Item 1.
Business
The Company
Midwest Banc Holdings, Inc., the Company, a Delaware corporation founded in 1983, is a community-based bank holding company headquartered in Melrose Park, Illinois. Through its wholly owned subsidiaries, the Company provides a wide range of services, including traditional banking services, personal and corporate trust services, and insurance brokerage and retail securities brokerage services. The Company’s principal operating subsidiary is Midwest Bank and Trust Company, the Bank, an Illinois state bank that operates 27 banking centers in the Chicago metropolitan area. The Company operates in one business segment, community banking, providing a full range of services to individual and corporate customers. Midwest Financial and Investment Services, Inc., a subsidiary of the Bank, is a Financial Industry Regulatory Authority, FINRA, registered broker/dealer that provides securities brokerage and insurance services to customers of the Bank.
The Company focuses on establishing and maintaining long-term relationships with customers and is committed to providing for the financial services needs of the communities it serves. In particular, the Company continues to emphasize its relationships with individual customers and small-to-medium-sized businesses. The Company actively evaluates the credit needs of its markets, including low- and moderate-income areas, and offers products that are responsive to the needs of its customer base. The markets served by the Company provide a mix of real estate, commercial and industrial, and consumer lending opportunities, as well as a stable core deposit base. The Company has expanded its trust administration and trust services activities along with broker/dealer activities.
Recent Developments
On January 29, 2009, the Company announced that Jay Fritz had been appointed to serve as its President and Chief Executive Officer, and that the Bank appointed Mr. Fritz to serve as its Chief Executive Officer. Mr. Fritz has served as Executive Vice President of the Company and President and Chief Operating Officer of the Bank since July of 2006. Mr. Fritz is a seasoned executive with over thirty years of banking experience. Prior to joining the Company, he served as Chairman and Chief Executive Officer of Royal American Bank, which was acquired by the Company in July of 2006. He has served as Chief Executive Officer of First Chicago Bank of Mt. Prospect, Illinois, and has held various management positions at Northern Trust, First National Bank of Libertyville and Continental Illinois National Bank. Mr. Fritz replaced James J. Giancola.
In response to the financial crises affecting the overall banking system and financial markets, on October 3, 2008, the Emergency Economic Stabilization Act of 2008, EESA, was enacted. Under the EESA, the United States Treasury Department (the “U.S. Treasury”) has the authority to, among other things, purchase mortgages, mortgage backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.
On October 3, 2008 the Troubled Asset Relief Program, TARP, became effective. The TARP gave the U.S. Treasury authority to deploy up to $700 billion into the financial system with an objective of improving liquidity in capital markets. On October 14, 2008, the U.S. Treasury announced plans to direct $250 billion of this authority into preferred stock investments in financial institutions. The general terms of this preferred stock program are as follows for a participant: pay 5% dividends on the U.S. Treasury’s preferred stock for the first five years and 9% dividends thereafter; cannot increase common stock dividends for three years while Treasury is an investor without their permission; the U.S. Treasury receives warrants entitling it to buy a participant’s common stock equal to 15% of the U.S. Treasury’s total initial investment in the participant; and the participating company’s executives must agree to certain compensation restrictions, and restrictions on the amount of executive compensation which is tax deductible and other detailed terms and conditions. The term of this preferred stock program could reduce investment returns to participating companies’ stockholders by restricting dividends to common stockholders, diluting existing stockholders’ interests, and restricting capital management practices. The TARP capital purchase program is a voluntary program designed to help healthy institutions build capital to support the U.S. economy by increasing the flow of financing to U.S. businesses and consumers.
Although the Company exceeded all applicable regulatory capital requirements, it submitted an application for participation in the TARP capital purchase program and it sold 84,784 shares of Series T preferred stock to the U.S. Treasury for an aggregate purchase price of $84.784 million and issued a warrant to the U.S. Treasury which will allow it to acquire 4,282,020 shares of its common stock for $2.97 per share. The Series T preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The senior preferred stock is non-voting, other than class voting rights on certain matters that could amend the rights of or adversely affect the stock.
If the Company completes one or more qualified equity offerings on or prior to December 31, 2009 that result in its receipt of aggregate gross proceeds of not less than $84.784 million, which is equal to 100% of the aggregate liquidation preference of the Series T preferred stock, the number of shares of common stock underlying the warrant then held by the selling securityholders will be reduced by 50% to 2,141,010 shares. The number of shares for which the warrant may be exercised and the exercise price applicable to the warrant will be proportionately adjusted in the event the Company pays stock dividends or makes distributions of its common stock, subdivides, combines or reclassifies outstanding shares of its common stock.
The Federal Deposit Insurance Corporation, FDIC, insures deposits at FDIC insured financial institutions up to certain limits. The FDIC charges insured financial institutions premiums to maintain the Deposit Insurance Fund. Current economic conditions have increased expectations for bank failures, in which case the FDIC would take control of failed banks and ensure payment of deposits up to insured limits using the resources of the Deposit Insurance Fund. In 2009, the FDIC plans to increase premium assessments to maintain adequate funding of the Deposit Insurance Fund. Assessment rates set by the FDIC effective December 5, 2009 range from 5 to 43 basis points. These increases in premium assessments will increase the Company’s expenses. See “Item 1. Business - Supervision and Regulation - FDIC Insurance Premiums on Deposit Accounts.”
On February 27, 2009, the FDIC board agreed to impose an emergency special assessment of 20 basis points on all banks to restore the Deposit Insurance Fund to an acceptable level. The assessment, which will be payable on September 30, 2009, is in addition to a planned increase in premiums and a change in the way regular premiums are assessed, which the board also approved on that date. This emergency special assessment for the Company is projected to be $5.0 million based on December 31, 2008 data.
The EESA included a provision for an increase in the amount of deposits insured by the FDIC to $250,000 until December 2009. On October 14, 2008, the FDIC announced a new program, the Temporary Liquidity Guarantee Program, that provides unlimited deposit insurance on funds in noninterest-bearing transaction deposit accounts not otherwise covered by the existing deposit insurance limit of $250,000. The Company has elected to participate in the Temporary Liquidity Guarantee Program and will incur a 10 basis point surcharge as a cost of participation. The behavior of depositors in regard to the level of FDIC insurance could cause the Company’s existing customers to reduce the amount of deposits held at the Company, and or could cause new customers to open deposit accounts. The level and composition of the Company’s deposit portfolio directly impacts its funding cost and net interest margin.
The EESA followed, and has been followed by, numerous actions by the Federal Reserve, the U.S. Congress, U.S. Treasury, the FDIC, the SEC and others to address the current liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.
On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009, ARRA, more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposes new executive compensation and corporate governance limits on current and future participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury. The new limits remain in place until the participant has redeemed the preferred stock
sold to U.S. Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to U.S. Treasury’s consultation with the recipient’s appropriate federal regulator.
There can also be no assurance as to the actual impact that the EESA, the ARRA and other programs will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of the EESA, the ARRA and other programs to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.
The EESA and the ARRA are relatively new legislation and, as such, is subject to change and evolving interpretation. This is particularly true given the change in administration that occurred on January 20, 2009. There can be no assurances as to the effects that such changes will have on the effectiveness of the EESA or on our business, financial condition or results of operations.
The purpose of these legislative and regulatory actions is to stabilize the U.S. banking system. The EESA, the ARRA and the other regulatory initiatives described above may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, our business, financial condition, results of operations and cash flows could be materially and adversely affected.
Developments
The Company recognized a non-cash, non-operating, other-than-temporary impairment charge of $47.8 million at September 30, 2008 on certain FNMA and FHLMC preferred equity securities similar to the impairment charge of $17.6 million taken in the first quarter of 2008. In September 2008, the Company sold a portion of its FNMA and FHLMC preferred equity securities recognizing a $16.7 million loss. It also recognized an impairment charge of $80.0 million on its goodwill intangible asset based upon an appraisal by an independent third party. The decline in value was primarily the result of a decline in market capitalization. During 2008, the Company recognized net loan charge-offs of $54.1 million and recorded a $71.8 million loan loss provision, reflecting management’s updated assessments of impaired loans and concerns about the continued deterioration of economic conditions. During the first quarter of 2008, the Company also incurred a $7.1 million loss on the early extinguishment of debt arising from the prepayment of $130.0 million in FHLB advances, and recognized a $15.2 million gain on the sale of real estate.
On December 16, 2008, the Board of Directors of the Company and the Bank elected Percy L. Berger Chairman of the Board of Directors of the Company and the Bank effective December 31, 2008. Mr. Berger replaced Homer J. Livingston, Jr. who resigned as a Director and Chairman of the Company and the Bank effective December 31, 2008.
Developments
On October 1, 2007, the Company completed its acquisition of Northwest Suburban Bancorp, Inc., Northwest Suburban, in a cash and stock merger transaction. At acquisition, Northwest Suburban had total assets of $546.2 million. The agreement and plan of merger provided that the Company’s stock comprised up to 45% of the purchase price, at an exchange ratio of 2.4551 shares of Company common stock for each Northwest Suburban common share, and that the remainder be paid in cash at the rate of $42.75 for each share of Northwest Suburban common stock. The Company issued 3.7 million shares of common stock, paid $81.2 million in cash, and incurred $414,000 in costs which were capitalized for a total purchase price of $136.7 million. The Company used the proceeds from a $75.0 million term note under a borrowing facility it has with a correspondent bank to pay for a portion of the cash requirement of the acquisition. The term note had an initial rate of one-month LIBOR plus 140 basis points and matures on September 28, 2010.
This acquisition added five more branches and made the Company, based on deposits, the 17th largest bank in the Chicago area as well as expanding the Company’s geographic footprint in the northwest suburbs. Northwest Suburban’s branch locations in Des Plaines, Lakemoor, Lake Zurich, Mount Prospect, and North Barrington provided a complimentary addition to the Company’s branches in northwest Cook, Kane, Lake, and McHenry counties. In addition, the Company believes that this acquisition contributed to the expansion and diversification of its loan portfolio, its deposit base, and its noninterest income.
In December 2007, the Company raised $41.4 million in new equity capital, net of issuance costs, through an offering of 1,725,000 depositary shares, including the over-allotment exercised by the underwriters, each representing 1/100th of a share of its Series A noncumulative redeemable convertible perpetual preferred stock, at $25.00 per depositary share. The infusion of capital strengthened the Company’s balance sheet as well as allowed it to partially pay down balances outstanding on its term note and revolving line of credit and contribute capital to the Bank.
Strategy
The Company’s strategic plan emphasizes expanded penetration of the community banking market in the Chicago metropolitan area, along with strong management of asset quality and risk. Among the strategies developed to achieve growth targets are:
Expand and diversify loan portfolio. The Company has increased its staff of commercial loan officers and will continue to recruit or develop internally the best lending talent in the marketplace. Through acquisitions made in 2006 and 2007, the Company significantly enhanced loan portfolio diversification along with adding seasoned management with strong credit and new business development skills. Growth is expected in commercial and industrial lending, as construction lending continues to decline as a percentage of the total loan portfolio. The Company will continue to seek out quality real estate loans, using appropriate underwriting standards, in order to build strong borrower relationships as opposed to transaction volume. All loan growth will be consistent with serving our market while maintaining appropriate levels of liquidity and ensuring a safe and secure environment for our depositors.
Expand deposit base. To fund loan growth, the Company is focused on core deposit generation, including demand, interest-bearing demand, money market, and savings deposits. Acquisitions in 2006 and 2007 added strong core deposit bases. The Company has changed and expanded staffing and management at its banking centers and initiated a number of customer outreach initiatives to expand deposits in a highly competitive market. The Company maintains a performance-driven sales environment and seeks to increase customer activity in its branches. The competitive Chicago market continues to be a challenging environment for attracting low cost core deposits.
Expand noninterest income. The Company is focusing on opportunities to build the contribution of fees as a percentage of revenue, emphasizing corporate cash management, and insurance, investment, and trust services.
Management believes its growth strategies to be fundamentally sound and based on reasonable opportunities available in the Chicago market. The Company has established internal benchmarks for each growth initiative and has taken a number of steps to align compensation with achievement of these benchmarks.
The Company continues to pursue opportunities to control expenses. In July 2007, the Company entered into a joint marketing arrangement with the largest privately held mortgage bank in Chicago. Through this arrangement, approximately fifteen of the Company’s employees became employees of this mortgage bank, eliminating the fixed costs and inherent risks associated with this very cyclical business. This also enabled the Company to offer its customers an even broader array of residential mortgage products.
Certain information with respect to the Bank and the Company’s nonbank subsidiaries as of December 31, 2008, is set forth below:
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Provides additional investment portfolio management to the Bank.
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Provides real estate management services to the Bank.
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The trust is a statutory business trust formed as a financing subsidiary of the Company.
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Provides securities brokerage services.
History
The Bank
Midwest Bank and Trust Company was established in 1959 in Elmwood Park, Illinois to provide community and commercial banking services to individuals and businesses in the neighboring western suburbs of Chicago. The Company has pursued growth opportunities through acquisitions and the establishment of new branches. The more recent are described below.
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On July 1, 2006, the Company completed its acquisition of Royal American. The Company issued 2.9 million common shares, paid $64.6 million in cash, and incurred $795,000 in costs that were capitalized for a total purchase price of $129.2 million. Royal American Bank merged into the Bank on July 1, 2006. Royal American had total assets of $561.2 million.
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On October 1, 2007, the Company completed its acquisition of Northwest Suburban. The Company issued 3.7 million common shares, paid $81.2 million in cash, and incurred $414,000 in costs which were capitalized for a total purchase price of $136.7 million. Mount Prospect National Bank merged into the Bank on October 1, 2007. Northwest Suburban had total assets of $546.2 million.
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During December 2008, the Company closed two unprofitable branches located in Addison and Lake Zurich, Illinois. The Company also took steps to relocate its Bucktown and Michigan Avenue Chicago branches and to open a second branch in the downtown Chicago business district.
Non-bank Subsidiaries
The Company’s non-bank subsidiaries were established to support the retail and commercial banking activities of the Bank.
In August 2002, the Bank established MBTC Investment Company. This subsidiary was capitalized through the transfer of investment securities from the Bank and was formed to diversify management of that portion of the Company’s securities portfolio. In May 2006, MBTC Investment Company established Midwest Funding, L.L.C. This subsidiary holds real estate assets.
In July 2006, the Bank acquired Midwest Financial and Investment Services, Inc., Midwest Financial, a registered bank-affiliated securities broker-dealer and registered investment advisor, through the Royal American merger. Midwest Financial is registered with the SEC as a broker-dealer and is a member of FINRA. It operates a general securities business as an introducing broker-dealer.
The Company formed four statutory trusts between October 2002 and June 2005 to issue $54.0 million in floating-rate trust preferred securities. Through the Royal American merger in July 2006, the Company acquired a statutory trust that in April 2004 had issued $10.0 million in trust preferred securities which have a fixed rate until the optional redemption date of July 23, 2009 and a floating rate thereafter until maturity. Through the Northwest Suburban merger in October 2007, the Company acquired a statutory trust that in May 2004 had issued $10.0 million in floating-rate trust preferred securities. These offerings were pooled private placements exempt from registration under the Securities Act pursuant to Section 4(2) thereunder. In November 2007, the Company redeemed $15.0 million in trust preferred securities originally issued through MBHI Capital Trust II. The Company has provided a full, irrevocable, and unconditional subordinated guarantee of the obligations of the five existing trusts under the preferred securities. The Company is obligated to fund dividends on these securities before it can pay dividends on its shares of common and preferred stock. See Note 13 to the Notes to the Consolidated Financial Statements. These five trusts and their trust preferred securities are detailed below as follows:
(1)
Redeemable at option of the Company.
Markets
The largest segments of the Company’s customer base live and work in relatively mature markets in Cook, DuPage, Kane, Lake, and McHenry Counties. The Company considers its primary market areas to be those areas immediately surrounding its offices for retail customers and generally within a 10-20 mile radius for commercial relationships. The Bank operates 27 full-service locations in the Chicago metropolitan area. The communities in which the Bank’s offices are located have a broad spectrum of demographic characteristics. These communities include a number of densely populated areas as well as suburban areas, and some extremely high-income areas as well as many middle-income and some low-to-moderate income areas.
Competition
The Company competes in the financial services industry through the Bank and Midwest Financial. The financial services business is highly competitive. The Company encounters strong direct competition for deposits, loans, and other financial services with the Company’s principal competitors including other commercial banks, savings banks, savings and loan associations, mutual funds, money market funds, finance companies, credit unions,
mortgage companies, insurance companies and agencies, private issuers of debt obligations and suppliers of other investment alternatives, such as securities firms.
Several major multi-bank holding companies operate in the Chicago metropolitan market. Generally, these financial institutions are significantly larger than the Company and have access to greater capital and other resources. Over the past few years, several hundred new bank branches have opened in the Company’s marketplace. Deposit pricing is competitive with promotional rates frequently offered by competitors. In addition, many of the Company’s non-bank competitors are not subject to the same degree of regulation as that imposed on bank holding companies, federally insured banks, and Illinois-chartered banks. As a result, such non-bank competitors have advantages over the Company in providing certain services.
The Company addresses these competitive challenges by creating market differentiation and by maintaining an independent community bank presence with local decision-making within its markets. The Bank competes for deposits principally by offering depositors a variety of deposit programs, convenient office locations and hours, and other services. The Bank competes for loan originations primarily through the interest rates and loan fees charged, the efficiency and quality of services provided to borrowers, the variety of loan products, and a trained staff of professional bankers.
The Chicago market is highly competitive making it more difficult to retain and attract customer relationships. The Company recognizes this and has initiatives to address the competition. Part of the Company’s marketing strategy is to create a performance-driven sales environment, increase activity in its branches, launch a renewed promotional image, and build and market a strong private banking program. The Company competes for qualified personnel by offering competitive levels of compensation, management and employee cash incentive programs, and by augmenting compensation with stock options and restricted stock grants pursuant to its stock and incentive plan. Attracting and retaining high quality employees is important in enabling the Company to compete effectively for market share.
Products and Services
Deposit Products
Management believes the Bank offers competitive deposit products and programs which address the needs of customers in each of the local markets served. These products include:
Checking and Interest-bearing Checking Accounts. The Company has developed a range of different checking account products (e.g., Free Checking and Business Advantage Checking) designed and priced to meet specific target segments of the local markets served by each branch.
Savings and Money Market Accounts. The Company offers multiple types of money market accounts and savings accounts (e.g., Relationship Savings which offers higher rates with deeper banking relationships).
Time Deposits. The Company offers a wide range of innovative time deposits (including traditional and Roth Individual Retirement Accounts), usually offered at premium rates with special features to protect the customer’s interest earnings in changing interest rate environments.
Lending Services
The Company’s loan portfolio consists of commercial loans, construction loans, commercial real estate loans, consumer real estate loans, and consumer loans. Management emphasizes credit quality and seeks to avoid undue concentrations of loans to a single industry or based on a single class of collateral. The Company generally requires personal guarantees of the principal except on cash secured, state or political subdivision, or not-for-profit organization loans. The Company has focused its efforts on building its lending business in the following areas:
Commercial Loans. Commercial and industrial loans are made to small-to medium-sized businesses that are sole proprietorships, partnerships, and corporations. Generally, these loans are secured with collateral including accounts receivable, inventory and equipment. The personal guarantees of the principals may also be required. Frequently, these loans are further secured with real estate collateral. Beginning with the fourth quarter of 2007,
owner-occupied commercial real estate loans, where repayment is not dependent on the real estate collateral, were reclassified as commercial loans where previously they were included in the commercial real estate classification.
Construction Loans. Construction loans include loans for land development and for commercial and residential development and improvements. The majority of these loans are in-market to known and established borrowers. During the past two years, these types of loans decreased as a percentage of the loan portfolio to 14.6% at December 31, 2008 from 21.8% at December 31, 2006.
Commercial Real Estate Loans. Commercial real estate loans are loans secured by real estate including farmland, multifamily residential properties, and other nonfarm-nonresidential properties. These loans are generally short-term balloon loans, with fixed or adjustable rate mortgages and terms of one to five years.
Consumer Real Estate Loans. Consumer real estate loans are made to finance residential units that will house from one to four families. While the Company originates both fixed and adjustable rate consumer real estate loans, most medium-term fixed-rate loans originated pursuant to Fannie Mae and Freddie Mac guidelines were sold in the secondary market. In the normal course of business, the Company retains one-to five-year adjustable rate loans. The Company exited the residential mortgage origination business in June 2007.
Home equity lines of credit, included within the Company’s consumer real estate loan portfolio, are secured by the borrower’s home and can be drawn at the discretion of the borrower. These lines of credit are generally at variable interest rates. Home equity lines, combined with the outstanding loan balance of prior mortgage loans, generally do not exceed 80% of the appraised value of the underlying real estate collateral.
Consumer Loans. Consumer loans (other than consumer real estate loans) are collateralized loans to individuals for various personal purposes such as automobile financing.
Lending officers are assigned various levels of loan approval authority based upon their respective levels of experience and expertise. Loan approval is also subject to the Company’s formal loan policy, as established by the Bank’s Board of Directors. The Bank’s loan policies establish lending authority and limits on an individual and committee basis. The loan approval process is designed to facilitate timely decisions while adhering to policy parameters and risk management targets.
ATMs
The Bank maintains a network of 29 ATM sites generally located within the Bank’s local market. All ATMs are owned by the Bank. Twenty-five of the ATM sites are located at various banking centers and four are maintained off-site. The Bank is a member of the STAR, Allpoint/STARsf, and MoneyPass Networks. The Bank’s participation in the STARsf/Allpoint and MoneyPass networks allows customers to have surcharge free access to their accounts at thousands of ATMs nationwide.
Trust Activities
The Bank offers personal and corporate trust, employee benefit trust, land trust, and agencies, custody, and escrow services. As of December 31, 2008, the Bank maintained trust relationships holding an aggregate market value of $154.5 million in assets and administered 1,608 land trust accounts.
Insurance and Securities Brokerage
The Bank’s subsidiary, Midwest Financial is registered with the SEC as a broker-dealer and is a member of FINRA. Midwest Financial operates a general securities business as an introducing broker-dealer. The area served by Midwest Financial is the Chicago metropolitan area. It holds neither customer accounts nor customers’ securities. Licensed brokers serve all branches and provide insurance and investment-related services, including securities trading, financial planning, mutual funds sales, fixed and variable rate annuities, and tax-exempt and conventional unit trusts. This activity furthers one of the Company’s strategic goals of increasing revenues from investment sources to enhance the Company’s profitability.
Employees
As of December 31, 2008, the Company and its subsidiaries had 536 full-time equivalent employees compared to 539 full-time equivalent employees a year ago. Management considers its relationship with its employees to be good.
Available Information
The Company’s internet address is www.midwestbanc.com. The Company is an SEC registrant and posts its SEC filings, including Forms 10-K, 10-Q, 8-K, proxy statements, and amendments thereto, on its website under Investor Relations on the day they are filed. The Company will also provide free copies of its filings upon written request to: Investor Relations, 501 West North Ave., Melrose Park, IL 60160.
The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company is an electronic filer. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at the SEC’s site: http://www.sec.gov.
The Company has a Corporate Governance webpage. The public can access information about the Company’s corporate governance at www.midwestbanc.com and by selecting Investor Relations and then Corporate Governance. The Company posts the following on its Corporate Governance webpage:
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Asset/Liability Committee Charter
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Code of Business Conduct and Ethics
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Director Independence Standards
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Audit Committee Charter
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Compensation Committee Charter
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Corporate Governance and Nominating Committee Charter
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Enterprise Risk Management Committee Charter
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Strategic Opportunities Committee Charter
SUPERVISION AND REGULATION
Bank holding companies and banks are extensively regulated under federal and state law. References under this heading to applicable statutes or regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to those statutes and regulations. Any change in applicable laws or regulations may have a material adverse effect on the business of commercial banks and bank holding companies, including the Company and the Bank. However, management is not aware of any current recommendations by any regulatory authority which, if implemented, would have or would be reasonably likely to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Finally, please remember that the supervision, regulation and examination of banks and bank holding companies by bank regulatory agencies are intended primarily for the protection of depositors rather than stockholders of banks and bank holding companies.
Recent Developments
In response to the financial crises affecting the overall banking system and financial markets, on October 3, 2008, the Emergency Economic Stabilization Act of 2008, was enacted. Under the EESA, the U.S. Treasury has the authority to, among other things, purchase mortgages, mortgage backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.
As indicated above, on December 5, 2008, the Company sold 84,784 shares of Series T preferred stock to the U.S. Treasury for an aggregate purchase price of $84.784 million and issued a warrant to the U.S. Treasury to acquire 4,282,020 shares of its common stock for $2.97 per share pursuant to the Letter Agreement.
The Company has agreed that, until such time as the U.S. Treasury ceases to own any of the Company’s debt or equity securities acquired pursuant to the Letter Agreement, the Company will take all necessary action to ensure that its benefit plans with respect to its senior executive officers comply with Section 111(b) of the EESA as implemented by any guidance or regulation under the EESA that has been issued and is in effect as of December 5, 2008 and has agreed to not adopt any benefit plans with respect to, or which covers, its senior executive officers that do not comply with the EESA, and the applicable executives have consented to the foregoing.
Section 111(b)(2)(A) of EESA requires limits on compensation which would encourage the Company’s senior executive officers subject to EESA to take unnecessary and excessive risks that threaten the value of the Company during the period that the U.S. Treasury holds an equity or debt position in the Company. The Company’s compensation committee must certify that it has conducted a review of the incentive compensation arrangements of these senior executive officers. This certification must appear in the Compensation Committee Report included in the Company’s proxy statement for its annual meeting of stockholders.
Section 111(b)(2)(B) of EESA requires that a provision be included in incentive compensation arrangements for the recovery of any bonus or incentive compensation paid to a senior executive officer subject to EESA based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate. Section 111(b)(2)(C) of EESA prohibits the Company from making any golden parachute payment to its senior executive officers subject to EESA during the period that the U.S. Treasury holds an equity or debt position in the Company. The Company also has to comply with Section 162m(5) of the Internal Revenue Code which limits the federal income tax deduction for executive remuneration to a senior executive officer subject to EESA to $500,000.
Under the rules, the Company’s CEO, CFO and the three next most highly compensated executive officers are subject to the EESA rules. All of the compensation arrangements between these officers and the Company were amended prior to the receipt of the funds from the U.S. Treasury so that such arrangements comply with EESA.
The Company’s CEO must certify to the U.S. Treasury within 135 days of the end of each fiscal year, the Company’s compliance with the EESA rules discussed above.
In addition, the Company expects that participation in the Capital Purchase Program, the CPP, will subject it to increased oversight by the U.S. Treasury, regulators and Congress. Under the terms of the CPP, the U.S. Treasury would have the power to unilaterally amend the terms of the purchase agreement to the extent required to comply with changes in applicable federal law and to inspect the Company’s corporate books and records through its federal banking regulator.
On January 12, 2009, the FDIC announced that State nonmember institutions should implement a process to monitor their use of capital injections, liquidity support and/or financing guarantees obtained through recent financial stability programs established by the Treasury, the FDIC and the Federal Reserve. In particular, the FDIC indicated that the monitoring processes should help to determine how participation in these federal programs has assisted institutions in supporting prudent lending and/or supporting efforts to work with existing borrowers to avoid unnecessary foreclosures. The FDIC has encouraged institutions to include a summary of this information in stockholder and public reports, annual reports and financial statements, as applicable. While the Company is not subject to this directive, it is foreseeable that similar requirements may be imposed on the Company by its primary banking regulator.
Congress has held hearings on implementation of TARP. On January 21, 2009, the U.S. House of Representatives approved legislation amending the TARP provisions of EESA to include quarterly reporting requirements with respect to lending activities, examinations by an institution’s primary federal regulator of use of funds and compliance with program requirements, restrictions on acquisitions by depository institutions receiving TARP funds, and authorization for the U.S. Treasury to have an observer at board meetings of recipient institutions, among other things. Although it is unclear whether this legislation will be enacted into law, its provisions, or similar ones, may be imposed administratively by the U.S. Treasury. In addition, Congress may adopt other legislation impacting financial institutions that obtain funding under the CPP or changing lending practices that legislators believe led to
the current economic situation. Such provisions could restrict or require changes to the Company’s lending or governance practices or increase governmental oversight of our businesses. See “Item 1. Business - Supervision and Regulation” and “Item 1A.
Item 1A.
Risk Factors
The Company’s business, financial condition or results of operations could be materially adversely affected by any of these risks.
Changes in economic conditions, in particular a continued economic slowdown in Chicago, Illinois, could hurt the Company’s business materially.
The Company’s business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond its control. Deterioration in economic conditions, in particular an economic slowdown in Chicago, Illinois, and surrounding areas, could result in the following consequences, any of which could hurt the Company’s business materially:
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loan delinquencies may increase;
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problem assets and foreclosures may increase;
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demand for its products and services may decline;
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low cost or noninterest bearing deposits may decrease; and
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collateral for loans made by us, especially real estate, may decline in value, in turn reducing customers’ borrowing power, and reducing the value of assets and collateral associated with the Company’s existing loans.
A large percentage of the Company’s loans are collateralized by real estate, including its construction loans, and an adverse change in the real estate market may result in losses and adversely affect its profitability.
A majority of the Company’s loan portfolio is comprised of loans at least partially collateralized by real estate; a substantial portion of this real estate collateral is located in the Chicago market. As of December 31, 2008, commercial real estate loans, where a portion of the collateral consists of real estate, totaled $1.2 billion, or 47.0% of its total loan portfolio, and construction loans, including land acquisition and development loans, totaled an additional $411.1 million, or 16.4% of its total loan portfolio.
Based on source of re-payment, as of December 31, 2008, commercial real estate loans totaled $729.7 million, or 29.1% of the Company’s total loan portfolio, and construction loans, including land acquisition and development, totaled an additional $366.2 million, or 14.6% of its total loan portfolio.
An adverse change in the economy affecting real estate values generally or in the Chicago market specifically could significantly impair the value of the Company’s collateral and its ability to sell the collateral upon foreclosure. In the event of a default with respect to any of these loans, amounts received upon sale of the collateral may be insufficient to recover outstanding principal and interest on the loans. As a result, the Company’s profitability could be negatively impacted by an adverse change in the real estate market.
Construction and land acquisition and development lending involve additional risks because funds may be advanced based upon values associated with the completed project, which is uncertain. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest. If the Company’s appraisal of the anticipated value of the completed project proves to be overstated, the Company may have inadequate security for the loan.
The Company’s allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect its results of operations or its financial condition.
As a lender, the Company is exposed to the risk that its loan customers may not repay their loans according to their terms and that the collateral securing the payment of these loans may be insufficient to assure repayment. The Company may experience significant loan losses which could have a material adverse effect on its operating results. Management makes various assumptions and judgments about the collectibility of the Company’s loan portfolio, which are based in part on:
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current economic conditions and their estimated effects on specific borrowers;
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an evaluation of the existing relationships among loans, potential loan losses and the present level of the allowance;
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management’s internal review of the loan portfolio; and
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results of examinations of its loan portfolio by regulatory agencies.
The Company maintains an allowance for loan losses in an attempt to cover probable incurred loan losses inherent in its loan portfolio. Additional loan losses will likely occur in the future and may occur at a rate greater than experienced historically. In determining the amount of the allowance, the Company relies on an analysis of its loan portfolio, experience, and evaluation of general economic conditions. If the Company’s assumptions and analysis prove to be incorrect, its current allowance may not be sufficient. In addition, adjustments may be necessary to allow for unexpected volatility or deterioration in the local or national economy or other factors such as changes in interest rates that may be beyond its control. In addition, federal and state regulators periodically review its allowance for loan losses and may require the Company to increase its provision for loan losses or recognize further loan charge-offs, based on judgments different than those of management. Any increase in the Company’s loan allowance or loan charge-offs could have a material adverse effect on its results of operations.
In 2008, the Company charged off $11.6 million of loan balances related to the previously announced Large Problem Credit, reduced outstanding balances on these loans by a net $5.7 million through the sale of assets, and took title to a substantial piece of real estate previously serving as collateral at an estimated net realizable value of $5.3 million. At December 31, 2008, total outstanding loan balances related to the Large Problem Credit represented $6.1 million, or 10.0%, of nonaccrual loans. While the current carrying value of these loans at December 31, 2008 reflects management’s best current estimate of net realizable value, there can be no assurance that additional losses will not be recognized or that such additional losses would not have a material adverse effect on the Company’s results of operations or its financial condition.
The Company’s nonperforming assets, which consist of nonaccrual loans, troubled debt restructured loans, foreclosed real estate and other repossessed assets, may also impact the sufficiency of the Company’s allowance for loan losses. Nonperforming assets totaled $84.1 million as of December 31, 2008, an increase of $32.7 million, or 63.7%, from $51.4 million at December 31, 2007.
In addition to those loans currently identified and classified as nonperforming loans, management is aware that other possible credit problems may exist with some borrowers. These include loans that are migrating from grades with lower risk of loss probabilities into grades with higher risk of loss probabilities as performance and potential repayment issues surface. The Company monitors these loans and adjusts loss rates in its allowance for loan losses accordingly. The most severe of these loans are credits that are classified as substandard assets due to either less than satisfactory performance history, lack of borrower’s paying capacity, or inadequate collateral.
While the Company attempts to manage the risk from changes in market interest rates, interest rate risk management techniques are not exact. In addition, the Company may not be able to economically hedge its interest rate risk. A rapid or substantial increase or decrease in interest rates could adversely affect its net interest income and results of operations.
The Company’s net income depends primarily upon its net interest income. Net interest income is income that remains after deducting, from total income generated by earning assets the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans,
investment securities and short-term investments. The amount of interest income is dependent on many factors, including the volume of earning assets, the general level of interest rates, the dynamics of changes in interest rates and the level of nonperforming loans. The cost of funds varies with the amount of funds required to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of non-interest-bearing demand deposits and equity capital.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. The Company expects that it will periodically experience “gaps” in the interest rate sensitivities of its assets and liabilities. That means either its interest-bearing liabilities will be more sensitive to changes in market interest rates than its interest earning assets, or vice versa. When interest-bearing liabilities mature or reprice more quickly than interest earning assets, an increase in market rates of interest could reduce the Company’s net interest income. Likewise, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could reduce net interest income. The Company is unable to predict changes in market interest rates which are affected by many factors beyond its control including inflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets. Based on its net interest income simulation model, if market interest rates were to increase immediately by 100 or 200 basis points (a parallel and immediate shift of the yield curve) net interest income would be expected to increase by 3.7% and 8.2%, respectively, from what it would be if rates were to remain at December 31, 2008 levels. The actual amount of any increase or decrease may be higher or lower than that predicted by the Company’s simulation model. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, relationships between interest sensitive instruments and key driver rates, balance sheet growth, client loan and deposit preferences and the timing of changes in these variables.
As result of current market conditions, the Company’s net interest income simulation model did not test the effects of 1.0% and 2.0% decreases in market interest rates at December 31, 2008 as those decreases would result in some deposit interest rate assumptions falling below zero. Nonetheless, the Company’s net interest income could decline in those scenarios as yields on earning assets could continue to adjust downward. Although the Company is seeking to mitigate this risk by instituting interest rate floors into its variable-rate loan products, continuation of the existing interest rate environment, featuring an historically low absolute level of market rates of interest, could have a material adverse effect on the Company.
The Company attempts to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate-sensitive assets and interest rate-sensitive liabilities. The Company continually reviews its interest rate risk position and modifies its strategies based on projections to minimize the impact of future interest rate changes. The Company also uses financial instruments with optionality to modify its exposure to changes in interest rates. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect results of operations and financial performance.
Conditions in the financial markets may limit the Company’s access to additional funding to meet its liquidity needs.
Liquidity is essential to the Company’s business. An inability to raise funds through deposits, borrowings, the sale of loans, the capital markets and other sources could have a substantial negative effect on the Company’s liquidity. The Company’s access to funding sources in amounts adequate to finance its activities could be impaired by factors that affect it specifically or the financial services industry in general. Factors that could detrimentally impact the Company’s access to liquidity sources include a decrease in the level of its business activity due to a market downturn or adverse regulatory action against it. The Company’s ability to borrow could also be impaired by factors that are not specific to it, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole as evidenced by the recent turmoil faced by banking organizations and the deterioration in the domestic and worldwide credit markets.
The Bank derives liquidity through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. Additionally, the Bank has access to financial market borrowing sources on an unsecured, and a collateralized basis for both short-term and long-term purposes including, but not limited to,
the Federal Reserve and Federal Home Loan Banks; the Bank is a member of both. If these funding sources are not sufficient, the Company may have to acquire funds through higher-cost sources.
The Company’s cost of funds for banking operations may increase as a result of general economic conditions, interest rates and competitive pressures.
The Bank has traditionally obtained funds principally through deposits and borrowings. As a general matter, deposits are a cheaper source of funds than borrowings, because interest rates paid for deposits are typically less than interest rates charged for borrowings. Historically and in comparison to commercial banking averages, the Bank has had a higher percentage of its time deposits in denominations of $100,000 or more and brokered certificates of deposit. Within the banking industry, the amounts of such deposits are generally considered more likely to fluctuate than deposits of smaller denominations. If, as a result of general economic conditions, market interest rates, competitive pressures or otherwise, the value of deposits at the Bank decrease relative to its overall banking operations, the Bank may have to rely more heavily on borrowings as a source of funds in the future.
Changes in the mix of the Company’s funding sources could have an adverse effect on its income. Almost 35.2% of the Company’s funding sources are in lower-rate transactional deposit accounts. Market rate increases or competitive pricing could heighten the risk of moving to higher-rate funding sources, which would cause an adverse impact on its net income.
The Company is party to loan agreements that require it to observe certain covenants that limit its flexibility in operating its business.
The Company currently has a $25.0 million short-term revolving line of credit and $55.0 million term note with a single lender. As of December 31, 2008, $8.6 million was outstanding under the revolving line of credit and $55.0 million was outstanding under the term loan. These loans are secured by the stock of the Bank.
The Company is obligated to meet certain covenants under the loan agreement relating to these loans. A breach of any of these covenants could result in a default under the loan agreements. Upon the occurrence of an event of default, all amounts outstanding under loan agreements could become immediately due and payable and our lender could terminate all commitments to extend further credit. The lender also could, at their option, increase the interest rate on those loans by 300 basis points. If the Company is unable to repay those amounts, the lender could proceed against the collateral granted to it to secure that indebtedness. If the lender accelerates the repayment of borrowings, we may not have sufficient assets to make the payments when due.
The revolving line of credit matures on April 3, 2009 and the term loan matures on September 28, 2010. Neither loan agreement includes a commitment to refinance the remaining outstanding balance of the loans when they mature and there is no guarantee that the lender will renew its loans on the maturity dates. Refusal to provide renewals or refinancing opportunities would cause the Company’s indebtedness to become immediately due and payable upon the contractual maturity of such indebtedness.
If we fail to meet our payment obligations under the loan agreements, such failure will constitute an event of default. When an event of default occurs, the lender, may among other remedies, (1) cease permitting us to borrow further under the line of credit, (2) terminate any outstanding commitment and (3) seize the outstanding shares of the Bank’s capital stock held by the Company which have been pledged as collateral for borrowings under the loan agreements. If the lender were to take one or more of these actions, it could have a material adverse affect on our reputation, operations and ability to continue as a going concern, and you could lose your investment in the securities.
If the Company is unable to renew, replace or expand our sources of financing on acceptable terms, it may have an adverse effect on the Company’s business and results of operations and its ability to make distributions to stockholders. Upon liquidation, holders of our debt securities and lenders with respect to other borrowings will receive, and any holders of preferred stock that is currently outstanding and that we may issue in the future may receive, a distribution of the available assets prior to holders of common stock. The decisions by investors and lenders to enter into equity and financing transactions with us will depend upon a number of factors, including our historical and projected financial performance, compliance with the terms of our current loan arrangements,
industry and market trends, the availability of capital and our investors’ and lenders’ policies and rates applicable thereto, and the relative attractiveness of alternative investment or lending opportunities. There can be no assurance that the Company will be able to raise sufficient capital to pay the loans in full by the maturity dates. In the event the correspondent bank declares the Company to be in default of any covenants, the Company has 30 days to cure the default, or the lender could, at its option, call the term note and any amounts outstanding on the revolving line of credit due and payable or increase the rate on those loans by 300 basis points.
As a result of the effects of recent economic conditions, the increase in nonperforming assets, and the impairment charges on goodwill and the FNMA and FHLMC preferred securities, the Company sought covenant waivers on two occasions since December 31, 2007. First, the lender waived a covenant violation in the first quarter of 2008 resulting from the Company’s net loss recognized in that period. Second, the lender waived a covenant violation in the third quarter of 2008 resulting from the Company’s net loss recognized in that period, contingent upon the Company making accelerated principal payments under the aforementioned term loan agreement in the amounts and on or prior to the dates shown below:
July 1, 2009 - $5.0 million
October 1, 2009 - $5.0 million
January 4, 2010 - $5.0 million
Previously, no principal payments were due under the term loan agreement until the final maturity date of September 28, 2010. The waiver further provides that if the Company raises $15.0 million in new capital pursuant to an offering of common or convertible preferred stock, then the Company shall not be obligated to make any of the accelerated principal payments specified above that fall due after the date on which the Company receives such $15.0 million in new capital until the final maturity date of September 28, 2010. The Company has the capacity to satisfy all payment obligations outlined above. The Company was in compliance with the debt covenants at December 31, 2008.
The Bank will only be able to pay dividends on common stock in 2009 upon receipt of regulatory approval. The Company’s annual debt service currently includes approximate $6.2 million in annual interest expense related to its debt and trust preferred securities and $7.6 million in annual dividend obligations on the Company’s Series A Preferred Stock and Series T Preferred Stock. As of December 31, 2008, the Company had $43.5 million in cash on hand. In the event the Bank is unable to pay dividends, the Company may not be able to service debt, pay obligations or pay dividends on its Series A Preferred Stock (and, therefore, its Series A depository shares), Series T Preferred Stock, or its common stock.
Markets have experienced, and may continue to experience, periods of high volatility accompanied by reduced liquidity.
Financial markets are susceptible to severe events evidenced by rapid depreciation in asset values accompanied by a reduction in asset liquidity. Under these extreme conditions, hedging and other risk management strategies may not be as effective at mitigating trading losses as they would be under more normal market conditions. Moreover, under these conditions market participants are particularly exposed to trading strategies employed by many market participants simultaneously and on a large scale, such as crowded trades. The Company’s risk management and monitoring processes seek to quantify and mitigate risk to more extreme market moves. Severe market events have historically been difficult to predict, however, and the Company could realize significant losses if unprecedented extreme market events were to occur, such as the recent conditions in the global financial markets and global economy.
Concern of the Company’s customers over deposit insurance may cause a decrease in deposits.
With recent increased concerns about bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured. Decreases in deposits may adversely affect the Company’s funding costs, net income, and liquidity.
The Company’s deposit insurance premium could be substantially higher in the future, which could have a material adverse effect on our future earnings.
The FDIC insures deposits at FDIC insured financial institutions, including the Bank. The FDIC charges the insured financial institutions premiums to maintain the Deposit Insurance Fund at a certain level. Current economic conditions have increased bank failures and expectations for further failures, in which case the FDIC ensures payments of deposits up to insured limits from the Deposit Insurance Fund.
On October 7, 2008, the FDIC released a five-year recapitalization plan and a proposal to raise premiums to recapitalize the fund. In order to implement the restoration plan, the FDIC proposed to change both its risk-based assessment system and its base assessment rates. Assessment rates would increase by seven basis points across the range of risk weightings. In December 2008, the FDIC adopted its rule, uniformly increasing the risk-based assessment rates by seven basis points, annually, resulting in a range of risk-based assessment of 12 basis points to 50 basis points. Changes to the risk-based assessment system would include increasing premiums for institutions that rely on excessive amounts of brokered deposits, increasing premiums for excessive use of secured liabilities, and lowering premiums for smaller institutions with very high capital levels.
On February 27, 2009, the FDIC board agreed to impose an emergency special assessment of 20 basis points on all banks to restore the Deposit Insurance Fund to an acceptable level. The assessment, which will be payable on September 30, 2009, is in addition to a planned increase in premiums and a change in the way regular premiums are assessed, which the board also approved on that date. This emergency special assessment for the Company is projected to be $5.0 million based on December 31, 2008 data.
Defaults by another financial institution could adversely affect financial markets generally.
Since mid-2007, the financial services industry as a whole, as well as the securities markets generally, have been materially and adversely affected by very significant declines in the values of nearly all asset classes and by a very serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence.
The commercial soundness of many financial institutions may be closely interrelated as a result of credit, trading, clearing, or other relationships between the institutions. As a result, concerns about, or a default or threatened default by, one institution could lead to significant market-wide liquidity and credit problems, losses, or defaults by other institutions. This is sometimes referred to as “systemic risk” and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which the Company interacts on a daily basis, and therefore could adversely affect the Company.
The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. As a result, defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due us. There is no assurance that any such losses would not materially and adversely affect our business, financial condition or results of operations.
The widespread effect of falling housing prices on financial markets could adversely affect the Company’s profitability, liquidity, and financial condition.
Turmoil in the financial markets, precipitated by falling housing prices and rising delinquencies and foreclosures, has negatively impacted the valuation of securities supported by real estate collateral, including certain securities owned by the Company. The Company relies on its investment securities portfolio as a source of net interest income and as a means to manage its funding and liquidity needs. If defaults in the underlying collateral are such that the security can no longer meet its debt service requirements, the Company’s net interest income, cash flows, and capital will be reduced.
The value of securities in the Company’s investment securities portfolio may be negatively affected by continued disruptions in securities markets.
The market for some of the investment securities held in the Company’s portfolio has become extremely volatile over the past twelve months. Volatile market conditions may detrimentally affect the value of these securities, such as through reduced valuations due to the perception of heightened credit and liquidity risks. There can be no assurance that the declines in market value associated with these disruptions will not result in other than temporary impairments of these assets, which would lead to accounting charges that could have a material adverse effect on our net income and capital levels.
If the Company is required to write down goodwill or other intangible assets or if it is required to mark-to-market certain of its assets or reduce its deferred tax assets by a valuation allowance, its financial condition and results of operations would be negatively affected.
When the Company acquires a business, a portion of the purchase price of the acquisition may be allocated to goodwill and identifiable intangible assets. The amount of the purchase price which is allocated to goodwill is determined by the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired. At December 31, 2008, the Company’s goodwill and identifiable intangible assets were approximately $93.5 million. Under generally accepted accounting principles, if the Company determines that the carrying value of its goodwill or intangible assets is impaired, the Company is required to write down the value of these assets. The Company conducts an annual review to determine whether goodwill and identifiable intangible assets are impaired.
The Company’s goodwill and intangible assets are reviewed annually for impairment as of September 30th of each year. This review in 2008 was conducted with the assistance of a third party valuation specialist. In conducting the review, the market value of the Company’s common stock, estimated control premiums, projected cash flow and various pricing analyses are all taken into consideration to determine if the fair value of the assets and liabilities in its business exceed their carrying amounts.
On September 30, 2008, the Company recorded a non-cash goodwill impairment charge of $80.0 million. This goodwill impairment charge was not tax deductible, did not impact its tangible equity or regulatory capital ratios, and did not adversely affect its overall liquidity position. It is classified as a noninterest expense item.
Under SFAS No. 142, goodwill must be tested for impairment annually and, under certain circumstances, at intervening interim dates. A goodwill impairment test also could be triggered between annual testing dates if an event occurs or circumstances change that would more likely than not reduce the fair value below the carrying amount. Examples of those events or circumstances would include the following:
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Significant adverse change in business climate;
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Significant unanticipated loss of clients/assets under management;
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Unanticipated loss of key personnel;
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Sustained periods of poor investment performance;
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Significant loss of deposits or loans;
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Significant reductions in profitability; or
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Significant changes in loan credit quality.
The Company does not believe that any new events or changes in circumstance have occurred since September 30, 2008 (the date of our most recent annual test and resulting impairment recognition) that would require an interim impairment analysis to be conducted as of December 31, 2008. Management will continue to assess any shortfall in the Company’s market capitalization relative to its total book value and tangible book value, which management currently attributes to both industry-wide and Company-specific factors, and to evaluate whether any additional adjustments are required in the carrying value of goodwill. If the Company’s common stock
continues to trade at a price below book value, the Company may be required in a future period to recognize an impairment of all, or some portion, of its remaining goodwill.
The Company cannot assure that it will not be required to take additional goodwill impairment charges in the future. Any impairment charge would have a negative effect on its stockholders’ equity and financial results.
If an impairment charge is significant enough to result in negative net income for the period, it could affect the ability of the Bank to upstream dividends to the Company, which could have a material adverse effect on the Company’s liquidity and its ability to pay dividends to stockholders.
If the Company decides to sell a loan or a portfolio of loans it is required to classify those loans as held for sale, which requires it to carry such loans at the lower of cost or market. If it decides to sell loans at a time when the fair market value of those loans is less than their carrying value, the adjustment will result in a loss. The Company may from time to time decide to sell particular loans or groups of loans, for example to resolve classified loans, and the required adjustment could negatively affect its financial condition or results of operations.
The Company is required, under generally accepted accounting principles, to assess the need for a valuation allowance on its deferred tax assets. If, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized, the Company would be required to reduce its deferred tax assets by a valuation allowance and increase income tax expense. At December 31, 2008, the Company’s net deferred tax asset was $56.5 million.
If the Company’s investment in the common stock of the Federal Home Loan Bank of Chicago is other than temporarily impaired, its financial condition and results of operations could be materially impaired.
The Bank owns common stock of the Federal Home Loan Bank of Chicago, FHLBC. The common stock is held to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the FHLBC’s advance program. The aggregate cost and fair value of the Company’s FHLBC common stock as of December 31, 2008 was $19.0 million based on its par value. There is no market for the FHLBC common stock.
On October 10, 2007, the FHLBC entered into a consensual cease and desist order with the Federal Housing Finance Board, now known as the Federal Housing Finance Agency, the FHFA. Under the terms of the order, capital stock repurchases and redemptions, including redemptions upon membership withdrawal or other termination, are prohibited unless the FHLBC receives the prior approval of the Director of the Office of Supervision of the FHFA, the Director. The order also provides that dividend declarations are subject to the prior written approval of the Director and required the FHLBC to submit a capital structure plan to the FHFA. The FHLBC has not declared any dividends since the order was issued and it has not received approval of a capital structure plan. In July of 2008, the FHFA amended the order to permit the FHLBC to repurchase or redeem newly-issued capital stock to support new advances, subject to certain conditions set forth in the order. The Company’s FHLBC common stock is not newly-issued and is not affected by this amendment.
Recent published reports indicate that certain member banks of the Federal Home Loan Bank System could have materially lower regulatory capital levels due to the application of certain accounting rules and asset quality issues. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLBC, could be substantially diminished or reduced to zero. The Company’s FHLBC common stock is accounted for in accordance with the AICPS Statement of Position (“SOP”) No. 01-6, Accounting by Certain Entities that Lend to or Finance the Activities of Others. SOP 01-6 provides that, for impairment testing purposes, the value of long term investments such as FHLBC common stock is based on the “ultimate recoverability” of the par value of the security without regard to temporary declines in value. Consequently, if events occur that give rise to substantial doubt about the ultimate recoverability of the par value of the Companys’ FHLBC common stock, this investment could be deemed to be other-than-temporarily impaired, and the impairment loss that we would be required to record would cause our earnings to decrease by the after-tax amount of the impairment loss.
As a bank holding company that conducts substantially all of the Company’s operations through its subsidiaries, its ability to pay dividends, repurchase its shares, or to repay its indebtedness depends upon liquid assets held by the bank holding company as well as the results of operations of the Company’s subsidiaries; the Company and its subsidiaries are subject to other restrictions.
The Company is a separate and distinct legal entity from its subsidiaries and it receives substantially all of its revenue from dividends from its subsidiaries. The Company’s net income depends primarily upon its net interest income. Net interest income is income that remains after deducting from total income generated by earning assets the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities and short-term investments. The amount of interest income is dependent on many factors including the volume of earning assets, the general level of interest rates, the dynamics of changes in interest rates and the levels of nonperforming loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of noninterest-bearing demand deposits and equity capital.
Most of the Company’s ability to pay dividends and make payments on its debt securities come from amounts paid to it by the Bank. Under applicable banking law, the total dividends declared in any calendar year by the Bank may not, without the approval of the Federal Reserve exceed the aggregate of the Bank’s net profits and retained net profits for the preceding two years. The Bank is also subject to limits on dividends under the Illinois Banking Act. The Bank will not be able to pay dividends to the Company in 2009 without prior approval of the Federal Reserve.
If, in the opinion of the federal bank regulatory agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution, could include the payment of dividends), the agency may require that the bank cease and desist from the practice. The Federal Reserve has similar authority with respect to bank holding companies. In addition, the federal bank regulatory agencies have issued policy statements which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. Finally, these regulatory authorities have established guidelines with respect to the maintenance of appropriate levels of capital by a bank, bank holding company or savings association under their jurisdiction. Compliance with the standards set forth in these guidelines could limit the amount of dividends that the Company and its affiliates may pay in the future.
Under the terms of junior subordinated debentures the Company has issued, it has agreed not to declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of its common stock or preferred stock if, at that time, there is a default under the junior subordinated debentures or a related guarantee or it has delayed interest payments on the securities issued under the junior indenture.
The Company’s outstanding Series A and Series T preferred stock has preference over the Company’s common stock with respect to the payment of dividends and distribution of the Company’s assets in the event of a liquidation or dissolution.
Future dividend payments and common stock repurchases are restricted by the terms of the U.S. Treasury’s equity investment in the Company.
Under the terms of the Company’s agreement with the U.S. Treasury, for so long as any Series T preferred stock remains outstanding, the Company is prohibited from paying dividends on its common stock, and from making certain repurchases of equity securities, including its common stock, without the U.S. Treasury’s consent until the third anniversary of the U.S. Treasury’s investment or until the U.S. Treasury has transferred all of the Series T preferred stock to third parties. Furthermore, as long as the Series T preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including its common stock, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions.
The Company may elect or be compelled to seek additional capital in the future, but capital may not be available when it is needed.
The Company is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. To the extent the Company continues to expand its operations, the Company will be required to support the growth in its operations by increasing its capital. In that regard, a number of financial institutions have recently raised considerable amounts of capital as a result of deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors, which may diminish our ability to raise additional capital.
The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside its control, and on its financial performance. Accordingly, the Company cannot be assured of its ability to raise additional capital if needed or on terms acceptable to it. If the Company cannot raise additional capital when needed, it may have a material adverse effect on its financial condition, results of operations and prospects. If the Company cannot raise additional capital when needed, it may be subject to increased regulatory supervision and the imposition of restrictions on its growth. These restrictions could negatively impact the Company’s ability to further expand its operations and may result in significant increases in its operating expenses or decreases in its revenues.
The Company’s effective tax rates may be adversely affected by changes in federal and state tax laws.
The Company’s effective tax rates may be adversely affected by changes in federal or state tax laws, regulations and agency interpretations. In this regard, recent changes in Illinois laws may adversely affect the Company’s results of operations. Under current tax law, the Company enjoyed favorable tax treatment with respect to the dividends it received from Midwest Funding, L.L.C., a captive real estate investment trust, or a REIT. A change in Illinois tax law relating to the deductibility of captive REIT dividends eliminated this tax benefit beginning January 1, 2009, and is likely to increase the Company’s effective tax rate beginning in that year.
In addition, in connection with the determination of the Company’s provision for income and other taxes and during the preparation of its tax returns, management makes certain judgments based upon reasonable interpretations of tax laws, regulations and agency interpretations which are inherently complex. Management’s interpretations are subject to challenge upon audit by the tax authorities, which have become increasingly aggressive in challenging tax positions taken by financial institutions, including certain positions that it has taken. If the Company is not successful in defending the tax positions that it has taken, the Company’s financial condition and results of operations may be adversely affected.
An interruption in or breach in security of the Company’s information systems may result in a loss of customer business.
The Company relies heavily on communications and information systems to conduct its business. Any failure or interruptions or breach in security of these systems could result in failures or disruptions in its customer relationship management, general ledger, deposits, servicing, or loan origination systems. The occurrence of any failures or interruptions or breach in security could result in a loss of customer business, costly remedial actions, or legal liabilities and have a material adverse effect on the Company’s results of operations and financial condition.
Management regularly reviews and updates our 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 our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations, cash flows and financial condition.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of the Company’s information systems, there
can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. Additionally, the Company outsources a portion of its data processing to a third party. If our third party provider encounters difficulties or if we have difficulty in communicating with such third party, it will significantly affect our ability to adequately process and account for customer transactions, which would significantly affect our business operations. Furthermore, breaches of such third party’s technology may also cause reimbursable loss to our consumer and business customers, through no fault of our own. The occurrence of any failures, interruptions or security breaches of information systems used to process customer transactions could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition, results of operations and cash flows.
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 our operations. Many 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. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business and, in turn, its financial condition, results of operations and cash flows.
The Company’s business may be adversely affected by the highly regulated environment in which it operates.
The Company is subject to extensive federal and state legislation, regulation and supervision. The burden of regulatory compliance has increased under current legislation and banking regulations and is likely to continue to have a significant impact on the financial services industry. Recent legislative and regulatory changes, as well as changes in regulatory enforcement policies and capital adequacy guidelines, are increasing the Company’s costs of doing business and, as a result, may create an advantage for its competitors who may not be subject to similar legislative and regulatory requirements. In addition, future regulatory changes, including changes to regulatory capital requirements, could have an adverse impact on the Company’s future results. In addition, the federal and state bank regulatory authorities who supervise the Company have broad discretionary powers to take enforcement actions against banks for failure to comply with applicable regulations and laws. If the Company fails to comply with applicable laws or regulations, it could become subject to enforcement actions that have a material adverse effect on its future results.
There can be no assurance that the recently enacted Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009 and other recently enacted government programs will help stabilize the U.S. financial system.
On October 3, 2008, the Emergency Economic Stabilization Act of 2008, EESA, was enacted. The U.S. Treasury and banking regulators are implementing a number of programs under this legislation and otherwise to address capital and liquidity issues in the banking system, including the TARP Capital Purchase Program. In addition, other regulators have taken steps to attempt to stabilize and add liquidity to the financial markets, such as the FDIC Temporary Liquidity Guarantee Program, TLG Program, which we did not “opt-out” of. However, there can be no assurance that we will issue any guaranteed debt under the TLG Program, or that we will participate in any other stabilization programs in the future.
The EESA followed, and has been followed by, numerous actions by the Federal Reserve, the U.S. Congress, U.S. Treasury, the FDIC, the SEC and others to address the current liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial
institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.
On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009, ARRA, more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposes new executive compensation and corporate governance limits on current and future participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury. The new limits remain in place until the participant has redeemed the preferred stock sold to U.S. Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to U.S. Treasury’s consultation with the recipient’s appropriate federal regulator.
There can also be no assurance as to the actual impact that the EESA, the ARRA and other programs will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of the EESA, the ARRA and other programs to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.
The EESA and the ARRA are relatively new legislation and, as such, is subject to change and evolving interpretation. This is particularly true given the change in administration that occurred on January 20, 2009. There can be no assurances as to the effects that such changes will have on the effectiveness of the EESA or on our business, financial condition or results of operations.
The purpose of these legislative and regulatory actions is to stabilize the U.S. banking system. The EESA, the ARRA and the other regulatory initiatives described above may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, our business, financial condition, results of operations and cash flows could be materially and adversely affected.
The limitations on incentive compensation contained in the ARRA may adversely affect the Company’s ability to retain its highest performing employees.
The ARRA imposes new executive compensation limits on current and future participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury. The ARRA contains restrictions on bonus and other incentive compensation payable to the five executives named in a company’s proxy statement, imposes restrictions on severance payments to the ten highest paid employees, and requires the repayment of bonuses in certain circumstances by the 25 highest paid employees. Depending upon the limitations placed on incentive compensation by the final regulations issued under the ARRA, it is possible that the Company may be unable to create a compensation structure that permits it to retain its highest performing employees. If this were to occur, the Company’s business and results of operations could be adversely affected, perhaps materially.
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
From time to time, customers make claims and take legal action pertaining to our performance of our fiduciary responsibilities. Whether customer claims and legal action related to our performance of our fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to us, they may result in significant financial liability and/or adversely affect the market perception of us and our products and services as well as impact customer demand for our products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition, results of operations and cash flows.
The Company is exposed to risk of environmental liabilities with respect to properties to which we take title.
In the course of our business, we may own or foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, cash flows, liquidity and results of operations could be materially and adversely affected.
Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact our business.
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. Although management has established disaster recovery policies and procedures and is insured for these situations, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition, results of operations and cash flows.
Non-Compliance with USA PATRIOT Act, Bank Secrecy Act, or Other Laws and Regulations Could Result in Fines or Sanctions, and Curtail Expansion Opportunities
Financial institutions are required under the USA PATRIOT and Bank Secrecy Acts to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. Financial institutions are also obligated to file suspicious activity reports with the U.S. Treasury Department’s Office of Financial Crimes Enforcement Network if such activities are detected. These rules also require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure or the inability to comply with these regulations could result in fines or penalties, curtailment of expansion opportunities, intervention or sanctions by regulators and costly litigation or expensive additional controls and systems. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. We have developed policies and continue to augment procedures and systems designed to assist in compliance with these laws and regulations.
Provisions in the Company’s amended and restated certificate of incorporation and its amended and restated by-laws may delay or prevent an acquisition of the Company by a third party.
The Company’s amended and restated certificate of incorporation and its amended and restated by-laws contain provisions that may make it more difficult for a third party to gain control or acquire the Company without the consent of its board of directors. These provisions also could discourage proxy contests and may make it more difficult for dissident stockholders to elect representatives as directors and take other corporate actions.
These provisions of the Company’s governing documents may have the effect of delaying, deferring or preventing a transaction or a change in control that some or many of its stockholders might believe to be in their best interest.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
The following table sets forth certain information regarding the Company’s principal office and bank branches.
*
Land is leased and building is owned.
Management believes that the facilities are of sound construction, in good operating condition, appropriately insured, and adequately equipped for carrying on the business of the Company. During December 2008, the Company closed two unprofitable branches located in Addison and Lake Zurich, Illinois.
Item 3.
Item 3.
Legal Proceedings
The Company and its subsidiaries are from time to time parties to various legal actions arising in the normal course of business. Management believes that there is no proceeding pending against the Company or any of its subsidiaries which, if determined adversely, would have a material adverse effect on the financial condition or results of operations of the Company.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
The Company held a special meeting of the holders of the Series A Noncumulative Redeemable Convertible Perpetual Preferred Stock (the “Series A preferred stock”) on December 5, 2008. One proposal was submitted to a vote of the Series A preferred stockholders as described in the Company’s proxy statement, dated November 21, 2008. The following is a brief description of the matter voted upon, which was approved by the holders of the Series A preferred stock:
•
To authorize the issuance by the Company of up to $85.5 million of fixed rate, cumulative perpetual preferred stock, Series T to the U.S. Treasury:
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s common stock is traded over-the-counter and quoted on the NASDAQ Global Market under the symbol “MBHI.” As of March 10, 2009, the Company had approximately 879 stockholders of record, based upon securities position listings furnished by the Company’s transfer agent. The Company believes the number of beneficial owners is greater than the number of record holders because a large portion of the Company’s common stock is held through brokerage firms in “street name.” The table below sets forth the high and low sale prices of the common stock and the cash dividends declared during the periods indicated.
Issuer Purchases of Equity Securities
On May 3, 2006, the Company announced a 5.0% stock repurchase program. During 2006, the Company repurchased 204,188 shares of its common stock at an average price of $23.37. During 2007, the Company repurchased 661,500 shares of its common stock at an average price of $14.25. These shares were acquired in private and public transactions as part of the Company’s stock repurchase program. No shares were repurchased during 2008. As of December 31, 2008, there were 374,111 shares remaining for repurchase under this program, should the Company decide to do so with the approval of the U.S. Treasury.
Information regarding the equity compensation plan is included in Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters and the information included therein is incorporated herein by reference.
Holders of common stock are entitled to receive such dividends that may be declared by the Board of Directors from time to time and paid out of funds legally available therefor. Because the Company’s consolidated net income consists largely of net income of the Bank, the Company’s ability to pay dividends depends upon its receipt of dividends from the Bank. The Bank’s ability to pay dividends is regulated by banking statutes. The Bank will not be able to pay dividends to the Company in 2009 without prior approval of the Federal Reserve. See “Supervision and Regulation, Financial Institution Regulation - Dividend Limitations.” The declaration of dividends by the Company is discretionary and depends on the Company’s earnings and financial condition, regulatory limitations, tax considerations and other factors including limitations imposed by the terms of the Company’s outstanding junior subordinated debentures owed to its unconsolidated trusts. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity.” The Company will only be able to pay dividends with the approval of the U.S. Treasury Department.
Issuance of Preferred Stock - Use of Proceeds
The Company, on December 5, 2008, issued and sold to the U.S. Treasury (i) 84,784 shares of the Company’s fixed rate cumulative perpetual preferred stock, Series T and (ii) a warrant to purchase for $2.97 per share 4,282,020 shares of the Company’s common stock, par value $0.01 per share, for an aggregate purchase price of $84.784 million in cash. The preferred stock and warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. The new equity strengthened the Company’s balance sheet and allowed it to infuse capital into the Bank through a subordinated debenture as well as allowed it to partially pay down $12.0 million in balances outstanding on its revolving line of credit.
Performance Graph
The following graph shows a comparison of the cumulative returns for the Company, the S&P 500 Index, and the NASDAQ Market Bank Stocks Index for the period beginning December 31, 2003 and ending December 31, 2008. The information assumes that $100 was invested at the closing price on December 31, 2003 in the common stock of the Company and each index and that all dividends were reinvested.
Item 6.
Item 6.
Selected Consolidated Financial Data
The following table sets forth certain selected consolidated financial data at or for the periods indicated. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the results of operations and gain on sale of Midwest Bank of Western Illinois are shown in the Company’s statements of income for 2004 and 2005 as “discontinued operations.” This information should be read in conjunction with the Company’s Consolidated Financial Statements and notes thereto included herein. See “Item 8, Consolidated Financial Statements and Supplementary Data.”
(1)
Net income divided by average assets.
(2)
Net income divided by average equity.
(3)
Net interest income, on a fully tax-equivalent basis, divided by average earning assets.
(4)
The following table reconciles reported net interest income on a fully tax-equivalent basis for the periods presented:
(5)
Reflects continuing operations due to the sale of bank subsidiary on September 30, 2005.
(6)
Noninterest expense less noninterest income, excluding security gains or losses, divided by average assets.
(7)
Noninterest expense excluding amortization of intangible assets and foreclosed properties expense divided by noninterest income, excluding security gains or losses, plus net interest income on a fully tax-equivalent basis.
(8)
Includes total nonaccrual, impaired and all other loans 90 days or more past due.
(9)
Includes total nonaccrual and all other loans 90 days or more past due, trouble-debt restructured loans and foreclosed properties.
(10)
Stockholders’ equity less goodwill, core deposit intangible and other intangible assets. Management believes that tangible stockholders’ equity (non-GAAP measure) is a more useful measure since it excludes the balances of intangible assets. The following table reconciles reported stockholders’ equity to tangible stockholders’ equity for the periods presented:
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The Company’s principal business is conducted by the Bank which provides of a full range of community-based financial services, including commercial and retail banking. The profitability of the Company’s operations depends primarily on its net interest income, provision for loan losses, noninterest income, noninterest expenses, and income taxes. Net interest income is the difference between the income the Company receives on its loan and securities portfolios and its cost of funds, which consists of interest paid on deposits and borrowings. The provision for loan losses reflects the cost of credit risk in the Company’s loan portfolio. Noninterest income consists of service charges on deposit accounts, securities gains or losses or impairments, net trading profits or losses, gains or losses on sales of loans, insurance and brokerage commissions, trust income, increase in cash surrender value of life insurance, gains on sale of property and extinguishment of debt, and other noninterest income. Noninterest expenses include salaries and employee benefits, occupancy and equipment expenses, professional services, marketing expenses, amortization of intangible assets, goodwill impairment, loss on extinguishment of debt, merger-related expenses, and other noninterest expenses. The Company is subject to state and federal income taxes.
Net interest income is dependent on the amounts of and yields on interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities. Net interest income is sensitive to changes in market interest rates and is dependent on the Company’s asset/liability management procedures to react appropriately to such changes. The provision for loan losses is based upon management’s assessment of the collectibility of the loan portfolio under current economic conditions. Noninterest expenses are influenced by the growth of operations. Growth in the number of account relationships directly affects such expenses as data processing costs, supplies, postage, and other miscellaneous expenses. The provision for income taxes is affected by tax law and regulation, accounting principles and policies, and income tax strategies. See Note 2 and Note 22 of the Notes to the consolidated financial statements for more details.
The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated. The discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto and the Selected Consolidated Financial Data presented herein. In addition to historical information, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed in this report.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. By their nature, changes in these assumptions and estimates could significantly affect the Company’s financial position or results of operations. Actual results could differ from those estimates. Discussed below are those critical accounting policies that are of particular significance to the Company.
Allowance for Loan Losses: The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Company’s methodology for determining the allowance for loan losses represents an estimation performed pursuant to SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of all loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which potentially result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for credit losses could be required that could adversely affect the Company’s earnings or financial position in future periods.
A loan is impaired when full payment of all principal and interest under the original loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Income Taxes: The Company recognizes expense for federal and state income taxes currently payable as well as for deferred federal and state taxes for estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the consolidated balance sheets, as well as loss carryforwards and tax credit carryforwards. Realization of deferred tax assets is dependent upon generating sufficient taxable income in either the carryforward or carryback periods to cover net operating losses generated by the reversal of temporary differences. A valuation allowance is provided by way of a charge to income tax expense if it is determined that it is not more likely than not that some or all of the deferred tax asset will be realized. If different assumptions and conditions were to prevail, the valuation allowance may not be adequate to absorb unrealized deferred taxes and the amount of income taxes payable may need to be adjusted by way of a charge or credit to expense. Furthermore, income tax returns are subject to audit by the IRS and state taxing authorities. Income tax expense for current and prior periods is subject to adjustment based upon the outcome of such audits. The Company believes it has adequately accrued for all probable income taxes payable. Accrual of income taxes payable and valuation allowances against deferred tax assets are estimates subject to change based upon the outcome of future events.
The Company has entered into tax allocation agreements with its subsidiary entities included in the consolidated US federal and unitary and combined state income tax returns. These agreements govern the timing and amount of income tax payments required by the various entities.
In June 2006, the Financial Accounting Standards Board (“FASB”) released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in the application of income tax laws, providing a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax positions taken or expected to be taken in income tax returns. The Company’s adoption of FIN 48 on January 1, 2007 did not have a material impact on the Company’s consolidated financial position and results of operations. See Note 22 - Income Taxes of the Notes to the consolidated financial statements for more details.
Evaluation of Securities for Impairment: Securities are classified as held-to-maturity when the Company has the ability and intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and
losses, net of taxes, reported in other comprehensive income (loss). Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on the disposition of securities available-for-sale are based on the net proceeds and the adjusted carrying amounts of the securities sold, using the specific identification method. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are recognized in earnings as realized losses. In estimating other than temporary losses, management considers (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Accounting Pronouncements
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to provide guidance in the process of quantifying financial statement misstatements. SAB No. 108 requires registrants to quantify an error under two methods: (1) quantify the misstatement based on the amount of the error originating in the current-year income statement (“Rollover Approach”) and (2) quantify the misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current-year irrespective of the misstatement’s year(s) origination (“Iron Curtain Approach”). Consequently, a registrant’s financial statements would require adjustment when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. SAB No. 108 was effective for financial statements issued for fiscal years ending after November 15, 2006. The application of SAB No. 108 as of January 1, 2007 did not have any impact on the Company’s results of operations or financial position.
The Company adopted SFAS No. 157, “Fair Value Measurements,” on January 1, 2008, which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements where the FASB had previously concluded in those pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new financial assets or liabilities to be measured at fair value. In February 2008, FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, “Effective Date of FASB Statement No. 157.” This FSP delays the effective dates of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. In October 2008, the FASB issued Staff Position 157-3, “Determining the Fair Value of a Financial Asset in a Market That Is Not Active” (“FSP No. 157-3”), which clarifies the application of SFAS No. 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is to be determined when the market for that financial asset is not active. FSP No. 157-3 became effective for the Company’s interim financial statements as of September 30, 2008 and did not significantly impact the methods by which the Company determines the fair values of its financial assets. The adoption of SFAS No. 157 did not have a material effect on the Company’s results of operations or consolidated financial position. See Note 17 - Fair Value of the Notes to the consolidated financial statements for more details.
In December 2007, FASB issued SFAS No. 141R, “Business Combinations,” which replaces the current standard on business combinations, modifies the accounting for business combinations and requires, with limited exceptions, the acquirer in a business combination to recognize all of the assets acquired, liabilities assumed, and any noncontrolling interests in the acquiree at the acquisition-date, at fair value. SFAS No. 141R also requires certain contingent assets and liabilities acquired as well as contingent consideration to be recognized at fair value. In addition, the statement requires payments to third parties for consulting, legal, audit, and similar services associated with an acquisition to be recognized as expenses when incurred rather than capitalized as part of the cost of the acquisition. SFAS No. 141R is effective for fiscal years beginning on or after December 15, 2008 and early adoption is not permitted.
In June 2008, the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”) on Issue No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF No. 07-5”). EITF No. 07-5 provides guidance for determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock. EITF No. 07-5 applies to any freestanding financial
instrument or embedded feature that has all of the characteristics of a derivative or freestanding instrument that is potentially settled in an entity’s own stock (with the exception of share-based payment awards within the scope of SFAS 123(R)). To meet the definition of “indexed to own stock,” an instrument’s contingent exercise provisions must not be based on (a) an observable market, other than the market for the issuer’s stock (if applicable), or (b) an observable index, other than an index calculated or measured solely by reference to the issuer’s own operations, and the variables that could affect the settlement amount must be inputs to the fair value of a “fixed-for-fixed” forward or option on equity shares. EITF No. 07-5 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The Company does not anticipate a material effect on its results of operations or consolidated financial position from adopting EITF No. 07-5.
In December 2008, the FASB issued FASB Staff Position FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities” (“FSP No. FAS 140-4 and FIN 46(R)-8”). FSP No. FAS 140-4 and FIN 46(R)-8 amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” and FIN No. 46, “Consolidation of Variable Interest Entities,” requiring additional disclosures about transfers of financial assets and the involvement with variable interest entities. These additional disclosures are intended to provide greater transparency about a transferor’s continuing involvement with transferred assets and variable interest entities. FSP No. FAS 140-4 and FIN 46(R)-8 is effective for fiscal years ending after December 15, 2008. The adoption of FSP No. FAS 140-4 and FIN 46(R)-8 did not have a material effect on the Company’s results of operations or consolidated financial position.
Recent Developments
On January 29, 2009, the Company announced that Jay Fritz had been appointed to serve as its President and Chief Executive Officer, and that the Bank appointed Mr. Fritz to serve as its Chief Executive Officer. Mr. Fritz has served as Executive Vice President of the Company and President and Chief Operating Officer of the Bank since July of 2006. Mr. Fritz is a seasoned executive with over thirty years of banking experience. Prior to joining the Company, he served as Chairman and Chief Executive Officer of Royal American Bank, which was acquired by the Company in July of 2006. He has served as Chief Executive Officer of First Chicago Bank of Mt. Prospect, Illinois, and has held various management positions at Northern Trust, First National Bank of Libertyville and Continental Illinois National Bank. Mr. Fritz replaced James J. Giancola.
On February 23, 2009, the Company granted 159,000 shares of restricted stock, with a grant-date fair value of $1.15 to certain officers of the Company under its incentive program. These shares of restricted stock will vest on the third anniversary of the date of grant and have voting and dividend rights. The Company also granted 409,146 options to purchase its common stock at an exercise price of $1.15, the fair value of the Company’s common stock at the date of grant, to certain officers of the Company under its incentive program. These stock options will become exercisable on the third anniversary of the date of grant and expire in 10 years from the date of grant. None of the shares of restricted stock or stock options were granted to executive vice presidents or above.
In response to the financial crises affecting the overall banking system and financial markets, on October 3, 2008, the Emergency Economic Stabilization Act of 2008, EESA, was enacted. Under the EESA, the United States Treasury Department, the U.S. Treasury, has the authority to, among other things, purchase mortgages, mortgage backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.
On October 3, 2008 the Troubled Asset Relief Program, TARP, became effective. The TARP gave the U.S. Treasury authority to deploy up to $700 billion into the financial system with an objective of improving liquidity in capital markets. On October 14, 2008, the U.S. Treasury announced plans to direct $250 billion of this authority into preferred stock investments in financial institutions. The general terms of this preferred stock program are as follows for a participant: pay 5% dividends on the U.S. Treasury’s preferred stock for the first five years and 9% dividends thereafter; cannot increase common stock dividends for three years while Treasury is an investor without their permission; the U.S. Treasury receives warrants entitling it to buy a participant’s common stock equal to 15% of the U.S. Treasury’s total initial investment in the participant; and the participating company’s executives must agree to certain compensation restrictions, and restrictions on the amount of executive compensation which is tax deductible and other detailed terms and conditions. The terms of this preferred stock program
could reduce investment returns to participating companies’ stockholders by restricting dividends to common stockholders, diluting existing stockholders’ interests, and restricting capital management practices. The TARP capital purchase program is a voluntary program designed to help healthy institutions build capital to support the U.S. economy by increasing the flow of financing to U.S. businesses and consumers.
Although the Company exceeds all applicable regulatory capital requirements, it submitted an application for participation in the TARP capital purchase program and, on December 5, 2008, it sold 84,784 shares of Series T preferred stock to the U.S. Treasury for an aggregate purchase price of $84.784 million and issued a warrant to the U.S. Treasury which will allow it to acquire 4,282,020 shares of its common stock for $2.97 per share. The Series T preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Series T preferred stock may be redeemed by the Company after three years. Prior to the end of three years, the Series T preferred stock may be redeemed by the Company only with proceeds from the sale of qualifying equity securities. The senior preferred stock is non-voting, other than class voting rights on certain matters that could amend the rights of or adversely affect the stock.
If the Company completes one or more qualified equity offerings on or prior to December 31, 2009 that result in its receipt of aggregate gross proceeds of not less than $84.784 million, which is equal to 100% of the aggregate liquidation preference of the Series T preferred stock, the number of shares of common stock underlying the warrant then held by the selling securityholders will be reduced by 50% to 2,141,010 shares. The number of shares for which the warrant may be exercised and the exercise price applicable to the warrant will be proportionately adjusted in the event the Company pays stock dividends or makes distributions of its common stock, subdivide, combine or reclassify outstanding shares of its common stock.
The EESA included a provision for an increase in the amount of deposits insured by the FDIC to $250,000 until December 2009. On October 14, 2008, the FDIC announced a new program, the Temporary Liquidity Guarantee Program, that provides unlimited deposit insurance on funds in noninterest-bearing transaction deposit accounts not otherwise covered by the existing deposit insurance limit of $250,000. The Company has elected to participate in the Temporary Liquidity Guarantee Program and incur a 10 basis point surcharge as a cost of participation. The behavior of depositors in regard to the level of FDIC insurance could cause the Company’s existing customers to reduce the amount of deposits held at the Company, and or could cause new customers to open deposit accounts. The level and composition of the Company’s deposit portfolio directly impacts its funding cost and net interest margin.
The EESA followed, and has been followed by, numerous actions by the Federal Reserve, the U.S. Congress, U.S. Treasury, the FDIC, the SEC and others to address the current liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.
On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009, ARRA, more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, ARRA imposes new executive compensation and corporate governance limits on current and future participants in TARP, including the Company, which are in addition to those previously announced by U.S. Treasury. The new limits remain in place until the participant has redeemed the preferred stock sold to U.S. Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to U.S. Treasury’s consultation with the recipient’s appropriate federal regulator.
On February 27, 2009, the FDIC board agreed to impose an emergency special assessment of 20 basis points on all banks to restore the Deposit Insurance Fund to an acceptable level. The assessment, which will be payable on September 30, 2009, is in addition to a planned increase in premiums and a change in the way regular premiums are assessed, which the board also approved on that date. This emergency special assessment for the Company is projected to be $5.0 million based on December 31, 2008 data.
As a result of the effects of recent economic conditions, the increase in nonperforming assets, and the impairment charges on goodwill and the FNMA and FHLMC preferred securities, the Company sought covenant waivers on two occasions since December 31, 2007. First, the lender waived a covenant violation in the first quarter of 2008 resulting from the Company’s net loss recognized in that period. Second, the lender waived a covenant violation in the third quarter of 2008 resulting from the Company’s net loss recognized in that period, contingent upon the Company making accelerated principal payments under the aforementioned term loan agreement. See Note 14 - Credit Agreements of the Notes to the consolidated financial statements for more details.
Developments
In December 2008, the Company raised $84.8 million in new equity through an offering of 84,784 shares of Series T fixed rate cumulative perpetual preferred stock and a warrant to purchase 4,282,020 shares of common stock at $2.97 per share to the Treasury under the TARP. The Series T preferred stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The new equity strengthened the Company’s balance sheet and allowed it to infuse capital into the Bank through a subordinated debenture.
The Company recognized a non-cash, non-operating, other-than-temporary impairment charge of $47.8 million at September 30, 2008 on certain FNMA and FHLMC preferred equity securities similar to the impairment charge of $17.6 million taken in the first quarter of 2008. In September 2008, the Company sold a portion of its FNMA and FHLMC preferred equity securities recognizing a $16.7 million loss. It also recognized an impairment charge $80.0 million on its goodwill intangible asset based upon an appraisal by an independent third party. The decline in value was primarily the result of a decline in market capitalization. During 2008, the Company recognized net loan charge-offs of $54.1 million and recorded a $71.8 million loan loss provision, reflecting management’s updated assessments of impaired loans and concerns about the continued deterioration of economic conditions. During the first quarter of 2008, the Company also incurred a $7.1 million loss on the early extinguishment of debt arising from the prepayment of $130.0 million in FHLB advances, and recognized a $15.2 million gain on the sale of real estate.
On December 16, 2008, the Board of Directors of the Company and the Bank elected Percy L. Berger Chairman of the Board of Directors of the Company and the Bank effective December 31, 2008. Mr. Berger replaced Homer J. Livingston, Jr. who resigned as a Director and Chairman effective December 31, 2008.
Developments
On October 1, 2007, the Company completed its acquisition of Northwest Suburban in a cash and stock merger transaction. At acquisition, Northwest Suburban had total assets of $546.2 million. The agreement and plan of merger provided that the Company’s stock comprised up to 45% of the purchase price, at an exchange ratio of 2.4551 shares of Company common stock for each Northwest Suburban common share, and that the remainder be paid in cash at the rate of $42.75 for each share of Northwest Suburban common stock. The Company issued 3.7 million shares of common stock, paid $81.2 million in cash, and incurred $414,000 in costs that were capitalized for a total purchase price of $136.7 million. Mr. Dennis M. O’Hara, a director of Northwest Suburban, joined the Board of Directors of the Company and the Bank upon closing. Mr. John G. Eilering, Northwest Suburban’s Chairman and Chief Executive Officer joined the Bank as Area President - Northwest. Mr. Stephan L. Markovits, President of Northwest Suburban joined the Bank as Executive Vice President - Commercial Lending. The systems conversions were successfully completed during the weekend of October 27. The Company used the proceeds from a $75.0 million term note under a borrowing facility it has with a correspondent bank to pay for a portion of the cash requirement of the acquisition. The term note had an initial rate of one-month LIBOR plus 140 basis points and matures on September 28, 2010.
This acquisition added five more branches and made the Company, based on deposits, the 17th largest bank in the Chicago area as well as expanding the Company’s geographic footprint in the northwest suburbs. Northwest Suburban’s branch locations in Des Plaines, Lakemoor, Lake Zurich, Mount Prospect, and North Barrington provide a complimentary addition to the Company’s branches in northwest Cook, DuPage, Kane, Lake, and McHenry counties. In addition, the Company believes that this acquisition will contribute to expansion and
diversification of its loan portfolio, its deposit base, and its noninterest income. All key sales professionals from Northwest Suburban were retained.
In December 2007, the Company raised $41.4 million in new equity capital, net of issuance costs, through an offering of 1,725,000 depositary shares, each representing 1/100th of a share of its Series A noncumulative redeemable convertible perpetual preferred stock, at $25.00 per depositary share. The infusion of capital strengthened the Company’s balance sheet as well as allowed it to partially pay down balances outstanding on its term note and revolving line of credit and contribute capital to the Bank.
Consolidated Results of Operations
Compared to 2007
The Company had a net loss of $158.3 million for the year ended December 31, 2008. This loss was mainly attributed to the recognition of impairment charges on its securities and goodwill of $65.4 million and $80.0 million, respectively, and a $71.8 million provision for loan losses. Set forth below are some highlights of 2008 results compared to 2007.
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Net loss was $158.3 million for the year ended December 31, 2008 compared to net income of $18.6 million for the prior year.
•
Basic and diluted (loss) earnings per share for the year ended December 31, 2008 were both $(5.82) compared to $0.72 for 2007.
•
The return on average assets was (4.32)% for 2008 compared to a 0.58% for 2007.
•
The return on average equity was (46.65)% in 2008 compared to a 6.13% in 2007.
•
Top line revenue (net interest income plus noninterest income) decreased by $61.7 million, or 62.9%, to $36.4 million for 2008 compared to $98.1 million in the prior year. Excluding the gains, losses and impairment charges on securities and the gain on sale of property, top line revenue increased 5.2%, or $5.1 million.
Net Interest Income. Net interest income on a fully tax-equivalent basis increased $3.3 million, or 3.9%, to $89.6 million in 2008 from $86.2 million in 2007. This increase was due to interest expense decreasing to a greater extent than interest income due to the drops in the federal funds and prime rates. The Federal Open Market Committee (“FOMC”) cut the federal funds rate target by 225 basis points during 2008. As a result, the Company aggressively re-priced its deposits downward and benefited from the decreases in the federal funds rate. The Northwest Suburban acquisition completed on October 1, 2007 also contributed to this increase. The Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) decreased to 2.75% for 2008 compared to 3.02% for 2007. The increase in nonaccrual loans and decrease in dividends on FNMA and FHLMC preferred stock contributed to the decline in the net interest margin. Impairment charges on FNMA and FHLMC preferred stock and net charge-offs partially offset the overall increase in earning assets.
Trends in fully tax equivalent interest income and average earning assets include:
•
Interest income decreased $7.2 million to $190.3 million in 2008 compared to $197.5 million in 2007. Average earning assets increased by $398.4 million ($498.3 million of earning assets were acquired through the Northwest Suburban acquisition on October 1, 2007) but average yields decreased by 107 basis points.
•
Interest income on loans decreased $4.0 million to $151.4 million in 2008 from $155.3 million in 2007 due to a 134 basis point drop in yield despite an increase of $394.4 million in average loans; $439.2 million in loans were acquired in the Northwest Suburban acquisition on October 1, 2007. The decline in loan yield was primarily due to the re-pricing of variable-rate loans resulting from decreases in the prime rate as well as the increase in nonaccrual loans. Most new and renewing loans beginning in the fourth quarter of 2008 have floors in place which will help mitigate future margin contraction.
•
Interest income on securities decreased $2.6 million to $37.8 million in 2008 from $40.4 million in 2007 as a result of a decrease in yields from 5.55% in 2007 to 5.20% while average securities increased slightly. The
decline in securities yield was primarily due to the decrease in dividends on FNMA and FHLMC preferred stock in the second half of the year.
•
Dividend income on FHLB stock was $333,000 in 2007 compared to none in 2008.
Trends in interest expense and average interest-bearing liabilities include:
•
Interest expense decreased $10.5 million to $100.7 million in 2008 from $111.2 million in 2007. Average balances on interest-bearing liabilities increased by $398.1 million in 2008 to $3.0 billion compared to $2.6 billion in the prior year while rates paid decreased 94 basis points to 3.40% during 2008 compared to 4.34% in 2007.
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Interest expense on deposits decreased by $10.7 million to $66.0 million in 2008 from $76.7 million in 2007. Average interest-bearing deposits increased $240.2 million to $2.1 billion in 2008 compared to $1.9 billion in the prior year; $405.4 million in interest-bearing deposits were acquired in the Northwest Suburban acquisition on October 1, 2007. Average rates paid on interest-bearing deposits decreased by 98 basis points to 3.15% in 2008 compared to 4.13% in the prior year.
•
Average interest-bearing core deposits (interest-bearing demand deposit, money market, and savings accounts) increased $16.4 million in 2008 compared to 2007 and average rates paid decreased 115 basis points.
•
Average certificates of deposit less than $100,000 increased by $21.8 million and average rates paid decreased by 90 basis points. Average certificates of deposit greater than $100,000 increased $202.0 million in 2008 and average rates paid decreased 109 basis points. Average brokered deposits increased by $144.8 million in 2008 compared to the prior year.
•
Interest expense on borrowings increased slightly to $34.7 million in 2008 from $34.5 million in 2007. Average borrowings increased by $157.9 million to $866.7 million in 2008 compared to $708.8 million in the prior year, primarily as a result of the Company’s asset growth exceeding deposit growth and the $81.2 million cash used for the Northwest Suburban acquisition in October 2007.
•
Interest expense on Federal funds purchased and securities sold under agreements to repurchase increased by $2.2 million in 2008 as a result of the increases in average balances of $86.1 million, even as the average rates decreased 39 basis points.
•
Interest expense on FHLB advances decreased by $2.9 million in 2008 compared to the prior year while average balances increased by $17.8 million during the same period. Average rates paid on FHLB advances dropped by 113 basis points in 2008 to 3.53% compared to 4.66% in 2007. In March 2008, the Company prepaid $130.0 million of FHLB advances at a weighted average rate of 4.94% and recognized a loss on the early extinguishment of debt of $7.1 million. The Company replaced these borrowings at a weighted average rate of 2.57% in the second quarter of 2008.
•
Average junior subordinated debentures decreased by $5.4 million in 2008 compared to the prior year while rates paid decreased by 190 basis points. The Company acquired $10.3 million in junior subordinated debentures at LIBOR plus 2.70% through the Northwest Suburban acquisition on October 1, 2007, but redeemed $15.5 million at LIBOR plus 3.45% in November 2007.
•
Average notes payable, including revolving, term and subordinated notes, increased by $59.3 million in 2008 compared to the prior year. The Company used the proceeds from a $75.0 million term note it has with a correspondent bank to pay the cash portion of the Northwest Suburban acquisition.
•
Short-term LIBOR rates, to which many of the Company’s borrowings are indexed, did not decline as quickly as prime and other short-term rates which dropped quickly in late 2008 as the economy faltered.
Provision for Loan Losses. The provision for loan losses increased by $66.9 million to $71.8 million in 2008 from $4.9 million in 2007; the large 2008 provision reflected the deterioration in credit quality of the portfolio as economic conditions reduced: (i) the borrowers ability to make debt service payments; and (ii) the value of the underlying collateral for many loans. As of December 31, 2008, the allowance for loan losses totaled $44.4 million,
or 1.77% of total loans, and 73% of nonaccrual loans compared to $26.7 million, or 1.08% of total loans, and 54% of nonaccrual loans at December 31, 2007.
Noninterest Income. The Company’s total noninterest income was $(50.6) million in 2008 compared to $15.5 million in 2007. In 2008 losses on securities of $82.0 million were mostly related to sales and impairments recorded on FHLMC and FNMA preferred stock holdings. The Company also recorded a gain on the sale of a branch of $15.2 million in the first quarter. Ignoring those items, noninterest income for 2008 would have been $16.2 million or $746,000 million higher than 2007. Other changes in noninterest income are noted below:
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$1.0 million increase in service charges on deposits as a result of the increased deposit base from the Northwest Suburban acquisition;
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$446,000 increase in the cash surrender value of life insurance reflecting the addition of $12.9 million of such insurance acquired with Northwest Suburban;
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$234,000 decrease in trust income due mostly to the drop in trust asset values from the difficult economy and the departure of trust customers;
•
$263,000 decrease in insurance and brokerage commissions mostly attributable to the difficult economy and the departure of employees; and
•
$518,000 decrease in gains on sale of loans resulting from the outsourcing of residential mortgage origination operations in mid-2007.
Noninterest Expense. The Company’s total noninterest expense increased by $106.6 million, to $178.0 million in 2008, from $71.4 million in 2007. Noninterest expense for 2008 included an $80.0 million non-cash goodwill impairment charge and a $7.1 million loss on the early extinguishment of debt. Without those items, noninterest expense for 2008 would have been $90.8 million or 27.2% higher than 2007. Noninterest expense as a percentage of average assets was 4.86% for 2008 or 2.48% without the goodwill impairment charge and loss on extinguishment of debt, which management believes is a better measure of noninterest expense. This compares to 2.24% for 2007. Other changes in noninterest expense are noted below:
•
Salaries and employee benefits increased $8.2 million or 19.4% reflecting the additions to management and employees from the Northwest Suburban acquisition, some key additions to the management team and separation benefits of $1.2 million
•
Occupancy and equipment increased $3.2 million in 2008 compared to the prior year reflecting the five additional branches acquired in the Northwest Suburban acquisition;
•
Professional services increased $3.1 in 2008 due to an increase in loan workout legal fees and consulting expense;
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Marketing expenses increased by $397,000 or 17.2% in 2008 compared to the prior year as deposit retention and Company image campaigns were increased;
•
Foreclosed properties expense increased by $298,000 in 2008 compared to the prior year as a result of the increase in properties;
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Amortization of intangible assets increased by $659,000 as a direct result of the increase in intangible assets from the Northwest Suburban acquisition in October 2007; and
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Non-capitalized merger related expense was $271,000 in 2008 compared to $1.3 million in 2007; and
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Other expense increased $4.6 million or 51.8% in 2008 compared to the prior year. The Company was granted a one-time credit to offset FDIC premiums as a result of the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”). This one-time credit artificially reduced the Company’s 2007 FDIC insurance expense, but the credit was fully utilized by the end of 2007, and as a result of the expiration of that credit and the addition of the Northwest Suburban deposits in late 2007, the Company incurred an FDIC insurance expense increase of $2.4 million in 2008. Additions to reserves for off-balance sheet losses related to letters of credit were $877,000 for 2008 compared to none for 2007.
The efficiency ratio was 144.87% for the year ended December 31, 2008 compared to 68.29% in 2007.
Federal and State Income Tax. The Company’s consolidated income tax rate varies from statutory rates. The Company recorded income tax benefit of $55.1 million in 2008 compared to expense of $3.2 million in 2007. Set forth below is a reconciliation of the effective tax rate for the years ended December 31, 2008 and 2007 to statutory rates.
Compared to 2006
Set forth below are some highlights of 2007 results compared to 2006.
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Net income was $18.6 million for the year ended December 31, 2007 compared to $17.7 million for the prior year.
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Basic and diluted earnings per share for the year ended December 31, 2007 were both $0.72 compared to basic earnings per share of $0.76 and diluted of $0.75 for 2006.
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The return on average assets was 0.58% for 2007 compared to a 0.67% for 2006.
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The return on average equity was 6.13% in 2007 compared to a 7.04% in 2006.
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Top line revenue (net interest income plus noninterest income) increased by $8.3 million, or 9.2%, to $98.1 million for 2007 compared to $89.8 million in the prior year.
•
The carrying cost of the previously disclosed Large Problem Credit continued to have a substantial negative impact on earnings, reducing net income by approximately $0.10 per diluted share in 2007. The Large Problem Credit accounted for $29.0 million of nonaccrual loans at year end 2007.
Net Interest Income. Net interest income on a fully tax-equivalent basis increased $6.7 million, or 8.4%, to $86.2 million in 2007 from $79.6 million in 2006. The Northwest Suburban acquisition contributed to the increase in the net interest income for the year ended December 31, 2007 along with loan growth, but interest expense increased to a greater extent. The Company’s net interest margin (tax equivalent net interest income as a percentage of earning assets) decreased to 3.02% for 2007 compared to 3.32% for 2006.
Trends in fully tax equivalent interest income and average earning assets include:
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Interest income increased $33.9 million to $197.5 million in 2007 compared to $163.5 million in 2006. Average earning assets increased by $464.1 million ($498.3 million of earning assets were acquired through the Northwest Suburban acquisition on October 1, 2007) and average yields increased by 8 basis points.
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Interest income on loans increased $31.2 million to $155.3 million in 2007 from $124.1 million in 2006 due to an increase of $429.8 million in average loans; $439.2 million in loans were acquired in the Northwest Suburban acquisition on October 1, 2007.
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Interest income on securities increased $2.3 million to $40.4 million in 2007 from $38.1 million in 2006 as a result of an increase in yields on securities from 5.39% in 2006 to 5.55% while average securities increased $21.2 million, or 3.0%.
Trends in interest expense and average interest-bearing liabilities include:
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Interest expense increased $27.3 million to $111.2 million in 2007 from $84.0 million in 2006. Average balances on interest-bearing liabilities increased by $436.4 million in 2007 to $2.6 billion compared to $2.1 billion in the prior year while rates paid increased 39 basis points to 4.34% during 2007 compared to 3.95% in 2006.
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Interest expense on deposits increased by $19.2 million to $76.7 million in 2007 from $57.5 million in 2006. Average interest-bearing deposits increased $273.0 million to $1.9 billion in 2007 compared to $1.6 billion in the prior year; $405.4 million in interest-bearing deposits were acquired in the Northwest Suburban acquisition on October 1, 2007. Average rates paid on interest-bearing deposits increased by 50 basis points to 4.13% in 2007 compared to 3.63% in the prior year.
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Average interest-bearing core deposits (interest-bearing demand deposit, money market, and savings accounts) increased $71.6 million in 2007 compared to 2006 and average rates paid increased 46 basis points.
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Average certificates of deposit less than $100,000 decreased by $34.0 million while average rates paid increased by 65 basis points. Average certificates of deposit greater than $100,000 increased $247.1 million in 2007 and average rates paid increased 27 basis points. Average brokered deposits increased by $129.4 million in 2007 compared to the prior year.
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Interest expense on borrowings increased by $8.1 million to $34.5 million in 2007 from $26.5 million in 2006. Average borrowings increased by $163.4 million to $708.8 million in 2007 compared to $545.4 million in the prior year, primarily a result of the Company’s asset growth exceeding deposit growth and $81.2 million cash used for the Northwest Suburban acquisition.
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Interest expense on Federal funds purchased and securities sold under agreements to repurchase increased by $1.2 million in 2007 as a result of the increases in average balances of $48.4 million.
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Interest expense on FHLB advances increased by $5.0 million in 2007 compared to the prior year while average balances increased by $88.4 million during the same period. Average rates paid on FHLB advances rose by 37 basis points in 2007 to 4.66% compared to 4.29% in 2006.
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Average junior subordinated debentures decreased by $5.3 million in 2007 compared to the prior year while rates paid increased by 18 basis points. The Company acquired $10.3 million in junior subordinated debentures at LIBOR plus 2.70% through the Northwest Suburban acquisition, and redeemed $15.5 million at LIBOR plus 3.45% in November 2007.
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Average notes payable increased by $21.2 million in 2007 compared to the prior year. The Company used the proceeds from a $75.0 million term note it has with a correspondent bank to pay the cash portion of the Northwest Suburban acquisition. The term note has an initial rate of one-month LIBOR plus 140 basis points.
Provision for Loan Losses. The provision for loan losses decreased by $7.2 million to $4.9 million in 2007 from $12.1 million in 2006; the 2006 provision reflected the deterioration in the credit quality of the Large Problem Credit.
The Company recorded a $5.5 million provision for loan losses and charged off $7.5 million of Large Problem Credit loans in the fourth quarter of 2006. The Company recorded a loan loss provision of $5.0 million relating to this problem relationship in the second quarter of 2006. Net outstandings for the Large Problem Credit increased by $3.2 million from December 31, 2006 to $29.0 million representing 59.0% of total nonaccrual loans at December 31, 2007.
As of December 31, 2007, the allowance for loan losses totaled $26.7 million, or 1.08% of total loans, and was equal to 54.4% of nonaccrual loans compared to $23.2 million, or 1.19% of total loans, and 54.2% of nonaccrual loans at December 31, 2006. The allowance was increased by $2.8 million as a result of the Northwest Suburban acquisition.
Noninterest Income. The Company’s total noninterest income was $15.5 million in 2007 compared to $14.6 million in 2006. Noninterest income as a percentage of average assets was 0.49% for 2007 compared to 0.55% for the prior year. The changes in noninterest income are noted below:
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$964,000 increase in service charges on deposits as a result of an increased deposit base;
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$669,000 increase in the cash surrender value of life insurance reflecting an addition of $12.9 million of such insurance acquired from Northwest Suburban;
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$938,000 increase in trust income reflecting an entire year’s earnings from the trust assets under management previously acquired from Royal American on July 1, 2006;
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$297,000 increase in insurance and brokerage commissions mostly as a result of increased annuity sales;
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$317,000 decrease in gains on sale of loans resulting from the outsourcing of residential mortgage origination operations;
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$1.3 million gain on extinguishment of debt in 2006; and
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$624,000 decrease in trading profits.
Noninterest Expense. The Company’s total noninterest expense increased by $12.8 million, or 21.8%, to $71.4 million in 2007 from $58.6 million in 2006. Noninterest expense as a percentage of average assets was 2.24% for 2007 compared to 2.22% for 2006. Other changes in noninterest expense are noted below
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Salaries and employee benefits increased $7.7 million reflecting the additions to management and employees from the Royal American and Northwest Suburban acquisitions;
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Non-capitalized merger related expense was $1.3 million in 2007 compared to $1.6 million in 2006;
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Occupancy and equipment increased $2.4 million in 2007 compared to the prior year reflecting the additional branches acquired in the Royal American and Northwest Suburban acquisitions;
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Marketing expenses increased by $260,000 in 2007 compared to the prior year due to increased marketing activity;
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Amortization of intangible assets increased by $700,000; and
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Professional services increased $499,000 in 2007 due to an increase in loan workout legal fees and consulting expense.
The efficiency ratio was 68.29% for the year ended December 31, 2007 compared to 60.55% in 2006.
Federal and State Income Tax. The Company’s consolidated income tax rate varies from statutory rates. The Company recorded income tax expense of $3.2 million in 2007 compared to $1.4 million in 2006. Set forth below is a reconciliation of the effective tax rate for the years ended December 31, 2007 and 2006 to statutory rates.
Interest-Earning Assets and Interest-Bearing Liabilities
The following table sets forth the average balances, net interest income and expense and average yields and rates for the Company’s interest-earning assets and interest-bearing liabilities for the indicated periods on a tax-equivalent basis assuming a 35.0% tax rate.
(1)
Adjusted for 35% tax rate and adjusted for the dividends-received deduction where applicable.
(2)
Not adjusted for 35% tax rate or for the dividends-received deduction.
(3)
Nonaccrual loans are included in the average balances; however, these loans are not earning any interest.
(4)
Includes loan fees (in thousands) of $2,866, $2,747, and $3,113 for 2008, 2007, and 2006, respectively.
(5)
The following table reconciles reported net interest income on a tax equivalent basis for the periods presented (in thousands):
(6)
Includes construction loans.
Changes in Interest Income and Expense
The changes in net interest income from period to period are reflective of changes in the interest rate environment, changes in the composition of assets and liabilities as to type and maturity (and the inherent interest rate differences related thereto), and volume changes. Later sections of this discussion and analysis address the changes in maturity composition of loans and investments and in the asset and liability repricing gaps associated with interest rate risk, all of which contribute to changes in net interest margin.
The following table sets forth an analysis of volume and rate changes in interest income and interest expense of the Company’s average interest-earning assets and average interest-bearing liabilities for the indicated periods on a tax-equivalent basis assuming a 35.0% tax rate. The table distinguishes between the changes related to average outstanding balances (changes in volume holding the interest rate constant) and the changes related to average interest rates (changes in average rate holding the outstanding balance constant). The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Financial Condition
Set forth below are some balance sheet highlights at December 31, 2008 compared to December 31, 2007.
•
Total assets decreased $122.6 million, or 3.3%, mainly as a result of the securities and goodwill impairment charges as well as loan charge-offs.
•
Loans increased $35.4 million, or 1.4%, reflecting internal growth. Without charged off loans of $55.8 million and transfers of $10.4 million into foreclosed properties, loan growth would have been $101.6 million, or 4.1%.
•
Securities decreased by $96.3 million, or 12.9%, following impairment charges on certain FHLMC and FNMA preferred equity securities.
•
Deposits decreased by $45.4 million, or 1.9%.
Set forth below are some asset quality highlights at December 31, 2008 compared to December 31, 2007.
•
The allowance for loan losses was 1.77% of total loans at December 31, 2008 versus 1.08% at December 31, 2007. The allowance for loan losses increased by $17.7 million, reflecting management’s updated assessments of impaired loans and concerns about the continued deterioration of economic conditions.
•
Nonaccrual loans increased to 2.43% of total loans at December 31, 2008 from 1.99% at December 31, 2007. The Large Problem Credit accounted for $6.1 million, or 10.0%, of the $61.1 million in nonaccrual loans at December 31, 2008.
•
Allowance to nonaccrual loans coverage 0.73x for 2008 compared to 0.54x for 2007.
•
Net loans charged off to average total loans were 2.18% for 2008 compared to 0.20% for 2007.
Loans
The following table sets forth the composition of the Company’s loan portfolio as of the indicated dates.
(1)
Source of repayment classification.
(2)
Amounts have been reclassified to conform to current period presentation.
(3)
Collateral-based classification.
During the fourth quarter of 2007, the Company revised its classification of commercial loans and commercial real estate loans, changing its prior practice of classifying as commercial real estate loans all loans to a business that included real estate as collateral (“collateral-based” classification). The classification of construction, home equity, and residential mortgages were also reviewed. The new method of presentation (“source of repayment” classification) recognizes that loans to owner-occupied businesses engaged in manufacturing, sales and/or services are commercial loans, regardless of whether real estate is taken as collateral. These loans generally have a lower risk profile than traditional commercial real estate loans. They are primarily dependent on the borrower’s business-
generated cash flows for repayment, not on the conversion of real estate that may be pledged as collateral. Loans related to rental income producing properties and properties intended to be sold will continue to be classified as commercial real estate loans. Completing this change in methodology involved a loan-by-loan review of the Company’s commercial and commercial real estate loans. The new presentation methodology was implemented only as of December 31, 2007 and prospectively, as it is impracticable to apply it to prior years’ data.
Set forth below are other highlights of changes in the loan portfolio at December 31, 2008 compared to December 31, 2007.
•
Total loans increased $35.4 million, or 1.4%. Without charged off loans of $55.8 million and transfers of $10.4 million into foreclosed properties, loan growth would have been $101.6 million, or 4.1%.
•
Commercial loans increased $10.4 million, or 1.0%.
•
Construction loans decreased by $98.4 million, or 21.2%.
•
A reduction in construction lending that began earlier in the 2008 continued throughout the year with construction and land development loans declining to 14.6% of the total loan portfolio, down from 18.8% one year ago.
•
Commercial real estate loans rose by $101.8 million, or 16.2%.
•
Home equity loans increased $52.5 million, or 36.9%.
•
Consumer loans decreased $4.4 million, or 40.8%.
•
Residential mortgage loans decreased $26.5 million, or 17.7%.
•
The Company had loan growth in the latter part of the fourth quarter of 2008 which was facilitated by the new capital raised in December 2008 under the TARP program. In addition, most new and renewing loans beginning in the fourth quarter of 2008 have floors in place which will help mitigate future margin contraction.
There were no loans held for sale at December 31, 2008 and 2007. In July 2007, the Company entered into a joint marketing arrangement with a leading privately held mortgage bank in Chicago and exited the mortgage banking business resulting in no loans held for sale at year-end 2007. Management believes that this arrangement enabled the Company to provide better pricing to its customers while also providing the Company with a high quality source of additional loan volume.
The Company attempts to balance the types of loans in its portfolio with the objective of managing risk. Some of the risks the Company evaluates in its lending business include:
•
The primary risks associated with commercial loans are the quality of the borrower’s management, financial strength and cash flow resources, and the impact of local economic factors.
•
Risks associated with real estate loans include concentrations of loans in a certain loan type, such as commercial or residential, and fluctuating land and property values.
•
Consumer loans also have risks associated with concentrations of loans in a single type of loan, as well as the risk a borrower may become unemployed as a result of deteriorating economic conditions.
The Company does not hold any sub-prime loans in its portfolio.
Loan Maturities
The following table sets forth the remaining maturities, based upon contractual dates, for selected loan categories (source of repayment classification) as of December 31, 2008.
Nonaccrual Loans
The accrual of interest on loans is discontinued at the time a loan is 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. A loan is returned to accrual status when all the principal and interest amounts contractually due are current and future payments are reasonably assured.
Under SFAS No. 114 and No. 118, the Company currently defines loans that are individually evaluated for impairment to include all loans over $300,000 where the internal credit rating is at or below a predetermined classification. All other smaller balance loans with similar attributes are evaluated for impairment in total.
The classification of a loan as impaired or nonaccrual does not necessarily indicate that the principal is uncollectible, in whole or in part. Subject to the de minimus level noted above, the Company makes a determination as to the collectibility on a case-by-case basis based upon the specific facts of each situation. The Company considers both the adequacy of the collateral and the other resources of the borrower in determining the steps to be taken to collect impaired or nonaccrual loans. Alternatives that are typically considered to collect impaired or nonaccrual loans are foreclosure, collection under guarantees, loan restructuring, or judicial collection actions.
Loans that are considered to be impaired are reduced to the present value of expected future cash flows or to the fair value of the related collateral, adjusted for selling and other discounts, by allocating a portion of the allowance to such loans. If these allocations require an increase to be made to the allowance for loan losses, such increases are included in the provision for loan losses charged to expense.
The following table sets forth information on the Company’s nonaccrual loans and nonperforming assets as of the indicated dates.
In addition to the loans summarized above, on December 31, 2008, the Company had $71.0 million of loans currently performing that have been internally assigned higher credit risk ratings. The higher risk ratings are primarily due to internally identified specific or collective credit characteristics including decreased capacity to repay loan obligations due to adverse market conditions, a lack of borrower or guarantor’s capital capacity and reduced collateral valuations securing the loans as a secondary source of repayment. These loans continue to accrue interest. Management does not expect losses on these loans, but recognizes that a higher level of scrutiny is prudent under the circumstances. Similarly rated loans were $43.0 million as of September 30, 2008 and $3.5 million as of December 31, 2007.
Interest payments on impaired loans are generally applied to principal, unless the loan principal is considered to be fully collectible, in which case interest is recognized on a cash basis. During 2008, 2007, and 2006, the Company recognized interest income on impaired loans of $836,000, $1.4 million, and $2.9 million, respectively.
Nonaccrual loans increased $11.9 million to $61.1 million at December 31, 2008 from $49.2 million at December 31, 2007. This increase in nonaccrual loans is net of $53.3 million of nonaccrual loans charged-off during the year and reflects the continued deterioration of economic conditions.
In 2008, the Company charged off $11.6 million of loan balances related to the previously announced Large Problem Credit, reduced outstanding balances on these loans by a net $5.7 million through the sale of assets, and took title to a substantial piece of real estate previously serving as collateral at an estimated net realizable value of $5.3 million. At December 31, 2008, total outstanding loan balances related to the Large Problem Credit represented $6.1 million, or 10.0%, of nonaccrual loans. While the current carrying value of these loans at December 31, 2008 reflects management’s best current estimate of net realizable value, there can be no assurance that additional losses may not be incurred.
Foreclosed properties increased to $12.0 million in 2008 from $2.2 million in 2007 mainly as a result of the $5.3 million Large Problem Credit property and a condominium development property. Foreclosed properties are carried at their estimated net realizable value.
Total nonperforming assets increased by $32.7 million from $51.4 million in 2007 to $84.1 million in 2008. The Company had $11.0 million in troubled-debt restructuring to one borrower as of December 31, 2008 and none as of December 31, 2007. In order to improve the collectibility of the troubled-debt restructuring, the Company restructured the terms of the debt by terminating the forebearance agreement and lowering the interest rates including changing them from fixed to floating rates. No additional commitments were outstanding on the troubled-debt restructured loans as of December 31, 2008. These troubled-debt restructured loans were still accruing and no allowance was allocated at December 31, 2008.
Analysis of Allowance for Loan Losses
The Company recognizes that credit losses will be experienced and the risk of loss will vary with, among other things; general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and in the case of a collateralized loan, the quality of the collateral. The allowance for loan losses represents the Company’s estimate of the amount deemed necessary to provide for probable future losses to be incurred in the portfolio. In making this determination, the Company analyzes the ultimate collectibility of the loans in its portfolio by incorporating feedback provided by internal loan staff.
On a quarterly basis, management of the Bank meets to review the adequacy of the allowance for loan losses. Each loan officer grades his or her individual commercial credits and the Company’s independent loan review personnel review the officers’ grades. In the event that the loan is downgraded during this review, the loan is included in the allowance analysis at the lower grade. The grading system is in compliance with the regulatory classifications, and the allowance is allocated to the loans based on the regulatory grading, except in instances where there are known differences (e.g., collateral value is nominal).
Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Company’s methodology for determining the allowance for loan losses represents an estimation performed pursuant to SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of all loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance (which management believes adequately considers all of the potential factors which potentially result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for credit losses could be required that could adversely affect the Company’s earnings or financial position in future periods.
The following table sets forth loans charged off and recovered by type of loan and an analysis of the allowance for loan losses for the indicated periods.
(1)
Includes construction loans.
The provision for loan losses increased $66.9 million to $71.8 million for the year ended December 31, 2008 from $4.9 million for the year ended December 31, 2007, reflecting management’s updated assessments of impaired loans and concerns about the continued deterioration of economic conditions. The allowance for loan losses was $44.4 million at December 31, 2008 and $26.7 million at December 31, 2007. Total recoveries on loans previously charged off were $1.8 million for the year ended December 31, 2008 and 2007.
Net charge-offs increased $49.9 million to $54.1 million, or 2.18% of average loans, in 2008 compared to $4.1 million, or 0.20% of average loans in 2007. Allowance for loan losses to nonaccrual loans ratio was 0.73x at December 31, 2008 and 0.54x at December 31, 2007.
The following table sets forth the Company’s allocation of the allowance for loan losses by types of loans (collateral based classification) as of the indicated dates.
Due to concerns about the collectibility of loan balances that could grow due to letter of credit draw downs, the Company increased the accrual for losses on unfunded commitments to $1.1 million at December 31, 2008 from $233,000 at December 31, 2007.
The Company uses an internal asset classification system as a means of reporting problem and potential problem assets. At each scheduled Bank Board of Directors meeting, a watch list is presented, showing significant loan relationships listed by internal risk rating as Special Mention, Substandard, and Doubtful. Set forth below is a discussion of each of these classifications.
Special Mention: A special mention extension of credit is defined as having potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may, at some future date, result in the deterioration of the repayment prospects for the credit or the institution’s credit position. Special mention credits are not considered as part of the classified extensions of credit category and do not expose an institution to sufficient risk to warrant classification. They are currently protected but are potentially weak. They constitute an undue and unwarranted credit risk.
Loans in this category have some identifiable problem but, in management’s opinion, offer no immediate risk of loss. An extension of credit that is not delinquent also may be identified as special mention. These loans are classified due to Bank management’s actions or the servicing of the loan. The lending officer may be unable to properly supervise the credit because of an inadequate loan or credit agreement. There may be questions regarding the condition of and/or control over collateral. Economic or market conditions may unfavorably affect the obligor in the future. A declining trend in the obligor’s operations or an imbalanced position in the balance sheet may exist, although it is not to the point that repayment is jeopardized. Another example of a special mention credit is one that has other deviations from prudent lending practices.
If the Bank may have to consider relying on a secondary or alternative source of repayment, then collection may not yet be in jeopardy, but the loan may be considered special mention. Other trends that indicate that the loan may deteriorate further include such “red flags” as continuous overdrafts, negative trends on a financial statement, such as a deficit net worth, a delay in the receipt of financial statements, accounts receivable ageings, etc. These loans on a regular basis can be 30 days or more past due. Judgments, tax liens, delinquent real estate taxes, cancellation of insurance policies and exceptions to Bank policies are other “red flags.”
Substandard: A substandard extension of credit is one inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Extensions of credit so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. In other words, there is more than a normal risk of loss. Loss potential, while existing in the aggregate amount of substandard credits, does not have to exist in individual extensions of credit classified substandard.
The likelihood that a substandard loan will be paid from the primary source of repayment may also be uncertain. Financial deterioration is underway and very close attention is warranted to insure that the loan is collected without a loss. The Bank may be relying on a secondary source of repayment, such as liquidating collateral, or collecting on guarantees. The borrower cannot keep up with either the interest or principal payments. If the Bank is forced into a subordinated or unsecured position due to flaws in documentation, the loan may also be substandard. If the loan must be restructured, or interest rate concessions made, it should be classified as such. If the bank is contemplating foreclosure or legal action, the credit is likely substandard.
Doubtful: An extension of credit classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high; however, because of certain important and reasonably specific pending factors that may work to the advantage of and strengthen the credit, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors may include a proposed merger or acquisition, liquidation proceedings, capital injection, perfecting liens on additional collateral, or refinancing plans.
If the primary source of repayment is gone, and there is doubt as to the quality of the secondary source, then the loan will be considered doubtful. If a court suit is pending, and is the only means of collection, a loan is generally doubtful. As stated above, the loss amount in this category is often undeterminable, and the loan is classified doubtful until said loss can be determined.
The Company’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Bank’s primary regulators in the course of its regulatory examinations, which can order the establishment of additional general or specific loss allowances. There can be no assurance that regulators, in reviewing the Company’s loan portfolio, will not request the Company to materially increase its allowance for loan losses. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependent upon future events and, as such, further additions to the level of specific and general loan loss allowances may become necessary. The Company’s allowance for loan losses at December 31, 2008 is considered by management to be adequate.
The Company holds certain loans that are accounted for under Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”), which addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in purchase business combinations and applies to all nongovernmental entities. SOP 03-3 does not apply to loans originated by the Company. The Company’s assessment identified $5.9 million in acquired loans to which the application of the provisions of SOP 03-3 was required. As a result of the application of SOP 03-3, the Company recorded purchase accounting adjustments reflecting a reduction in loans of $2.0 million related to acquired impaired loans, thus reducing the carrying value of these loans to $3.9 million as of December 31, 2007. See Note 3 - Business Combinations to the consolidated financials statements. The carrying value of these loans was $778,000 as of December 31, 2008, and there continues to be no allowance for loan losses regarding these loans. The Company does not consider prepayments in the determination of contractual or expected cash flows.
Securities
The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Company has an asset/liability committee which develops current investment policies based upon its operating needs and market circumstances. The investment policy of the Bank is reviewed by senior financial management of the Company in terms of its objectives, investment guidelines and consistency with overall Company performance and risk management goals. The Bank’s investment policy is formally reviewed and approved annually by its Board of Directors. The asset/liability committee of the Bank is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to the Bank’s Board of Directors and the Board of Directors of the Company on a regular basis.
The following tables set forth the composition of the Company’s securities portfolio by major category as of the indicated dates. The securities portfolio as of December 31, 2008, 2007, and 2006 has been categorized as either available-for-sale or held-to-maturity in accordance with SFAS No. 115.
As of December 31, 2008, the Company held no securities of a single issuer with a book value exceeding 10% of stockholders’ equity other than those of the U.S. government or government-sponsored entities.
The total fair value of the securities portfolio was $652.3 million as of December 31, 2008, or 99.7% of amortized cost. The total fair value of the securities portfolio was $747.8 million and $634.7 million as of December 31, 2007 and 2006, respectively.
Securities available-for-sale are carried at fair value, with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. At December 31, 2008, unrealized losses on securities available-for-sale were $2.4 million, or $1.4 million net of taxes, compared to $23.0 million, or $13.9 million net of taxes, at December 31, 2007. The Company recognized an other-than-temporary impairment charge of $17.6 million at March 31, 2008 on certain FNMA and FHLMC preferred equity securities with a cost basis of $85.1 million. In September 2008, the Company sold $16.9 million of the remaining $67.5 million recognizing a $16.7 million loss. The Company recognized an additional other-than-temporary impairment charge of $47.8 million at September 30, 2008 on the remaining securities and thereby reduced the amortized cost to their fair value of $2.7 million. Management believes this impairment was primarily attributable to economic conditions at that time, FNMA and FHLMC being placed into the Federal Housing Finance Agency’s conservatorship, and the discontinued dividend payments. Since recovery did not appear likely in the near future, the Company recognized the impairment losses. See Note 4 - Securities of the Notes to the consolidated financial statements for more details on the Company’s securities portfolio. The securities portfolio does not contain any sub-prime or Alt-A mortgage-backed securities.
The Company’s securities available-for-sale portfolio decreased $88.9 million, or 12.5%, in 2008 compared to 2007 mainly as a result of the impairment charges and sales of the FNMA and FHLMC preferred equity securities. The Company also changed the mix of its securities portfolio to improve earnings through the sale of certain mortgage-backed securities and the investment in higher-yielding U.S. government-sponsored entities notes during 2008. Set forth below is a summary of the change in the available-for-sale securities:
•
U.S. Treasury and obligations of U.S. government-sponsored entities increased by $81.8 million to $265.4 million, or 40.3% of the securities portfolio, at December 31, 2008 compared to $183.6 million at year end 2007.
•
U.S. government agency and government-sponsored entity mortgage-backed securities decreased 25.2%, or $95.4 million, from $379.0 million at December 31, 2007 to $283.7 million at December 31, 2008.
•
As noted above, the Company recognized a impairment charges of $65.4 million on the FHLMC and FNMA preferred equities in 2008 bringing the amortized cost to $2.7 million. During 2008, $16.9 million in equity securities were sold at a loss of $16.7 million. Equity securities were $930,000 at December 31, 2008 compared to $66.0 million at December 31, 2007. Equity securities included capital securities of U.S. government-sponsored entities.
•
Obligations of state and political subdivisions decreased $4.7 million to $56.7 million at December 31, 2008 from $61.4 million at December 31, 2007.
•
Other bonds decreased by $5.6 million to $15.2 million at December 31, 2008 compared to $20.8 million at December 31, 2007. Other bonds include high grade corporate bonds primarily issued by financial institutions.
Securities held-to-maturity decreased $7.3 million, or 19.5%, from $37.6 million at December 31, 2007 to $30.3 million at December 31, 2008, due to paydowns and sales of mortgage-backed securities as permitted under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These securities sold had paid down to less than 15% of their original face value.
There were no trading securities held at December 31, 2008 or December 31, 2007. When acquired, the Company holds trading securities and derivatives on a short-term basis based on market and liquidity conditions.
Investment Maturities and Yields
The following tables set forth the contractual or estimated maturities of the components of the Company’s securities portfolio as of December 31, 2008 and the weighted average yields. The table assumes estimated fair values for available-for-sale securities and amortized cost for held-to-maturity securities:
(1)
Equity securities, although they do not have a maturity date, are included in the after ten years column.
Deposits
The following table sets forth the changes in deposits as of the periods presented.
(1)
Includes noninterest-bearing and interest-bearing demand, money market, and savings.
Set forth below is a summary of the change in the Company’s deposits:
•
Deposits decreased by $45.4 million, or 1.8%; noninterest-bearing deposits increased by $13.2 million while interest-bearing deposits decreased by $58.5 million.
•
Core deposits, which include noninterest-bearing demand, interest-bearing demand, money market, and savings deposits, decreased $120.2 million, or 12.4%.
•
Certificates of deposits less than $100,000 increased 9.0% or $56.9 million.
•
Certificates of deposit over $100,000 decreased $76.1 million, or 14.9%.
•
Brokered certificates of deposit increased $94.0 million, or 27.3%. The Company purchased brokered certificates of deposit in order to move away from purchasing Federal funds during the financial system disruption. The underlying certificates of deposits of the brokered certificates of deposit are in denominations of less than $100,000.
The Company continues to participate in the FDIC’s Temporary Liquidity Guarantee Program. This program consists of two components. The first is the Transaction Account Guarantee Program where all noninterest-bearing transaction deposit accounts, including all personal and business checking deposit accounts, and NOW accounts, which are capped at a rate no higher than 0.50% are fully guaranteed, through December 31, 2009, regardless of dollar amount. All other deposit accounts continue to be covered by the FDIC’s expanded deposit insurance limit of $250,000 through December 31, 2009. The second component is the Debt Guarantee Program, which guarantees newly issued senior unsecured debt.
In 2009, the FDIC plans to increase premium assessments to maintain adequate funding of the Deposit Insurance Fund. Assessment rates set by the FDIC effective December 5, 2009 range from 5 to 43 basis points. These increases in premium assessments will increase the Company’s expenses. See “Item 1. Business - Supervision and Regulation - FDIC Insurance Premiums on Deposit Accounts.”
On February 27, 2009, the FDIC board agreed to impose an emergency special assessment of 20 basis points on all banks to restore the Deposit Insurance Fund to an acceptable level. The assessment, which will be payable on September 30, 2009, is in addition to a planned increase in premiums and a change in the way regular premiums are assessed, which the board also approved on that date. This emergency special assessment for the Company is projected to be $5.0 million based on December 31, 2008 data.
The Company competes for core deposits in the heavily-banked Chicago Metropolitan Statistical Area. Competitive pricing has made it difficult to maintain and grow these types of deposits. The level of competition for core deposits is not expected to ease in the near term. To overcome this challenge, the Company has changed and expanded staffing and management at its banking centers and initiated a number of customer outreach initiatives. The Company is also pursuing a new on-line account opening process to further develop the growth of core deposit relationships. The Company’s “Big Bank Relief” marketing campaign is focused on building relationships.
The Company’s recent campaigns have been promoting relationship savings accounts and other core products. In conjunction with this strategy, the Bank’s retail incentive program has shifted its focus to relationship building, with incentives being paid for cross-selling achievements. Relationship building, along with a continued focus on providing excellent customer service, is key to solidifying and growing the Bank’s customer base.
The following table sets forth the average amount of and the average rate paid on deposits by category for the indicated periods.
(1)
Certificates of deposit exclusive of public funds.
(2)
Includes brokered deposits.
The following table summarizes the maturity distribution of certificates of deposit in amounts of $100,000 or more as of the dates indicated. These deposits have been made by individuals, businesses, and public and other not-for-profit entities, most of which are located within the Company’s market area.
Borrowings
The following table summarizes the Company’s borrowings as of the dates indicated.
The Company’s borrowings include overnight federal funds purchased, securities sold under agreements to repurchase, FHLB advances, junior subordinated debentures, and commercial bank notes payable and subordinated debt. The following tables set forth categories and the balances of the Company’s borrowings for the periods indicated.
(1)
Based on amounts outstanding at each month end during the year.
(2)
During 2008, the federal funds target rate decreased by 225 basis points.
(1)
Based on amount outstanding at month end during each year.
The Bank is a member of the FHLB. Membership requirements include common stock ownership in the FHLB. At December 31, 2008, the majority of the FHLB advances have various call provisions ranging from three months to two years. The Bank is currently in compliance with the FHLB’s membership requirements.
The following table sets forth categories and the balances of the Company’s FHLB advances as of the indicated dates or for the indicated periods.
(1)
Based on amount outstanding at month end during each year.
The Company’s credit agreements with a correspondent bank at December 31, 2008 consisted of a revolving line of credit, a term note loan, and subordinated debenture in the amounts of $8.6 million, $55.0 million, and $15.0 million, respectively.
The revolving line of credit has a maximum availability of $25.0 million, an interest rate of one-month LIBOR plus 155 basis points, and matures on April 3, 2009. During the fourth quarter of 2007, the Company utilized the
proceeds from a $75.0 million term note loan to pay for the cash requirements of the Northwest Suburban acquisition. On March 31, 2008, the Company converted $15.0 million of this term note into subordinated debt and further reduced the remaining term note balance to $55.0 million. The resulting term note had an interest rate of one-month LIBOR plus 155 basis points at December 31, 2008 and matures on September 28, 2010.
The subordinated debt had an interest rate of one-month LIBOR plus 350 basis points at December 31, 2008, matures on March 31, 2018, and qualifies as Tier 2 capital.
The revolving line of credit and term note included the following covenants at December 31, 2008: (1) the Bank must not have nonperforming loans (loans on nonaccrual status and 90 days or more past due and troubled-debt restructured loans) in excess of 3.00% of total loans, (2) the Bank must report a quarterly profit, excluding charges related to acquisitions, and (3) the Bank must remain well capitalized. The Company was in compliance with these debt covenants at December 31, 2008.
As a result of the effects of recent economic conditions, the increase in nonperforming assets, and the impairment charges on goodwill and the FNMA and FHLMC preferred securities, the Company sought covenant waivers on two occasions since December 31, 2007. First, the lender waived a covenant violation in the first quarter of 2008 resulting from the Company’s net loss recognized in that period. Second, the lender waived a covenant violation in the third quarter of 2008 resulting from the Company’s net loss recognized in that period, contingent upon the Company making accelerated principal payments under the aforementioned term loan agreement. See Note 14 - Credit Agreement of the Notes to the consolidated financial statements for more details.
At December 31, 2008, the Company had $60.8 million in junior subordinated debentures owed to unconsolidated trusts that were formed to issue trust preferred securities.
The following table details the unconsolidated trusts and their common and trust preferred securities:
(1)
Redeemable at option of the Company.
Capital Resources
The Company monitors compliance with bank and bank-holding company regulatory capital requirements, focusing primarily on risk-based capital guidelines. Under the risk-based capital method of capital measurement, the ratio computed is dependent upon the amount and composition of assets recorded on the balance sheet and the amount and composition of off-balance-sheet items, in addition to the level of capital. Included in the risk-based capital method are two measures of capital adequacy: Tier 1, or core capital, and total capital, which consists of Tier 1 plus Tier 2 capital. See “Business - Supervision and Regulation - Bank Holding Company Regulation” for definitions of Tier 1 and Tier 2 capital and Note 16 to the Notes to the consolidated financial statements.
The following tables set forth the Company’s capital ratios as of the indicated dates.
In December 2008, the Company issued 84,784 shares of Series T fixed cumulative perpetual preferred stock at $1,000 per share to the U.S. Treasury under the TARP CPP raising $84.8 million in capital, which qualifies for Tier I capital.
In October 2007, the Company issued 3.7 million shares of common stock as a result of the Northwest Suburban acquisition increasing capital by $55.1 million. In December 2007, the Company issued 1,725,000 depositary shares each representing 1/100th of a share of its Series A noncumulative redeemable convertible perpetual preferred stock at $25.00 per share through a public offering raising net new equity capital of $41.4 million.
In July 2006, the Company issued 2.9 million shares of common stock as a result of the Royal American acquisition increasing capital by $63.8 million. In August 2005, the Company issued 3.5 million new common shares through a public offering raising a net amount of new capital of $67.9 million.
The Company includes $59.0 million for 2008 and 2007 and $64.0 million for 2006 of trust preferred securities in Tier I capital based on regulatory limitations.
Liquidity
The Company manages its liquidity position with the objective of maintaining access to sufficient funds to respond to the needs of depositors and borrowers and to take advantage of earnings enhancement opportunities. At December 31, 2008, the Company had cash and cash equivalents of $63.1 million. In addition to the normal inflow of funds from its securities portfolio, and repayments and maturities of loans and securities, the Company utilizes other short-term, intermediate-term and long-term funding sources such as securities sold under agreements to repurchase and overnight funds purchased from correspondent banks.
The FHLB provides an additional source of liquidity which has been used by the Bank since 1999. The Bank also has various funding arrangements with commercial and investment banks in the form of Federal funds lines, repurchase agreements, and brokered certificate of deposit programs. The Bank maintains these funding arrangements to achieve favorable costs of funds, manage interest rate risk, and enhance liquidity in the event of deposit withdrawals. The FHLB advances and repurchase agreements are subject to the availability of collateral. The Company believes it has sufficient liquidity to meet its current and future liquidity needs.
The Company monitors and manages its liquidity position on several levels, which vary depending upon the time period. As the time period is expanded, other data is factored in, including estimated loan funding requirements, estimated loan payoffs, securities portfolio maturities or calls, and anticipated depository buildups or runoffs.
The Company classifies the majority of its securities as available-for-sale, thereby maintaining significant liquidity. Certain available-for-sale securities were temporarily impaired at December 31, 2008, primarily due to changes in interest rates as well as current economic conditions that appear to be cyclical in nature. The Company has both the intent and ability to hold each of the temporarily impaired securities for the time necessary to recover its
amortized cost. See the “Securities” section and “Risk Factors” for more details. The Company’s liquidity position is further enhanced by the structuring of a majority of its loan portfolio interest payments as monthly.
The Company’s cash flows are comprised of three classifications: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. See Statement of Cash Flows in the Consolidated Financial Statements.
The Company continues to seek opportunities to diversify the customer base, enhance the product suite, and improve the overall liquidity position. The Company has developed analytical tools to help support the overall liquidity forecasting and contingency planning. In addition, the Company is developing a more efficient collateral management process which will further strengthen the Company’s liquidity.
Contractual Obligations, Commitments, and Off-Balance Sheet Arrangements
(1)
Duration of liability is not determinable.
The following table details the amounts and expected maturities of significant commitments as of December 31, 2008.
Asset/Liability Management
The business of the Company and the composition of its consolidated balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and other securities) that are primarily funded by interest-bearing liabilities (deposits and borrowings). All of the financial instruments of the Company as of December 31, 2008 were held for other-than-trading purposes. Such financial instruments have varying levels of sensitivity to changes in market rates of interest. The Company’s net interest income is dependent on the amounts of and yields on its interest-earning assets as compared to the amounts of and rates on its interest-bearing liabilities. Net interest income is therefore sensitive to changes in market rates of interest.
The Company’s asset/liability management strategy is to maximize net interest income while limiting exposure to risks associated with changes in interest rates. This strategy is implemented by the Company’s ongoing analysis and management of its interest rate risk. A principal function of asset/liability management is to coordinate the levels of interest-sensitive assets and liabilities to manage net interest income fluctuations within limits in times of fluctuating market interest rates.
Interest rate risk results when the maturity or repricing intervals and interest rate indices of the interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments are different, thus creating a risk that will result in disproportionate changes in the value of and the net earnings generated from the Company’s interest-earning assets, interest-bearing liabilities, and off-balance-sheet financial instruments. The Company’s exposure to interest rate risk is managed primarily through the Company’s strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. Because the Company’s primary source of interest-bearing liabilities is customer deposits, the Company’s ability to manage the types and terms of such deposits may be somewhat limited by customer maturity preferences in the market areas in which the Company operates. Over the past decade, hundreds of new bank branches have opened in the Company’s marketplace. Deposit pricing is competitive with promotional rates frequently offered by competitors. Ongoing competition for core and time deposits are driving up yields paid. Borrowings, which include FHLB advances, short-term borrowings, and long-term borrowings, are generally structured with specific terms which, in management’s judgment, when aggregated with the terms for outstanding deposits and matched with interest-earning assets, reduce the Company’s exposure to interest rate risk. The rates, terms, and interest rate indices of the Company’s interest-earning assets result primarily from the Company’s strategy of investing in securities and loans (a substantial portion of which have adjustable rates). This permits the Company to limit its exposure to interest rate risk, together with credit risk, while at the same time achieving a positive interest rate spread from the difference between the income earned on interest-earning assets and the cost of interest-bearing liabilities.
Management uses a duration model for the Bank’s internal asset/liability management. The model uses cash flows and repricing information from loans and certificates of deposit, plus repricing assumptions on products
without specific repricing dates (e.g., savings and interest-bearing demand deposits), to calculate the durations of the Bank’s assets and liabilities. Securities are stress tested, and the theoretical changes in cash flow are key elements of the Company’s model. The model also projects the effect on the Company’s earnings and theoretical value for a change in interest rates. The model computes the duration of the Bank’s rate sensitive assets and liabilities, a theoretical market value of the Bank’s rate sensitive assets and liabilities and the effects of rate changes on the Bank’s earnings and market value. The Bank’s exposure to interest rates is reviewed on a monthly basis by senior management and the Company’s Board of Directors.
Effects of Inflation
Interest rates are significantly affected by inflation, but it is difficult to assess the impact, since neither the timing nor the magnitude of the changes in the various inflation indices coincide with changes in interest rates. Inflation does impact the economic value of longer term, interest-earning assets and interest-bearing liabilities, but the Company attempts to limit its long-term assets and liabilities, as indicated in the tables set forth under “Financial Condition” and “Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
The Company performs a net interest income analysis as part of its asset/liability management practices. Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% and 2.0% increases in market interest rates. The tables below present the Company’s projected changes in net interest income for the various rate shock levels at December 31, 2008 and December 31, 2007, respectively. As result of current market conditions, 1.0% and 2.0% decreases in market interest rates are not applicable for 2008 as those decreases would result in some deposit interest rate assumptions falling below zero. Nonetheless, the Company’s net interest income could decline in those scenarios as yields on earning assets could continue to adjust downward.
As shown above, at December 31, 2008, the effect of an immediate 200 basis point increase in interest rates would increase the Company’s net interest income by 8.23%, or $6.3 million. Overall net interest income sensitivity remains within the Company’s and recommended regulatory guidelines.
The changes in the Company’s net interest income sensitivity were due, in large part, to the addition of optionality on both sides of the balance sheet. The changes in net interest income over the one year horizon for December 31, 2008 under the 1.0% and 2.0% increases in market interest rates scenarios are reflective of this optionality. In a rising rate environment, yields on floating rate loans and investment securities are expected to re-price upwards more quickly than the cost of funds. The Company believes it manages such volatility to acceptable levels and is being appropriately compensated for the additional risk.
The Company does not have any sub-prime or Alt-A mortgage-backed securities in its securities portfolio nor does it have any sub- prime loans.
“Gap” analysis is used to determine the repricing characteristics of the Company’s assets and liabilities. The following table sets forth the interest rate sensitivity of the Company’s assets and liabilities as of December 31, 2008, and provides the repricing dates of the Company’s interest-earning assets and interest-bearing liabilities as of that date, as well as the Company’s interest rate sensitivity gap percentages for the periods presented.
The chart above shows the Company was asset sensitive or had a positive Gap in the short-term (0-3 months) meaning a greater amount of interest-earning assets are repricing or maturing than the amount of interest-bearing liabilities during the same time period. A positive gap generally indicates the Company is positioned to benefit from a rising interest rate environment. The cumulative interest sensitivity Gap is still positive but substantially decreased in the 4-12 month period, indicating the Company’s GAP position is much more closely matched through that time period and rate changes would theoretically have much less effect on net interest income. In the 1-5 year period the cumulative interest sensitivity Gap becomes much more positive again showing the Company’s benefit from rising interest rates would increase. The Gap position does not necessarily indicate the level of the Company’s interest rate sensitivity or the impact to net interest income because the interest-earning assets and interest-bearing liabilities are repricing off of different indices.
Mortgage-backed securities, including adjustable rate mortgage pools, are included in the above table based on their estimated principal paydowns obtained from outside analytical sources. Loans are included in the above table based on contractual maturity or contractual repricing dates. Deposits are based on management’s analysis of industry trends and customer behavior.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates. These computations should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from assumptions used in preparing the analyses. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates. The “Gap” analysis is based upon assumptions as to when assets and liabilities will reprice in a changing interest rate environment. Because such assumptions can be no more than estimates, certain assets and liabilities indicated as maturing or otherwise repricing within a stated period may, in fact, mature or reprice at different times and at different volumes than those estimated. Also, the renewal or repricing of certain assets and liabilities can be discretionary and subject to competitive and other pressures. Therefore, the gap table included above does not and cannot necessarily indicate the actual future impact of general interest rate movements on the Company’s net interest income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management.”
Item 8.
Item 8.
Consolidated Financial Statements and Supplementary Data
See “Consolidated Financial Statements” beginning on page.
Item 9.
Item 9.
Changes in and Disagreements With Independent Accountants On Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer of the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Company’s disclosure controls and procedures as of December 31, 2008 are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and such information is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). The Company’s internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. There are inherent limitations to the effectiveness of any control system. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework.
Based on management’s assessment, it determined that, as of December 31, 2008, the Company’s internal control over financial reporting is effective based on those criteria.
The effectiveness of the Company’s internal control over financial reporting as of December 31, 2008, has been audited by PricewaterhouseCoopers LLP, the independent registered public accounting firm who also audited the Company’s consolidated financial statements, as stated in their report included under Item 8.
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors and Executive Officers and Corporate Governance
Information regarding directors of the Company is included in the Company’s Proxy Statement for its 2009 Annual Meeting of Stockholders (the “Proxy Statement”) under the heading “Election of Directors” and the information included therein is incorporated herein by reference. Information regarding the executive officers of the Company is included in Item 1. Business of this report.
Information regarding compliance with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 by the Company’s directors and certain officers, and certain other owners of the Company’s common stock is included in the Proxy Statement under the heading “Section 16(a) Beneficial Ownership Compliance” and the information included therein is incorporated herein by reference.
Information regarding the Company’s director nomination procedures is included in the Proxy Statement under the heading “Director Nomination Procedures” and the information included therein is incorporated herein by reference.
Information regarding the Company’s audit committee is included in the Proxy Statement under the heading “Audit Committee” and the information included therein is incorporated herein by reference.
Information regarding the Company’s Code of Business and Conduct and Ethics is included in the Proxy Statement under the heading “Code of Business and Conduct and Ethics” and the information included therein is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation
Information regarding compensation of executive officers and directors, compensation committee, and compensation committee interlocks, are included in the Proxy Statement under the headings “Directors’ Compensation,” “Executive Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” and the information included therein is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information regarding the equity compensation plan and security ownership of certain beneficial owners and management are included in the Proxy Statement under the heading “Equity Compensation Plan Information” and “Security Ownership of Certain Beneficial Owners,” and the information included therein is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Information regarding certain relationships and related transactions and the independence of the Company’s directors under its director independence standards are included in the Proxy Statement under the heading “Transactions with Certain Related Persons” and “Director Independence,” and the information included therein is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
Information regarding principal accountant fees and services is included in the Proxy Statement under the heading “Independent Auditor,” and the information included therein is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) (1) Index to Financial Statements
The consolidated financial statements of the Company and its subsidiaries as required by Item 8 of Form 10-K are filed as a part of this document. See “Contents of Consolidated Financial Statements” on page.
(a) (2) Financial Statement Schedules
All financial statement schedules as required by Item 8 and Item 15 of Form 10-K have been omitted because the information requested is either not applicable or has been included in the consolidated financial statements or notes thereto.
(a) (3) Exhibits
The following exhibits are either filed as part of this report or are incorporated herein by reference:
*
Indicates management contracts or compensatory plans or arrangements required to be filed as an exhibit.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Midwest Banc Holdings, Inc.
By:
/s/ J. J. Fritz
J. J. Fritz
President and Chief Executive Officer
Date: March 11, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Each person whose signature appears below constitutes and appoints J. J. Fritz, JoAnn Sannasardo Lilek, and Jan R. Thiry his true and law attorneys-in-fact and agents, each acting alone, with full powers of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in order to effectuate the filing of such report, as fully for all intents and purposes as he might or could do in person, thereby ratifying and confirming all that said attorneys-in-fact and agents, and each of them, or his substitutes, may lawfully do or cause to be done by virtue hereof.
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED FINANCIAL STATEMENTS
CONTENTS
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
MIDWEST BANC HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
See accompanying notes to consolidated financial statements.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 -
Nature of Operations
Midwest Banc Holdings, Inc. (the “Company”) is a bank holding company organized under the laws of the State of Delaware. Through its commercial bank and non-bank subsidiaries, the Company provides a full line of financial services to corporate and individual customers located in the greater Chicago metropolitan area. These services include demand, time, and savings deposits; lending; brokerage and insurance products; and trust services. While the Company’s management monitors the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. The Company operates in one business segment, community banking, providing a full range of services to individual and corporate customers. The following disclosures are all related to continuing operations. The Company acquired Northwest Suburban Bancorp., Inc. and Royal American Corporation effective October 1, 2007 and July 1, 2006, respectively. See Note 3 - Business Combinations for more details.
Note 2 -
Summary of Significant Accounting Policies
Basis of Presentation: The consolidated financial statements of the Company include the accounts of the Company and its wholly owned subsidiary, Midwest Bank and Trust Company (the “Bank”). Included in the Bank are its wholly owned subsidiaries MBTC Investment Company, Midwest Funding, L.L.C., and Midwest Financial and Investment Services, Inc. (formerly known as Royal American Investment Services, Inc.). Significant intercompany balances and transactions have been eliminated.
Use of Estimates: The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change are the allowance for loan losses, income taxes, and the fair value of financial instruments.
Cash and Cash Equivalents: Cash and cash equivalents include cash, deposits with other financial institutions under 90 days, and federal funds sold. The Bank is required to maintain reserve balances in cash or on deposit with the Federal Reserve Bank, based on a percentage of deposits. The total of those reserve balances was $3.0 million at December 31, 2008.
Securities: Securities are classified as held-to-maturity when the Company has the ability and the positive intent to hold those securities to maturity. Accordingly, they are stated at cost adjusted for amortization of premiums and accretion of discounts. Securities are classified as available-for-sale when the Company may decide to sell those securities due to changes in market interest rates, liquidity needs, changes in yields or alternative investments, and for other reasons. They are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income. Interest income is reported net of amortization of premium and accretion of discount. Realized gains and losses on disposition of securities available-for-sale are based on the net proceeds and the adjusted carrying amounts of the securities sold, using the specific identification method. Trading securities are carried at fair value. Realized and unrealized gains and losses on trading securities are recognized in the statement of income as they occur. No trading securities were held at December 31, 2008 or 2007. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary, if any, are reflected in earnings as realized losses. In estimating other-than-temporary losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Loans: Loans are reported net of the allowance for loan losses and deferred fees. Impaired loans are carried at the present value of expected future cash flows or the fair value of the related collateral, if the loan is considered to be collateral dependent. Interest on loans is included in interest income over the term of the loan based upon the
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
principal balance outstanding. The accrual of interest on loans is discontinued at the time the loan becomes 90 days past due unless the credit is well-secured and in process of collection. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Deferred Loan Fees and Costs: Loan origination fees and origination costs are deferred and amortized over the life of the loan as an adjustment to yield.
Allowance for Loan Losses: The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows and collateral values on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The Company’s methodology for determining the allowance for loan losses represents an estimation pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The allowance reflects expected losses resulting from analyses developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on regular analyses of all loans over $300,000 where the internal credit rating is at or below a predetermined classification. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The allowance for loan losses also includes consideration of concentrations and changes in portfolio mix and volume, and other qualitative factors. In addition, regulatory agencies, as an integral part of their examinations, may require the Company to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. The process for determining the allowance includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect earnings or financial position in future periods.
A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of a similar nature such as residential mortgage and consumer loans and on an individual basis for other loans that exceed a set threshold. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Cash Surrender Value of Life Insurance: The Company has purchased life insurance policies on certain executive and other officers. Life insurance is recorded at its cash surrender value or the amount that can be realized.
Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization. Provisions for depreciation and amortization, included in operating expenses, are computed on the straight-line method over the estimated useful lives of the assets ranging from three to thirty-nine years. The cost of maintenance and repairs is charged to income as incurred; significant improvements are capitalized.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Foreclosed Properties: Real estate acquired in settlement of loans is recorded at fair value when acquired, establishing a new cost basis. Expenditures that increase the fair value of properties are capitalized as an adjustment to the cost basis. If fair value declines below the cost basis, a valuation allowance is recorded through expense.
Core Deposit and Other Intangibles: Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank, branch, and non-bank acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives.
Goodwill: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired net tangible assets and identifiable intangible assets. Goodwill is not amortized but assessed at least annually, at September 30, for impairment, and any such impairment is recognized in the period it is identified.
Income Taxes: Deferred tax assets and liabilities are recognized for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities. Deferred taxes are recognized for the estimated taxes ultimately payable or recoverable based on enacted tax laws. Changes in enacted tax rates and laws are reflected in the financial statements in the periods they occur. Deferred tax assets are reduced by a valuation allowance when, in the judgment of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
Securities Sold Under Agreements to Repurchase: All securities sold under agreements to repurchase represent amounts advanced by various primary dealers. Securities are pledged to secure these liabilities.
Transfers of Financial Assets: Transfers of financial assets are accounted for as sales only when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Fair Value of Financial Instruments and Derivatives: Fair values of financial instruments, including derivatives, are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. There is no readily available market for a significant portion of the Company’s financial instruments. Accordingly, fair values are based on various factors relative to expected loss experience, current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment. As a consequence, fair values cannot be determined with precision. Changes in assumptions or in market conditions could significantly affect these estimates.
Stock Compensation: Employee compensation cost relating to share-based payment transactions, including grants of employee stock options and restricted stock awards, are measured at fair value and recognized in the financial statements as prescribed by SFAS No. 123(R), “Share-Based Payment.” The Company adopted SFAS No. 123(R) in 2006 using the modified prospective method. Employee compensation expense for stock options and restricted stock granted is recorded in the consolidated income statement based on the grant’s vesting schedule. Forfeitures of stock options and restricted stock grants are estimated for those grants where the requisite service is not expected to be rendered. The grant-date fair value for each stock options grant is calculated using the Black-Scholes option pricing model.
Comprehensive Income: Comprehensive income includes both net income and other comprehensive income elements, including the change in unrealized gains and losses on securities available-for-sale as well as the prior service cost and unrealized gains and losses related to the projected benefit obligation of the Supplemental Executive Retirement plan, net of tax.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Earnings Per Common Share: Basic earnings per common share is net income available to common stockholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options, the warrant, and restricted stock awards as well as under the “if converted” method for the noncumulative redeemable convertible perpetual preferred stock. Earnings and dividends per share are restated for all stock splits and dividends through the date of issue of the financial statements.
Dividend Restriction: Banking regulations require the Company and the Bank to maintain certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to stockholders. The Company will only be able to pay dividends with the approval of the U.S. Treasury Department.
Reclassifications: Certain items in the prior year financial statements were reclassified to conform to the current year’s presentation. Such reclassifications had no effect on net income.
Accounting Pronouncements:
In June 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in the application of income tax laws, providing a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax positions taken or expected to be taken in income tax returns. The Company’s adoption of FIN 48 on January 1, 2007 did not have a material impact on the Company’s consolidated financial position and results of operations. See Note 22 - Income Taxes for more details.
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to provide guidance in the process of quantifying financial statement misstatements. SAB No. 108 requires registrants to quantify an error under two methods: (1) quantify the misstatement based on the amount of the error originating in the current-year income statement (“Rollover Approach”) and (2) quantify the misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current-year irrespective of the misstatement’s year(s) origination (“Iron Curtain Approach”). Consequently, a registrant’s financial statements would require adjustment when either approach results in quantifying a misstatement that is material, after considering all relevant quantitative and qualitative factors. SAB No. 108 was effective for financial statements issued for fiscal years ending after November 15, 2006. The application of SAB No. 108 as of January 1, 2007 did not have any impact on the Company’s results of operations or financial position.
The Company adopted SFAS No. 157, “Fair Value Measurements,” on January 1, 2008, which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements where the FASB had previously concluded in those pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new financial assets or liabilities to be measured at fair value. In February 2008, FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, “Effective Date of FASB Statement No. 157.” This FSP delays the effective dates of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. In October 2008, the FASB issued Staff Position 157-3, “Determining the Fair Value of a Financial Asset in a Market That Is Not Active” (“FSP No. 157-3”), which clarifies the application of SFAS No. 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is to be determined when the market for that financial asset is not active. FSP No. 157-3 became effective for the Company’s interim financial statements as of September 30, 2008 and did not significantly impact the methods by which the Company determines the fair values of its financial assets. The adoption of SFAS No. 157 did not have a material effect on the Company’s results of operations or consolidated financial position. See Note 17 - Fair Value for more information.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In December 2007, FASB issued SFAS No. 141(R), “Business Combinations,” which replaces the current standard on business combinations, modifies the accounting for business combinations and requires, with limited exceptions, the acquirer in a business combination to recognize all of the assets acquired, liabilities assumed, and any noncontrolling interests in the acquiree at the acquisition-date, at fair value. SFAS No. 141(R) also requires certain contingent assets and liabilities acquired as well as contingent consideration to be recognized at fair value. In addition, the statement requires payments to third parties for consulting, legal, audit, and similar services associated with an acquisition to be recognized as expenses when incurred rather than capitalized as part of the cost of the acquisition. SFAS No. 141(R) is effective for fiscal years beginning on or after December 15, 2008 and early adoption is not permitted.
In June 2008, the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”) on Issue No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF No. 07-5”). EITF No. 07-5 provides guidance for determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock. EITF No. 07-5 applies to any freestanding financial instrument or embedded feature that has all of the characteristics of a derivative or freestanding instrument that is potentially settled in an entity’s own stock (with the exception of share-based payment awards within the scope of SFAS 123(R)). To meet the definition of “indexed to own stock,” an instrument’s contingent exercise provisions must not be based on (a) an observable market, other than the market for the issuer’s stock (if applicable), or (b) an observable index, other than an index calculated or measured solely by reference to the issuer’s own operations, and the variables that could affect the settlement amount must be inputs to the fair value of a “fixed-for-fixed” forward or option on equity shares. EITF No. 07-5 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The Company does not anticipate a material effect on its results of operations or consolidated financial position from adopting EITF No. 07-5.
In December 2008, the FASB issued FASB Staff Position FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities” (“FSP No. FAS 140-4 and FIN 46(R)-8”). FSP No. FAS 140-4 and FIN 46(R)-8 amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” and FIN No. 46, “Consolidation of Variable Interest Entities,” requiring additional disclosures about transfers of financial assets and the involvement with variable interest entities. These additional disclosures are intended to provide greater transparency about a transferor’s continuing involvement with transferred assets and variable interest entities. FSP No. FAS 140-4 and FIN 46(R)-8 is effective for fiscal years ending after December 15, 2008. The adoption of FSP No. FAS 140-4 and FIN 46(R)-8 did not have a material effect on the Company’s results of operations or consolidated financial position.
Note 3 -
Business Combinations
Northwest Suburban Bancorp, Inc.
On October 1, 2007, the Company acquired Northwest Suburban Bancorp, Inc. (“Northwest Suburban”), in a cash and stock merger transaction. The agreement and plan of merger provided that the Company’s stock comprise up to 45% of the purchase price, at an exchange ratio of 2.4551 shares of Company common stock for each Northwest Suburban common share, and that the remainder be paid in cash at the rate of $42.75 for each share of Northwest Suburban common stock. The Company issued 3.7 million shares of common stock, paid $81.2 million in cash, and incurred $414,000 in acquisition costs which were capitalized for a total purchase price of $136.7 million at the closing on October 1, 2007. The Company used the proceeds from a $75.0 million term note it has under a borrowing facility with a correspondent bank to pay for a portion of the cash requirement of the acquisition. Northwest Suburban was merged into the Company, thus canceling 100% of Northwest Suburban’s voting shares outstanding.
The acquisition of Northwest Suburban constituted a business combination under SFAS No. 141, “Business Combinations,” and was accounted for using the purchase method. Accordingly, the purchase price was allocated to the respective assets acquired and liabilities assumed based on their estimated fair values on the date of acquisition.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The excess of purchase price over the fair value of net assets acquired was recorded as goodwill, which is not deductible for tax purposes. The purchase price allocation was finalized in the third quarter of 2008. The results of operations of Northwest Suburban have been included in the Company’s results of operations since October 1, 2007, the date of acquisition.
The following are the adjustments made to record the transaction and to adjust Northwest Suburban’s assets and liabilities to their estimated fair values at acquisition.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following are the assets acquired and liabilities assumed from Northwest Suburban at October 1, 2007, including the adjustments made to record the transaction and to adjust the assets and liabilities to their estimated fair values.
Royal American Corporation
Effective July 1, 2006, the Company acquired Royal American Corporation (“Royal American”), a bank holding company, in a cash and stock merger transaction. At acquisition, Royal American had total assets of $561.2 million. The Company’s stock comprised approximately 50% of the purchase price, at an exchange ratio of 3.58429 shares of Company common stock for each Royal American common share, and the remainder was paid in cash at the rate of $80 for each share of Royal American common stock. The Company issued 2.9 million common shares, paid $64.6 million in cash, and incurred $795,000 in costs which were capitalized for a total purchase price of $129.2 million. Royal American was merged into the Company, thus canceling 100% of Royal American’s voting shares outstanding.
The acquisition of Royal American constituted a business combination under SFAS No. 141, “Business Combinations,” and was accounted for using the purchase method. Accordingly, the purchase price was allocated to the respective assets acquired and liabilities assumed, based on their estimated fair values on the date of acquisition. The excess of purchase price over the fair value of net assets acquired was recorded as goodwill, which is not deductible for tax purposes. The purchase price allocation was finalized in the first quarter of 2007. The results of operations of Royal American have been included in the Company’s results of operations since July 1, 2006, the date of acquisition.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following are the adjustments made to record the transaction and to adjust Royal American’s assets and liabilities to their estimated fair values at July 1, 2006.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following are the assets acquired and liabilities assumed from Royal American at July 1, 2006, including the adjustments made to record the transaction and to adjust the assets and liabilities to their estimated fair values.
The following are the unaudited pro forma consolidated results of operations of the Company for the years ended December 31, 2007 and 2006 as though Northwest Suburban and Royal American had been acquired as of January 1, 2006.
Included in the pro forma results of operations for the years ended December 31, 2007 and 2006 were merger-related expenses, primarily change-in-control and severance payments, investment banker, legal and audit fees, net of tax of $4.3 million and $6.8 million, respectively.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 4 -
Securities
The amortized cost and fair value of securities available-for-sale and held-to-maturity are as follows:
(1)
Includes obligations of the Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA).
(2)
Includes obligations of the Government National Mortgage Association (GNMA).
(3)
Includes issues from government-sponsored entities (FNMA and FHLMC).
(1)
Includes obligations of the FHLMC and FNMA.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(2)
Includes obligations of the GNMA.
(3)
Includes issues from government-sponsored entities (FNMA and FHLMC).
The following is a summary of the fair value of securities held-to-maturity and available-for-sale with unrealized losses and the time period of those unrealized losses:
(1)
Includes obligations of the FHLMC and FNMA.
(2)
Includes issues from government-sponsored entities (FNMA and FHLMC).
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(1)
Includes obligations of the FHLMC and FNMA.
(2)
Includes issues from government-sponsored entities (FNMA and FHLMC).
(3)
Includes obligations of the GNMA.
The unrealized loss on available-for-sale securities is included, net of tax, in other comprehensive loss on the consolidated balance sheets. Management does not believe any individual unrealized loss as of December 31, 2008, identified in the preceding table, represents other-than-temporary impairment. These unrealized losses are primarily attributable to the current credit environment and turmoil in the market for securities related to the housing industry. The Company has both the intent and ability to hold each of the securities shown in the table for the time necessary to recover its amortized cost.
•
The unrealized loss for U.S. government-sponsored entities’ mortgage-backed securities relate primarily to debt securities issued by FNMA and FHLMC. Each of these securities has a stated maturity date. FNMA has an issuer rating of Aaa by Moody’s and a long-term issuer default rating of AAA by Fitch. FHLMC has senior secured and unsecured debt ratings of Aaa by Moody’s and a long-term issuer default rating of AAA by Fitch. These mortgage-backed securities are notes with a weighted average maturity of approximately 26 years and a weighted average interest rate of 4.06%.
•
The unrealized losses on corporate and other debt securities relate to securities which were rated A- or better by either Moody’s or S&P as of December 31, 2008. These debt securities have a weighted average maturity of approximately 19 years and a weighted average interest rate of 3.35%.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company recognized an other-than-temporary impairment charge of $17.6 million at March 31, 2008 on certain FNMA and FHLMC preferred equity securities with a cost basis of $85.1 million. In September 2008, the Company sold $16.9 million of the remaining $67.5 million recognizing a $16.7 million loss. The Company recognized an additional other-than-temporary impairment charge of $47.8 million at September 30, 2008 on the remaining securities and thereby reduced the amortized cost to their fair value of $2.7 million. Management believes this impairment was primarily attributable to economic conditions at that time, FNMA and FHLMC being placed into the Federal Housing Finance Agency’s conservatorship and the discontinued dividend payments. Since recovery did not appear likely in the near future, the Company recognized the impairment losses.
Securities with an approximate carrying value of $623.7 million and $600.2 million at December 31, 2008 and 2007 were pledged to secure public deposits, borrowings, and for other purposes as required or permitted by law. Included in securities pledged at December 31, 2008 and 2007 are $113.5 million and $183.9 million, respectively, which have been pledged for FHLB borrowings.
The amortized cost and fair value of securities by contractual maturity at December 31, 2008 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Proceeds from sales of securities available-for-sale and the realized gross gains and losses are as follows:
As permitted under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” certain securities held-to-maturity, where a substantial portion of their principal outstanding was collected and had a carrying value of $4.3 million were sold in 2008 at a gain of $151,000 and securities held-to-maturity with a carrying value of $2.1 million were sold in 2007 at a loss of $30,000. These securities had paid down to less than 15% of their original face value.
Note 5 -
Loans
Major classifications of loans are summarized as follows:
(1)
Amounts have been reclassified to conform to current period presentation.
During the fourth quarter of 2007, the Company revised its classification of commercial loans and commercial real estate loans, changing its prior practice of classifying as commercial real estate loans all loans to businesses that included real estate as collateral (“collateral-based” classification). The classification of construction, home equity, and residential mortgages were also reviewed. The new method of presentation (“source of repayment” classification) recognizes that loans to owner-occupied businesses engaged in manufacturing, sales and/or services are commercial loans regardless of whether real estate is taken as collateral. These loans generally have a lower risk profile than traditional commercial real estate loans. They are primarily dependent on the borrower’s business-generated cash flows for repayment, not on the conversion of real estate that may be pledged as collateral. Loans related to rental income producing properties and properties intended to be sold will continue to be classified as commercial real estate loans. Completing this change in methodology involved a loan-by-loan review of the Company’s commercial and commercial real estate loans.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company reclassified $5.0 million and $1.9 million in overdraft deposits to loans as of December 31, 2008 and 2007, respectively.
Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”) addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in purchase business combinations and applies to all nongovernmental entities. SOP 03-3 does not apply to loans originated by the Company. The Company’s assessment of loans acquired in the acquisition of Northwest Suburban as of October 1, 2007 identified $5.9 million in acquired loans to which the application of the provisions of SOP 03-3 was required. As a result of the application of SOP 03-3, the Company recorded purchase accounting adjustments reflecting a reduction in loans of $2.0 million related to acquired impaired loans, thus reducing the carrying value of these loans to $3.9 million as of December 31, 2007. The carrying value of these loans was $778,000 as of December 31, 2008, and there continues to be no allowance for loan losses regarding these loans. The Company does not consider prepayments in the determination of contractual or expected cash flows.
The following is the carrying value by source of repayment category for loans subject to SOP 03-3:
The following is a summary of changes in the accretable yield for the year ended December 31, 2008 and 2007:
The full contractual payment was received on a loan originally accounted for under SOP 03-3, and goodwill was reduced in second quarter of 2008 by the remaining fair value adjustment of that loan.
Note 6 -
Related Party Transactions
Certain executive officers, directors, and their related interests are loan customers of the Bank. These loans were made under comparable terms as for non-related parties and were determined to be arms-length transactions. A summary of loans made by the Bank to or for the benefit of directors, executive officers, and their related interests is as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 7 -
Allowance for Loan Losses
The following is a summary of changes in the allowance for loan losses:
A portion of the allowance for loan losses is allocated to impaired loans. Information with respect to impaired loans and the related allowance for loan losses is as follows:
Interest payments on impaired loans are generally applied to principal, unless the loan principal is considered to be fully collectible, in which case interest is recognized on a cash basis.
Nonaccrual loans were $61.1 million and $49.2 million as of December 31, 2008 and 2007, respectively. There were no loans past due 90 days but still accruing as of December 31, 2008 and 2007. There was $11.0 million in troubled-debt restructured loans as of December 31, 2008 and none as of December 31, 2007. In order to improve the collectibility of the troubled-debt restructuring, the Company restructured the terms of the debt by lifting the forebearance agreement and lowering the interest rates including changing them from fixed to floating rates. No additional commitments were outstanding on the troubled-debt restructured loans as of December 31, 2008. These troubled-debt restructured loans were still accruing and no allowance was allocated at December 31, 2008.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 8 -
Premises and Equipment
Premises and equipment are summarized as follows:
On March 28, 2008, the Company sold two pieces of real property for $18.4 million creating a pre-tax gain of $15.2 million. The properties (a building with a parking lot and a second parking lot) are located in the Bucktown area of Chicago at 1601 North Milwaukee Avenue and 1617-1622 North Damen Avenue. The Company will continue to operate its existing Milwaukee Avenue branch in Bucktown through a continuing occupancy arrangement with the buyer after which it expects to relocate to a new branch in close proximity to the existing branch location in the second quarter of 2009. The Company pays $75,000 per month to rent the Milwaukee Avenue space and has vacated the Damen Avenue parking lot. The Company is responsible for one-half of the real estate taxes and the premiums for casualty and liability insurance on the Milwaukee Avenue property during the occupancy period.
Note 9 -
Goodwill and Core Deposit Intangibles
The following table presents the carrying amount and accumulated amortization of intangible assets (in thousands):
The amortization of intangible assets was $2.4 million for the year ended December 31, 2008. At December 31, 2008, the projected amortization of intangible assets is $2.3 million, $2.2 million, $1.9 million, $1.8 million, $1.7 million for the years ending December 31, 2009, 2010, 2011, 2012, 2013, respectively, and $4.8 million in total for the subsequent years. The weighted average amortization period for the core deposit intangibles is approximately eight years as of December 31, 2008.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents the changes in the carrying amount of goodwill and other intangibles during the years ended December 31, 2008 and 2007 (in thousands):
(1)
On January 3, 2003, the Company purchased Big Foot Financial Corp. As a result of this acquisition, the Company had unrecognized tax benefits related to employee severance payments and acquisition costs. These unrecognized tax benefits were recognized in the first quarter of 2007, when the statute of limitations for Internal Revenue Service (“IRS”) audit of the final short period return closed. These unrecognized tax benefits, totaling $429,000, were credited to the core deposit intangible created as a result of the acquisition. A reversal of $283,000 in tax liability established on the date of acquisition was also credited to the core deposit intangible in the first quarter of 2007. During the third quarter of 2007, the core deposit intangible was increased by $124,000 due to an adjustment related the estimated tax liability established on the date of acquisition. Goodwill was reduced in the second quarter of 2008 by the remaining fair value adjustment of a loan accounted for under SOP 03-3 for which full contractual payment was received. Goodwill was also adjusted in the third quarter of 2008 for the final purchase price allocation for the Northwest Suburban acquisition.
Goodwill is not amortized but assessed at least annually for impairment, and any impairment recognized in the period it is identified. As of September 30, 2008, based upon the guidelines contained in SFAS No. 142, “Goodwill and Other Intangible Assets,” it was determined that the fair value of the Company’s assets and liabilities was lower than amounts recorded in the Company’s financial statements. Accordingly, the Company recognized a goodwill impairment charge of $80.0 million. Management believes this impairment was primarily attributable to the weakened economic conditions at that time as well as lower market valuations for banking institutions. The method for estimating the value of the Company included a weighted average of the discounted cash flows method, the guideline company method, and the guideline transaction methods. The Company cannot assure that it will not be required to take goodwill impairment charges in the future.
Note 10 -
Time Deposits
Interest-bearing time deposits in denominations of $100,000 and greater were $874.6 million as of December 31, 2008 and $856.6 million as of December 31, 2007. Interest expense related to deposits in denominations of $100,000 and greater was $33.9 million for 2008, $33.8 million for 2007, and $20.5 million for 2006.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Certificates of deposit have scheduled maturities for the years 2009 through 2013 and thereafter as follows:
Note 11 -
Securities Sold Under Agreements to Repurchase
The Company has repurchase agreements with brokerage firms, which are in possession of the underlying securities. The same securities are returned to the Company at the maturity of the agreements. The following summarizes certain information relative to these borrowings:
At December 31, 2008, securities sold under agreements to repurchase are summarized below:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 12 -
Advances from the Federal Home Loan Bank
Advances from the Federal Home Loan Bank are summarized as follows:
At December 31, 2008, the majority of the Federal Home Loan Bank advances have various call provisions ranging from three months to two years. Various securities are pledged as collateral as discussed in Note 4 - Securities. In addition, the Company has collateralized the advances with a blanket lien arrangement at December 31, 2008 and 2007.
Note 13 -
Junior Subordinated Debentures
At December 31, 2008, the Company had $60.8 million in junior subordinated debentures owed to unconsolidated trusts that were formed to issue trust preferred securities. The trust preferred securities offerings were pooled private placements exempt from registration under the Securities Act pursuant to Section 4(2) thereunder. The Company has provided a full, irrevocable, and unconditional subordinated guarantee of the obligations of these trusts under the preferred securities. The Company is obligated to fund dividends on these securities before it can pay dividends on shares of its common stock and preferred stock. The Company is not deemed to have a controlling financial interest in these variable interest entities, and therefore is required to deconsolidate them.
The following table details the unconsolidated trusts and their common and trust preferred securities:
(1)
Redeemable at option of the Company.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company acquired $10.3 million in junior subordinated debentures at LIBOR plus 2.70% through the acquisition of Northwest Suburban effective October 1, 2007 and redeemed $15.5 million in junior subordinated debentures at LIBOR plus 3.45% on November 7, 2007.
Note 14 -
Credit Agreements
The Company’s credit agreements with a correspondent bank at December 31, 2008 consisted of a revolving line of credit, a term note loan, and a subordinated debenture in the amounts of $8.6 million, $55.0 million, and $15.0 million, respectively.
The revolving line of credit has a maximum availability of $25.0 million, $16.4 million available at December 31, 2008, an interest rate of one-month LIBOR plus 155 basis points, and matures on April 3, 2009. During the fourth quarter of 2007, the Company utilized the proceeds from a $75.0 million term note loan to pay for the cash requirements of the Northwest Suburban acquisition. On March 31, 2008, the Company converted $15.0 million of this term note into subordinated debt and further reduced the remaining term note balance to $55.0 million. The resulting term note had an interest rate of one-month LIBOR plus 155 basis points at December 31, 2008 and matures on September 28, 2010. The subordinated debt had an interest rate of one-month LIBOR plus 350 basis points at December 31, 2008, matures on March 31, 2018, and qualifies as Tier 2 capital.
The revolving line of credit and term note included the following covenants at December 31, 2008: (1) the Bank must not have nonperforming loans (loans on nonaccrual status and 90 days or more past due and troubled-debt restructured loans) in excess of 3.00% of total loans, (2) the Bank must report a quarterly profit, excluding charges related to acquisitions, and (3) the Bank must remain well capitalized. The Company was in compliance with these debt covenants at December 31, 2008.
As a result of the effects of recent economic conditions, the increase in nonperforming assets, and the impairment charges on goodwill and the FNMA and FHLMC preferred securities, the Company sought covenant waivers on two occasions since December 31, 2007. First, the lender waived a covenant violation in the first quarter of 2008 resulting from the Company’s net loss recognized in that period. Second, the lender waived a covenant violation in the third quarter of 2008 resulting from the Company’s net loss recognized in that period, contingent upon the Company making accelerated principal payments under the aforementioned term loan agreement in the amounts and on or prior to the dates shown below:
July 1, 2009 - $5.0 million
October 1, 2009 - $5.0 million
January 4, 2010 - $5.0 million
Previously, no principal payments were due under the term loan agreement until the final maturity date of September 28, 2010. The waiver further provides that if the Company raises $15.0 million in new capital pursuant to an offering of common or convertible preferred stock, then the Company shall not be obligated to make any of the accelerated principal payments specified above that fall due after the date on which the Company receives such $15.0 million in new capital until the final maturity date of September 28, 2010. The Company has the capacity to satisfy all payment obligations outlined above.
In the event the lender declares the Company to be in default of any covenants, the Company has 30 days to cure the default, or the correspondent bank could, at its option, call the term note and any amounts outstanding on the revolving line of credit due and payable or increase the rate on those loans by 300 basis points.
Note 15 -
Preferred Stock and Warrant
Series T In December 2008, the Company raised $84.8 million in new equity through an offering of 84,784 shares of Series T fixed rate cumulative perpetual preferred stock and issued a warrant to purchase
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
4,282,020 shares of common stock at $2.97 per share to the U.S. Treasury Department (“Treasury”) under the Troubled Assets Relief Program (“TARP”) Capital Purchase Program. The Series T preferred stock has a cumulative dividend rate of 5.00% per annum of the stated liquidation preference for five years and increases to 9.00% thereafter.
The Series T preferred stock qualifies as Tier 1 capital. The Company may redeem the Series T preferred stock at its liquidation preference ($1,000 per share) plus accrued and unpaid dividends under the American Recovery and Reinvestment Act of 2009, subject to the Treasury’s consultation with the Company’s appropriate federal regulator.
Prior to the third anniversary of the Treasury’s purchase of the Series T preferred stock, unless the preferred stock has been redeemed or the Treasury has transferred all of the Series T preferred stock to third parties, the consent of the Treasury will be required for the Company to (i) pay any dividend on its common stock or (ii) repurchase its common stock or other equity or capital securities, including trust preferred securities, other than in connection with benefit plans consistent with past practice and certain other circumstances specified in the Purchase Agreement. The Series T preferred stock will be non-voting except for the class voting rights on matters that would adversely affect the rights of the holders of the Series T preferred stock.
Warrant The warrant has a 10-year term and is immediately exercisable upon its issuance, with an initial per share exercise price of $2.97. The warrant provides for the adjustment of the exercise price and the number of shares of common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of common stock, and upon certain issuances of common stock at or below a specified price relative to the initial exercise price. If the Company receives aggregate gross cash proceeds of not less than $84.784 million from qualified equity offerings on or prior to December 31, 2009, the number of shares of common stock issuable pursuant to Treasury’s exercise of the warrant will be reduced by one half of the original number of shares, taking into account all adjustments, underlying the warrant.
Series A In December 2007, the Company raised $41.4 million in new equity capital, net of issuance costs, through an offering of 1,725,000 depositary shares each representing 1/100th of a share of its Series A noncumulative redeemable convertible perpetual preferred stock, at $25.00 per depositary share. The depositary shares have a dividend rate of 7.75% per annum of the stated liquidation preference, which is initially equivalent to $1.937500 per year and $0.484375 per quarter per depositary share. Dividends are noncumulative and are payable if, when and as declared by the Company’s board of directors.
The depositary shares are convertible, at the option of the holder, at any time into the number of shares of the Company’s common stock equal to $25.00 divided by the conversion price then in effect. The depositary shares are convertible, at the option of the Company, on or after the fifth anniversary of the issue date, into the number of shares of the Company’s common stock equal to $25.00 divided by the conversion price then in effect. The current conversion price is $15.00. The Company may exercise this conversion option only if its common stock price equals or exceeds 130% of the then prevailing conversion price for at least 20 trading days in a period of 30 consecutive trading days and the Company has paid full dividends on the depositary shares for four consecutive quarters.
The depositary shares are redeemable, at the option of the Company, on or after the fifth anniversary of the issue date, for $25.00 per share, plus declared and unpaid dividends, if any, provided that the payment of dividends for prior periods has been approved by the Federal Reserve Board.
The preferred stock outstanding has preference over the Company’s common stock with respect to the payment of dividends and distribution of the Company’s assets in the event of a liquidation or dissolution. The holders of preferred stock have no voting rights, except in certain circumstances.
Note 16 -
Capital Requirements
The Company and the Bank are subject to regulatory capital requirements administered by the federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, banks must
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require banks and bank holding companies to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and Tier 1 capital to average assets. If a bank does not meet these minimum capital requirements, as defined, bank regulators can initiate certain actions that could have a direct material effect on the bank’s financial statements. Management believes that, as of December 31, 2008 and 2007, the Company and the Bank met all capital adequacy requirements to which they were subject.
As of December 31, 2008, the most recent Federal Deposit Insurance Corporation notification categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s categories. To be categorized as well capitalized, banks must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios.
The risk-based capital information for the Company is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The actual capital amounts and ratios for the Company and the Bank are presented in the following table:
Note 17 -
Fair Value of Financial Instruments
The Company adopted SFAS No. 157, “Fair Value Measurement,” on January 1, 2008. SFAS No. 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between willing market participants on the measurement date. SFAS No. 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
•
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
•
Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
•
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company’s available-for-sale investment securities are the only financial assets that are measured at fair value on a recurring basis; it does not hold any financial liabilities that are measured at fair value on a recurring basis. The fair values of available-for-sale securities are determined by obtaining either quoted prices on nationally
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
recognized securities exchanges or matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on these securities’ relationship to other benchmark quoted securities. If quoted prices or matrix pricing are not available, the fair value is determined by an adjusted price for similar securities including unobservable inputs. The fair values of the available-for-sale securities were measured at December 31, 2008 using the following:
The following is a summary of changes in the fair value of the available-for-sale securities that were measured using significant unobservable inputs for the year ended December 31, 2008:
The Company’s impaired loans that are measured using the fair value of the underlying collateral are measured on a non-recurring basis. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” At December 31, 2008, $41.3 million of the total impaired loans were evaluated based on the fair value of the collateral. The fair value of the collateral is determined by obtaining an observable market price or by obtaining an appraised value with management applying selling and other discounts to the underlying collateral value. If an appraised value is not available, the fair value of the impaired loan is determined by an adjusted appraised value including unobservable cash flows.
At December 31, 2008, the fair values of the impaired loans based on the fair value of the collateral were measured using the following:
Loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a gross carrying amount of $41.3 million, with an associated valuation allowance of $4.2 million for a fair value of $37.1 million at December 31, 2008. The provision for loan losses for the year ended December 31, 2008, included $39.0 million of specific allowance allocations for impaired loans.
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The methods and assumptions used to determine fair values for each class of financial instrument are presented below.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The carrying amount is equivalent to the estimated fair value for cash and cash equivalents, federal funds purchased, Federal Reserve Bank and Federal Home Loan Bank stock, accrued interest receivable and payable, due from and to broker, noninterest-bearing deposits, short-term borrowings, and variable rate loans, interest-bearing deposits, or notes payable that reprice frequently and fully. The fair values of securities are determined by obtaining either quoted prices on nationally recognized securities exchanges or matrix pricing. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, and securities sold under agreements to repurchase, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. The fair value of fixed rate debt is based on current rates for similar financing. The fair value of off-balance-sheet items, loan commitments, is not material.
The estimated fair values of the Company’s financial instruments were as follows:
The remaining other assets and liabilities of the Company are not considered financial instruments and are not included in the above disclosures.
There is no readily available market for a significant portion of the Company’s financial instruments. Accordingly, fair values are based on various factors relative to expected loss experience, current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment and, therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect these estimated values.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 18 -
Off-Balance-Sheet Risk and Concentrations of Credit Risk
In the normal course of business and to meet financing needs of customers, the Company is a party to financial instruments with off-balance-sheet risk. Since many commitments to extend credit expire without being used, the amounts below do not necessarily represent future cash commitments. These financial instruments include lines of credit, letters of credit, and commitments to extend credit. These are summarized as of December 31, 2008 as follows:
At December 31, 2008, commitments to extend credit included $26.0 million of fixed rate loan commitments. These commitments are due to expire within 30 to 90 days of issuance and have rates ranging from 5.25% to 8.00%. Substantially all of the unused lines of credit are at adjustable rates of interest.
In the normal course of business, the Company is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the Company’s financial position or results of operations.
Note 19 -
Leases
The Bank leases a portion of its premises. The leases expire in various years through the year 2029. Future rental commitments under these noncancelable operating leases for the years 2009 through 2013 and thereafter are as follows:
Rent expense included in occupancy and equipment expense was $2.1 million, $1.3 million, and $1.1 million for the years ended December 31, 2008, 2007, and 2006. Occupancy expense has been reduced by $566,000, $494,000, and $475,000 for the years ended December 31, 2008, 2007, and 2006 due to rental income received on leased premises.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 20 -
Stock Compensation and Restricted Stock Awards
Under the Company’s Stock and Incentive Plan (the “Plan”), officers, directors, and key employees may be granted incentive stock options to purchase the Company’s common stock at no less than 100% of the market price on the date the option is granted. Options can be granted to become exercisable immediately or in installments of 25% a year on each of the first through the fourth anniversaries of the grant date or may be issued subject to performance targets. In all cases, the options have a maximum term of ten years. The Plan also permits the issuance of nonqualified stock options, stock appreciation rights, restricted stock, and restricted stock units. The Plan authorizes a total of 3,900,000 shares for issuance. There are 1,881,507 shares remaining for issuance under the Plan at December 31, 2008. It is the Company’s policy to issue new shares of its common stock in conjunction with the exercise of stock options or grants of restricted stock.
During 2008, 16,500 employee stock options were exercised. Total employee stock options outstanding at December 31, 2008 were 379,371 with exercise prices ranging between $8.83 and $22.03, with a weighted average exercise price of $14.28, and expiration dates between 2009 and 2015. No stock options have been granted since 2005.
Information about option grants follows:
Options exercisable at year end are as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Options outstanding at December 31, 2008 were as follows:
At December 31, 2008, the aggregate intrinsic value of the options outstanding and exercisable were $1.8 million and $1.7 million, respectively. The total intrinsic value of options exercised during the years ended December 31, 2008, 2007, and 2006 was $50,000, $116,000, and $647,000, respectively.
The Company adopted SFAS No. 123(R), “Share-Based Payment,” in the first quarter of 2006 using the modified prospective application. Employee compensation expense for stock options previously granted was recorded in the consolidated income statement based on the grant’s vesting schedule. Forfeitures of stock option grants are estimated for those stock options where the requisite service is not expected to be rendered. The grant-date fair value for each grant was calculated using the Black-Scholes option pricing model, using the following weighted-average assumptions as of grant date. The following table reflects the only grant (those options granted in 2005) included in employee compensation expense.
For the years ended December 31, 2008 and 2007, employee compensation expense related to stock options was $19,000 and $22,000, respectively. The total compensation cost related to nonvested stock options not yet recognized was $13,600 at December 31, 2008 and the weighted average period over which this cost is expected to be recognized is 18 months.
Under the Plan, officers, directors, and key employees may also be granted awards of restricted shares of the Company’s common stock. Holders of restricted shares are entitled to receive cash dividends paid to the Company’s common stockholders and have the right to vote the restricted shares prior to vesting. The existing restricted share grants vest over various time periods not exceeding five years and some may be accelerated subject to achieving certain performance targets. Compensation expense for the restricted shares equals the market price of the related stock at the date of grant and is amortized on a straight-line basis over the vesting period assuming certain performance targets are met when applicable. All restricted shares had a grant-date fair value equal to the market price of the underlying common stock at date of grant.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Information about restricted share grants follows:
For the years ended December 31, 2008, 2007, and 2006, the Company recognized $2.9 million, $3.1 million, and $2.2 million, respectively, in compensation expense related to the restricted stock grants. The Company realized a tax benefit of $3,000 and $54,000 for the years ended December 31, 2008 and 2007, respectively. The total fair value of shares outstanding was $10.0 million as of December 31, 2008. The total fair value of shares vested during the years ended December 31, 2008, 2007, and 2006 was $764,000, $1.8 million, and $683,000, respectively. The total compensation cost related to nonvested restricted shares not yet recognized was $4.6 million at December 31, 2008 and the weighted average period over which this cost is expected to be recognized is 37 months.
Note 21 -
Other Employee Benefit Plans
The Company maintains a 401(k) plan covering substantially all employees. Eligible employees may elect to make tax deferred contributions within a specified range of their compensation as defined in the plan. The Company contributes 1% more than the employee’s contribution up to a maximum 5% employer contribution. Contributions to the plan are expensed currently and were $1.2 million, $1.1 million, and $812,000 for the years ended December 31, 2008, 2007, and 2006, respectively.
The Company and various members of senior management have entered into a Supplemental Executive Retirement Plan (“SERP”). The SERP is an unfunded plan that provides for guaranteed payments, based on a percentage of the individual’s final salary, for 15 years after age 65. The benefit amount is reduced if the individual retires prior to age 65.
Effective April 1, 2008, the SERP agreements with employees constituted a pension plan under SFAS No. 87, “Employers’ Accounting for Pensions.” The objective of SFAS No. 87 is to recognize the compensation cost of pension benefits (including prior service cost) over that employee’s approximate service period. The benefit obligation was $6.4 million and $3.5 million as of December 31, 2008 and 2007, respectively, and is included in other liabilities. Expense of $1.8 million, $1.1 million, and $451,000 was recorded for the years ended December 31, 2008, 2007, and 2006, respectively, and has been included in salaries and employee benefits expense in the statements of operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following is a summary of changes in the benefit obligation for the year ended December 31, 2008:
(1)
Reflects acceleration of benefits to a participant.
The following is a summary of the net periodic costs for the year ended December 31, 2008:
The following are the weighted-average assumptions used to determine the benefit obligation at December 31, 2008:
The Company weighted-average assumptions were determined at December 31, 2008, the measurement date, based on common benchmarks used for measuring benefit liabilities, the Moody’s As corporate bond rate and Citigroup pension liability discount rate.
The Company recognized a $477,000 reduction associated with the prior service in accumulated other comprehensive income as of April 1, 2008. The prior service cost amortization expense for 2008 was $44,000, net of tax; $433,000 was unamortized as of December 31, 2008. The prior service cost amortization expense is projected to be $95,000 for 2009. The Company recognized a $240,000 actuarial loss in accumulated other comprehensive income as of December 31, 2008.
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
The Company has purchased life insurance policies on various members of management. The Company is the beneficiary of these life insurance policies, which have an aggregate death benefit of approximately $217.0 million at December 31, 2008. In addition, the policies had aggregate cash surrender values of approximately $84.7 million at December 31, 2008 and $81.2 million at December 31, 2007.
Note 22 -
Income Taxes
The provision for income taxes from continuing operations consists of the following:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The difference between the provision for income taxes in the consolidated financial statements and amounts computed by applying the current federal statutory income tax rate of 35% to income before income taxes is reconciled as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The net deferred tax asset, included in other assets and other liabilities in the accompanying consolidated balance sheets, consisted of the following components:
As of December 31, 2008 and 2007, the Company believes it is more likely than not that deferred tax assets will be realized and, therefore, no allowance was considered necessary.
The unrecognized tax benefits at December 31, 2008 were as follows:
The Company adopted the provisions of FIN No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109,” on January 1, 2007. The adoption of this standard did not have an impact on the Company’s consolidated financial position and results of operations. The Company recognizes interest accrued related to unrecognized tax benefits and penalties, if any, in income tax expense. As of the date of adoption, the Company had approximately $20,000 of interest accrued for potential income tax exposures and
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$526,000 of unrecognized tax benefits that, if recognized, would affect the effective tax rate and $429,000 of unrecognized tax benefits that, if recognized, would not affect the effective tax rate. During the year ended December 31, 2007, the Company recognized approximately $20,000 in interest expense. At December 31, 2007, the Company had approximately $40,000 of interest accrued for potential income tax exposures and $729,000 of unrecognized tax benefits that, if recognized, would affect the effective tax rate. During the year ended December 31, 2008, the Company recognized approximately $127,000 in interest expense and $91,000 of penalty. At December 31, 2008, the Company had approximately $167,000 of interest and $91,000 of penalty accrued for potential income tax exposures and $2.1 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate.
On January 3, 2003, the Company purchased Big Foot Financial Corp. As a result of the acquisition, the Company had various unrecognized tax benefits related to the acquisition. These unrecognized tax benefits were recognized in the first quarter of 2007, when the statute of limitations for IRS audit of the final short period return closed. These unrecognized tax benefits, totaling $429,000, were credited to a core deposit intangible created at the acquisition.
The Company is currently being audited by the Illinois Department of Revenue for the years 2003 through 2005. Thus it anticipates that it is reasonably possible within twelve months of December 31, 2008, that significant changes in the balance of the unrecognized tax benefit of up to $1.4 million may occur as a result of settlement of the Illinois income tax audit. The primary issue under exam is fully reserved for and relates to the exclusion from taxable income of interest on certain state-qualified U.S. obligations. The Company does not anticipate any adjustments that would result in a significant change to its financial position. An IRS audit for the years 2002 to 2005 was completed during the second quarter of 2007 and there were no changes made to the reported tax amounts for those years. Years that remain subject to examination include Federal from 2006 to present, Illinois from 2003 to present, 2005 to present for Indiana, and 2005 to present for Federal and Illinois for various acquired entities.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 23 -
Earnings Per Share
(1)
No dilutive shares from stock options or restricted stock were included in the computation of diluted earnings per share for any period there was a loss.
Options to purchase 379,371 shares at a weighted average exercise price of $14.28 and 117,750 shares at $20.56 were not included in the computation of diluted earnings per share for the years ended December 31, 2008 and 2007, respectively, because the options’ exercise price was greater than the average market price of the common stock and the options were, therefore, anti-dilutive. The warrant to purchase 4,282,020 shares at an exercise price of $2.97 was not included in the computation of diluted earnings per share because the warrant’s exercise price was greater than the average market price of common stock and was, therefore, anti-dilutive. The dilutive effect of the 609,901 shares of restricted stock was not included because of the anti-dilutive effect for the year ended December 31, 2008. Because of the anti-dilutive effect, the shares that would be issued if the Series A noncumulative redeemable convertible perpetual preferred stock were converted are not included in the computation of diluted earnings per share for the years ended December 31, 2008 and 2007.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 24 -
Other Comprehensive Income
Changes in other comprehensive income or loss components and related taxes are as follows:
MIDWEST BANC HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 25 -
Parent Company Financial Statements
The following are condensed balance sheets and statements of operations and cash flows for the Company, without subsidiaries:
CONDENSED BALANCE SHEETS
CONDENSED STATEMENTS OF OPERATIONS
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note 26 -
Quarterly Results of Operations (Unaudited)
Certain infrequent items are reflected in the quarterly results of 2008. The Company recognized a non-cash, non-operating, other-than-temporary impairment charge of $47.8 million at September 30, 2008 on certain FNMA and FHLMC preferred equity securities similar to the impairment charge of $17.6 million taken in the first quarter of 2008. In September 2008, the Company sold a portion of its FNMA and FHLMC preferred equity securities recognizing a $16.7 million loss. The income tax benefits related to the first and third quarter 2008 losses on FNMA and FHLMC securities were appropriately recognized as capital losses in those periods. As a result of subsequent law changes, $16.6 million in tax benefits were recognized in the fourth quarter of 2008 for losses reported in the third quarter of 2008.
During the third and fourth quarters of 2008, the Company recorded $42.0 million and $20.0 million in loan loss provision, respectively, reflecting management’s updated assessments of impaired loans and concerns about the continued deterioration of economic conditions. The Company also recognized an impairment charge of $80.0 million on its goodwill intangible asset during the third quarter of 2008 based upon an appraisal by an independent third party. During the first quarter of 2008, the Company incurred a $7.1 million loss on the early extinguishment of debt arising from the prepayment of $130.0 million in FHLB advances and recognized a $15.2 million gain on the sale of real estate.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(a)
Earnings per share for the quarters and fiscal years have been calculated separately. Accordingly, quarterly amounts may not add to the annual amounts because of differences in the average common shares outstanding during each period.
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors of Midwest Banc Holdings, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Midwest Banc Holdings, Inc. and its subsidiaries at December 31, 2008 and December 31, 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, 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 these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PRICEWATERHOUSECOOPERS LLP
Chicago, Illinois
March 11, 2009