ITEM 1 - BUSINESS
United Bancorp, Inc. (the "Company") was incorporated on May 31, 1985 as a business corporation under the Michigan Business Corporation Act, pursuant to the authorization and direction of the Directors of United Bank & Trust ("UBT").
The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). The Company has corporate power to engage in such activities as permitted to business corporations under the Michigan Business Corporation Act, subject to the limitations of the Bank Holding Company Act and regulations of the Federal Reserve System. In general, the Bank Holding Company Act and regulations restrict the Company with respect to its own activities and activities of any subsidiaries to the business of banking or such other activities which are closely related to the business of banking.
United Savings Bank opened in 1933 as a result of a merging of charters of Lilley State Bank and Tecumseh State Savings Bank. United Savings Bank was acquired by the Company on January 1, 1986. United Savings Bank changed its name to United Bank & Trust on January 1, 1992, at the time it acquired Thompson Savings Bank in Hudson. In November of 2000, the Company filed applications with its regulators for permission to establish a second bank as a subsidiary of the Company. United Bank & Trust - Washtenaw ("UBTW") opened for business on April 2, 2001, and is headquartered in Ann Arbor. UBTW operates with its own local management and board of directors, and targets the Washtenaw County market for its growth. In 2003, UBT sold its three Washtenaw County offices to UBTW.
UBT delivers financial services through a system of twelve banking offices and one Trust office, plus fourteen automated teller machines, located in Lenawee and Monroe Counties, Michigan. The business base of the area is primarily agricultural and light manufacturing, with its manufacturing sector exhibiting moderate dependence on the automotive and refrigeration and air conditioning industries.
Banking services are delivered by UBTW through five banking offices and five automated teller machines in Washtenaw County, Michigan. The employment base of Washtenaw County is centered around health care, education and automotive high technology. Economic stability is provided to a great extent by the University of Michigan, which is a major employer and is not as economically sensitive to the fluctuations of the automotive industry. The services and public sectors account for a substantial percentage of total industry employment, in a large part due to the University of Michigan and the University of Michigan Medical Center.
The Company's subsidiary banks (the "Banks") offer a full range of services to individuals, corporations, fiduciaries and other institutions. Banking services include checking, NOW accounts, savings, time deposit accounts, money market deposit accounts, safe deposit facilities and money transfers. Lending operations provide real estate loans, secured and unsecured business and personal loans, consumer installment loans, credit card and check-credit loans, home equity loans, accounts receivable and inventory financing, equipment lease financing and construction financing.
The Banks maintain correspondent bank relationships with a small number of larger banks, which involve check clearing operations, securities safekeeping, transfer of funds, loan participation, and the purchase and sale of federal funds and other similar services. UBTW also maintains a correspondent banking relationship with UBT.
The Banks offer the sale of nondeposit investment products through licensed representatives in their banking offices, and sell credit and life insurance products. In addition, the Company and/or the Banks are co-owners of Michigan Banker's Title Insurance Company of Mid-Michigan LLC, and derive income from the sale of various insurance products to banking clients.
The following table shows comparative information concerning the Banks as of December 31, 2006, in thousands of dollars:
UBT operates a trust department, and provides trust services to UBTW on a contract basis. The Wealth Management Group offers a variety of fiduciary services to individuals, corporations and governmental entities, including services as trustee for personal, pension, and employee benefit trusts. The department provides trust services, financial planning services, investment services, custody services, pension paying agent services and acts as the personal representative for estates. These products help to diversify the Company's sources of income.
Supervision and Regulation
General. The Company and the Banks are subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders.
Set forth below is a description of the significant elements of some of the laws and regulations applicable to the Company and the Banks. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to the Company and the Banks could have a material effect on the business of the Company and the Banks.
As a bank holding company within the meaning of the Bank Holding Company Act, the Company is required to file quarterly and annual reports of its operations and such additional information as the Federal Reserve Board may require and is subject, along with its subsidiaries, to examination by the Federal Reserve Board. The Federal Reserve Board is the primary regulator of the Company.
The Bank Holding Company Act requires every bank holding company to obtain prior approval of the Federal Reserve Board before it may merge with or consolidate into another bank holding company, acquire substantially all the assets of any bank, or acquire ownership or control of any voting shares of any bank if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank holding company or bank. The Federal Reserve Board may not approve the acquisition by the Company of voting shares or substantially all the assets of any bank located in any state other than Michigan unless the laws of such other state specifically authorize such an acquisition. The Bank Holding Company Act also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. However, holding companies may engage in, and may own shares of companies engaged in, certain businesses found by the Federal Reserve Board to be so closely related to banking or the management or control of banks as to be a proper incident thereto.
Under current regulations of the Federal Reserve Board, a holding company and its nonbank subsidiaries are permitted, among other activities, to engage, subject to certain specified limitations, in such banking related business ventures as sales and consumer finance, equipment leasing, credit bureau services and software operations, data processing and services transmission, discount securities brokerage, insurance, mortgage banking and brokerage, sale and leaseback and other forms of real estate banking. The Bank Holding Company Act does not place territorial restrictions on the activities of nonbank subsidiaries of bank holding companies. In addition, federal legislation prohibits acquisition of "control" of a bank or bank holding company without prior notice to certain federal bank regulators. "Control" in certain cases may include the acquisition of as little as 10% of the outstanding shares of capital stock.
In March of 2000, the Gramm-Leach-Bliley Act of 1999 (the "GLB Act") was enacted. Under the GLB Act, new opportunities became available for bank holding companies, banks and other depository institutions, insurance companies and securities firms to enter into combinations that permit a single financial services organization to offer customers a more complete array of financial products and services. The GLB Act provided a new regulatory framework for regulation through the "financial holding company," with the Federal Reserve Board as the umbrella regulator. Functional regulation of the separately regulated subsidiaries of a financial holding company are conducted by their primary functional regulator. The Company became a financial holding company in 2000.
UBT and UBTW are Michigan banking corporations, and as such are subject to the regulation of, and supervision and regular examination by, the Michigan Office of Financial and Insurance Services ("OFIS") and the FDIC. OFIS is the primary regulator of the Banks. Deposit accounts of the Banks are insured by the FDIC. Requirements and restrictions under the laws of the United States and the State of Michigan include the requirement that banks maintain reserves against certain deposits, restrictions on the nature and amount of loans which may be made by a bank and the interest that may be charged thereon, restrictions on the payment of interest on certain deposits and restrictions relating to investments and other activities of a bank.
Dividends. The Company is a legal entity, separate and distinct from the Banks. While the Banks contract with the Company and pay for services provided, much of the Company's revenue will be received in the form of dividends, if any, paid by UBT and UBTW. Thus, the Company's ability to pay dividends to its shareholders will be limited by statutory and regulatory restrictions on UBT and UBTW concerning dividends. Michigan's banking laws restrict the payment of cash dividends by a state bank by providing, subject to certain exceptions, that dividends may be paid only out of net profits then on hand after deducting therefrom its losses and bad debts and no dividends may be paid unless the bank will have a surplus amounting to not less than twenty percent (20%) of its capital after the payment of the dividend. Federal law generally prohibits a bank from making any capital distribution (including payment of a dividend) or paying any management fee to its parent company if the depository institution would thereafter be undercapitalized.
The Federal Deposit Insurance Corporation ("FDIC") may prevent an insured bank from paying dividends if the Bank is in default of payment of any assessment due to the FDIC. In addition, the FDIC may prohibit the payment of dividends by a bank, if such payment is determined, by reason of the financial conditions of the bank, to be an unsafe and unsound banking practice.
Holding Company Support of Subsidiary Banks. Under Federal Reserve Board policy, the Company is expected to act as a source of financial and managerial strength to its Banks and to commit resources to support such subsidiaries. This support of its subsidiary banks may be required at times when, absent such Federal Reserve Board policy, the Company might not otherwise be inclined to provide it.
In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and certain other indebtedness of such subsidiary banks.
Liability of Commonly Controlled Depository Institutions. Under the Federal Deposit Insurance Act, as amended ("FDIA"), FDIC-insured depository institutions, such as any of the Banks, can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the "default" of a commonly controlled FDIC-insured depository institution, or (ii) any assistance provided by the FDIC to any commonly controlled depository institution in "danger of default." For these purposes, the term "default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur without federal regulatory assistance.
Capital Adequacy and Prompt Corrective Action. The Federal Reserve Board and the FDIC have established guidelines for risk-based capital by bank holding companies and banks. These guidelines establish a risk adjusted ratio relating capital to risk- weighted assets and off-balance-sheet exposures. These capital guidelines primarily define the components of capital, categorize assets into different risk classes, and include certain off-balance- sheet items in the calculation of capital requirements. Generally, Tier 1 capital consists of shareholders' equity less intangible assets and unrealized gain or loss on securities available for sale, and Tier 2 capital consists of Tier 1 capital plus qualifying loan loss reserves.
The FDIC Improvement Act of 1991 established a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, federal banking regulators have established five capital categories, well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, in which all institutions are placed. The federal banking agencies have also specified by regulation the relevant capital levels for each of the categories.
Federal banking regulators are required to take specified mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. An institution in any of the under-capitalized categories is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. An undercapitalized institution is also generally prohibited from paying any dividends, increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.
Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and other restrictions on its business. In addition, such a bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless the bank could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time. The capital ratios of the Company and the Banks exceed the regulatory guidelines for well capitalized institutions. Information in Note 18 on Page A-40 hereof provides additional information regarding the Company's capital ratios, and is incorporated herein by reference.
The federal regulatory authorities' risk-based capital guidelines are based upon the 1988 capital accord of the Basel Committee on Banking Supervision (the "BIS"). The BIS is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country's supervisors in determining the supervisory policies they apply. In 2004, the BIS published a new capital accord to replace its 1988 capital accord. The new capital accord would, among other things, set capital requirements for operational risk and refine the existing capital requirements for credit risk and market risk. Operational risk is defined to mean the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems in connection with external events. The 1988 capital accord does not include separate capital requirements for operational risk. The United States federal regulatory authorities have released proposed rules to implement the BIS's new capital accord, and comments are due in the first quarter of 2007. The Company cannot predict the timing or final form of the United States rules implementing the new capital accord and their impact on the Company. The new capital requirements that may arise from the final rules could increase the minimum capital requirements applicable to the Company and the Banks.
Affiliate Transactions. Banks are subject to restrictions imposed by federal law on extensions of credit to, purchases of assets from, and certain other transactions with affiliates and on investments in stock or other securities issued by affiliates. Such restrictions prevent the Banks from making loans to affiliates unless the loans are secured by collateral in specified amounts and have terms at least as favorable to the Banks as the terms of comparable transactions between the Banks and non-affiliates. Further, applicable federal and state laws significantly restrict extensions of credit by the Banks to directors, executive officers and principal stockholders and related interests of such persons.
Deposit Insurance. Substantially all of the deposits of the Banks are insured up to applicable limits by the Deposit Insurance Fund ("DIF") of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a matrix that takes into account a bank's capital level and supervisory rating.
Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC modified its method of calculating FDIC insurance assessments effective November 2006, and provided credits to certain banks for the calendar year 2007, to be applied to future assessments. UBT has earned assessment credits, while UBTW has not, since it is a relatively new institution. These changes will result in increased FDIC insurance premiums for UBTW, while UBT will be able to offset all of its FDIC assessments for 2007 and much of 2008 using credits it has earned. The assessment methodology allows the FDIC to set its assessment rates in the future in connection with declines in the insurance funds or increases in the amount of insurance coverage. An increase in the assessment rate could have a material adverse effect on the Company's earnings, depending on the amount of the increase.
During 2006, the Banks paid $75,131 in Financing Corporation ("FICO") assessments related to outstanding FICO bonds to the FDIC as collection agent. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings and Loan Insurance Corporation. FICO assessments will continue in the future for both banks.
Depositor Preference. The FDIA provides that, in the event of the "liquidation or other resolution" of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.
Community Reinvestment Act. The Community Reinvestment Act of 1977 ("CRA") requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings. In order for a financial holding company to commence any new activity permitted by the Bank Holding Company Act, or to acquire any company engaged in any new activity permitted by the Bank Holding Company Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least "satisfactory" in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of a proposed transaction.
Financial Privacy. In accordance with the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted and conveyed to outside vendors.
Anti-Money Laundering Initiatives and the USA Patriot Act. A major focus of governmental policy on financing institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the "USA Patriot Act") which was renewed in substantially the same form on March 9, 2006, substantially broadened the scope of the United States and anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as the Banks. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing by verifying the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institutions.
Legislative Initiatives. From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations or regulatory policies applicable to the Company or the Banks could have a material effect on the business of the Company.
Consumer Protection Regulation. Other aspects of the lending and deposit businesses of the Banks that are subject to federal and state regulation include disclosure requirements with respect to interest, payment and other terms of consumer and residential mortgage loans, disclosure of interest and fees and other terms of, and the availability of, funds for withdrawal from consumer deposit accounts,
prohibiting certain forms of discrimination in credit transactions, and imposing certain recordkeeping, reporting and disclosure requirements with respect to residential mortgage loan applications.
Accounting Standards
Information regarding accounting standards adopted by the Company are discussed beginning on Page A-26 hereof, and is incorporated herein by reference.
Competition
The banking business in the Company's service area is highly competitive. In their markets, the Banks compete with a number of community banks and subsidiaries of large multi-state, multi-bank holding companies. In addition, the banks face competition from credit unions, savings associations, finance companies, loan production offices and other financial services companies.
The Company believes that the market perceives a competitive benefit to an independent, locally controlled commercial bank. Much of the Company's competition comes from affiliates of organizations controlled from outside the area. Against these competitors, the subsidiary banks continue to expand their loan and deposit portfolios.
Employees
On December 31, 2006, the Company and its subsidiaries employed 202 full-time and 42 part-time employees. This compares to 195 full-time and 39 part-time employees at December 31, 2005.
Available Information
You can find more information about us at our website, located at www.ubat.com. Our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available as soon as reasonably practicable after such forms have been filed with or furnished to the Securities and Exchange Commission (the "SEC") free of charge on our website through a link to the SEC website.
I SELECTED STATISTICAL INFORMATION
(A) DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY;
(B) INTEREST RATES AND INTEREST DIFFERENTIAL:
The information required by these sections are contained on Pages A-3 through A-9 hereof, and is incorporated herein by reference.
II INVESTMENT PORTFOLIO
(A) BOOK VALUE OF INVESTMENT SECURITIES
The table below reflects the book value of various categories of investment securities of the Company at December 31:
(B) CARRYING VALUES AND YIELDS OF INVESTMENT SECURITIES
The following table reflects the carrying values and yields of the Company's securities portfolio for 2006. Average yields are based on amortized costs and the average yield on tax exempt securities of states and political subdivisions is adjusted to a taxable equivalent basis, assuming a 34% marginal tax rate.
Carrying Values and Yields of Investments
(1) Reflects the scheduled amortization and an estimate of future prepayments based on past and current experience of amortizing U.S. agency securities.
(2) Reflects the scheduled amortization and an estimate of future prepayments based on past and current experience of the issuer for various collateralized mortgage obligations.
As of December 31, 2006, the Company's securities portfolio contains no concentrations by issuer greater than 10% of shareholders' equity. Additional information concerning the Company's securities portfolio is included on Page A-9, and in Note 3 on Page A-30 hereof, and is incorporated herein by reference.
III LOAN PORTFOLIO
(A) TYPES OF LOANS
The tables below show loans outstanding (net of unearned interest) at December 31, and the percentage makeup of the portfolios. All loans are domestic and contain no concentrations by industry or customer. Balances are stated in thousands of dollars.
(1) Includes loans held for sale
(B) MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES
The following table presents the maturity of total loans outstanding, other than residential mortgages and personal loans, as of December 31, 2006, according to scheduled repayments of principal. All figures are stated in thousands of dollars.
(C) RISK ELEMENTS
Non-Accrual, Past Due and Restructured Loans
The following shows the effect on interest revenue of nonaccrual and troubled debt restructured loans as of December 31, 2006, in thousands of dollars:
Additional information concerning nonperforming loans, the Company's nonaccrual policy, and loan concentrations is provided on Pages A-10 through A-13, in Note 1 on Pages A-27 and A-28 and Notes 4 and 5 on Page A-32 hereof, and is incorporated herein by reference
At December 31, 2006, the Banks had eight loans, other than those disclosed above, for a total of $4,652,000 which would cause management to have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms. These loans were included on the Banks' "watch lists" and were classified as impaired; however, payments are current.
(D) OTHER INTEREST BEARING ASSETS
As of December 31, 2006, other than $1,063,000 in other real estate, there were no other interest bearing assets that would be required to be disclosed under Item III, Parts (C)(1) or (C)(2) of the Loan Portfolio listing if such assets were loans.
IV SUMMARY OF LOAN LOSS EXPERIENCE
(A) CHANGES IN ALLOWANCE FOR LOAN LOSSES
The table below summarizes changes in the allowance for loan losses for the years 2002 through 2006, in thousands of dollars.
CHANGES IN ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level believed adequate by Management to absorb losses inherent in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, amount and composition of the loan portfolio, and other factors. The provision charged to earnings was $2,123,000 in 2006, compared to $1,332,000 in 2005 and $1,048,000 in 2004. The allowance is based on the analysis of the loan portfolio and a four year historical average of net charge offs to average loans of 0.14% of the portfolio.
(B) ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
The following table presents the portion of the allowance for loan losses applicable to each loan category in thousands of dollars, as of December 31. A table showing the percent of loans in each category to total loans is included in Section III (A), above.
The allocation method used takes into account specific allocations for identified credits and a four year historical loss average in determining the allocation for the balance of the portfolio.
V DEPOSITS
The information concerning average balances of deposits and the weighted-average rates paid thereon, is included on Page A-5 and maturities of time deposits is provided in Note 9 on Page A-33 hereof, and is incorporated herein by reference. There were no foreign deposits. As of December 31, 2006, outstanding time certificates of deposit in amounts of $100,000 or more were scheduled to mature as shown below. All amounts are in thousands of dollars.
VI RETURN ON EQUITY AND ASSETS
Various ratios required by this section and other ratios commonly used in analyzing bank holding company financial statements are included on Page A-3 and A-4 hereof, and are incorporated herein by reference.
VII SHORT-TERM BORROWINGS
Some of the information required by this section is contained in Note 10 on Page A-33 hereof, and is incorporated herein by reference. No additional information is required, as for all reporting periods, there were no categories of short-term borrowings for which the average balance outstanding during the period was 30% or more of shareholders' equity at the end of the period.
ITEM 1A
ITEM 1A - RISK FACTORS
An investment in the Company's common stock is subject to risks inherent to the Company's business. The material risks and uncertainties that management believes affect the Corporation are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company's business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company's financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company's common stock could decline significantly, and you could lose all or part of your investment.
RISKS RELATED TO THE COMPANY'S BUSINESS
The Company Is Subject To Interest Rate Risk
The Company's earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Company's control, including general economic conditions and policies of various governmental and regulatory agencies and, in
particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Company receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Company's ability to originate loans and obtain deposits, and (ii) the fair value of the Company's financial assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Company's net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
The Company Is Subject To Lending Risk
There are inherent risks associated with the Company's lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Company operates. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company.
As of December 31, 2006, approximately 71% of the Company's loan portfolio consisted of business and commercial mortgage and construction loans. Because the Company's loan portfolio contains a significant number of business and commercial and mortgage and personal construction loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non- performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company's financial condition and results of operations.
The Company's Allowance For Possible Loan Losses May Be Insufficient
The Company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management's best estimate of probable losses that may be incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company's control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Company's allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Company's financial condition and results of operations.
The Company's Profitability Depends Significantly On Economic Conditions In The State Of Michigan The Company's success depends primarily on the general economic conditions of the State of Michigan and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the Lenawee, Monroe and Washtenaw Counties, Michigan. The local economic conditions in these areas have a significant impact on the demand for the Company's products and services as well as the ability of the Company's customers to repay loans, the value of the collateral securing loans and the stability of the Company's deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Company's financial condition and results of operations. See, however, the disclosure under "Management's Discussion and Analysis of Financial Condition and Results of Operations - Background" on page A-2.
The Company Operates In A Highly Competitive Industry and Market Area
The Company faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include credit unions, savings associations and various finance companies and loan production offices, in addition to a number of community banks and subsidiaries of large multi-state and multi-bank holding companies. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Company's competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Company can.
The Company believes that the market perceives a competitive benefit to an independent, locally controlled commercial bank. Much of the Company's competition comes from affiliates of organizations controlled from outside the area. Against these competitors, the subsidiary banks continue to expand their loan and deposit portfolios.
The Company Is Subject To Extensive Government Regulation and Supervision
The Company and the Banks are subject to extensive federal and state regulation and supervision as disclosed under "Item 1. Business - Supervision and Regulation." Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Company's lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways.
The Company Continually Encounters Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases
efficiency and enables financial institutions to better serve customers and to reduce costs. The Company's future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company's operations. Many of the Company's competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers.
The Company's Stock Price Can Be Volatile
Stock price volatility may make it more difficult for you to resell your common stock when you want to and at prices you find attractive. The Company's stock price can fluctuate significantly in response to a variety of factors.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Company's stock price to decrease regardless of operating results. In addition, the trading volume in the Company's common stock is significantly less than that of other larger financial services companies. This can make the Company's stock price volatile as significant sales of the Company's common stock, or the expectation of these sales, could cause the Company's stock price to fall.
An Investment In The Company's Common Stock Is Not An Insured Deposit
The Company's common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity. Investment in the Company's common stock is inherently risky for the reasons described in this "Risk Factors" section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire the Company's common stock, you may lose some or all of your investment.
The Company's Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates the Company's internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company's controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company's business, results of operations and financial condition.
ITEM 1B
ITEM 1B - UNRESOLVED STAFF COMMENTS
None.
ITEM 2
ITEM 2 - PROPERTIES
The executive offices of the Company are located at the main office (Hickman Financial Center) of United Bank & Trust, 205 East Chicago Boulevard, Tecumseh, Michigan. UBT owns and occupies the
entire two-story building, which was built in 1980. UBT operates three other banking offices in the Tecumseh area, two in the city of Adrian, one each in the cities of Hudson and Morenci, one in the village of Blissfield, and one each in Clinton, Rollin and Raisin Townships, all in Lenawee County. In addition, the bank operates one office in Dundee, Monroe County, Michigan. In 2005, the Bank moved its Trust & Investment Group to a new leased facility in Tecumseh. The bank owns all of the buildings except for the Trust facility, and leases the land for one office in the city of Adrian. All offices other than the Hickman Financial Center offer drive-up facilities. UBI owns and occupies a 12,000 square foot operations and training center in Tecumseh.
United Bank & Trust - Washtenaw operates one banking office in the City of Ann Arbor and one office each in the city of Saline, the villages of Dexter and Manchester, and Scio Township, Washtenaw County, Michigan. The bank owns the Saline and Dexter buildings, leases the buildings for the Manchester and Scio Township offices, and leases the land for the Dexter office. UBTW holds a long-term lease on the facilities for its administrative and banking offices, which it moved into in 2003. All offices offer ATM services, and all offices other than Manchester offer drive-up facilities.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
On September 22, 2006, Annette Theisen and various entities controlled by her, filed a complaint in Washtenaw Circuit Court against a number of defendants, including UBTW and its President, Todd C. Clark. The complaint alleges that UBTW and its President had a fiduciary duty and a duty of good faith to plaintiffs and that UBTW and its President breached those duties in connection with secured loans made to plaintiffs by, among other things, allegedly allowing plaintiffs to make imprudent investments with such loans, causing transfers of, and mortgages to be placed on, certain of plaintiffs' assets contrary to plaintiffs' interests, not disclosing certain alleged conflicts of interest, and failing to pay the premium on, and causing the cancellation of, Ms. Theisen's long-term supplemental medical insurance policy. Plaintiffs seek damages of $6 million. The Company is vigorously defending such claims.
The Company and its subsidiaries are not involved in any other material legal proceedings. They are involved in ordinary routine litigation incident to its business; however, no such proceedings are expected to result in any material adverse effect on the operations or earnings of the Company. Neither the Company nor it subsidiaries are involved in any proceedings to which any director, principal officer, affiliate thereof, or person who owns of record or beneficially more than five percent (5%) of the outstanding stock of the Company, or any associate of the foregoing, is a party or has a material interest adverse to the Company.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
PRICE RANGE FOR COMMON STOCK
The following table shows the high and low selling prices of common stock of the Company for each quarter of 2006 and 2005 as quoted on the OTC Bulletin Board, under the symbol of UBMI. These prices do not reflect private trades not involving brokers or dealers. Such over-the-counter market
quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The Company had 1,341 shareholders of record as of December 31, 2006. The prices and dividends per share have been adjusted to reflect stock dividends paid in 2006 and 2005.
Banking laws and regulations restrict the amount the Banks can transfer to the Company in the form of cash dividends and loans. Those restrictions are discussed in Note 15 on Page A-36 hereof. As a result of a change in the timing of declaration of cash dividends, only three cash dividends were declared in 2006, although four cash dividends were paid.
STOCK PERFORMANCE GRAPH
The following chart shows the yearly percentage change in the Company's cumulative total shareholder return on its common stock. This increase is compared in the chart to similar changes in the NASDAQ Bank Index and the Standard & Poor's 500 Stock Index. All prices are adjusted for stock splits and stock dividends. The graph assumes $100 invested on December 31, 2001. The total return assumes reinvestment of dividends.
The NASDAQ Bank Index is a broad-based capitalization- weighted index of domestic and foreign common stocks of banks that are traded on the NASDAQ National Market System as well as the Small Cap Market. The Index contains various types of NASDAQ listed banks and savings institutions and related holding companies, establishments performing functions closely related to banking, such as check cashing agencies, currency exchanges, safe deposit companies and corporations for banking abroad. The index is made up of 532 institutions at December 31, 2006.
TOTAL SHAREHOLDER RETURN CUMULATIVE YEARLY PERCENTAGE AT DECEMBER 31
(PERFORMANCE GRAPH)
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
The following tables present five years of financial data for the Company, for the years ended December 31 (In thousands, except per share data).
(1) Earnings per share data is based on average shares outstanding plus average contingently issuable shares.
(2) Adjusted to reflect the stock dividends paid in 2006, 2005, 2004, 2003 and 2002.
ITEM 7
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item is contained on pages A-2 through A-21 hereof, and is incorporated by reference herein.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is contained on pages A-13 through A-17 hereof, and is incorporated by reference herein.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Selected Quarterly Financial Data - The information required by this item is contained on page A-3 hereof, and is incorporated by reference herein.
Other information required by this item is contained on pages A-22 through A-42 hereof, and is incorporated by reference herein.
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
(a) The term "disclosure controls and procedures" is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the "Exchange Act"). These rules refer to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported, within required time periods. Our Chief Executive Officer and Principal Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report (the "Evaluation Date"), and have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in providing them with material information relating to the Company known to others within the Company which is required to be included in our periodic reports filed under the Exchange Act.
(b) The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control system was designed to provide reasonable assurance to the Company's management and Board of Directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
The Company's management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2006. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of Treadway Commission (COSO) in "Internal Control - Integrated Framework." Based on our assessment we believe that, as of December 31, 2006, the Company's internal control over financial reporting is effective based on those criteria.
The Company's independent auditors have issued an audit report on our assessment of the Company's internal control over financial reporting. The report immediately follows this report.
/S/ Robert K. Chapman /S/ Dale L. Chadderdon - ------------------------------------- ---------------------------------------- Robert K. Chapman Dale L. Chadderdon President and Chief Executive Officer Executive Vice President and Chief Financial Officer
(c) To the Shareholders of United Bancorp, Inc.:
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that United Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective 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. An audit includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our 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 principals. A company's internal control over financial reporting includes these 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 principals, 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 of timely detection or unauthorized acquisition, use of 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 misstatement. 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 United Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, United Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of United Bancorp, Inc. and our report dated March 16, 2007, expressed an unqualified opinion thereon.
/S/ BKD, LLP ---------------------------------------- BKD, LLP
Indianapolis, Indiana March 16, 2007
(d) There has been no change in the Company's internal control over financial reporting that occurred during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to affect, the Company's internal control over financial reporting.
ITEM 9B
ITEM 9B - OTHER INFORMATION
None
PART III
ITEM 10
ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
On December 9, 2003, the Company adopted a code of ethics (the "Code") that applies to all co-workers, officers and Directors of the Company and its subsidiaries. The Code is designed to deter wrongdoing and to promote:
- Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
- Full, fair, accurate, timely and understandable disclosure in reports and documents that the Company files with, or submits to, the Commission and in other public communications made by the registrant;
- Compliance with applicable governmental laws, rules and regulations;
- Prompt internal reporting of violations of the Code to an appropriate person or persons identified in the Code; and
- Accountability for adherence to the Code.
A copy of the Code is included in this report as Exhibit 14.
The information required by this item, other than as set forth above, is contained under the heading "Directors and Executive Officers, Committees and Meetings of the Board of Directors" and "Beneficial Ownership Reporting Compliance" in the Company's 2007 Proxy Statement and is incorporated herein by reference.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this item is contained under the heading "Compensation of Directors and Executive Officers" in the Company's 2007 Proxy Statement and is incorporated herein by reference.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is contained under the heading "Equity Compensation Plan Information", "Security Ownership of Certain Beneficial Owners," and "Security Ownership of Management" and under the headings "Compensation Committee Report" and "Compensation and Governance Interlocks and Insider Particpation" in the Company's 2007 Proxy Statement and is incorporated herein by reference.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is contained under the headings "Directors and Executive Officers" and "Directors, Executive Officers, Principal Shareholders and their Related Interests - Transactions with the Banks" in the Company's 2007 Proxy Statement and in Note 14 on Page A-36 hereof and is incorporated herein by reference.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is contained under the heading "Relationship With Independent Public Accountants" in the Company's 2007 Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 15
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as a part of this report:
2. Financial statement schedules are not applicable.
(b) Listing of Exhibits (numbered as in Item 601 of Regulation S-K):
Exhibit #
3(a) Restated Articles of Incorporation of United Bancorp, Inc., filed as Exhibit (4)(a) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference.
3(b) Bylaws of United Bancorp, Inc., filed as Exhibit (4)(b) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference.
4(a) Restated Articles of Incorporation of United Bancorp, Inc., filed as Exhibit (4)(a) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference.
4(b) Bylaws of United Bancorp, Inc., filed as Exhibit (4)(b) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference.
4(c) United Bancorp, Inc. Director Retainer Stock Plan, filed as Appendix A to registrant's proxy statement dated March 25, 1996 (file number 0-16640) and incorporated herein by reference.
4(d) United Bancorp, Inc. Senior Management Bonus Deferral Stock Plan, filed as Appendix B to registrant's proxy statement dated March 25, 1996 (file number 0-16640) and incorporated herein by reference.
4(e) United Bancorp, Inc. 1999 Stock Option Plan, filed as Appendix B to the Company's proxy statement dated March 24, 2000 (file number 0-16640) and incorporated herein by reference.
4(f) United Bancorp, Inc. 2005 Stock Option Plan, filed as Appendix B to the Company's proxy statement dated March 15, 2004 (file number 0-16640) and incorporated herein by reference.
10.1 Management Agreement effective January 1, 2006, between United Bancorp, Inc. and David S. Hickman, filed as Exhibit C to the Company's Form 8-K dated December 3, 2005 (file number 0-16640) and incorporated herein by reference.
10.2 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and Robert K. Chapman, filed as Exhibit 10.1 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
10.3 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and Randal J. Rabe, filed as Exhibit 10.2 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
10.4 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and Dale L. Chadderdon, filed as Exhibit 10.3 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
Exhibits (continued)
10.5 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and Todd C. Clark, filed as Exhibit 10.4 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
10.6 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and Thomas C. Gannon, filed as Exhibit 10.5 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
10.7 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and Jamice W. Guise, filed as Exhibit 10.6 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
10.8 Employment Agreement effective January 1, 2007, between United Bancorp, Inc. and John A. Odenweller, filed as Exhibit 10.7 to the Company's Form 8-K dated January 10, 2007 (file number 0-16640) and incorporated herein by reference.
11 Statement re Computation of Per Share Earnings - this information is incorporated by reference in Note 1 on Page A-29 and Note 19 on Page A-39 hereof.
14 Registrant's Code of Business Conduct and Ethics as adopted December 9, 2003
21 Listing of Subsidiaries, filed herewith.
23 Consent of BKD LLP, Independent Accountants, filed herewith.
24 Power of Attorney contained on the signature pages of the 2007 Annual Report on Form 10-K.
31.1 Certification of Principal Executive Officer
31.2 Certification of Principal Accounting Officer
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(c) All other 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.
UNITED BANCORP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND CONSOLIDATED FINANCIAL STATEMENTS
NATURE OF BUSINESS
United Bancorp, Inc. (the "Company") is a Michigan Bank Holding Company headquartered in Tecumseh, Michigan. The Company's subsidiary banks (the "Banks") have local Boards of Directors and are locally managed. The Banks offer a full range of financial services through a system of seventeen banking offices located in Lenawee, Monroe and Washtenaw Counties. While the Company's chief decision makers monitor the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Companywide basis. Accordingly, all of the Company's financial services operations are considered by management to be aggregated in one reportable operating segment.
Page A-1
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion provides information about the consolidated financial condition and results of operations of the Company and its subsidiary banks, United Bank & Trust ("UBT") and United Bank & Trust - Washtenaw ("UBTW").
BACKGROUND
The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act. The Company has corporate power to engage in such activities as permitted to business corporations under the Michigan Business Corporation Act, subject to the limitations of the Bank Holding Company Act and regulations of the Federal Reserve System. The Company's subsidiary banks offer a full range of services to individuals, corporations, fiduciaries and other institutions. Banking services include checking, NOW accounts, savings, time deposit accounts, money market deposit accounts, safe deposit facilities, electronic banking and bill payment, and money transfers. Lending operations provide real estate loans, secured and unsecured business and personal loans, consumer installment loans, check-credit loans, home equity loans, accounts receivable and inventory financing, equipment lease financing and construction financing.
The Banks offer the sale of nondeposit investment products through licensed representatives in their banking offices, and sell credit and life insurance products. In addition, the Company and/or the Banks are co-owners of Michigan Banker's Title Insurance Company of Mid-Michigan LLC, and derive income from the sale of various insurance products to banking clients.
UBT operates a trust department, and provides trust services to UBTW on a contract basis. The Wealth Management Group offers a variety of fiduciary services to individuals, corporations and governmental entities, including services as trustee for personal, pension, and employee benefit trusts. The department provides trust services, financial planning services, investment services, custody services, pension paying agent services and acts as the personal representative for estates. These products help to diversify the Company's sources of income.
Unemployment for the State of Michigan at the end of December, 2006 was 7.1%, which places it second-highest among the fifty states. The Lenawee County unemployment rate of 7.2% is just above the State's level, while the Washtenaw County unemployment rate of 4.4% is the lowest in the State. The Banks have experienced some slowing of loan growth relating to current economic conditions. On the other hand, while the Company's loan quality had experienced some declines toward the end of 2005, loan quality improved during 2006 as the Banks maintained a strong focus on loan quality. Management continues to keep an eye on the quality of the loan portfolios and the softening economy while continuing efforts to gain market share.
Page A-2
EXECUTIVE SUMMARY
United Bancorp, Inc. net income for 2006 was $648,000 above the level achieved in 2005, as the Company reached record levels of earnings. This strong earnings performance was driven primarily by an 11.0% improvement in net interest income over 2005, in spite of the increasing cost of funding balance sheet growth. Noninterest income for the year improved by 4.3% over the prior year, while noninterest expenses increased by 6.8% as a result of continued growth of the Banks. Earnings per share of $3.38 for 2006 was up from $3.15 per share for the prior year. Return on average shareholders' equity for 2006 was 12.62%, compared to 12.75% for 2005, and return on average assets for the year ended December 31, 2006 was 1.23%, compared to 1.21% for 2005.
Gross loans increased by $43.7 million over 2005, representing growth of 7.8% for the year. Investment balances declined while fed funds sold increased, and total assets grew by 5.2% in 2006 over 2005. This growth was funded by deposit growth of 6.3%, or $37.4 million, as well as a net increase in capital of $6.9 million resulting primarily from net income for the year, net of cash dividends paid.
2006 marked the first full year of the Company's operations with Robert K. Chapman as Chief Executive Officer, following the retirement of David S. Hickman at the end of 2005. During the year, the Company continued to strengthen its management team. Gary D. Haapala joined the Company as head of Wealth Management, and United added David Kersch as head of its mortgage business. In the fourth quarter, UBTW opened its fifth banking office in Scio Township, and expanded its office space at its Ann Arbor main office location.
RESULTS OF OPERATIONS
Earnings Summary and Key Ratios
Consolidated net income improved 7.8% over record levels achieved in 2005, compared to an increase of 8.8% in 2005 over 2004. Both banks contributed to the increase in earnings, and much of the earnings growth in 2006 was a result of continued improvement in the Company's net interest income. This improvement resulted both from balance sheet growth and improvement in asset yields in excess of the cost of funding those assets. The Banks were able to maintain and slightly improve their margin and spread in spite of economic conditions that caused the yield curve to invert during the year, significantly increasing the Company's cost of funds.
At the same time, noninterest income increased by 4.3% from the levels achieved in 2005. Income from the sale and servicing of residential real estate mortgages in the secondary market was down from 2005 levels and Trust fee income declined slightly for the year. These reductions of income were more than offset by increases in other areas, as the diversity of the Company's earnings stream provided significant protection against declining income in any one area. Expenses were up 6.8% from 2005, compared to an increase of 11.3% in 2005 over 2004.
Net income for the second half of the year is typically stronger than in the first six months, and 2006 was no exception. Net interest income was strong during the third and fourth quarters, while noninterest income remained relatively flat and expenses declined slightly quarter over quarter. The chart below shows the trends of the major components of earnings for the four quarters of 2006.
Page A-3
(a) Basic earnings per share, adjusted for stock dividends paid
(b) Annualized
Return on average assets improved to 1.23% for 2006, up from 1.21% for 2005. Return on average average shareholders' equity for 2006 was 12.62%, compared to 12.75% for 2005. At the same time, book value per share and cash dividends per share continue to improve. The following chart shows trends in these and other ratios. As a result of a change in the timing of declaration of cash dividends, only three cash dividends were declared in 2006, although four cash dividends were paid. To facilitate comparison to prior periods, the figure shown in the table represent the dividends actually paid during the year. All figures are adjusted to reflect stock dividends.
Book value per share is based on shares outstanding at December 31 of 2,623,716 for 2006, 2,617,886 for 2005 and 2,596,494 for 2004 as adjusted for stock dividends. Dividends per share does not include contingently issuable shares, and is based on average adjusted shares outstanding of 2,623,469 for 2006, 2,614,068 for 2005 and 2,593,463 for 2004, as adjusted for stock dividends.
Net Interest Income
United Bancorp, Inc. derives the greatest portion of its income from net interest income. During 2005 and much of 2006, rising short term interest rates caused the yield curve to flatten and eventually to invert. In spite of the challenges that the inverted curve presented, the Company managed to improve its net interest income in 2006 over 2005, with growth in net interest income of $2.891 million.
Interest income increased 21.8% in 2006 over 2005, for the same percentage improvement as in 2005 over 2004. At the same time, interest expense increased 44.9% for 2006, compared to an increase of 45.9% in all of 2005. The net result was an increase of 11.0% in net interest income for 2006 over 2005. Tax-equivalent yields on earning assets improved to 7.05% for 2006, up from 6.18% for 2005, with the improvement occurring in both the investment and loan portfolios. The Company's average cost of funds increased by 84 basis points, and tax equivalent spread moved from 3.86% in 2005 to 3.88% in 2006. Net interest margin experienced similar improvement, moving from 4.25% in 2005 to 4.42% in 2006. The next table provides insight into the various components of net interest income, as well as the results of changes in balance sheet makeup that have helped to keep the margin strong.
Page A-4
YIELD ANALYSIS OF CONSOLIDATED AVERAGE ASSETS AND LIABILITIES
(a) Non-accrual loans and overdrafts are included in the average balances of loans.
(b) Fully tax-equivalent basis, net of nondeductible interest impact; 34% tax rate.
Page A-5
The following tables demonstrate the effect of volume and rate changes on net interest income on a taxable equivalent basis for the past two years. The data reflects the fact that the increase in the Company's net interest income during 2006 was a result of balance sheet growth, combined with changes in yields and rate. For the year, the net increase in net interest income as a result of changes in volume was slightly larger than the increase resulting from changes in rate. This contrasts to the change from 2004 to 2005, when the largest portion of the improvement resulted from growth.
The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Nonaccrual loans are included in total loans, and changes are treated as volume variances.
Provision for Loan Losses
The Company's gross charge-offs within its loan portfolio declined in 2006, following a similar decline in 2005 from 2004. At the same time, recoveries were down from 2005 levels, and net charge-offs of $635,000 for 2006 were below 2005 net charge-offs of $737,000. The provision for 2006 increased from the prior two years, exceeding the 2005 figure by 59.4%. This provision provides for currently anticipated losses inherent in the current portfolio, and Management continues to evaluate its allocation methodology to assure that the Banks are adequately protected against these losses.
The Company consistently has low to moderate levels of nonperforming loans, and loan loss history continues to compare favorably to peers. The use of third-party independent loan review for business loans and careful monitoring of loans by Management allows the Banks to maintain a high level of quality in their loan portfolios. These factors combine with the Company's level of residential real estate loans to support an allowance as a percent of total loans at a level that Management believes is appropriate for the risks in its loan portfolio.
Page A-6
Noninterest Income
Total noninterest income improved 4.3% in 2006 over 2005, compared to an increase of 6.0% in 2005 over 2004. The following table summarizes changes in noninterest income by category for 2006 and 2005, in thousands of dollars where appropriate.
Change in Categories of Noninterest Income
Service charges on deposit accounts were up 11.5% in 2006 over 2005, compared to an increase of 8.8% in 2005 and 5.8% in 2004. This compares to a growth in total deposits of 6.3% during 2006, with short-term deposit products making up a smaller portion of total deposits. Those categories of deposits generate fee income, while certificates of deposit do not. 2006 marked the second full year of the Banks' utilization of a High Performance Checking promotion as a method of gathering deposits, and deposit service charges were restructured as a result of this new program. No significant changes to service charge structure was implemented in 2006.
The Wealth Management Group of UBT continues to provide a steady contribution to the Company's income statement. However, Trust fee income declined 2.7% in 2006 compared to 2005. This compares to a 3.2% increase in 2005 over 2004. In 2006, the department exited the 401k recordkeeping business, resulting in a reduction of $235,000 in fee income and $25 million of assets under management. Assets managed by the department at December 31, 2006 were $564.4 million, down from $605.9 million at the end of 2005 and $616.9 million at the end of 2004.
The Banks generally market their production of fixed rate long-term residential mortgages in the secondary market, and retain adjustable rate mortgages for their portfolios. The Company maintains a portfolio of sold residential real estate mortgages, which it continues to service. This servicing provides ongoing income for the life of the loans. Income from loan sales and servicing was down 25.4% in 2006 compared to 2005, following a decline of 0.6% in 2005. During 2006, the volume of loans sold on the secondary market declined substantially from 2005 levels. This decline was a result of a number of factors, including the fact that mortgage originations overall for the Company were down from 2005 levels.
During 2005, clients exhibited a preference for fixed rate loans as market rates declined, resulting in a portion of those loans originated by the Banks being sold in the secondary market. In addition, some of the mortgages previously held on the balance sheets of the Banks were refinanced and sold in the secondary market, providing additional servicing income. In 2006, the Banks experienced the opposite effect, as fewer loans were sold on the secondary market and more loans were added to the portfolios.
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Late in 2006, the Company initiated significant restructuring of its mortgage business, including the hiring of a seasoned mortgage professional as head of the Company's mortgage department. Management anticipates that mortgage volume should increase substantially in 2007 as a result of this change in leadership and focus. As the Company is conservative in its approach to valuation of mortgage servicing rights, no write-downs in mortgage servicing rights were required in 2006, 2005 or 2004 as a result of impairment or other reasons.
ATM, debit and credit card fee income continues to provide a steady source of noninterest income for the Company. The Banks operate nineteen ATMs throughout their market areas, and Bank clients are active users of debit cards. The Banks continue to receive ongoing fee income from credit card referrals and operation of its credit card merchant business. Income from these areas was up 13.6% in 2006 over 2005, compared to an increase of 14.2% in 2005 over 2004.
Income from the sale of nondeposit investment products is derived from the sale of investments and insurance products to clients, including credit and title insurance policies, annuities, mutual funds and other investment vehicles. Sales volume was particularly strong in 2006, and this category of income increased 24.4% in 2006 over 2005, compared to an increase of 10.7% in 2005 over 2004.
Income from bank-owned life insurance increased modestly in 2006, following a decline in 2005. The improvement reflects increases in interest crediting rates during the year, as the Banks made no change in the amount of their BOLI holdings. Other noninterest income during the year consisted of income from various fee-based banking services, such as sale of official checks, wire transfer fees, safe deposit box income, sweep account and other fees. This category of noninterest income improved 18.4% from 2005 to 2006, following an increase of 5.3% from 2004 to 2005, with no one area contributing significantly more than others to the improvement. Overall, total noninterest income increased $506,000 from 2005 to 2006, following an increase of $659,000 from 2004 to 2005. This continued improvement reflects the diversity of the Company's noninterest income sources. Management anticipates continued improvement in the future as the sources of noninterest income remain fluid.
Noninterest Expense
The following table summarizes changes in the Company's noninterest expense by category for 2006 and 2005, in thousands of dollars where applicable.
Change in Categories of Noninterest Expense
Total noninterest expenses were up 6.8% in 2006, compared to an increase of 11.3% in 2005 over 2004. The largest percentage increases for the year were in occupancy and equipment expense, external data processing and Director fees. The increase in external data processing resulted from a change in processing within the Wealth Management group during the year, as back office processing functions of the department were outsourced. This change in processing also resulted in additional costs relating to the conversion. Occupancy and equipment expenses reflect continued growth of the Banks, including
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the addition of one new banking office and office space expansion in Ann Arbor during the year. The increase in Director fees reflects a change in rates paid in 2006 compared to 2005, as well as an increase in the number of meetings for which Directors were paid.
Salaries and benefits are the organization's largest single area of expense. During 2006, this category of expense increased 2.6% from 2005 levels, compared to an increase of 8.6% in 2005. Benefits costs continue to be a large contributor to personnel expense, while the amounts paid to co-workers for profit sharing bonuses and 401(k) profit sharing contributions increased in 2006 as the Company exceeded its earnings targets and other objectives.
Occupancy and equipment expense increased 6.6% in 2006, compared to an increase of 1.4% in 2005. This increase reflects the partial-year impact of three expansion initiatives. In mid-2005, the Wealth Management Group moved into new office space, and the full-year effect of those costs were experienced in 2006. UBTW opened its fifth banking office in the fourth quarter of 2006 and expanded the amount of occupied office space at its Ann Arbor main office, and a portion of those expenses were in the 2006 income statement. There were no other significant additions to the Company's technology or banking office infrastructure in 2006.
Advertising and marketing expenses declined modestly in 2006, following a increase of 189.5% in 2005. The increase in 2005 included costs of the High Performance Checking program, along with the cost of increased marketing and advertising presence in the communities served by the Banks, and those efforts continued in 2006. Other expenses were up 4.7% over 2005, with no one category contributing disproportionately to the increase in expenses.
Federal Income Tax
The following chart shows the effective federal tax rates of the Company for the past three years, in thousands of dollars where applicable.
The Company's effective federal tax rate remained unchanged from 2006, following a decline from 2004 to 2005. Income from bank owned life insurance and tax credits from participation in low-income housing partnerships help to reduce the Company's federal income taxes. Tax exempt income continues to be a significant factor in the tax calculation for the Company, due to the percentage of the investment portfolio carried in tax exempt municipal securities and loans. The Banks intend to continue to invest in tax-exempt assets as long as liquidity, safety and tax equivalent yields make them an attractive alternative.
FINANCIAL CONDITION
Securities
Dollars of loan growth in excess of net deposit growth resulted in a decline of $7.6 million in the Company's securities portfolio during 2006. The makeup of the Company's investment portfolio continues to evolve with the growth of the Company, and the mix of the consolidated investment portfolio has continued to shift to meet liquidity and interest rate risk needs. On a consolidated basis, investment in all categories of securities declined in 2006, with the largest decrease in U.S. agency investments.
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Changes in the various categories of the Company's investment portfolio are shown in the chart below.
These changes are also reflected in the percentage makeup of the portfolio. The following chart shows the percentage mix of the securities portfolio.
Investments in U.S. Treasury and agency securities are considered to possess low credit risk. Obligations of U.S. government agency mortgage-backed securities possess a somewhat higher interest rate risk due to certain prepayment risks. The municipal portfolio contains a small amount of geographic risk, as approximately 26% of that portfolio is issued by political subdivisions located within Lenawee County, Michigan. The Company's portfolio contains no "high risk" mortgage securities or structured notes.
The Company's current and projected tax position continues to make carrying tax-exempt securities valuable to the Banks, and the Company does not anticipate being subject to alternative minimum tax in the near future. The Banks' investment in local municipal issues also reflects their commitment to the development of the local area through support of its local political subdivisions.
Unrealized gains and losses within the investment portfolio are temporary, since they are a result of market changes, rather than a reflection of credit quality. Management has no specific intent to sell any securities, although the entire investment portfolio is classified as available for sale. The chart below summarizes unrealized gains and losses in each category of the portfolio at the end of 2006 and 2005, in thousands of dollars.
Loans
As full service lenders, the Banks offer a variety of loan products in their markets. Loan growth was 7.8% in 2006, with much of that increase in personal loans and residential mortgages. Business loan volume slowed during the year, in part as a result of anticipated payoffs within the portfolio and a decline in nonperforming loans. At the same time, expanded offerings of ARM products by the Banks in 2006 have resulted in higher volume of ARM products for the year, which are generally retained in the loan portfolios of the Banks
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The chart below shows the percentage change in each category of the loan portfolio for 2006 and 2005.
Personal loan balances grew 11.6% in 2006, following an increase of 10.0% in 2005 over 2004. Activity in 2006 was in all categories of personal loans, but the largest growth was in home equity loans and personal lines of credit. Personal loans on the Company's balance sheet include direct and indirect loans for automobiles, boats and recreational vehicles, and other items for personal use. In addition, amounts outstanding in personal lines of credit and home equity loans are included in this loan category.
The Banks generally sell their production of fixed-rate mortgages on the secondary market, and retain shorter-term adjustable rate mortgages in their portfolios. As a result, the mix of mortgage production for any given year will have an impact on the amount of mortgages held in the portfolios of the Banks. In 2005, a significant portion of mortgage production included refinancing of existing portfolio loans into products that were sold on the secondary market. In 2006, as a result of expanded ARM product offerings, a much larger portion of the Company's mortgage production was in shorter term adjustable rate mortgages, and much of this volume was retained on the balance sheets of the Banks. As a result, Total dollars in the mortgage portfolio increased 27.3% in 2006 over 2005, following a decline of 11.8% in 2005.
Construction loan balances increased by 9.7% in 2006, following an increase of 33.6% in 2005. The rate of increase in construction loan volume declined primarily as a result of a slowing of the commercial mortgage and residential housing activity in the Company's market area. Residential construction loans will convert to residential mortgages to be retained in the Banks' portfolios or to be sold in the secondary market, while commercial construction loans will eventually be converted to commercial mortgages.
Business loan growth slowed in 2006, following the strong growth experienced in 2005. Total loans outstanding to businesses increased 2.4% in 2006, compared to growth of 14.8% in 2005. The slowing of loan growth in this category was primarily the result of anticipated and unanticipated loan payoffs within the portfolio. These payoffs reflect our efforts to maintain loan quality within the portfolio, as well as increased competition within the Banks' markets.
This growth in loans to commercial enterprises is derived from all of the markets the Banks serve, including significant contributions from the Ann Arbor and Dexter markets. In addition, the Banks purchase and sell participations in business loans, in order to diversify their geographic risk. Participation in tax exempt financing reflects continued involvement in funding local community expansion at local municipalities and school districts, reduced by normal amortizations of loan balances. Tax-exempt loan balances declined slightly in 2006 and 2005, following a large increase in 2004.
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Credit Quality
The Company continues to maintain a high level of asset quality as a result of actively monitoring delinquencies, nonperforming assets and potential problem loans. The aggregate amount of non- performing loans is presented in the table below. For purposes of that summary, loans renewed on market terms existing at the time of renewal are not considered troubled debt restructurings. The accrual of interest income is discontinued when a loan becomes ninety days past due unless it is both well secured and in the process of collection, or the borrower's capacity to repay the loan and the collateral value appear sufficient.
The chart below shows the amount of nonperforming assets by category at December 31 for each of the past five years.
The Company experienced modest improvement in its total nonperforming assets from year-end 2005 to 2006. Nonaccrual loans were down slightly, while delinquent loans were at their lowest level since 2003. The accrual of interest income is discontinued when a loan becomes ninety days past due unless it is both well secured and in the process of collection, or the borrower's capacity to repay the loan and the collateral value appear sufficient. Collection efforts continue with all delinquent clients, to bring them back to performing status. Holdings of other real estate was up from the end of 2005, and total nonperforming loans as a percent of total loans moved from 1.21% at the end of 2005 to 1.04% at the end of 2006.
The amount listed in the previous table as other real estate reflects three properties that were acquired through foreclosure or in lieu of foreclosure. All are vacant and are for sale, and no significant loss on these properties is anticipated. Total dollars in this category have increased from 2005 levels, but remain relatively low as a percentage of assets.
Credit quality is dependent in part on the makeup of the loan portfolio. The following chart shows the percentage makeup of the loan portfolio.
Loans to finance residential mortgages, including construction loans, make up 29.9% of the portfolio at year-end, compared to 27.4% at the end of 2005. This increase is primarily reflected in increases in portfolio mortgages during the year. Loans in this category are well-secured and have had historically low levels of net losses.
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The personal loan portfolio consists of direct and indirect installment, home equity and unsecured revolving line of credit loans. Installment loans consist primarily of loans for consumer durable goods, principally automobiles. Indirect personal loans consist of loans for automobiles, boats and manufactured housing, but make up a small percent of the personal loans.
Business loans carry the largest balances per loan, and therefore, any single loss would be proportionally larger than losses in other portfolios. Because of this, the Banks use an independent loan review firm to assess the continued quality of its business loan portfolio. This is in addition to the precautions taken with credit quality in the other loan portfolios. Business loans consist of approximately 63.6% of loans secured by nonfarm, nonresidential real estate. There are no other significant concentrations in the business loan portfolio. Further information concerning credit quality is contained in Note 6 of the Notes to Consolidated Financial Statements.
Deposits
Deposit totals increased $37.4 million in 2006, or 6.3% for the year, compared to deposit growth of 11.5% in 2005. While non-CD interest bearing deposit products continue to be popular with clients, much of the deposit growth during 2006 was in certificates of deposit. Although clients continue to evaluate alternatives to certificates of deposit in search of the best yields on their funds, traditional banking products continue to be an important part of the Company's product line.
While the Banks maintain a small amount of purchased or brokered deposits, they do not support their growth through the use of those products. The Banks' deposit rates are consistently competitive with other banks in its market area. The majority of the Company's deposits are derived from core client sources, relating to long term relationships with local personal, business and public clients. The following chart shows the percentage change in deposits by category for 2006 and 2005.
The chart below shows the percentage makeup of the deposit portfolio in 2006 and 2005.
Cash Equivalents and Borrowed Funds
The Company maintains correspondent accounts with a number of other banks for various purposes. In addition, cash sufficient to meet the operating needs of its banking offices is maintained at its lowest practical levels. The Banks are also participants in the federal funds market, either as borrowers or sellers. Federal funds are generally borrowed or sold for one-day periods. The Banks also have the ability to utilize short term advances from the Federal Home Loan Bank of Indianapolis ("FHLBI") and borrowings at the discount window of the Federal Reserve Bank as additional short-term funding sources. Federal funds were used during 2006 and 2005, and short term advances and discount window borrowings were not utilized during either year.
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The Company periodically finds it advantageous to utilize longer term borrowings from the FHLBI. These long-term borrowings, as detailed in Note 11 of the Notes to Consolidated Financial Statements, served to provide a balance to some of the interest rate risk inherent in the Company's balance sheet. Additional information regarding borrowed funds is found in the section below.
LIQUIDITY, FUNDS MANAGEMENT AND MARKET RISK
Liquidity
During 2006, the Company's cash and cash equivalents increased as a result of normal activities within the balance sheet and income statement. Throughout 2006, the Company participated in the federal funds market; at times as a provider of funds and at other times as a purchaser. Funding needs varied throughout the year, and overall, the Company's net excess funds during 2006 were marginally higher than in 2005. The Company averaged net federal funds sold of $5.9 million during 2006, compared to $3.5 million during 2005. These changes were primarily a result of timing differences between loan, investment and deposit growth.
Deposits grew $37.4 million in 2006, and FHLB advances declined by $1.3 million as a result of maturities in excess of new borrowings. Net portfolio loans increased by $42.2 million, and total investments declined by $7.6 million. All of these changes contributed to the Company's increase in excess funds.
The Banks monitor their liquidity position regularly, and are in compliance with regulatory guidelines for liquidity. The cash flows of the Company are relatively predictable. While loan and deposit cash flows are determined to a large extent by the actions of its clients, the Company is able to control its cash flows with regard to borrowings and investments. The Company has a number of liquidity sources other than deposits, including federal funds and other lines of credit with correspondent banks, securities available for sale, and lines of credit with the FHLB. Information concerning available lines is contained in Note 10 of the Notes to Consolidated Financial Statements.
Funds Management and Market Risk
The composition of the Company's balance sheet consists of investments in interest earning assets (loans and investment securities) that are funded by interest bearing liabilities (deposits and borrowings). These financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk.
Policies of the Company place strong emphasis on stabilizing net interest margin, with the goal of providing a sustained level of satisfactory earnings. The Funds Management, Investment and Loan policies provide direction for the flow of funds necessary to supply the needs of depositors and borrowers. Management of interest sensitive assets and liabilities is also necessary to reduce interest rate risk during times of fluctuating interest rates.
Interest rate risk is the exposure of the Company's financial condition to adverse movements in interest rates. It results from differences in the maturities or timing of interest adjustments of the Company's assets, liabilities and off-balance-sheet instruments; from changes in the slope of the yield curve; from imperfect correlations in the adjustment of interest rates earned and paid on different financial instruments with otherwise similar repricing characteristics; and from interest rate related options embedded in the Company's products such as prepayment and early withdrawal options.
A number of measures are used to monitor and manage interest rate risk, including interest sensitivity and income simulation analyses. An interest sensitivity model is the primary tool used to assess this
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risk, with supplemental information supplied by an income simulation model. The simulation model is used to estimate the effect that specific interest rate changes would have on twelve months of pretax net interest income assuming an immediate and sustained up or down parallel change in interest rates of 200 basis points. Key assumptions in the models include prepayment speeds on mortgage related assets; cash flows and maturities of financial instruments; changes in market conditions, loan volumes and pricing; and management's determination of core deposit sensitivity. These assumptions are inherently uncertain and, as a result, the models cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions. Based on the results of the simulation model as of December 31, 2006, the Company would expect a maximum potential reduction in net interest margin of less than 5% if market rates increased or decreased under an immediate and sustained parallel shift of 200 basis points.
During 2006 and 2005, the Company decreased its usage of long term fixed rate FHLB advances. In addition, the Company moved to a liability-sensitive position in the twelve-month timeframe based on internal interest sensitivity measures.
The following table provides information about the Company's financial instruments used for purposes other than trading that are sensitive to changes in interest rates. For loans, securities, and liabilities with contractual maturities, the table presents principal cash flows and related weighted average interest rates by the earlier of the contractual maturity or call dates as well as market and historical experience of the impact of interest rate fluctuations on the prepayment of mortgage-backed securities. Weighted average variable rates are based on current rates and indexes. The Company currently has no market sensitive instruments entered into for trading purposes and no off-balance-sheet interest rate swaps or caps. The information is in thousands of dollars as of December 31, 2006 and 2005.
FINANCIAL INSTRUMENTS AT DECEMBER 31, 2006
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FINANCIAL INSTRUMENTS AT DECEMBER 31, 2005
The Company's primary market risk exposure decreased from 2005 to 2006, based on data supplied by its measurement systems. This market risk exposure is if rates decline. The Company's exposure to market risk is reviewed on a regular basis by the Funds Management Committee. The policy objective is to manage the Company's assets and liabilities to provide an optimum and consistent level of earnings within the framework of acceptable risk standards.
The Funds Management Committee is also responsible for evaluating and anticipating various risks other than interest rate risk. Those risks include prepayment risk, credit risk and liquidity risk. The Committee is made up of senior members of management, and continually monitors the makeup of interest sensitive assets and liabilities to assure appropriate liquidity, maintain interest margins and to protect earnings in the face of changing interest rates and other economic factors.
The Funds Management policy provides for a level of interest sensitivity which, Management believes, allows the Company to take advantage of opportunities within the market relating to liquidity and interest rate risk, allowing flexibility without subjecting the Company to undue exposure to risk. In addition, other measures are used to evaluate and project the anticipated results of Management's decisions.
The following table shows the rate sensitivity of earning assets and interest bearing liabilities as of December 31, 2006. Loans and investments are categorized using the earlier of their scheduled payment, call, or repricing dates, where applicable. Savings, NOW and money market deposit accounts are considered to be immediately repriceable. All other liabilities are reported by their scheduled maturities, and no adjustments for possible prepayments are included in the table.
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INTEREST SENSITIVITY SUMMARY
CAPITAL RESOURCES
The common stock of the Company is traded on the Over The Counter Bulletin Board ("OTCBB") as UBMI. It is the policy of the Company to pay 30% to 45% of net earnings as cash dividends to shareholders. The payout ratio for 2006 was 42.5%, compared to 42.6% for 2005. Cash dividends per share have continued to increased, providing steady return to shareholders. Book value of the Company's stock increased from $25.83 at the end of 2005 to $28.41 at December 31, 2006. Five percent stock dividends were paid to shareholders in 2006 and 2005.
The ratios of average equity to average assets of the Banks and the Company increased in 2006 over 2005, as average capital grew at a faster pace than did average assets as a result of strong earnings. The Company's capital ratios exceed the levels required by its regulators, and Management continues to evaluate methods to optimize the high levels of equity of the Company. The table in Note 18 of the Notes to Consolidated Financial Statements details the capital ratios of the Company. The Company and the Banks are considered to be well-capitalized by the regulators.
The Company maintains short-term strategic plan and a five year plan, and utilizes a formal strategic planning process. Management and the Board continue to monitor long term goals, which include maintaining capital growth in relation to asset growth, and the retention of a portion of earnings to fund growth while providing a reasonable return to shareholders.
CONTRACTUAL OBLIGATIONS
The following table details the Company's known contractual obligations at December 31, 2006, in thousands of dollars:
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PROSPECTIVE ACCOUNTING AND REGULATORY CHANGES
In May 2005, the Financial Accounting Standards Board ("FASB") issued Statement No. 154, "Accounting Changes and Error Corrections" ("SFAS No. 154"), a replacement of APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements." SFAS No. 154 requires retrospective application for voluntary changes in accounting principles unless it is impracticable to do so. SFAS No. 154 was effective for the Company beginning October 1, 2006. We have evaluated the requirements of SFAS No. 154 and determined that it will not have a material effect on our financial condition or results of operations.
In February 2006, FASB issued Statement No. 155. "Accounting for Certain Hybrid Financial Instruments" ("SFAS No. 155"), which amends FASB Statement No. 133 and 140. This statement permits fair value remeasurement for any hybrid financial instrument containing an embedded derivative that would otherwise require bifurcation, and broadens a Qualified Special Purpose Entity's ("QSPE") permitted holdings to include passive derivative financial instruments that pertain to other derivative instruments. This statement is effective for the Company for all financial instruments acquired, issued or subject to a remeasurement event occurring on or after October 1, 2006. We have evaluated the requirements of SFAS No. 155 and determined that it will not have a material effect on our financial condition or results of operations.
In March 2006, FASB issued Statement of Financial Accounting Standards No. 156 ("SFAS No. 156"), Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, which requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable and permits the entities to elect either the fair value measurement with changes to fair value reflected in earnings or the amortization and impairment requirements of Statement 140 for subsequent measurement. The subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value eliminates the necessity for entities that manage the risks inherent in servicing assets and servicing liabilities with derivatives to qualify for hedge accounting treatment and eliminates the characterization of declines in fair value as impairments or direct write-downs. Statement No. 156 was effective for the Company beginning October 1, 2006. We have evaluated the requirements of SFAS No. 156 and determined that it will not have a material effect on our financial condition or results of operations.
In June 2006, FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes," an interpretation of SFAS No. 109, "Accounting for Income Taxes" ("Interpretation No. 48"). Interpretation No. 48 clarifies the accounting for uncertainty in income taxes in financial statements and prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Interpretation No. 48 was effective for the Company beginning October 1, 2006. We have evaluated the requirements of Interpretation No. 48 and determined that it will not have a material effect on our financial condition or results of operations.
In September 2006, FASB issued SFAS No. 157, "Fair Value Measurements." SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting standards, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15 2007, and interim periods within those fiscal years. We do not expect that the adoption of SFAS No. 157 will have a material impact on our financial condition or results of operations.
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Also in September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletine No. 85-4 (Accounting for Purchases of Life Insurance). The issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that the policies will be surrendered on an individual basis. Lastly, the issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy. This issue is effective for fiscal years beginning after December 15, 2006. The Company has not completed its evaluation of the impact of adoption of this issue.
In September 2006, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements," which addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB No. 108 will require registrants to quantify misstatements using both the balance sheet and income-statement approaches and to evaluate whether either approach results in the quantifying an error that is material in light of relevant quantitative and qualitative factors. When the effect of the initial adoption is determined to be material, SAB No. 108 allows registrants to record that effect as a cumulative effect adjustment to beginning retained earnings. The requirements were effective for the Company beginning October 1, 2006. We have evaluated the requirements of SAB No. 108 and determined that it will not have a material effect on our financial condition or results of operations.
Management is not aware of any other trends, events or uncertainties that are likely to have a material effect on the Company's liquidity, capital resources, or operations. In addition, Management is not aware of any current recommendations by regulatory authorities, other than those previously discussed, which would have such an effect.
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The Company's significant accounting policies are described in detail in the notes to the Company's consolidated financial statements for the year ended December 31, 2006. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company's financial condition and results, and they require management to make estimates that are difficult, subjective, or complex.
Allowance for Credit Losses
The allowance for credit losses provides coverage for probable losses inherent in the Company's loan portfolio. Management evaluates the adequacy of the allowance for credit losses each quarter based on changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory
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guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management's estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs.
The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan's observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan's effective interest rate.
Regardless of the extent of the Company's analysis of client performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a client's financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or client-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company's evaluation of imprecision risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment.
Mortgage Servicing Rights
Mortgage servicing rights ("MSRs") associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets.
Goodwill and Other Intangibles
The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required by SFAS 141. Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line and accelerated methods, and are subject to impairment if events or circumstances indicate
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a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition.
FORWARD-LOOKING STATEMENTS
Statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations include forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about the Company itself. Words such as "anticipate," "believe," "determine," "estimate," "expect," forecast, "intend," "is likely," "plan," "project," "opinion," variations of such terms, and similar expressions are intended to identify such forward-looking statements. The presentations and discussions of the provision and allowance for loan losses and determinations as to the need for other allowances presented in this report are inherently forward-looking statements in that they involve judgments and statements of belief as to the outcome of future events.
These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Internal and external factors that may cause such a difference include those discussed under "Risk Factors" in Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2006 and generally include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior and customer ability to repay loans; software failure, errors or miscalculations; and the vicissitudes of the national economy. The Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM United Bancorp, Inc. and Subsidiaries
(BKD LLP LOGO)
Shareholders and Board of Directors United Bancorp, Inc. Tecumseh, Michigan
We have audited the accompanying consolidated balance sheets of United Bancorp, Inc. as of December 31, 2006 and 2005 and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2006. 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of United Bancorp, Inc. as of December 31, 2006 and 2005 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of United Bancorp, Inc. internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 16, 2007 expressed unqualified opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting.
(BKD, LLP)
BKD, LLP
Indianapolis, Indiana March 16, 2007
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CONSOLIDATED BALANCE SHEETS United Bancorp, Inc. and Subsidiaries
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME United Bancorp, Inc. and Subsidiaries
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS United Bancorp, Inc. and Subsidiaries
The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY United Bancorp, Inc. and Subsidiaries For the years ended December 31, 2006, 2005, 2004
(1) Includes Paid In Capital
(2) Accumulated Other Comprehensive Income (Loss), Net of Tax
The accompanying notes are an integral part of these consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS United Bancorp, Inc. and Subsidiaries
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS AND BASIS OF PRESENTATION
The consolidated financial statements include the accounts of United Bancorp, Inc. ("Company") and its wholly owned subsidiaries, United Bank & Trust and United Bank & Trust - Washtenaw ("Banks"), after elimination of significant intercompany transactions and accounts. The Company is engaged 100% in the business of commercial and retail banking, including insurance, and trust and investment services, with operations conducted through its offices located in Lenawee, Washtenaw, and Monroe Counties in southeastern Michigan. These counties are the source of substantially all of the Company's deposit, loan, insurance and trust activities.
USE OF ESTIMATES
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period as well as affecting the disclosures provided. Actual results could differ from those estimates. The allowance for loan losses and the fair values of financial instruments are particularly subject to change.
SECURITIES
Securities available for sale consist of bonds and notes which might be sold prior to maturity. Securities classified as available for sale are reported at their fair values and the related net unrealized holding gain or loss is reported in other comprehensive income. Other securities such as Federal Home Loan Bank stock are carried at cost. Premiums and discounts on securities are recognized in interest income using the interest method over the period to maturity. Realized gains or losses are based upon the amortized cost of the specific securities sold.
LOANS HELD FOR SALE
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or market value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income.
LOANS
Loans that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and the allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Loans are placed on non-accrual status at ninety days or more past due and interest is considered a loss, unless the loan is well-secured and in the process of collection.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level believed adequate by Management to absorb probable incurred credit losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, amount and composition of the loan portfolio, and other factors. The allowance is
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increased by provisions for loan losses charged to income. Loan losses are charged against the allowance when Management believes the uncollectability of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.
Loan impairment is reported when full payment under the loan terms is not expected. Impaired loans are carried at the present value of estimated future cash flows using the loan's existing rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to require increase, such increase is reported as a component of the provision for loan losses. Loans are evaluated for impairment when payments are delayed or when the internal grading system indicates a substandard or doubtful classification.
Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When credit analysis of borrower operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, including the Banks' loans to the borrower, the loan is evaluated for impairment. Often this is associated with a delay or shortfall of payments of thirty days or more. Loans are generally moved to nonaccrual status when ninety days or more past due or in bankruptcy. These loans are often also considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible. This typically occurs when the loan is 120 or more days past due unless the loan is both well-secured and in the process of collection.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost, less accumulated depreciation. The provisions for depreciation are computed principally by the straight line method, based on useful lives of ten to forty years for premises and three to eight years for equipment.
OTHER REAL ESTATE OWNED
Other real estate consists of properties acquired through foreclosure or acceptance of a deed in lieu of foreclosure and property acquired for possible future expansion. Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value, less estimated selling costs, at the date of foreclosure establishing a new cost basis. After foreclosure, valuations are periodically performed and the real estate is carried at the lower of cost basis or fair value, less estimated selling costs. The historical average holding period for such properties is less than eighteen months. As of December 31, 2006 and 2005, other real estate owned totaled $1,063,000 and $871,000, and is included in other assets on the consolidated balance sheets.
GOODWILL
Goodwill is tested annually for impairment. If the implied fair value of goodwill is lower than its carrying amount, a goodwill impairment is indicated and goodwill is written down to its implied fair value. Subsequent increases in goodwill value are not recognized in the financial statements.
SERVICING RIGHTS
Servicing rights are recognized as assets for the allocated value of retained servicing on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates, remaining loan terms and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance.
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LONG-TERM ASSETS
Long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are written down to discounted amounts.
INCOME TAX
The Company records income tax expense based on the amount of taxes due on its tax return plus deferred taxes computed based on the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, using enacted tax rates, adjusted for allowances made for uncertainty regarding the realization of deferred tax assets.
EARNINGS PER SHARE
Amounts reported as earnings per share are based upon the weighted average number of shares outstanding plus the weighted average number of contingently issuable shares associated with the Directors' and Senior Management Group's deferred stock plans. In 2006, 2005 and 2004, the Company paid five percent stock dividends. Earnings per share, dividends per share, and weighted average shares have been restated to reflect the stock dividends.
In years prior to 2006, cash dividends were declared in the last month of the quarter, payable the end of the month following quarter-end. Effective with the first quarter of 2006, cash dividends are declared and are payable in the month following the end of the quarter. As a result of this change in schedule, the cash dividend declared in December of 2005 was paid in January, 2006, but no dividends were declared in the first quarter of 2006. While this change in procedure has not changed the number of dividends to be paid during the calendar year, for 2006 the number of cash dividends declared during the calendar year has been reduced by one.
STOCK BASED COMPENSATION
At December 31, 2006, the Company has a stock-based employee compensation plan, which is described more fully in Note 16. Prior to 2006, the Company accounted for this plan under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees" and related Interpretations. Accordingly, in 2005, no stock based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock at the grant date.
Effective January 1, 2006 the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123R, "Share Based Payment". The Company selected the modified prospective application. Accordingly, after December 31, 2005 the Company began expensing the fair value of stock options granted, modified, repurchased or cancelled.
The following table illustrates the effect on net income and earnings per share if the company had applied the fair value provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation as of December 31, 2004.
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For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Based on the use of estimates and the subjective nature of the assumptions used, the information presented above may not be representative of the pro forma impact in future years.
STATEMENTS OF CASH FLOWS
For purposes of this Statement, cash and cash equivalents include cash on hand, demand balances with banks, and federal funds sold. Federal funds are generally sold for one day periods. The Company reports net cash flows for client loan and deposit transactions, deposits made with other financial institutions, and short term borrowings with an original maturity of ninety days or less.
COMPREHENSIVE INCOME
Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes net unrealized gains and losses on securities available for sale, net of tax, which are also recognized as separate components of shareholders' equity.
INDUSTRY SEGMENT
The Company and its subsidiaries are primarily organized to operate in the banking industry. Substantially all revenues and services are derived from banking products and services in southeastern Michigan. While the Company's chief decision makers monitor various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's banking operations are considered by Management to be aggregated in one business segment.
NOTE 2 - RESTRICTIONS ON CASH AND DEMAND BALANCES IN OTHER BANKS
The Banks are subject to average reserve and clearing balance requirements in the form of cash on hand or balances due from the Federal Reserve Bank. These reserve balances vary depending on the level of client deposits in the Banks. The amount of reserve and clearing balances required at December 31, 2006 totaled approximately $245,000.
NOTE 3 - SECURITIES
The fair value of securities as of December 31, 2006 and 2005 are as follows, in thousands of dollars:
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The Company's temporarily impaired investment securities as of December 31, 2006 and 2005 are shown below.
Unrealized losses within the investment portfolio are temporary, as they are a result of market changes rather than a reflection of credit quality. Management has no specific intent to sell any securities, although the entire investment portfolio is classified as available for sale.
Sales activities for securities for the years indicated are shown in the following table. All sales were of securities identified as available for sale.
The fair value of securities available for sale by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Asset-backed securities are included in periods based on their estimated lives.
Securities carried at $15,122,000 and $15,090,000 as of December 31, 2006 and 2005 were pledged to secure deposits of public funds, funds borrowed, repurchase agreements, and for other purposes as required by law.
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NOTE 4 - LOANS
The table below shows total loans outstanding, including loans held for sale, at December 31. All loans are domestic and contain no concentrations by industry or client.
At December 31, 2006 and 2005, accruing loans delinquent 90 days or more totaled $855,000 and $1,153,000. Non-accruing loans at December 31, 2006 and 2005 were $5,427,000 and $5,609,000.
NOTE 5 - ALLOWANCE FOR LOAN LOSSES
An analysis of the allowance for loan losses for the years ended December 31 follows:
Information regarding impaired loans for the years ended December 31 follows:
NOTE 6 - LOAN SERVICING
Mortgage loans serviced for others are not included in the accompanying consolidated financial statements. The unpaid principal balance of mortgage loans serviced for others was $230,066,000 and $237,221,000 at December 31, 2006 and 2005. The balance of loans serviced for others related to servicing rights that have been capitalized was $225,629,000 and $235,512,000 at December 31, 2006 and 2005.
No valuation allowance was considered necessary at December 31, 2006 and 2005. Unamortized cost of mortgage servicing rights included in accrued interest receivable and other assets on the consolidated balance sheet, for the years ended December 31 was as follows:
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NOTE 7 - PREMISES AND EQUIPMENT
Depreciation expense was approximately $1,251,000 in 2006, $1,275,000 in 2005 and $1,344,000 in 2004. Premises and equipment as of December 31 consisted of the following:
The company has several noncancellable operating leases, primarily for banking facilities, that expire over the next fifteen years. The leases generally contain renewal options for periods ranging from one to five years. Rental expense for these leases was $759,000, $710,000 and $630,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Future minimum lease payments under operating leases are shown in the table below:
NOTE 8 - GOODWILL
The Company follows the provisions of Statement of Financial Accounting Standards No. 142 and Statement of Financial Accounting Standards No. 147 with regard to accounting and financial reporting for goodwill and other intangible assets. There was no impairment of goodwill in 2006, 2005 or 2004.
NOTE 9 - DEPOSITS
Information relating to maturities of time deposits as of December 31 is summarized below:
NOTE 10 - SHORT TERM BORROWINGS
The Company has several credit facilities in place for short term borrowing which are used on occasion as a source of liquidity. These facilities consist of borrowing authority totaling $45.9 million from correspondent banks to purchase federal funds on a daily basis. There was $0 and $6.3 million of fed funds purchased outstanding at December 31, 2006 and 2005.
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The Banks may also enter into sales of securities under agreements to repurchase (repurchase agreements). These agreements generally mature within one to 120 days from the transaction date. U.S. Treasury, agency and other securities involved with the agreements are recorded as assets and are generally held in safekeeping by correspondent banks. Repurchase agreements are offered principally to certain clients as an investment alternative to deposit products. The maximum amount of outstanding agreements at any month end during 2006 and 2005 totaled $77,000 and $76,000 and the daily average of such agreements totaled $76,000 and $76,000. The balance outstanding at December 31, 2006 and 2005 was $77,000 and $76,000.
NOTE 11 - OTHER BORROWINGS
The Banks carried fixed rate, noncallable advances from the Federal Home Loan Bank of Indianapolis totaling $40.9 million and $42.2 million at December 31, 2006 and 2005. As of December 31, 2006, the rates on the advances ranged from 2.69% to 6.18% with a weighted average rate of 4.67%. These advances are primarily collateralized by residential mortgage loans under a blanket security agreement. The unpaid principal balance of the loans pledged as collateral must equal at least 145% of the funds advanced. Interest payments are made monthly, with principal due annually and at maturity. If principal payments are paid prior to maturity, advances are subject to a prepayment penalties.
Maturities and scheduled principal payments for other borrowings over the next five years as of December 31 are shown below.
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Banks are party to financial instruments with off-balance-sheet risk in the normal course of business to meet financing needs of their clients. These financial instruments include commitments to make loans, unused lines of credit, and letters of credit. The Banks' exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Banks follow the same credit policy to make such commitments as is followed for loans and investments recorded in the consolidated financial statements. The Banks' commitments to extend credit are agreements at predetermined terms, as long as the client continues to meet specified criteria, with fixed expiration dates or termination clauses. The following table shows the commitments to make loans and the unused lines of credit available to clients at December 31:
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Commitments to make loans generally expire within thirty to ninety days, while unused lines of credit expire at the maturity date of the individual loans. At December 31, 2006, the rates for amounts in the fixed rate category ranged from 5.88% to 8.50%.
In December 2001, United Bank & Trust entered into a limited partnership agreement to purchase tax credits awarded from the construction, ownership and management of an affordable housing project and a residual interest in the real estate. As of December 31, 2006 and 2005, the total recorded investment including the obligation to make additional future investments amounted to $1,589,000 and $1,895,000 and was included in other assets. As of December 31, 2006 and 2005, the obligation of UBT to the limited partnership amounted to $1,632,000 and $1,831,000 which was reported in other liabilities. While UBT is a 99% partner, the investment is accounted for on the equity method as UBT is a limited partner and has no control over the operation and management of the partnership or the affordable housing project.
On September 22, 2006, Annette Theisen and various entities controlled by her, filed a complaint in Washtenaw Circuit Court against a number of defendants, including UBTW and its President, Todd C. Clark. The complaint alleges that UBTW and its President had a fiduciary duty and a duty of good faith to plaintiffs and that UBTW and its President breached those duties in connection with secured loans made to plaintiffs by, among other things, allegedly allowing plaintiffs to make imprudent investments with such loans, causing transfers of, and mortgages to be placed on, certain of plaintiffs' assets contrary to plaintiffs' interests, not disclosing certain alleged conflicts of interest, and failing to pay the premium on, and causing the cancellation of, Ms. Theisen's long-term supplemental medical insurance policy. Plaintiffs seek damages of $6 million. The Company is vigorously defending such claims.
NOTE 13 - FEDERAL INCOME TAX
Income tax expense consists of the following for the years ended December 31:
The components of deferred tax assets and liabilities at December 31, are as follows:
No valuation allowance was considered necessary at December 31, 2006 and 2005.
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A reconciliation between total federal income tax and the amount computed through the use of the federal statutory tax rate for the years ended is as follows:
NOTE 14 - RELATED PARTY TRANSACTIONS
Certain directors and executive officers of the Company and the Banks, including their immediate families and companies in which they are principal owners, are clients of the Banks. Loans to these parties did not, in the opinion of Management, involve more than normal credit risk or present other unfavorable features. The aggregate amount of these loans at December 31, 2005 was $46,065,000. During 2006, new and newly reportable loans to such related parties amounted to $13,118,000 and repayments amounted to $21,332,000, resulting in a balance at December 31, 2006 of $37,851,000. Related party deposits totaled $14,577,000 and $13,062,000 at December 31, 2006 and 2005.
NOTE 15 - RESTRICTIONS ON SUBSIDIARY DIVIDENDS, LOANS OR ADVANCES
Banking laws and regulations restrict the amount the Banks can transfer to the Company in the form of cash dividends and loans. At December 31, 2006, $21.1 million of retained earnings of the Banks were available for distribution to the Company as dividends without prior regulatory approval. It is not the intent of Management to pay dividends in amounts which would reduce the capital of the Banks to a level below that which is considered prudent by Management and in accordance with the guidelines of regulatory authorities.
NOTE 16 - EMPLOYEE BENEFIT PLANS
EMPLOYEE SAVINGS PLAN
The Company maintains a 401(k) employee savings plan ("plan") which is available to substantially all employees. Individual employees may make contributions to the plan up to 100% of their compensation up to a maximum of $15,000 for 2006 and $14,000 for 2005 and 2004. The Banks offers discretionary matching of funds for a percentage of the employee contribution, plus an amount based on Company earnings. The expense for the plan for 2006, 2005, and 2004 was $974,000, $918,000 and $791,000.
The plan offers employees the option of purchasing Company stock with the match portion of their 401(k) contribution. On that basis 2,193 shares in 2006, 2,356 shares in 2005 and 2,746 shares in 2004 of United Bancorp, Inc. common stock were issued to the 401(k) plan for the benefit of plan participants who so elected Company stock for their match.
DIRECTOR RETAINER STOCK PLAN
The Company maintains a deferred compensation plan designated as the Director Retainer Stock Plan ("Director Plan"). The plan provides eligible directors of the Company and the Banks with a means of deferring payment of retainers and certain fees payable to them for Board service. Under the Director Plan, any retainers or fees elected to be deferred under the plan by an eligible director ultimately will be payable in common stock at the time of payment.
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SENIOR MANAGEMENT BONUS DEFERRAL STOCK PLAN
The Company maintains a deferred compensation plan designated as the Senior Management Bonus Deferral Stock Plan ("Management Plan"). The Management Plan has essentially the same purposes as the Director Plan discussed above and permits eligible employees of the Company and its affiliates to elect cash bonus deferrals and, after employment termination, to receive payouts in whole or in part in the form of common stock on terms substantially similar to those of the Director Plan.
STOCK OPTIONS
In 2005, Shareholders approved the Company's 2005 Stock Option Plan (the "2005 Plan"), which became effective January 1, 2005. The plan is a non-qualified stock option plan as defined under Internal Revenue Service regulations. Under the plan, directors and management of the Company and subsidiaries are given the right to purchase stock of the Company at the market price at the time the options are granted. The 2005 Plan replaced the 1999 Stock Option Plan ("the 1999 Plan"), under which no more options are to be granted.
The stock subject to the options are shares of authorized and unissued common stock of the Company. As defined in the 2005 Plan, options representing no more than 192,938 shares (adjusted for stock dividends declared) are to be made available to the plan. The options have a three-year vesting period, and with certain exceptions, expire at the end of ten years, or three years after retirement.
The following table summarizes option activity for the 1999 Plan and the 2005 Plan during 2006, 2005 and 2004, adjusted for stock dividends:
The following table provides information regarding stock options under the 2005 Plan at December 31, 2006:
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
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A summary of the status of the Company's nonvested shares as of December 31, 2006 and 2005, and changes during the years then ended, is presented below:
The Company has recorded approximately $222,000 in compensation expense related to vested stock options less estimated forfeitures for the twelve month period ended December 31, 2006. As of December 31, 2006, unrecognized compensation expense related to the stock options totaled $244,000 and is expected to be recognized over 3 years. The total fair value of shares vested during the years ended December 31, 2006, 2005 and 2004 was $180,000, $101,000 and $102,000, respectively'.
At December 31, 2006, the aggregate intrinsic value of options outstanding totaled $213,000. This value represents the difference between the Company's closing stock price on the last day of trading for 2006 and the exercise price multiplied by the number of in-the-money options assuming all option holders had exercised their stock options on December 31, 2006.
The aggregate intrinsic value of stock options exercised during 2006 was $79,000. Exercise of options during this same period resulted in cash receipts of $60,000 and the Company recognized a tax benefit of approximately $28,000 on the exercise of these options and has been recorded as an increase in equity.
NOTE 17 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts and estimated fair value of principal financial assets and liabilities were as follows:
Estimated fair values require subjective judgments and are approximate. The above estimates of fair value are not necessarily representative of amounts that could be realized in actual market transactions, nor of the underlying value of the Company. Changes in the following methodologies and assumptions could significantly affect the estimated fair value:
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Cash and cash equivalents, accrued interest receivable and accrued interest payable - Due to the short periods to maturity, the carrying amounts are reasonable estimates of the fair values of these instruments at the respective balance sheet dates.
Securities available for sale - Fair values for securities available for sale are based on quoted market prices, if available. If quoted values are not available, the estimated fair value is determined by using quoted market prices for similar securities.
Net loans - The carrying amount is a reasonable estimate of fair value for personal loans for which rates adjust quarterly or more frequently, and for business and tax exempt loans which are prime related and for which rates adjust immediately or quarterly. The fair value for residential mortgage loans which are held for sale on the secondary market is the price offered by the secondary market purchaser. The fair value of all other loans is estimated by discounting future cash flows using current rates for loans with similar characteristics and maturities. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns.
Total deposits - With the exception of certificates of deposit, the carrying value is deemed to be the fair value due to the demand nature of the deposits. The fair value of fixed maturity certificates of deposit is estimated by discounting future cash flows using the current rates paid on certificates of deposit with similar maturities.
Short term borrowings - The carrying value is a reasonable approximation of fair value.
Other borrowings - The fair value is estimated by discounting future cash flows using current rates on advances with similar maturities.
Off-balance-sheet financial instruments - Commitments to extend credit, standby letters of credit and undisbursed loans are deemed to have no material fair value as such commitments are generally fulfilled at current market rates.
NOTE 18 - REGULATORY CAPITAL REQUIREMENTS
The Company and Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and Banks to maintain minimum ratios of Total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets.
The Company and the Banks were categorized as well-capitalized at year end 2006 and 2005 by their regulators. Management is not aware of any conditions or events that have occurred since year end that would change this classification. The following table shows the Company's and the Banks' capital ratios and the Company's amounts compared to regulatory requirements at year end, and the amounts by which the Company's capital, on a consolidated basis, exceeds regulatory requirements. Dollars are shown in thousands of dollars where appropriate.
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(1) Represents minimum required to be considered adequately capitalized under Federal regulatory requirements.
(2) Represents minimum required to be considered well-capitalized under Federal regulatory prompt corrective action provisions.
NOTE 19 - EARNINGS PER SHARE
A reconciliation of basic and diluted earnings per share follows:
Stock options for 100,196 and 1,000 shares of common stock were not considered in computing diluted earnings per share for 2006 and 2005 because they were not dilutive. No options were excluded from the computation in 2004, as all options were dilutive.
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NOTE 20 - OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) components and related taxes were as follows:
NOTE 21 - PARENT COMPANY ONLY FINANCIAL INFORMATION
The condensed financial information for United Bancorp, Inc. is summarized below.
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF INCOME
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CONDENSED STATEMENTS OF CASH FLOWS
NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Quarterly financial information is summarized below.
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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.
United Bancorp, Inc.
/S/ Robert K. Chapman March 8, 2007 - ------------------------------------- Date Robert K. Chapman, President and Chief Executive Officer, Director
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Robert K. Chapman and Dale L. Chadderdon, and each of them, his true and lawful attorney(s)-in-fact and agent(s), with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this report and to file the same, with all exhibits and schedules thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney(s)-in-fact and agent(s) full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney(s)-in-fact and agent(s), or their substitute(s), may lawfully do or cause to be done by virtue hereof.
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, on March 14, 2007.
/S/ James D. Buhr /S/ David S. Hickman - ------------------------------------- ---------------------------------------- James D. Buhr, Director David S. Hickman, Chairman of the Board
/S/ Joseph D. Butcko /S/ James C. Lawson - ------------------------------------- ---------------------------------------- Joseph D. Butcko, Director James C. Lawson, Director
/S/ Robert K. Chapman /S/ Donald J. Martin - ------------------------------------- ---------------------------------------- Robert K. Chapman (Principal Donald J. Martin, Director Executive Officer) Director, President and Chief Executive Officer /S/ David E. Maxwell ---------------------------------------- /S/ George H. Cress David E. Maxwell, Director - ------------------------------------- George H. Cress, Director /S/ Kathryn M. Mohr ---------------------------------------- /S/ John H. Foss Kathryn M. Mohr, Director - ------------------------------------- John H. Foss, Director /S/ Dale L. Chadderdon ---------------------------------------- /S/ James G. Haeussler Dale L. Chadderdon (Principal Financial - ------------------------------------- Officer) Executive Vice President & James G. Haeussler, Director Chief Financial Officer
EXHIBIT INDEX