortgage-related securities. Accumulated other comprehensive income reflects the difference between the net current value of securities available for sale and the book value of those securities, net of tax, and any unfunded supplemental non-qualified benefit plan obligation, net of tax.
After the shareholders approved the 2004 Stock Incentive Plan, restricted shares were issued which increased unearned deferred compensation. Our shareholders equity to total assets ratio at December 31, 2004 was 19.5% as compared to 23.5% at December 31, 2003.
Average Balance Sheet and Yield/Rate Analysis
The following tables present, for the periods indicated, the total dollar amount of interest income from average interest-earning assets, the resultant yields, and the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. No tax equivalent adjustments were made since we do not have any tax exempt investments. Average balances are derived from average daily balances. The yield on securities available-for-sale is included in investment securities and mortgage-related securities and yields are calculated on the historical basis. The yields and rates are established by dividing income or expense dollars by the average balance of the asset or liability.
(1)
For the purposes of these computations, non-accruing loans and loans held for sale are included in the average loans outstanding.
(2)
FHLB stock is included in investment securities dollars outstanding and yields.
(3)
Interest rate spread is the difference between the average yield on interest-earning assets and the average cost on interest-bearing liabilities.
(4)
Net interest margin is determined by dividing net interest income by total interest-earning assets.
Rate/Volume Analysis
The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to:
(1) changes attributable to changes in volume (change in volume multiplied by prior rate);
(2) changes attributable to change in rate (changes in rate multiplied by prior volume); and
(3) the net change.
The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
Comparisons of Operating Results for Years Ended December 31, 2004 and 2003
General
Net income was $29.6 million for 2004 as compared to $22.6 million for 2003. The increase is primarily the result of investing the $404.8 million of net capital received from our stock offering in October 2003, which resulted in increases in interest income and the net interest margin, and from a $2.0 million gain on sale of real estate. These items were partially offset by reduction in the gains on the sales of loans, payment of a borrowing prepayment penalty, and increases in operating expenses.
Net Interest Income
Net interest income for 2004 increased $18.8 million, or 26.3% to $90.4 million as compared to $71.6 million for 2003. Net interest income increased primarily as a result of the investment of the $404.8 million of net stock proceeds and as a result of the investment of the proceeds, an increased net interest margin. The net interest margin for 2004 was 3.00% as compared to 2.58% for 2003.
The increase in the net interest margin for 2004 was primarily the result of investing the $404.8 million of net capital received from the stock offering (the capital bears no interest) in late 2003. The increase in the dollar amount of interest earning assets was also the result of the investment of the capital received from the Company’s stock offering. Most of the capital received was invested in mortgage-related securities. Going forward, since the effect of the increased capital was reflected for all of 2004, we do not expect to achieve a similar effect in 2005
Total Interest Income
Total interest income for 2004 increased $7.9 million or 5.6%, to $148.9 million as compared to $141.1 million for 2003. The increase was primarily the result of the increased dollar amount of mortgage-related securities partially offset by the decrease in the yields earned on the loan portfolio.
Interest income on loans decreased $7.3 million or 7.0% to $97.3 million as compared to $104.6 million in 2003. The decrease was primarily the result of the reduced average yield earned on the portfolio partially offset by an increase in the average dollar amount of the loan portfolio outstanding. Market interest rates on most loan originations throughout 2004 were below the existing yield on the loan portfolio and a large number of payoffs were on loans that were in excess of the average yield of loans in our loan portfolio. These events reduced our average yield on the loan to 5.41% in 2004 as compared to 6.01% in 2003.
Interest income on investment securities decreased $698,000 or 15.0% primarily as a result of reduced average dollar amount outstanding and reduced yield on those investments.
Interest income on mortgage-related securities increased $18.3 million or 62.6% as a result of investing the $404.8 million of net stock proceeds in late 2003 and additional borrowings in 2004 into mortgage-related securities. All of the funds were invested in mortgage-related securities with initial average lives of 3 to 4 years and at a yield of approximately 4.50%.
Interest income on interest-earning deposits (which includes federal funds sold) decreased $2.4 million or 92.2% as a result of reduced dollars outstanding partially offset by an increase in average yield on those deposits. The federal funds sold and interest-earning deposits at December 31, 2003 were reinvested into mortgage-related securities.
Interest Expense
Interest expense on deposits decreased $9.3 million or 18.1% as a result of decreased average cost of deposits and decreased dollar amount of deposits. The average cost of deposits for 2004 was 2.23% as compared to 2.51% in 2003. The decrease in the cost of deposits was the result of relatively flat market interest rates and our efforts to price deposits closer to the median of the market rather than at the higher end of the market offerings. However, as a result of this pricing decision, our deposit portfolio decreased throughout 2004.
Interest expense on borrowings decreased $1.6 million or 9.1% as a result of the reduced average cost of borrowings partially offset by an increase in the dollar amount of average borrowings. Average borrowings in 2004 increased $95.3 million and at December 31, 2004, borrowings were $462.0 million higher than at December 31, 2003. We used the proceeds of these borrowings as well as our existing capital resources, to fund an increase in the loan portfolio, an increase in mortgage-related securities, a decrease in the deposit portfolio and repurchases of our
shares. In the fourth quarter of 2004, we borrowed $200.0 million from the FHLB of Chicago at a cost of 2.77% and reinvested those funds into mortgage-related securities. The average cost of borrowings in 2004 was 3.94% as compared to 5.63% in 2003. The decrease in the average cost was the result of the new borrowings being added at a cost that was less than the average cost of borrowings and the refinancing of $200.0 million in September of 2004. The refinanced $200.0 million of borrowings had an average cost of 5.70% and were refinanced at an interest rate of 2.75%. As a result of prepaying the $200.0 million of FHLB borrowing, we paid a prepayment penalty of $1.7 million. The prepayment of the FHLB borrowings was done as a result of management anticipating a rise in interest rates at the time the original FHLB borrowings matured and its desire to lock in relatively lower interest rates, which should favorably affect related interest expense going forward; the prepayment fees were more than offset by interest savings. The balance of our borrowings at December 31, 2004 were overnight funds or fixed rate short term borrowings.
Provision for Loan Losses
Provisions for loan losses in 2004 and 2003 were $1.3 million. The $1.3 million in the provisions for loan losses for 2004 was primarily determined as a result of charge-offs of loans totaling $1.3 million. The charge-offs in 2004 were primarily attributed to one commercial loan that was placed in real estate owned and subsequently liquidated. In addition , there is one large commercial loan, of approximately $3.2 million that was non-performing at December 31, 2004 that we are closely monitoring and working with the business owners in an effort to arrange repayment.
The dollar amount of the typical commercial real estate, development and commercial loan tends to be larger than our single family loans and, therefore, any loss that we experience on these loans could be larger than what we have historically experienced on our single family loans. Depending on the type of commercial loan, the collateral may appeal only to a specialized group of people or businesses and therefore, may limit the number of potential buyers of the collateral, or in the case of collateral that is comprised of inventory, the liquidation of the collateral is more uncertain if a problem should arise.
The allowance for loan losses at December 31, 2004 was $13.9 million or 222.1% of non-performing loans and 176.5% of non-performing assets as compared to $13.8 million or 132.8% of non-performing loans and 125.2% of non-performing assets at December 31, 2003. The loan loss allowance to total loans was 0.74% at December 31, 2004 as compared to 0.80% at December 31, 2003.
Future provisions for loan losses will continue to be based upon our assessment of the overall loan portfolio and the underlying collateral, trends in non-performing loans, current economic conditions and other relevant factors in order to maintain the allowance for loan losses at adequate levels to provide for probable and estimatable losses. The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the adequacy of the allowance, which ultimately may or may not be correct. Higher rates of loan defaults than anticipated would likely result in a need to increase provisions in future years. Also, as multi-family and commercial loan portfolios increase, additional provisions would likely be added to the loan loss allowances as they carry a higher risk of loss. See also “Asset Quality” in Item 1, which is incorporated by reference, for certain other factors that may affect our provisions for loan losses on a go forward basis.
Noninterest Income
Total noninterest income decreased $3.4 million or 17.6% to $16.2 million as compared to $19.6 million for 2003. The decrease was primarily the result of decreased dollar amount of loan sales which correspondently decreased the gains on sales of loans.
Service charges on deposits decreased $184,000 in 2004 primarily as a result of the decreased number of deposit accounts and customer utilization of on-line banking and credit cards. We believe the reduced number of checking accounts is the result of our change in the checking account pricing policy in 2003.
Brokerage and insurance commissions increased $348,000 or 13.8% as a result of increased annuity and insurance sales.
Loan related fees and servicing revenue increased $954,000 or 150.0% in 2004 primarily as a result of $1.4 million of mortgage loan servicing rights becoming impaired in 2003, which offset related income in that year. In 2004, there were no impairments to the mortgage servicing rights. Mortgage servicing rights normally become impaired
from increased prepayments on mortgage loans which reduces the anticipated servicing fee income over the life of the loan.
Gains on sales of loans decreased substantially in 2004 as a result of reduced dollar amount of loan sales. Loan sales in 2004 were $120.5 million as compared to $461.1 million in 2003.
In the third quarter of 2004, we sold one-half of our interest in approximately 318 acres of owned real estate to an unrelated third party; the transaction resulted in a $2.0 million gain. We simultaneously established a limited liability company (Arrowood Development) with that party, in which we maintain a 50% interest, to develop the land. It is anticipated that the development of the real estate into a residential subdivision and subsequent sale of the developed lots will be a two-to four-year project.
Other income increased $37,000 or 0.8% in 2004 primarily as the result of increased ATM and checkcard fees.
Noninterest Expense
Compensation expense increased $4.5 million or 14.1% to $36.2 million in 2004 as compared to $31.7 million in 2003. The increase was primarily the result of reduced compensation and benefit cost deferrals on loan originations, vesting of restricted shares from the 2001 and 2004 Stock Incentive Plans and increased cost of benefits which included retirement and health expenses. Each loan that is originated has an incremental compensation and benefit cost determined and as loan originations decrease the incremental compensation and benefit cost deferrals decrease. In 2004, as a result of reduced refinancings of existing loans, the compensation and benefit cost deferrals decreased $2.2 million as compared to 2003.
At the 2004 Annual Meeting, shareholders approved a 2004 Stock Incentive Plan which authorized 4,106,362 stock options and 1,642,521 shares for a management recognition plan (“MRP” or “restricted stock”). In May 2004, 955,000 shares of restricted stock was granted to various officers. This grant and the fair market valuation of ESOP shares increased compensation expense approximately $1.8 million in 2004 as compared to 2003. Health insurance and pension costs increased a $1.1 million primarily as a result of increased health insurance premiums and decreased rates of return on pension investments.
Occupancy and equipment expense remained fairly constant when compared to 2003 primarily as a result of not adding any new offices in 2004. However, in 2005, we anticipate adding two new branch offices (in the Racine area) and one new office in the Waukesha area. The net effect of adding these new offices will be to increase our occupancy and equipment expense and other operating expenses in 2005.
Other expenses increased slightly in 2004 as compared to 2003. However, within the other expenses, marketing costs decreased $234,000 primarily as a result of the non-recurring expenses associated with the merger of our two subsidiary banks in March 2003. This marketing expense decrease was offset by increases in real estate owned expense associated with the disposal of a large commercial loan and increased auditing costs associated with the internal control attestation required as part of the implementation of Sarbanes-Oxley Act Section 404.
Income Taxes
The effective tax rate for 2004 was 34.6%, as compared to an effective tax rate of 34.1% in 2003.
Bank owned life insurance income is permanently tax deferred if the policy is held to the participant’s death. Therefore, the income earned on the life insurance is not included in taxable income for the calculation of tax expense.
Like many Wisconsin financial institutions, we have non-Wisconsin subsidiaries which hold and manage investment assets, the income on which has not been subject to Wisconsin tax. The Wisconsin Department of Revenue has instituted an audit program specifically aimed at out of state bank subsidiaries. The Department has asserted the position that some or all of the income of the out of state subsidiaries is taxable in Wisconsin. The Department is conducting audits of many such organizations, including our Nevada subsidiaries; its audit of Bank Mutual and its Nevada subsidiaries has not yet been concluded, and the Department has not asserted a claim against the Bank or its subsidiaries.
The Department sent letters in late July 2004 to Wisconsin financial institutions (whether or not they were undergoing an audit) reporting on settlements relating to these issues involving, at that time, 17 financial institutions
and their out-of-state investment subsidiaries. The letter provided a summary of available settlement parameters. For prior periods they include: restrictions on the types of subsidiary income excluded from Wisconsin taxation; assessment of certain back taxes relating to a limited time period; limitations on net operating loss carry forwards and interest on past-due taxes (but no penalties). For 2004 and going forward, the letter states similar provisions, including limits on subsidiaries’ assets which could be considered in determining income not subject to Wisconsin taxation. As outlined, the settlement would result in the rescission of prior letter rulings, and purport to be binding going forward except for future legislation or change by mutual agreement. However, the letter appears to implicitly accept the general proposition that some out-of-state investment subsidiary income is not subject to Wisconsin taxes. The Department’s positions may be challenged by one or more financial institution in the state.
The Company has engaged in discussions with the Department and has advised the Department that it wishes to receive and consider a proposal from the Department. In particular, the Company asked the Department to consider some specific factors which the Company believes may distinguish it from many other institutions. We have received certain information from the Department to further evaluate its position and our alternatives under our particular circumstances. The Company believes that it will need more specific detail than was included in the Department’s July letter or subsequent communications to quantify in any definitive way the Department’s view of its exposure, either for past periods or with respect to operations going forward, and to evaluate the Company’s alternatives. A determination on how to proceed will depend in part on further communication from and actions by the Department.
Depending upon the terms and circumstances, an adverse resolution of these matters could result in additional Wisconsin tax obligations for prior periods and/or higher Wisconsin taxes going forward, with a substantial negative impact on the earnings of Bank Mutual Corporation. The Company believes it has reported income and paid Wisconsin taxes in accordance with applicable legal requirements, and the Department‘s long standing interpretations thereof. We also may incur further costs in the future to address these issues.
Comparisons of Operating Results for Years Ended December 31, 2003 and 2002
General
Net income was $22.6 million for 2003 as compared to $26.5 million for 2002. The decrease is primarily the result of decreased net interest margin and increases in the provisions for loan losses and operating expenses These items were partially offset by an increase in the gains on the sale of loans.
Net Interest Income
Net interest income for 2003 decreased $6.2 million, or 7.9%, to $71.6 million as compared to $77.8 million for 2002. Net interest income decreased primarily as a result of a decrease in the net interest margin. The net interest margin for 2003 was 2.58% as compared to 2.88% for 2002. Although market interest rates for loans and deposits remained fairly stable throughout 2003, the high level of loan refinancing activity, in which higher interest rate loans were paid off, downward interest rate modifications on existing loans and the sales of fixed rate mortgage loans decreased the yield on the loan portfolio more than the decrease in the cost of funds.
Total Interest Income
Total interest income for 2003 decreased $24.4 million, or 14.7%, to $141.1 million as compared to $165.4 million for 2002. The decrease was primarily the result of: existing loans being refinanced to lower interest rate loans; sales of fixed rate mortgage loans in which the proceeds were invested in lower yielding mortgage-related securities; and prepayments of higher yielding mortgage-related securities.
Interest income on loans decreased $19.9 million, or 16.0% in 2003 to $104.6 million as compared to $124.5 million in 2002. The decrease was primarily the result of refinancing of existing loans to lower interest rate loans, loan originations that were at interest rates below the existing yield on the portfolio, downward interest rate modifications on certain existing loans and reduced average dollars outstanding for the year. Although 2003 was the second consecutive year of record originations, it was also a record year of loan sales. We sell our 30 year and some of our 20 and 15 year fixed rate mortgage loan originations to help us manage interest rate risk. All of these events reduced the average yield on our loan portfolio to 6.01% for 2003 as compared to 6.88% for 2002.
Interest income on investment securities decreased $926,000 or 16.6% primarily as a result of reduced dollars invested and a reduced yield on those investments. As investments matured the proceeds were either reinvested into an investment at a lower yield or invested into mortgage-related securities.
Interest income on mortgage-related securities decreased $3.1 million or 9.6%, as a result of higher yielding mortgage-related securities being prepaid and the reinvestment of those dollars into mortgage-related securities that were below the existing yield on the portfolio. In addition, we invested $329.3 million of the $404.8 million of proceeds from the stock offering by the end of November of 2003 and $74.9 million in December of 2003.
Interest income on interest earning deposits (which includes federal funds sold) decreased $477,000 or 15.3%, primarily as a result of the decreased yield earned on the deposits. The average balance of interest-earning deposits increased $63.0 million in 2003 to $253.2 million as compared to $190.1 million in 2002. The weighted average yield on interest-earning deposits for 2003 was 1.04% as compared to 1.63% for 2002.
Interest Expense
Interest expense on deposits decreased $13.5 million or 20.8% as a result of decreased costs of deposits. The average cost of deposits decreased to 2.51% in 2003 from 3.24% in 2002 primarily as a result of market interest rates trending lower throughout 2003 and the mix of the types of deposits. Savings deposits increased whereas, the higher cost time deposits decreased. We purposely reduced the offering interest rates on some of our time deposit products to decrease our cost of funds and to limit the growth. Although the cost of deposits decreased throughout 2003, and our policy to be somewhat less aggressive in pricing our deposit products as a result of our liquidity position, it did not decrease as much as the yield on interest-earning assets, therefore, our net interest margin was compressed.
Interest expense on borrowings decreased $4.6 million or 20.3%, as a result of less borrowings outstanding for 2003. Average borrowings outstanding for 2003 was $319.3 million as compared to $398.7 million for 2002.
Provisions for Loan Losses
Provisions for loan losses in 2003 were $1.3 million as compared to $760,000 for 2002. The increase in the provision for loan losses was primarily the result of increased commercial business loan delinquencies and, to a lesser extent, a change in the loan portfolio composition. We have two commercial borrowers with loans totaling $6.5 million that became non-performing in 2003. Both commercial borrowers have experienced reduced sales for their products and are experiencing
operating losses. One commercial borrower, with an aggregate of $3.3 million in loans, had been current in its loan payments until the fourth quarter of 2003 in which it became delinquent. The other borrower with an aggregate of $3.2 million in loans, has also experienced reduced sales however, they are delinquent in their payments.
The dollar amount of the typical commercial real estate, development and commercial loan tends to be larger than our single family loans and, therefore, any loss that we experience on these loans could be larger than what we have historically experienced on our single family loans. Depending on the type of commercial loan, the collateral may appeal only to a specialized group of people or businesses and therefore, may limit the number of potential buyers of the collateral, or in the case of collateral that is comprised of inventory, the liquidation of the collateral is more uncertain if a problem should arise.
The allowance for loan losses at December 31, 2003 was $13.8 million or 132.8% of non-performing loans and 125.2% of non-performing assets as compared to $12.7 million or 151.9% of non-performing loans and 139.4% of non-performing assets at December 31, 2002. The loan loss allowance to total loans was 0.80% at December 31, 2003 as compared to 0.76% at December 31, 2002.
Noninterest Income
Total noninterest income increased $2.9 million or 17.6% to $19.6 million for 2003 as compared to $16.7 million for 2002. The increase is primarily the result of increased gains on the sales of loans and the reduction of the valuation allowance for mortgage servicing rights.
Service charges on deposits increased $180,000 in 2003 as a result of increased number of accounts which pay service fees (normally checking accounts) and a pricing increase in which deposit fees were increased.
Brokerage and insurance commissions decreased $630,000 in 2003 primarily as a result of decreased securities and fixed rate tax deferred annuity sales.
Loan related fees and servicing revenues increased $1.7 million in 2003 as a result of reducing the valuation allowance for mortgage servicing rights. In 2002 and early 2003, mortgage servicing rights were determined to be temporarily impaired; therefore, servicing revenue was decreased and a valuation allowance was established to reflect the proper value. As loan refinancings decreased thereby reducing principal prepayments, the mortgage servicing rights increased in value. At that point, the entire valuation allowance was reduced, the effect of which is reflected in the increased loan related fees and servicing revenues.
Gains on the sale of investment increased $112,000 as a result of a sale of an investment.
Gains on the sales of loans increased $862,000 as a result of increased dollar amount of loans sold. We sold $461.1 million of fixed rate mortgage loans in 2003 as compared to $368.6 million in 2002. Gains on the sales of loans are primarily dependent on the dollar amount of fixed rate mortgage loan originations and the sale of those loans. If interest rates remain flat or increase, these gains could be reduced in future periods as sales are likely to decrease (as experienced in the fourth quarter of 2003).
Other noninterest income increased $726,000 in 2003 primarily as a result of an increase in debit card fees and income on assets held in a rabbi trust.
Noninterest Expense
Total noninterest expense increased $1.4 million primarily as a result of a modest increase in compensation and related expenses; an increase in costs associated with updating our data processing equipment and software; and an increase in costs associated with opening a new office and replacing an existing office.
Compensation, payroll taxes, and other employee benefit expense increased $397,000 or 1.3% as a result of compensation and benefit increases partially offset by a $275,000 recapture of a self funded health plan reserve.
Occupancy and equipment expense increased $338,000 as a result of deploying upgraded teller PCs, purchasing new teller software throughout our bank office network in 2002, and the construction of a new bank office and a replacement bank office in the later part of 2003.
Other expenses increased $705,000 primarily as a result of increased marketing expenses, costs associated with the consolidation of the two subsidiary banks and a branding campaign for the resulting bank, and ATM and electronic banking fees.
Income Taxes
The effective tax rate for 2003 was 34.1%, as compared to an effective tax rate of 32.8% in 2002.
Liquidity and Capital Resources
The term “liquidity” refers to our ability to generate adequate amounts of cash to fund loan originations, loan purchases, deposit withdrawals, and operating expenses. Our primary sources of funds are deposits, scheduled amortization, and prepayments of loan principal and mortgage-related securities, maturities and calls of investment securities, borrowings from the FHLB of Chicago and funds provided by our operations. Historically, these sources of funds have been adequate to maintain liquidity, with more borrowing in periods in which their operations generate less cash. In the event these sources of liquidity would become inadequate, Bank Mutual believes that it could access the wholesale deposit market, although there can be no assurances that wholesale deposits would be available if needed. During 2004, we substantially increased our levels of FHLB borrowings, in part to take advantage of what we believe were favorable borrowing opportunities and in part to fund growth without the need to grow deposits by offering above-market promotional interest rates.
Loan repayments and maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of investment securities and prepayments of loans and mortgage-related securities are strongly influenced by interest rates, general and local economic conditions and competition in the marketplace. For example, during 2004, loan prepayments decreased significantly because of the stable interest rate environment; another very different interest rate environment could lead to a significantly different result. These factors reduce the predictability of the timing of these sources of funds.
Our primary investing activities are the origination and purchase of one-to four-family real estate loans, multi-family and commercial real estate loans, home equity loans, other consumer loans, commercial business loans, the purchase of mortgage-related securities, and to a lesser extent, the purchase of investment securities.
These investing activities were funded by principal payments on mortgage loans and mortgage-related securities, calls and maturities on investment securities, borrowings, deposits, and funds provided by our operating activities.
At December 31, 2004, we exceeded each of the applicable regulatory capital requirements for our savings bank subsidiary. In order to be classified as “well-capitalized” by the FDIC we are required to have leverage (tier 1) capital of at least 5.00%. To be classified as a well-capitalized bank by the FDIC, we must also have a risk-based total capital ratio of at least 10.00%. At December 31, 2004, Bank Mutual had a risk-based total capital ratio of 28.85% and a leverage ratio of 13.74%. See “Notes to Consolidated Financial Statements-Note 8. Shareholders’ Equity.” We believe that our relatively high capital levels as compared to industry standards, which primarily resulted from our stock offering in 2003, provide us with the flexibility to increase leverage through borrowings, as we did in 2004, and to prudently repurchase shares, as we have with share repurchase programs in 2004 and 2005.
Shareholders’ equity is decreased by unearned ESOP shares, which represents shares in the Bank Mutual Employee Stock Ownership Plan which have not yet been earned by participating employees, and unearned deferred compensation, which represents stock grants under the management recognition plan (“MRP”) component of its 2004 and 2001 Stock Incentive Plans. See “Notes to Consolidated Financial Statements - Note 1. Summary of Significant Accounting Policies.” Shareholders’ equity is decreased by $4.8 million of accumulated other comprehensive income, consisting primarily of net unrealized losses, net of taxes, on securities available-for-sale. Bank Mutual Corporation in 2004 repurchased 6,642,521 shares under its stock repurchase programs, of which 955,000 restricted shares were re-issued to officers and directors in accordance with the 2004 Stock Incentive Plan and 298,736 were re-issued for exercises of stock options.
Cash and cash equivalents decreased $48.9 million during 2004; however, we still maintained $37.6 million of cash and cash equivalents at December 31, 2004. The Company used $378.6 million for investing activities, primarily as a result of purchases of mortgage-related and investment securities and an increase in the loan portfolio, partially offset by principal repayments on mortgage-related securities. The cash from operating activities of $27.7 million is primarily a result of Bank Mutual’s net income for the year, and non-cash expenses, offset by a net increase in other assets. Cash provided by financing activities of $302.0 million resulted primarily from the net proceeds of the borrowings, offset by our repurchases of securities and decreases in deposits.
Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance Sheet Arrangements
The Company has various financial obligations, including contractual obligations and commitments, that may require future cash payments.
The following table presents, as of December 31, 2004. significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements.
(a)
Excludes interest to be paid in the periods indicated.
The Company’s operating lease obligations represent short and long-term lease and rental payments for facilities, certain software and data processing and other equipment. Purchase obligations represent obligations under agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The purchase obligation amounts presented above primarily relate to certain contractual payments for services provided for information technology.
The Company also has obligations under its deferred retirement plan for directors as described in Note 10 to the consolidated financial statements.
The following table details the amounts and expected maturities of significant off balance sheet commitments as of December 31, 2004. Further discussion of these commitments is included in Note 13 to the consolidated financial statements.
Commitments to extend credit, including loan commitments, standby letters of credit, unused lines of credit and commercial letters of credit do not necessarily represent future cash requirements, since these commitments often expire without being drawn upon.
Impact of Inflation and Changing Prices
The financial statements and accompanying notes of Bank Mutual Corporation have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration for changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than do the effects of inflation.
Risk Factors
In addition to the various factors discussed above, you should consider carefully the following risk factors when evaluating Bank Mutual Corporation’s performance and outlook.
The Current Interest Rate Environment is Having an Adverse Impact on Our Net Interest Income. Beginning in June 2004, the Federal Reserve Board began increasing the Federal Funds target rate with the targeted rate being increased five times in 2004 and once in February 2005. Since these interest rate increases began, interest rates on short-term deposits have increased slightly. For example, the Federal Funds target rate was 1.00% as of December 31, 2003 and at December 31, 2004, the rate was 2.25%. The ten-year Treasury Bond rate was 4.25% as of December 31, 2003 and at December 31, 2004 the rate was 4.23%.
If interest rates continue to rise, the amount of interest we pay on deposits could increase more quickly than the amount of interest we receive on our loans, mortgage-related securities and investment securities. This could cause our profits to decrease. Rising interest rates would likely reduce the value of our mortgage-related securities and investment securities and may decrease demand for loans and make it more difficult for borrowers to repay their loans. Increasing market interest rates may also depress property values, which could affect the value of collateral securing our loans. For additional information on our exposure to interest rates, see “Quantitative and Qualitative Disclosures about Market Risk-Management of Interest Rate Risk.”
If Our Allowance for Loan Losses is Not Sufficient to Cover Actual Loan Losses, Our Earnings Could Decrease.
Our loan customers may not repay their loans according to the terms of the loans, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. We therefore may experience significant loan losses, which could have a material adverse effect on our operating results.
Material additions to our allowance also would materially decrease our net income, and the charge-off of loans may cause us to increase the allowance. We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We rely on our loan quality reviews, our experience and our evaluation of economic conditions, among other factors, in determining the amount of the allowance for loan losses. If our assumptions prove to be incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in additions to our allowance.
Our emphasis on a diverse loan portfolio has been one of the more significant factors we have taken into account in evaluating our allowance for loan losses and provision for loan losses. If we were to further increase the amount of loans in our portfolio other than traditional real estate loans, we may decide to make increased provisions for loan losses. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs.
We Are Expanding Our Lending Activities in Riskier Areas. We have identified commercial real estate, commercial business and consumer loans as areas for increased lending emphasis. While increased lending diversification is expected to increase interest income, non-residential loans carry greater risk of payment default than residential real estate loans. As the volume of these loans increase, credit risk increases. In the event of substantial borrower defaults, our provision for loan losses would increase and therefore, earnings would be reduced.
Our consumer loan portfolio included $53.3 million of indirect auto loans at December 31, 2004. Borrowers may be more likely to become delinquent on an automobile loan than on a residential real estate loan. Moreover, unlike the collateral for real estate loans, automobiles depreciate rapidly and, in the event of default, principal loss as a percent of the loan balance depends upon the mileage and condition of the vehicle at the time of repossession, over which
the Bank has no control. Similarly, any non-real estate collateral securing commercial business loans may depreciate over time and fluctuate in value.
Increases in Market Interest Rates are Likely to Adversely Affect Equity. As of December 31, 2004, we owned $1.3 billion of securities available-for-sale. Generally accepted accounting principles require that we carry these securities at fair value on our balance sheet. Unrealized gains or losses on these securities, reflecting the difference between the fair market value and the amortized cost, net of its tax effect, are carried as a component of shareholders’ equity. When market rates of interest increase, the fair value of our securities available-for-sale generally decreases and equity correspondingly decreases. When rates decrease, fair value generally increases and shareholders’ equity correspondingly increases. As of December 31, 2004, the Company’s available-for-sale portfolio had an unrealized loss of $5.8 million.
Low Demand for Real Estate Loans May Lower Our Profitability. Making loans secured by real estate is our primary business and primary source of profits. If customer demand for real estate loans decreases, our profits may decrease because our alternative investments, primarily securities, earn less income for us than real estate loans. Customer demand for loans secured by real estate could be reduced by a weaker economy, an increase in unemployment, a decrease in real estate values or an increase in interest rates.
Strong Competition Within Our Market Area May Reduce Our Customer Base. We encounter strong competition both in attracting deposits and originating real estate and other loans. We compete with commercial banks, savings institutions, mortgage banking firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms. Our market area includes branches of several commercial banks that are substantially larger than us in terms of deposits and loans. In addition, tax exempt credit unions operate in most of our market area and aggressively price their products and services to a large part of the population. Our profitability depends upon our continued ability to successfully maintain or increase our market share.
We Have Significant Intangible Assets Which May Need to be Written Off as an Expense in the Future. The Company has approximately $52.6 million in goodwill, $4.4 million in other intangible assets and $4.5 million of mortgage servicing rights as of December 31, 2004. As a result of SFAS No. 142, the Company no longer amortizes goodwill but will continue to amortize the other intangible assets over seven to fifteen years and will evaluate the mortgage servicing rights for impairment on a monthly basis. We will periodically check goodwill, and the other intangible assets for impairment. At some point in the future, our intangible assets may become impaired, and we would need to write them off as a reduction to earnings in the period in which they became impaired.
Stock-Based and Other Benefits Affect Our Results. We have adopted stock incentive plans which provided for the granting of options to purchase common stock and for awards of common stock to our eligible officers, employees and directors. We also have an employee stock ownership plan, and have adopted a restoration plan that will supplement the benefits to selected executive officers under the employee stock ownership plan and our 401(k) plan. The cost of the employee stock ownership plan will vary based on our stock price at specific points in the future. Additionally, we experienced an increase in employee health care costs in 2004, and expect further increases in 2005. These expenses will continue to affect our future earnings, as may other factors, such as government mandates, which would further increase the cost of compensation and/or benefits that are provided to employees.
Wisconsin Tax Developments Could Reduce Our Net Income. The Bank has Nevada subsidiaries which hold and manage investment securities and other investments. Because the subsidiaries are out of state, related income has not been subject to tax in Wisconsin. The Wisconsin Department of Revenue has implemented a program for the audit of Wisconsin financial institutions who have formed and contributed assets to subsidiaries located in Nevada, and presumably will seek to impose Wisconsin state income taxes on income from those operations, at least on a going forward basis. The Department has announced terms and conditions on which is has settled similar issues with other financial institutions in the state. The Company believes that it will need more specific detail than was included in that announcement or subsequent communications to quantify in any definitive way the Department’s view of its exposure, either for past periods or with respect to operations going forward, and to evaluate the Company’s alternatives. A determination on how to proceed will depend in part on further communication from and actions by the Department.
Depending upon the terms and circumstances, an adverse resolution of these matters could result in additional Wisconsin tax obligations for prior periods and/or higher Wisconsin taxes going forward, with a substantial negative impact on the earnings of Bank Mutual Corporation. We may also need to incur costs in the future to address any action taken against us by the Department.
Our Ability to Grow May be Limited if We Cannot Make Acquisitions. In an effort to fully deploy the capital we raised in our stock offering, we intend to seek to expand our banking franchise, internally by de novo branching and by acquiring other financial institutions or branches and other financial services providers. However, we have no specific plans for acquisitions at this time. Our ability to grow through selective acquisitions of other financial institutions or branches will depend on successfully identifying, acquiring and integrating those institutions or branches. We cannot assure you that we will be able to generate internal growth or identify attractive acquisition candidates, make acquisitions on favorable terms or successfully integrate any acquired institutions or branches.
Our Return on Shareholders’ Equity Is Reduced as a Result of the 2003 Offering. Net income divided by average shareholders’ equity, known as “return on equity,” is a ratio many investors use to compare the performance of a financial institution to its peers. Due to the large amount of additional capital that we raised in our stock offering in late 2003, our return on equity decreased as compared to our performance in prior years, pending optimal deployment of that additional capital. While we have deployed a significant amount of that capital (including market purchases of our shares in our share repurchase programs), our capital remains relatively high by industry standards. Until we can increase our net interest income and non-interest income, we expect that our return on equity may be below the industry average, which may negatively impact the value of our common stock.
Our Borrowings Have Significantly Increased, Which Further Exposes Us to the Risks of Leverage. Although our capital levels remain high, we substantially increased our borrowings in 2004. Borrowings tend to be a more costly source of funds than deposits. In addition, if interest rates change substantially, we may be less able to adjust our interest rate exposure on these borrowings than we would in the case of deposits. We will also need to have capital resources or other sources of funds to repay these borrowings when they come due, which we cannot assure.
Economic Conditions and World Events Could Affect Our Earnings. The United States economy began to improve in 2003 and continued to improve in 2004 according to economists. However, significant uncertainty remains in the economy. We do not know how swift or strong the recovery will be or how long it will continue. The effects of a recession, or a weak economy, can significantly affect our operations and profitability. For example, higher unemployment and reduced business sales or profits can make it more difficult for borrowers to repay their loans. Similarly, reduced income or confidence can lead consumers to reduce their purchases, and thus reduce loan demand.
The national and local economies were adversely affected by the attacks of September 11, 2001 and their aftermath and other world events such as the Iraq conflict. Bank Mutual Corporation, and the economy as a whole, may be affected by future world events, such as acts of terrorism, developments in the war on terrorism, conflict in the Middle East, and the international situation in North Korea and Iran.
Quarterly Financial Information
The following table sets forth certain unaudited quarterly data for the periods indicated:
Recent Accounting Developments
We discuss recent accounting changes in the “Notes to Consolidated Financial Statement-Note 1. Summary of Significant Accounting Policies-Recent Accounting Changes.”
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Management of Interest Rate Risk
The Bank’s ability to maintain net interest income depends upon earning a higher yield on assets than the rates we pay on deposits and borrowings. Fluctuations in interest rates will ultimately impact both our level of income and expense recorded on a large portion of our assets and liabilities. Fluctuations in interest rates will also affect the market value of all interest-earning assets, other than those which possess a short term to maturity.
Interest rate sensitivity is a measure of the difference between amounts of interest-earning assets and interest-bearing liabilities which either reprice or mature during a given period of time. The difference, or the interest rate sensitivity “gap,” provides an indication of the extent to which our interest rate spread will be affected by changes in interest rates. See “Gap Analysis” below.
Due to the nature of our operations, we are not directly subject to foreign currency exchange or commodity price risk. Instead, our real estate loan portfolio, concentrated in Wisconsin, is subject to risks associated with the local economy.
We seek to coordinate asset and liability decisions so that, under changing interest rate scenarios, earnings will remain within an acceptable range.
The primary objectives of our interest rate management strategy are to:
• maintain earnings and capital within self-imposed parameters over a range of possible interest rate environments;
• coordinate interest rate risk policies and procedures with other elements of our business plan, all within the context of the current business environment and our capital and liquidity requirements; and
• manage interest rate risk in a manner consistent with the approved guidelines and policies set by our board of directors.
To achieve the objectives of managing interest rate risk, our Asset/Liability committee meets periodically to discuss and monitor the market interest rate environment and provides reports to the board of directors. This committee is comprised of senior management.
Historically, our lending activities have emphasized one- to four-family first and second mortgage loans. Our primary source of funds has been deposits and borrowings, consisting primarily of time deposits and borrowings which have substantially shorter terms to maturity than the loan portfolio. We have employed certain strategies to manage the interest rate risk inherent in the asset/liability mix, including:
• emphasizing the origination of adjustable-rate and certain 15-year fixed rate mortgage loans for our portfolio, and selling certain 15 and 20 year fixed rate mortgage loans and all 30-year fixed rate mortgage loans;
• maintaining a significant level of investment securities and mortgage-related securities with a weighted average life of less than eight years or with interest rates that reprice in less than five years; and
• managing deposits and borrowings to provide stable funding.
We believe that the frequent repricing of our adjustable-rate mortgage loans, the cash flows from our 15-year fixed rate real estate loans, the shorter duration of our consumer loans, and adjustable rate features and shorter durations of our investment securities, reduce our exposure to interest rate fluctuations.
Gap Analysis. Repricing characteristics of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring a financial institution’s interest rate sensitivity “gap.” An asset or liability is said to be “interest rate sensitive” within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period.
A gap is considered positive when the amount of interest-earning assets maturing or repricing within a specific time period exceeds the amount of interest-bearing liabilities maturing or repricing within that specific time period. A gap is considered negative when the amount of interest-bearing liabilities maturing or repricing within a specific time period exceeds the amount of interest-earning assets maturing or repricing within the same period. During a period of rising interest rates, a financial institution with a negative gap position would be expected, absent the effects of other factors, to experience a greater increase in the costs of its liabilities relative to the yields of its assets and thus a decrease in the institution’s net interest income. An institution with a positive gap position would be expected, absent the effect of other factors, to experience the opposite result. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to reduce net interest income.
At December 31, 2004, based on the assumptions below, our interest-bearing liabilities maturing or repricing within one year exceeded our interest-earning assets maturing or repricing within the same period by $58.1 million. This represented a negative cumulative one-year interest rate sensitivity gap of 1.69%, and a ratio of interest-earning assets maturing or repricing within one year to interest-bearing liabilities maturing or repricing within one year of 95.5%.
The following table presents the amounts of our interest-earning assets and interest-bearing liabilities outstanding at December 31, 2004, which we anticipate to reprice or mature in each of the future time periods shown. The information presented in the following table is based on the following assumptions:
i) Investment securities - based upon contractual maturities and if applicable, call dates.
ii) Mortgage-related securities - based upon an independent outside source for determining cash flows (prepayment speeds).
iii) Loans - based upon contractual maturities, repricing date, if applicable, scheduled repayments of principal and projected prepayments of principal based upon our historical experience or anticipated prepayments.
iv) Deposits - based upon contractual maturities and our historical decay rates.
v) Borrowings - based upon the earlier of call date or final maturity.
The methods used in the previous table have some inherent shortcomings. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Certain assets, such as adjustable-rate loans, have features which limit changes in interest rates on a short-term basis and over the life of the loan. If interest rates change, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of borrowers to make payments on their adjustable-rate loans may decrease if interest rates increase.
Present Value of Equity
In addition to the gap analysis table, we also use a simulation model to monitor interest rate risk. The model reports the present value of equity in different interest rate environments, assuming an instantaneous and permanent interest rate shock to all interest rate-sensitive assets and liabilities. The present value of equity is the difference between the present value of expected cash flows of interest rate-sensitive assets and liabilities. The changes in market value of assets and liabilities due to changes in interest rates reflect the interest rate sensitivity of those assets and liabilities as their values are derived from the characteristics of the asset or liability (i.e., fixed rate, adjustable-rate, caps, floors) relative to the current interest rate environment. For example, in a rising interest rate environment the fair market value of a fixed rate asset will decline, whereas the fair market value of an adjustable-rate asset, depending on its repricing characteristics, may not decline. Increases in the market value of assets will increase the present value of equity whereas decreases in market value of assets will decrease the present value of equity. Conversely, increases in the market value of liabilities will decrease the present value of equity whereas decreases in the market value of liabilities will increase the present value of equity.
The following table presents the estimated present value of equity over a range of interest rate change scenarios at December 31, 2004. The present value ratio shown in the table is the present value of equity as a percent of the present value of total assets in each of the different rate environments. For purposes of this table, we have made assumptions such as prepayment rates and decay rates similar to those used for the gap analysis table.
As in the case of the gap analysis table, the methods we used in the previous table have some inherent shortcomings. This type of modeling requires that we make assumptions which may not reflect the manner in which actual yields and costs respond to changes in market interest rates. For example, we make assumptions regarding the acceleration rate of the prepayment speeds of higher yielding mortgage loans. Prepayments will accelerate in a falling rate environment and the reverse will occur in a rising rate environment. We also assume that decay rates on core deposits will accelerate in a rising rate environment and the reverse in a falling rate environment. The table assumes that we will take no action in response to the changes in interest rates, when in practice rate changes on certain products, such as savings deposits, may lag market changes. In addition, prepayment estimates and other assumptions within the model are subjective in nature, involve uncertainties, and therefore cannot be determined with precision. Accordingly, although the present value of the equity model may provide an estimate of our interest rate risk at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in interest rates on our present value of equity.
Item 8.
Item 8. Financial Statements and Supplementary Data
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
Report on Consolidated Financial Statements
Board of Directors
Bank Mutual Corporation and Subsidiaries
We have audited the accompanying consolidated statements of financial condition of Bank Mutual Corporation (the Company) and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 28, 2005 expressed an unqualified opinion thereon.
As discussed in Note 1, in 2003 the Company changed its method for accounting for goodwill.
Milwaukee, Wisconsin
January 28, 2005
Bank Mutual Corporation and Subsidiaries
Consolidated Statements of Financial Condition
See accompanaying notes to consolidated financial statements:
Bank Mutual Corporation and Subsidiaries
Consolidated Statements of Income
See accompanying notes to consolidated finacial statements.
Bank Mutual Corporation and Subsidiaries
Consolidated Statements of Changes in Shareholder’s Equity
Bank Mutual Corporation and Subsidiaries
Consolidated Statements of changes in Shareholder’s Equity
Bank Mutual Corporation and Subsidiaries
Consolidated Statements of Cash Flows
Bank Mutual Corporation and Subsidiaries
Consolidated Statements of Cash Flows (continued)
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies
Organization
From November 1, 2000 until October 29, 2003, Bank Mutual Corporation was an OTS chartered United States corporation which became the mid-tier holding company in the regulatory restructuring of Mutual Savings Bank, into mutual holding company form. Until October 29, 2003, Bank Mutual Bancorp, MHC (the “MHC”), a U.S.-chartered mutual holding company of which Mutual Savings Bank’s depositors held all of the voting and membership rights, owned a majority of Bank Mutual Corporation’s outstanding common stock.
On November 1, 2000, Bank Mutual Corporation also acquired First Northern Capital Corp., the parent of First Northern Savings Bank. On March 16, 2003, Mutual Savings Bank and First Northern Savings Bank combined to form a single OTS chartered savings bank subsidiary of Bank Mutual Corporation called Bank Mutual (“Bank Mutual” or the “Bank”).
On October 29, 2003, Bank Mutual Corporation completed a conversion and reorganization from a mutual holding company form, established a new Wisconsin chartered Bank Mutual Corporation and, in effect, sold the MHC’s interest in Bank Mutual Corporation to the public. Existing Bank Mutual Corporation shareholders exchanged each existing share for 3.6686 shares of the new Bank Mutual Corporation. The total number of shares issued and exchanged in the offering was 78,707,669 shares.
All share and per share numbers in these financial statements have been adjusted to reflect the full conversion transaction and related share exchange.
As used herein, the “Company” refers to Bank Mutual Corporation both before and after the full conversion transaction
Business
Bank Mutual is a federal savings bank offering a full range of financial services to customers who are primarily located in the state of Wisconsin. Bank Mutual is principally engaged in the business of attracting deposits from the general public and using such deposits to originate residential and commercial real estate loans, consumer loans, and commercial and industrial loans.
Principles of Consolidation
The consolidated financial statements include the accounts and transactions of the Company and its wholly owned subsidiaries. Bank Mutual has the following wholly owned subsidiaries: Lake Financial and Insurance Services, Mutual Investment Corporation, MC Development Ltd., and First Northern Investments Inc. Significant intercompany accounts and transactions have been eliminated in consolidation. Bank Mutual also has two 50% owned subsidiaries, Savings Financial Corporation, which is accounted for using the equity method, and Arrowood Development, LLC, which is consolidated into the financial statements.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenues and expenses for the period. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Company considers federal funds sold and interest-bearing deposits that have original maturities of three months or less to be cash equivalents.
Federal Home Loan Bank Stock
Stock of the Federal Home Loan Bank (“FHLB”) is owned due to regulatory requirements and carried at cost, which is its redeemable value.
Investment and Mortgage-Related Securities Available-for-Sale
Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of equity.
The amortized cost of securities classified as available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity, or in the case of mortgage-related securities, over the estimated life of the security. Such amortization is included in interest income from investments. Interest and dividends are included in interest income from investments. Realized gains and losses and declines in value judged to be other-than-temporary are included in net gain or loss on sales of securities and are based on the specific identification method.
Loans Held for Sale
Loans held for sale, which generally consist of current production of certain fixed-rate mortgage loans, are recorded at the lower of cost or market value, determined on an individual loan basis. Fees received from the borrower are deferred and recorded as an adjustment of the carrying value.
Loans Receivable and Related Interest Income
Interest on loans is accrued and credited to income as earned. Accrual of interest is generally discontinued either when reasonable doubt exists as to the full, timely collection of interest or principal or when a loan becomes contractually past due by more than 90 days with respect to interest or principal. At that time, any accrued but uncollected interest is reversed and additional income is recorded only to the extent that payments are received and the collection of principal is reasonably assured. Loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectibility of the total contractual principal and interest is reasonably assured.
Loan Fees and Related Costs
Loan origination and commitment fees and certain direct loan origination costs are deferred and amortized as an adjustment of the related loans’ yield. The Company amortizes these amounts using the level-yield method over the contractual life of the related loans.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
Allowance for Loan Losses
The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans and actual loss experience, current economic events in specific industries and geographical areas, including unemployment levels, and other pertinent factors, including regulatory guidance and general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends, all of which may be susceptible to significant change. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary.
Mortgage Servicing Rights
Mortgage servicing rights are recorded as an asset when loans are sold with servicing rights retained. The total cost of loans sold is allocated between the loan balance and the servicing asset based on their relative fair values. The total cost of loans sold is allocated between the loan balance and their servicing asset based on their relative fair values. The capitalized value of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net future servicing revenue. Mortgage servicing rights are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. The carrying values are periodically evaluated for impairment. For purposes of measuring impairment, the servicing rights are stratified into pools based on term and interest rate. Impairment represents the excess of the remaining capitalized cost of a stratified pool over its fair value, and is recorded through a valuation allowance. The fair value of each servicing rights pool is calculated based on the present value of estimated future cash flows using a discount rate, given current market conditions. Estimates of fair value include assumptions about prepayment speeds, interest rates and other factors which are subject to change over time. Changes in these underlying assumptions could cause the fair value of mortgage servicing rights, and the related valuation allowance, if any, to change significantly in the future.
Mortgage Banking Loan Commitments
In connection with its mortgage banking activities, the Company enters into loan commitments to fund residential mortgage loans at specified interest rates and within specified periods of time, generally up to 60 days from the time of rate lock. A loan commitment whose loan arising from exercise of the loan commitment will be held for sale upon funding is a derivative instrument under Statement of Financial Accounting Standards No. 133 (“SFAS No. 133”), “Accounting for Derivative Instruments and Hedging Activities,” (as amended), which must be recognized at fair value on the consolidated balance sheet in other assets and other liabilities with changes in its value recorded in income from mortgage banking operations.
In determining the fair value of its derivative loan commitments for economic purposes, the Company considers the value that would be generated when the loan arising from exercise of the loan commitment is sold in the secondary mortgage market. That value includes the price that the loan is expected to be sold for in the secondary mortgage market.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
Foreclosed Properties and Repossessed Assets
Foreclosed properties acquired through, or in lieu of, loan foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. Costs related to the development and improvement of property are capitalized, whereas costs related to holding the property are expensed. Gains and losses on sales are recognized based on the carrying value upon closing of the sale.
Premises and Equipment
Land, buildings, leasehold improvements and equipment are carried at amortized cost. Buildings and equipment are depreciated over their estimated useful lives using the straight-line method. Leasehold improvements are amortized over the shorter of their useful lives or lease terms. The Company reviews buildings, leasehold improvements and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment exists when the estimated undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.
Goodwill and Other Intangible Assets
Goodwill, representing the excess of purchase price over the fair value of net assets acquired, results from acquisitions made by the Company. Goodwill is reviewed at least annually for impairment based upon guidelines specified by Statement of Financial Accounting Standards (“SFAS”) No. 142 - “Goodwill and Other Intangible Assets.” Other intangible assets, primarily attributed to the customer relationships acquired, are amortized over their estimated useful lives, generally seven to fifteen years. Other intangible assets are reviewed if facts and circumstances indicate that they may be impaired. Prior to January 1, 2002, the Company amortized goodwill on a straight-line basis over periods of ten to twenty years and periodically assessed whether events or changes in circumstances indicated that the carrying amount of goodwill might be impaired.
Life Insurance Policies
Investments in life insurance policies owned by the Company are carried at the amount that could be realized under the insurance contract if the Company cashed them in on the respective dates.
Income Taxes
The Company files a consolidated federal income tax return and separate, or combined, state income tax returns, depending on the state. A deferred tax asset or liability is determined based on the enacted tax rates that will be in effect when the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in the Company’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date of the change. A valuation allowance is provided for any deferred tax asset for which it is more likely than not that the asset will not be realized. Changes in valuation allowances are recorded as a component of income taxes.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
Earnings Per Share
Basic and diluted earnings per share (“EPS”) are computed by dividing net income by the weighted-average number of common shares outstanding for the period. ESOP shares committed to be released are considered outstanding. Vested shares of restricted stock which have been awarded under the management recognition plan (“MRP”) provisions of the Company’s 2004 and 2001 Stock Incentive Plans, are considered common stock equivalents and are included in the weighted-average number of shares outstanding for basic EPS. Nonvested MRP shares are considered common stock equivalents and are included in the weighted-average number of shares outstanding for diluted EPS.
Pension Costs
The Company has both defined benefit and defined contribution plans. The Company’s net periodic pension cost of the defined benefit plan consists of the expected cost of benefits earned by employees during the current period and an interest cost on the projected benefit obligation, reduced by the expected earnings on assets held by the retirement plan, amortization of transitional assets over a period of 15 years, amortization of prior service cost and amortization of recognized actuarial gains and losses over the estimated future service period of existing plan participants. The costs associated with the defined contribution plan consist of a predetermined percentage of compensation, which is determined by the Company’s Board of Directors.
Segment Information
The Company has determined that it has one reportable segment - community banking. Bank Mutual offers a range of financial products and services to external customers, including: accepting deposits from the general public; originating residential, consumer and commercial loans; and marketing annuities and other insurance products.
Stock Compensation
In May 2001, the Company shareholders approved the 2001 Stock Incentive Plan (the “2001 Plan”), providing for restricted stock (“MRP”) awards up to 1,226,977 shares. Of these, 1,210,630 MRP shares were granted during the year ended December 31, 2001 to employees in management positions and directors and 124,737 shares were subsequently forfeited. No shares were granted during the years ended December 31, 2002 and 2003. The outstanding 2001 MRP grants had a fair value of $5,001 at December 31, 2004.
In May 2004, the Company shareholders approved the 2004 Stock Incentive Plan (the “2004 Plan”), providing for MRP awards up to 1,642,521 shares. Of these, 955,000 shares were granted during the year ended December 31, 2004. The outstanding 2004 MRP grants had a fair value of $11,622 at December 31, 2004. The 2001 and 2004 MRP grants are being amortized to compensation expense as the Company’s employees and directors become vested in the granted shares.
The amount amortized to expense was $2,156 for the year ended December 31, 2004 and $667 for the year ended December 31, 2003. The remaining unamortized cost of the MRP is reflected as a reduction of shareholders’ equity as unearned deferred compensation.
Options for 4,050,122 shares were granted on May 8, 2001 under the 2001 Plan at an exercise price of $3.2056 and expire on May 8, 2011. On May 3, 2004, options for an additional 2,382,000 shares were granted under the 2004 Plan at an exercise price of $10.673 per share and expire May 3, 2014.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
The following schedule reflects stock options for the years ended December 31, 2004, 2003 and 2002.
The estimated fair value of each option granted is calculated using the Black-Scholes option-pricing model. The following summarizes the weighted average assumptions used in the model:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models such as the Black-Scholes require the input of highly subjective assumptions including the expected stock price volatility. Bank Mutual’s stock options have characteristics significantly different from traded options and inasmuch, changes in the subjective input assumptions can materially affect the fair value estimate. In management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
The Company accounts for the stock options in accordance with APB Opinion 25, as allowed under SFAS No. 123, and, therefore, no compensation cost has been recognized in connection with stock options granted in any year. Pursuant to SFAS No. 123 disclosure requirements, pro forma net income and earnings per share are presented below as if compensation cost for stock options was determined under the fair value method and amortized to expense over the options’ vesting periods.
The pro forma amounts may not be indicative of the effect on reported net income and earnings per share for future years as current options vest over five years.
Recent Accounting Changes
In January 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation Number (“FIN”) 46. FIN 46 required the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interest in the entity. The provisions of this statement were effective immediately for variable interests in variable interest entities (“VIE’s”) created after January 31, 2003. The Corporation adopted FIN 46 for the quarter ended December 31, 2003.
Management has evaluated the applicability of FIN 46 on various investments and interests, including low-income housing partnership interests, small business commercial real estate partnerships and historic tax credit partnerships. The Company has determined as of December 31, 2003, that it did not have any VIEs. In 2004, a partnership, which is 50% owned by the Company, was established to develop 318 acres of owned real estate with an unrelated third party, which is classified as a VIE. This VIE is recorded on the statement of financial condition as an increase in other assets ($2.3 million) and is accompanied by an increase in minority interest in real estate development as a mezzanine item, after liabilities and before shareholders’ equity. The income and expenses of the partnership are presented in other income and expenses are presented in other expenses of the statement of income.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
1. Summary of Significant Accounting Policies (continued)
Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 105, “Application of Accounting Principles to Loan Commitments” was issued on March 9, 2004 and is effective for commitments to originate mortgage loans to be held for sale that are entered into after March 31, 2004. SAB No. 105 requires that fair-value measurement include only differences between the guaranteed interest rate in the loan commitment and a market interest rate, excluding expected future cash flows related to the customers relationship or loan servicing. Because of the SAB’s limit on the types of cash flows that can be considered in the fair-value measurement, mortgage-loan commitments could be recognized as liabilities if the guaranteed rate in the commitment is less than the market interest rate. In addition, SAB No. 105 requires registrants to disclose their accounting policy for loan commitments pursuant to APB Opinion No. 22, including methods and assumptions used to estimate fair value and any associated hedging strategies, as required by Statement No. 107, Statement No. 133 and Item No. 305 of Regulation S-K (Quantitative and Qualitative Disclosures About Market Risk). The provisions of SAB No. 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. This SAB had minimal impact on our financial condition or the results of operations.
The FASB Emerging Issues Task Force (“EITF”) issued EITF No. 03-01 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” to provide guidance on certain accounting issues. Specifically, it provided guidance to better define when and whether unrealized losses in the investment category of “Available-for-Sale” should be deemed other than temporary and if the unrealized losses are other than temporary requiring immediate recognition through the statement of income. In September 2004, FASB, after receiving input from businesses, delayed the implementation of certain aspects of the issue which addresses the determination of other-than-temporary issues and will reconsider in its entirety the EITF and all other guidance on disclosing, measuring and recognizing other-than-temporary impairments of debt and equity securities.
On December 16, 2004, FASB issued SFAS No. 123 (“R”evised 2004), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. We expect to adopt SFAS No. 123(R) on July 1, 2005.
As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)’s fair value method will have an impact on our results of operations, although it will have no material impact on our overall financial position. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in “Note 1. Summary of Significant Accounting Policies...Stock Compensation” to our consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were not material to the cash flows of the Company.
Reclassifications
Certain 2003 and 2002 amounts have been reclassified to conform to the 2004 presentation.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
2. Securities, Available-for-Sale
The amortized cost and fair value of investment securities available-for-sale are as follows:
The following schedule identifies securities by time in which the securities had a gross unrealized loss.
The Company does not believe any individual unrealized loss as of December 31, 2004 represents an other-than-temporary impairment. The unrealized losses reported for mortgage-backed securities relate primarily to securities issued by FNMA, FHLMC and private institutions. These unrealized losses are primarily attributable to changes in interest rates and individually were 2% or less of their respective amortized cost basis. The Company has the ability to hold the securities contained in the previous table for a time necessary to recover the amortized cost.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
2. Securities, Available-for-Sale (continued)
The amortized cost and fair values of securities by contractual maturity at December 31, 2004, are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations with or without call or prepayment penalties.
The following table summarizes the adjustment to other comprehensive income and the related tax effect for each of the three years ended December 31:
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
2. Securities, Available-for-Sale (continued)
Investment securities with a fair value of approximately $133,518 and $14,048 at December 31, 2004 and 2003, were pledged to secure deposits, borrowings and for other purposes as permitted or required by law. See also Notes 6 and 11 for additional information regarding security pledges.
3. Loans Receivable
Loans receivable consist of the following:
The Company’s first mortgage loans and home equity lines of credit are primarily secured by properties housing one-to-four families which are generally located in the Company’s local lending areas in Wisconsin, Michigan and Minnesota. Non-accrual loans at December 31, 2004 were $5,683 and at December 31, 2003, were $9,288.
A summary of the activity in the allowance for loan losses follows:
The unpaid principal balance of loans serviced for others was $620,055, $649,332, and $638,801 at December 31, 2004, 2003 and 2002, respectively. These loans are not reflected in the consolidated financial statements.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
3. Loans Receivable (continued)
The following table presents data on impaired loans:
4. Goodwill, Other Intangible Assets and Mortgage Servicing Rights
The carrying amount of mortgage servicing rights net of accumulated amortization and the associated valuation allowance at December 31, 2004 is presented in the following table.
In 2004, there were no permanent impairments, however in 2003, a charge of $1,419 was recorded for loans that had mortgage servicing rights that were permanently impaired. This amount is included with the amortization in the table above.
Deposit base intangibles had a carrying amount and a value net of accumulated amortization of $4,412 at December 31, 2004.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
4. Goodwill, Other Intangible Assets and Mortgage Servicing Rights (continued)
The projections of amortization expense shown below for mortgage servicing rights are based on existing asset balances and the existing interest rate environment as of December 31, 2004. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.
The following table shows the current period and estimated future amortization expense for amortizable intangible assets:
5. Other Assets
Other Assets are summarized as follows:
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
5. Other Assets (continued)
Foreclosed properties and repossessed assets are summarized as follows:
Premises and equipment are summarized as follows:
Depreciation expense for 2004, 2003 and 2002 was $3,253, $3,021 and $2,811, respectively.
Bank Mutual leases various branch offices, office facilities and equipment under noncancelable operating leases which expire on various dates through 2012. Future minimum payments under noncancelable operating leases with initial or remaining terms of one year or more for the years indicated are as follows at December 31, 2004:
Rental expenses totaled $999, $974, and $1,022 for 2004, 2003 and 2002, respectively.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
6. Deposits
Deposits are summarized as follows:
The aggregate amount of certificate accounts with balances of one hundred thousand dollars or more is approximately $155,117 and $149,690 at December 31, 2004 and 2003, respectively.
Interest expense on deposits was as follows:
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
7. Borrowings
Borrowings consist of the following:
Bank Mutual is required to maintain unencumbered mortgage loans in its portfolios aggregating at least 167% of the amount of outstanding advances from the FHLB as collateral. Bank Mutual’s borrowings at the FHLB are limited to the lesser of 35% of total assets or 60% of the book value of certain mortgage loans. In addition, these notes are collateralized by FHLB stock of $38,186 and $35,498 at December 31, 2004 and 2003, respectively.
Bank Mutual has a line of credit with two financial institutions which totals $10.0 million. At December 31, 2004 and 2003, no draws were outstanding.
8. Shareholders’ Equity
Bank Mutual is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional discretionary, actions by regulators, that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Bank Mutual must meet specific capital guidelines that involve quantitative measures of Bank Mutual’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Bank Mutual’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
8. Shareholders’ Equity (continued)
Quantitative measures established by federal regulation to ensure adequacy require Bank Mutual to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as these terms are defined in regulations) to risk-weighted assets (as these terms are defined in regulations), and of Tier I capital (as these terms are defined in regulations) to average assets (as these terms are defined in regulations). Management believes, as of December 31, 2004, that Bank Mutual met all capital adequacy requirements.
The Company is not aware of any conditions or events, which would change Bank Mutual’s status as well capitalized. There are no conditions or events since that notification that management believes have changed Bank Mutual’s category.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
8. Shareholders’ Equity (continued)
Following are reconciliations of Bank Mutual’s (subsidiary bank) equity under generally accepted accounting principles to capital as determined by regulators:
9. Earnings Per Share
The computation of the Company’s basic and diluted earnings per share is presented in the following table.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
10. Employee Benefit Plans
Bank Mutual Corporation
Bank Mutual Corporation has a discretionary, defined contribution savings plan (the Savings Plan). The Savings Plan is qualified under Sections 401 and 401(k) of the Internal Revenue Code and provides employees meeting certain minimum age and service requirements the ability to make contributions to the Savings Plan on a pretax basis. The Company then matches a percentage of the employee’s contributions. Matching contributions made by the Company were $159 in 2004, $146 in 2003 and $103 in 2002.
Bank Mutual Corporation also has a defined benefit pension plan covering employees meeting certain minimum age and service requirements and a supplemental pension plan for certain qualifying employees. The supplemental pension plan is funded through a “rabbi trust” arrangement. The benefits are generally based on years of service and the employee’s average annual compensation for five consecutive calendar years in the last ten calendar years which produces the highest average. The Company’s funding policy is to contribute annually the amount necessary to satisfy the requirements of the Employee Retirement Income Security Act of 1974. As of January 1, 2002, First Northern Savings Bank employees meeting certain minimum age and service requirements entered the defined benefit plan; for those First Northern Savings Bank employees, only years of service after that date are counted for funding. However, for vesting purposes, First Northern Savings Bank employees received credit under the defined benefit plan for their years of service since joining First Northern Savings Bank.
The following tables set forth the defined benefit pension plan’s funded status and net periodic benefit cost:
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
10. Employee Benefit Plans (continued)
Accumulated Benefit Obligations
The accumulated benefit obligations for the defined benefit pension plan was $27,075 and $22,596 at October 31, 2004 and 2003, respectively.
The expected long-term rate of return was estimated using a combination of the expected rate of return for immediate participation contracts and the historical rate of return for immediate participation contracts.
Pension plan assets which consist primarily of immediate participation guarantee contracts with an insurance company are actively managed by investment professionals.
The Company projects the following benefit payments under the various retirement plans.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
10. Employee Benefit Plans (continued)
The Company values its pension plan annually at October 31. The pension plan weighted-average asset allocations at October 31, 2004 and 2003, by asset category are as follows:
Investment Policy
The investment objective is to minimize risk. Asset allocation strongly favors immediate participation contracts with an Insurance Company. The equity securities are shares of stock issued by the insurance company when it demutualized.
Contributions
The amount of the 2005 contribution will be determined based on a number of factors, including the results of the Actuarial Valuation Report as of January 1, 2005. At this time, the amount of the 2005 contribution is not known.
Bank Mutual
Bank Mutual has a deferred retirement plan, which was formerly a Mutual Savings Bank plan, for non-officer directors who have provided at least five years of service. Four of the five existing eligible directors’ benefits have vested. In the event a director dies prior to completion of these payments, payments will go to the director’s heirs. Bank Mutual has funded these arrangements through “rabbi trust” arrangements, and based on actuarial analyses believes these obligations are adequately funded.
First Northern Savings Bank also had supplemental retirement plans for several executives. Total expense relating to these plans for the year ended December 31, 2004 and 2003 was $140 and $153, respectively.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
11. Stock-Based Benefit Plans
The Company established an ESOP for the employees of the Company and Bank Mutual. The ESOP is a qualifying plan under Internal Revenue Service guidelines. It covers all full-time employees who have attained at least 21 years of age and completed one year of service. At November 1, 2000, the ESOP borrowed $609 from the Company and purchased 223,454 shares of common stock issued in the public offering. Subsequent to this initial purchase, through December 31, 2000, the ESOP borrowed an additional $8,362 and purchased an additional 3,037,600 shares. In January 2001, the ESOP bought an additional 10,892 shares. Expense is recognized based on the fair value (average stock price) of shares scheduled to be released from the ESOP trust. One-tenth of the shares are scheduled to be released each year, which started in 2001. Also, additional shares may be released as the ESOP Trust receives cash dividends from the unallocated shares held in the Trust. In 2002, such additional shares were released. ESOP expense for the year ended December 31, 2004 was $3,695; for the year ended December 31, 2003 was $2,950; and for the year ended December 31, 2002 was $2,414.
The following table summarizes shares of Company common stock held by the ESOP at December 31.
12. Income Taxes
The provision for income taxes consists of the following:
For state income tax purposes, certain subsidiaries have net operating loss carryovers of $15,418 available to offset against future income. The carryovers expire in the years 2005 through 2019 if unused.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
12. Income Taxes (continued)
The income tax provision differs from the provision computed at the federal statutory corporate rate as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
The significant components of the Company’s deferred tax assets and liabilities are summarized as follows:
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
13. Financial Instruments with Off-Balance-Sheet Risk
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated statements of financial condition. The contract amounts reflect the extent of involvement the Company has in particular classes of financial instruments and also represents the Company’s maximum exposure to credit loss.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and generally require payment of a fee. As some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates the collateral needed and creditworthiness of each customer on a case by case basis. The Company generally extends credit only on a secured basis. Collateral obtained varies, but consists principally of one-to-four family residences.
Financial instruments whose contract amounts represent credit risk are as follows:
Forward commitments to sell mortgage loans of $10,545 at December 31, 2004, represent commitments obtained by the Company from a secondary market agency to purchase mortgages from the Company. Commitments to sell loans expose Bank Mutual to interest rate risk if market rates of interest decrease during the commitment period. Commitments to sell loans are made to mitigate interest rate risk on commitments to originate loans and loans held for sale. Forward commitments at December 31, 2003 were $8,315.
The Company participates in the FHLB Mortgage Partnership Finance Program (the “Program”). In addition to entering into forward commitments to sell mortgage loans to a secondary market agency, the Company enters into firm commitments to deliver loans to the FHLB through the Program. Under the Program, loans are funded by the FHLB and the Company receives an agency fee reported as a component of gain on sale of loans. The Company had no firm commitments outstanding to deliver loans through the Program at December 31, 2004. Once delivered to the Program, the Company provides a contractually agreed-upon credit enhancement and performs servicing of the loans. Under the credit enhancement, the Company is liable for losses on loans delivered to the Program after application of any mortgage insurance and a contractually agreed-upon credit enhancement provided by the Program subject to an agreed-upon maximum. The Company received a fee for this credit enhancement. The Company does not anticipate that any credit losses will be incurred in excess of anticipated credit enhancement fees.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
14. Fair Value of Financial Instruments
Disclosure of fair value information about certain financial instruments, whether or not recognized in the consolidated financial statements, for which it is practicable to estimate the value, is summarized below. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.
Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument.
Certain financial instruments and all nonfinancial instruments are excluded from this disclosure. Accordingly, the aggregate fair value of amounts presented does not represent the underlying value of the Company and is not particularly relevant to predicting the Company’s future earnings or cash flows.
The following methods and assumptions are used by the Company in estimating its fair value disclosures of financial instruments:
Cash and Cash Equivalents: The carrying amounts reported in the statements of financial condition for cash and cash equivalents approximate those assets’ fair values.
Investment and Mortgage-Related Securities: Fair values for these securities are based on quoted market prices or such prices of comparable instruments.
Loans Receivable and Loans Held-for-Sale: The fair value of one-to-four family fixed-rate mortgage loans was determined based on the current market price for securities collateralized by similar loans. For variable rate one-to-four family mortgage, consumer and other loans that reprice frequently and with no significant change in credit risk, carrying values approximate fair values. The fair value for fixed-rate commercial real estate, rental property mortgage, consumer and other loans was estimated by projecting cash flows at market interest rates.
Mortgage Servicing Rights: The Company has calculated the fair market value of mortgage servicing rights for those loans that are sold with servicing rights retained. For valuation purposes, loans are stratified by product type and, within product type, by interest rates. The fair value of mortgage servicing rights is based upon the present value of estimated future cash flows using current market assumptions for prepayments, servicing cost and other factors.
Federal Home Loan Bank Stock: Federal Home Loan Bank stock is carried at cost, which is its redeemable (fair) value, since the market for this stock is restricted.
Accrued Interest Receivable: The carrying value of accrued interest receivable approximates fair value.
Deposits and Advance Payments by Borrowers for Taxes and Insurance: Fair values for deposits are estimated using a discounted cash flow calculation that applies current market borrowing interest rates to a schedule of aggregated expected monthly maturities on deposits. The advance payments by borrowers for taxes and insurance are equal to their carrying amounts at the reporting date.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
14. Fair Value of Financial Instruments (continued)
Borrowings: The fair value of long-term borrowings is estimated using discounted cash flow calculations with the discount rates equal to interest rates currently being offered for borrowings with similar terms and maturities. The carrying value on short-term borrowings approximates fair value.
The above table does not include any amount for the value of any off-balance-sheet items (see Note 12) since the fair value of these items is not significant.
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
15. Condensed Parent Company Only Financial Statements
STATEMENT OF FINANCIAL CONDITION
Bank Mutual Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
December 31, 2004
(Dollars in Thousands, Except Per Share Amounts)
15. Condensed Parent Company Only Financial Statements (continued)
STATEMENT OF INCOME
STATEMENT OF CASH FLOWS
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures: Bank Mutual Corporation’s management, with the participation of Bank Mutual Corporation’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of Bank Mutual Corporation’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, Bank Mutual Corporation’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Bank Mutual Corporation’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Bank Mutual Corporation in the reports that it files or submits under the Exchange Act.
Change in Internal Control Over Financial Reporting: There have not been any changes in the Bank Mutual Corporation’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the final fiscal quarter of the year to which this report relates that have materially affected, or are reasonably likely to materially affect, Bank Mutual Corporation’s internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
The internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorization of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Management of Bank Mutual Corporation is responsible for establishing and maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Bank Mutual Corporation’s management, including its chief executive officer and chief financial officer, has assessed the effectiveness of its internal control over financial reporting as of December 31, 2004, based on the criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on their assessment and those criteria, management believes that as of December 31, 2004, Bank Mutual Corporation’s internal control over financial reporting is effective.
Ernst & Young LLP, independent registered public accounting firm, has issued an attestation report on management’s assessment of Bank Mutual Corporation’s internal control over financial reporting. That attestation report can be found below as part of this Item 9A.
Ernst & Young LLP, Report on Effectiveness of Internal Control Over Financial Reporting
Board of Directors
Bank Mutual Corporation and Subsidiaries
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Bank Mutual Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Bank Mutual Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Bank Mutual Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Bank Mutual Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Bank Mutual Corporation and Subsidiaries as of December 31, 2004 and 2003 and the consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2004 Bank Mutual Corporation and our report dated January 28, 2005 expressed an unqualified opinion thereon.
Milwaukee, Wisconsin
January 28, 2005
Item 9B.
Item 9B. Other Information.
In late 2004, the Employment Agreements of Messrs. Anderegg, Callen, Colberg and Maurer, and Ms. Scholz, were extended for one year periods, through December 31, 2005, in accordance with the provisions of those agreements. The Employment Agreements of Messrs. Crowley Sr. and Jr. extended automatically, in accordance with their terms.
Part III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information in response to this item is incorporated herein by reference to “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in Bank Mutual Corporation’s definitive Proxy Statement for its Annual Meeting of Shareholders on May 2, 2005 (the “2005 Annual Meeting Proxy Statement”). See also “Executive Officers of the Registrant” in Part I hereof, which is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
Information in response to this item is incorporated by reference to “Directors’ Compensation”, “Executive Compensation,” and “Compensation Committee Interlocks and Insider Participation” in the 2005 Annual Meeting Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information in response to this item is incorporated by reference to “Security Ownership of Certain Beneficial Owners” and “Executive Compensation - Stock Options and Equity Compensation Plans - Equity Compensation Plan Information” in the 2005 Annual Meeting Proxy Statement.
Equity Compensation Plan Information
The following chart gives aggregate information regarding grants under all equity compensation plans of Bank Mutual Corporation through December 31, 2004.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information in response to this item is incorporated by reference to “Election of Directors,” Compensation Committee Interlocks and Insider Participation” and “Certain Transactions with the Company” in the 2005 Annual Meeting Proxy Statement.
Item 14.
Item 14. Principal Accountant Fees and Services
Information in response to this item is incorporated by reference to “Independent Auditors” in the 2005 Annual Meeting Proxy Statement.
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) Documents filed as part of the Report:
1. and 2. Financial Statements and Financial Statement Schedules.
The following consolidated financial statements of Bank Mutual Corporation and subsidiaries are filed as part of this report under Item 8, “Financial Statements and Supplementary Data”:
Consolidated Statements of Financial Condition - December 31, 2004 and 2003.
Consolidated Statements of Income - Years Ended December 31, 2004, 2003 and 2002.
Consolidated Statements of Changes In Shareholders’ Equity - Years Ended December 31, 2004, 2003 and 2002.
Consolidated Statements of Cash Flows - Years Ended December 31, 2004, 2003 and 2002.
Notes to Consolidated Financial Statements.
Report of Ernst & Young LLP, Independent Auditors, on consolidated financial statements.
The Report of Ernst & Young LLP on effectiveness of internal control over financial reporting is filed as part of this report under Item 9A, “Controls and Procedures.”.
All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
(b). Exhibits. See Exhibit Index following the signature page of this report, which is incorporated herein by reference. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this report is identified in the Exhibit Index by an asterisk following its exhibit number.
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.
BANK MUTUAL CORPORATION
March 11, 2004
By: /s/ Michael T. Crowley, Jr.
Michael T. Crowley, Jr.
Chairman, President and Chief Executive Officer
POWER OF ATTORNEY
Each person whose signature appears below hereby authorizes Michael T. Crowley, Jr., Rick B. Colberg, and Marlene M. Scholz, or any of them, as attorneys-in-fact with full power of substitution, to execute in the name and on behalf of such person, individually, and in each capacity stated below or otherwise, and to file, any and all amendments to this report.
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 indicated.*
Signature and Title
/s/ Michael T. Crowley, Jr.
Michael T. Crowley, Jr., Chairman, President
Chief Executive Officer and Director
(Principal Executive Officer)
/s/ Raymond W. Dwyer, Jr.
Raymond W. Dwyer, Jr., Director
/s/ Rick B. Colberg
Rick B. Colberg, Chief Financial Officer
(Principal Financial Officer)
/s/ Thomas J. Lopina, Sr.
Thomas J. Lopina, Sr., Director
/s/ Marlene M. Scholz
Marlene M. Scholz, Senior Vice President
(Principal Accounting Officer)
/s/ William J. Mielke
William J. Mielke, Director
/s/ Thomas H. Buestrin
Thomas H. Buestrin, Director
/s/ Robert B. Olson
Robert B. Olson, Director
/s/ Mark C. Herr
Mark C. Herr, Director
/s/ David J. Rolfs
David J. Rolfs, Director
/s/ Jelmer G. Swoboda
Jelmer G. Swoboda, Director
BANK MUTUAL CORPORATION
(“Bank Mutual Corporation” or the “Company”)**
Commission File No. 000-32107
EXHIBIT INDEX
TO
2004 REPORT ON FORM 10-K
The following exhibits are filed with, or incorporated by reference in, this Report on Form 10-K for the year ended December 31, 2004:
EI-1
EI-2
EI-3
*
Designates management or compensatory agreements, plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K
**
As used in this Exhibit Index, references to Bank Mutual Corporation and the Company also include, where appropriate, Bank Mutual Corporation, a federally-chartered corporation and the predecessor of the current registrant.
***
Mutual Savings Bank is now known as “Bank Mutual.”
EI-4