ITEM 1. BUSINESS:
General
Farmers & Merchants Bancorp, Inc. (Company) is a bank holding company incorporated under the laws of Ohio in 1985. Our primary subsidiary, The Farmers & Merchants State Bank (Bank) is a community bank operating in Northwest Ohio since 1897. Our only other subsidiary, Farmers & Merchants Life Insurance Company, a reinsurance company for life, accident and health insurance for the Bank’s consumer credits, was formed in 1992. Farmers & Merchants Life Insurance Company was dissolved during 2007. We report our financial condition and net income on a consolidated basis and we report only one segment.
Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is (419) 446-2501.
For a discussion of the general development of the Company’s business throughout 2009, please see the portion of Management’s Discussion and Analysis of Financial Condition and Results of Operations captioned “2009 in Review”.
Nature Of Activities
The Farmers & Merchants State Bank engages in general commercial banking and savings business. Our activities include commercial, agricultural and residential mortgage, consumer, and credit card lending activities. Because our Bank’s offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of our loan portfolio is comprised of loans made to customers in the farming industry for such things as farm land, farm equipment, livestock and general operation loans for seed, fertilizer, feed, etc. Other types of lending activities include loans for home improvements, and loans for such items as autos, trucks, recreational vehicles, motorcycles, etc.
We also provide checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, ATM’s (automated teller machines) are also provided at our Ohio offices in Archbold, Wauseon, Stryker, West Unity, Bryan, Delta, Napoleon, Montpelier, Swanton, Defiance, and Perrysburg, along with ones at our Auburn and Angola, Indiana offices. Two ATM’s are located at Sauder Woodworking Co., Inc., a major employer in Archbold. Additional locations in Ohio are at Northwest State Community College, Archbold; Community Hospitals of Williams County, Bryan; Fairlawn Haven Wyse Commons, Archbold; R&H Restaurant, Fayette; Delta Eagles, Bryan Eagles; Sauder Village, Archbold; Fulton County Health Center, Wauseon; downtown Defiance; and a mobile trailer ATM. In Indiana, four additional ATM’s are located at St. Joe; at Kaiser’s Supermarket and Therma-Tru in Butler; and at DeKalb Memorial Hospital in Auburn.
Farmers & Merchants Life Insurance Company was established to provide services to our customers through the issuance of life and disability insurance policies. Our Bank’s lending officers were the selling agents of the policies to customers. The activities of Farmers & Merchants Life Insurance Co. were not significant to the consolidated company. The Company dissolved the Farmers & Merchants Life Insurance Company subsidiary as the Bank discontinued offering the credit life, accident and health insurance to its customers. The Bank continues to offer credit insurance related products to our residential real estate customers; however, it is through an unrelated third party vendor.
F&M Investment Services, the brokerage department of the Bank, opened for business in April, 1999. Securities are offered through Raymond James Financial Services, Inc.
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions, and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations.
The bank is participating in the expanded FDIC limits through all of 2013 and utilizing the additional insurance coverage provided in the Temporary Liquidity Guarantee Program through June 2010. The FDIC increased the insurance level for deposits from $100,000 to $250,000 on interest bearing accounts and unlimited FDIC insurance on non-interest bearing accounts. We believe the cost for this coverage is offset by the benefit to our depositors.
The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Henry, Williams, and Wood. The commercial banking business in this market is highly competitive, with approximately 17 other depository institutions currently doing business in the Bank’s primary market. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities. In a number of our locations, we compete against entities which are much larger than us. The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided. On December 31, 2007, the Bank acquired the Knisely Bank of Indiana, expanding its market with the addition of offices in Butler and Auburn, Indiana, both located in DeKalb County. An additional office was opened in the summer of 2008 in Angola, Indiana, located in Steuben County.
At December 31, 2009, we had 251 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which are contributory. We consider our employee relations to be excellent.
Supervision and Regulation
General
The Company is a corporation organized under the laws of the State of Ohio. The business in which the Company and its subsidiary are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities. The supervision, regulation and examination to which the Company and its subsidiary are subject are intended primarily for the protection of depositors and the deposit insurance funds that insure the deposits of banks, rather than for the protection of shareholders.
Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Company and its subsidiary are subject are discussed below, along with certain regulatory matters concerning the Company and its subsidiary. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and its subsidiary.
Regulatory Agencies
The Company is a registered bank holding company and is subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) pursuant to the Bank Holding Company Act of 1956, as amended.
The Bank is an Ohio chartered commercial bank. It is subject to regulation and examination by both the Ohio Division of Financial Institutions (ODFI) and the Federal Deposit Insurance Corporation (FDIC).
Holding Company Activities
As a bank holding company incorporated and doing business within the State of Ohio, the Company is subject to regulation and supervision under the Bank Holding Act of 1956, as amended (the “Act”). The Company is required to file with the Federal Reserve Board on a quarterly basis information pursuant to the Act. The Federal Reserve Board may conduct examinations or inspections of the Company and its subsidiary.
The Company is required to obtain prior approval from the Federal Reserve Board for the acquisition of more than five percent of the voting shares or substantially all of the assets of any bank or bank holding company. In addition, the Company is generally prohibited by the Act from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. The Company may, however, subject to the prior approval of the Federal Reserve Board, engage in, or acquire shares of companies engaged in activities which are deemed by the Federal Reserve Board by order or by regulation to be so closely related to banking or managing and controlling a bank as to be a proper activity.
On November 12, 1999, the Gramm-Leach-Bliley Act (the “GLB Act”) was enacted into law. The GLB Act made sweeping changes with respect to the permissible financial services which various types of financial institutions may now provide. The Glass-Steagall Act, which had generally prevented banks from affiliation with securities and insurance firms, was repealed. Pursuant to the GLB Act, bank holding companies may elect to become a “financial holding company,” provided that all of the depository institution subsidiaries of the bank holding company are “well capitalized” and “well managed” under applicable regulatory standards.
Under the GLB Act, a bank holding company that has elected to become a financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. Activities that are “financial in nature” include securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking, and activities that the Federal Reserve Board has determined to be closely related to banking. No Federal Reserve Board approval is required for the Company to acquire a company, other than a bank holding company, bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Prior Federal Reserve Board approval is required before the Company may acquire the beneficial ownership or control of more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association. If any subsidiary bank of the Company ceases to be “well capitalized” or “well managed” under applicable regulatory standards, the Federal Reserve Board may, among other actions, order the Company to divest the subsidiary bank. Alternatively, the Company may elect to conform its activities to those permissible for a bank holding company that is not also a financial holding company. If any subsidiary bank of the Company receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, the Company will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations. The Company has not elected to become a financial holding company and has no current intention of making such an election.
Affiliate Transactions
Various governmental requirements, including Sections 23A and 23B of the Federal Reserve Act, limit borrowings by holding companies and non-bank subsidiaries from affiliated insured depository institutions, and also limit various other transactions between holding companies and their non-bank subsidiaries, on the one hand, and their affiliated insured depository institutions on the other. Section 23A of the Federal Reserve Act also generally requires that an insured depository institution’s loan to its non-bank affiliates be secured, and Section 23B of the Federal Reserve Act generally requires that an insured depository institution’s transactions with its non-bank affiliates be on arms-length terms.
Interstate Banking and Branching
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act (“Riegle-Neal”), subject to certain concentration limits and other requirements, adequately capitalized bank holding companies such as the Company are permitted to acquire banks and bank holding companies located in any state. Any bank that is a subsidiary of a bank holding company is permitted to receive deposits, renew time deposits, close loans, service loans and receive loan payments as an agent for any other bank subsidiary of that bank holding company. Banks are permitted to acquire branch offices outside their home states by merging with out-of-state banks, purchasing branches in other states and establishing de novo branch offices in other states. The ability of banks to acquire branch offices is contingent, however, on the host state having adopted legislation “opting in” to those provisions of Riegle-Neal. In addition, the ability of a bank to merge with a bank located in another state is contingent on the host state not having adopted legislation “opting out” of that provision of Riegle-Neal. The Company could from time to time use Riegle-Neal to acquire banks in additional states.
Control Acquisitions
The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under the rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, a company is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of outstanding voting stock of a bank holding company, or otherwise obtaining control or a “controlling influence” over that bank holding company.
Liability for Banking Subsidiaries
Under the current Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to maintain resources adequate to support each subsidiary bank. This support may be required at times when the bank holding company may not have the resources to provide it. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a U.S. federal bank regulatory agency to maintain the capital of a subsidiary bank would be assumed by the bankruptcy trustee and entitled to priority of payment. Any depository institution insured by the FDIC can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC in connection with (1) the “default” of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to both a commonly controlled FDIC-insured depository institution “in danger of default.” The Company’s subsidiary bank is an FDIC-insured depository institution. If a default occurred with respect to the Bank, any capital loans to the Bank from its parent holding company would be subordinate in right of payment to payment of the Bank’s depositors and certain of its other obligations.
Regulatory Capital Requirements
The Company is required by the various regulatory authorities to maintain certain capital levels. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. The required capital levels and the Company’s capital position at December 31, 2009 are summarized in the table included in Note 14 to the consolidated financial statements.
FDICIA
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), and the regulations promulgated under FDICIA, among other things, established five capital categories for insured depository institutions-well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized-and requires U.S. federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements based on these categories. Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on certain other aspects of its operations. An undercapitalized bank must develop a capital restoration plan and its parent bank holding company must guarantee the bank’s compliance with the plan up to the lesser of 5% of the banks or thrift’s assets at the time it became undercapitalized and the amount needed to comply with the plan. As of December 31, 2009, the Company’s banking subsidiary was well capitalized pursuant to these prompt corrective action guidelines.
Dividend Restrictions
The ability of the Company to obtain funds for the payment of dividends and for other cash requirements will be largely dependent on the amount of dividends which may be declared by its banking subsidiary. Various U.S. federal statutory provisions limit the amount of dividends the Company’s banking subsidiaries can pay to the Company without regulatory approval. Dividend payments by the Bank are limited to its retained earnings during the current year and its prior two years. See Note 15 to the consolidated financial statements for the actual amount.
Deposit Insurance Assessments
The deposits of the Company’s banking subsidiary are insured up to regulatory limits by the FDIC, and, accordingly, are subject to deposit insurance assessments based on the Federal Deposit Insurance Reform Act of 2005, as adopted and took effect on April 21, 2006.
The Emergency Economic Stabilization Act of 2008 provided a temporary increase in deposit insurance coverage from $100,000 to $250,000 per depositor. This legislation was effective immediately upon the President’s signature on October 3, 2008. The basic deposit insurance limit was set to return to $100,000 on January 1, 2010, however, at this time, the date has been extended to December 31, 2013.
Depositor Preference Statute
In the “liquidation or other resolution” of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.
Government Monetary Policy
The earnings of the Company are affected primarily by general economic conditions and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve. Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company’s subsidiary Bank.
Capital Purchase Program
In response to the financial crisis affecting the banking system and financial markets, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law on October 3, 2008 creating the Troubled Assets Relief Program (“TARP”). As part of TARP, the U.S. Treasury established the Capital Purchase Program to provide up to $700 billion of funding to eligible financial institutions through the purchase of capital stock and other financial institutions for the purpose of stabilizing and providing liquidity to the United States financial markets. The Company did not participate in the TARP Capital Purchase Program. In connection with the EESA, there have been numerous actions by the Federal Reserve Board, the United States Congress, the U.S. Treasury, the FDIC, the SEC and others to further the economic and banking industry stabilization efforts under the EESA. It remains unclear at this time what further legislative and regulatory measures will be implemented under the EESA that affect the Company.
Additional Regulation
The Bank is also subject to federal regulation as to such matters as required reserves, limitation as to the nature and amount of its loans and investments, regulatory approval of any merger or consolidation, issuance or retirement of their own securities, limitations upon the payment of dividends and other aspects of banking operations. In addition, the activities and operations of the Bank are subject to a number of additional detailed, complex and sometimes overlapping laws and regulations. These include state usury and consumer credit laws, state laws relating to fiduciaries, the Federal Truth-in-Lending Act and Regulation Z, the Federal Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the Electronic Funds Transfer Act and Regulation E, the Truth in Savings Act and Regulation DD, the Bank Secrecy Act, the Community Reinvestment Act, HUD’s RESPA regulations, anti-discrimination laws and legislation, and antitrust laws.
Future Legislation
Changes to the laws and regulations, both at the federal and state levels, can affect the operating environment of the Company and its subsidiary in substantial and unpredictable ways. The Company cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Company or its subsidiary.
Available Information:
The Company maintains an Internet web site at the following internet address: www.fm-bank.com. The Company files reports with the Securities and Exchange Commission (SEC). Copies of all filings made with the SEC may be read and copied at the SEC’s Public Reference Room, 450 Fifth Street, Washington, DC, 20549. You may obtain information about the SEC’s Public Reference Room by calling (800/SEC-0330). Because the Company makes its filing with the SEC electronically, you may access such reports at the SEC’s website, www.sec.gov. The Company makes available, free of charge through its internet address, copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports as soon as reasonable practicable after such materials have been filed with or furnished to the SEC. Copies of these documents may also be obtained, either in electronic or paper form, by contacting Barbara J. Britenriker, Chief Financial Officer of the Company at (419) 446-2501.
Please see the Consolidated Financial Statements provided under Part II, Item 8 of this Form 10-K for information regarding the Company’s revenues from external customers, profits, and total assets for and as of, respectively, the fiscal year ended December 31, 2009.
ITEM 1A.
ITEM 1A. RISK FACTORS
Significant Competition from an Array of Financial Service Providers
Our ability to achieve strong financial performance and a satisfactory return on investment to shareholders will depend in part on our ability to expand our available financial services. In addition to the challenge of attracting and retaining customers for traditional banking services, our competitors now include securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies who seek to offer one-stop financial services to their customers that may include services that banks have not been able or allowed to offer to their customers in the past. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial services providers. If we fail to adequately address each of the competitive pressures in the banking industry, our financial condition and results of operations could be adversely affected.
Credit Risk
The risk of nonpayment of loans is inherent in commercial banking. Such nonpayment could have an adverse effect on the Company’s earnings and our overall financial condition as well as the value of our common stock. Management attempts to reduce the Bank’s credit exposure by carefully monitoring the concentration of its loans within specific industries and through loan application and approval procedures. However, there can be no assurance that such monitoring and procedures will reduce such lending risks. Credit losses can cause insolvency and failure of a financial institution and, in such event, its shareholders could lose their entire investment. For more information on the exposure of the Company and the Bank to credit risk, see the section under Part II, Item 7 of this Form 10-K captioned “Loan Portfolio.”
Susceptibility to Changes in Regulation
Any changes to state and federal banking laws and regulations may negatively impact our ability to expand services and to increase the value of our business. We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations. These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. In addition, the Company’s earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve. These policies, which include regulating the national supply of bank reserves and bank credit, can have a major effect upon the source and cost of funds and the rates of return earned on loans and investments. The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits. The Gramm-Leach-Bliley Act regarding financial modernization that became effective in November, 1999 removed many of the barriers to the integration of the banking, securities and insurance industries and is likely to increase the competitive pressures upon the Bank. We cannot predict what effect such Act and any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, but such changes could be materially adverse to our financial performance. For more information on this subject, see the section under Part I, Item 1 of this Form 10-K captioned “Supervision and Regulation.”
Interest Rate Risk
Changes in interest rates affect our operating performance and financial condition in diverse ways. Our profitability depends in substantial part on our “net interest spread,” which is the difference between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Historically, net interest spreads for other financial institutions have widened and narrowed in response to these and
other factors, which are often collectively referred to as “interest rate risk.” Over the last few years, the Bank, along with most other financial institutions, has experienced a “margin squeeze” as drastic interest rate fluctuations have made it difficult to maintain a more favorable net interest spread. During 2009, the Bank was able to improve its margin and spread slightly as the rate environment remained low and flat. Maturities of higher rate deposits aided the decrease in cost of funds.
The Bank manages interest rate risk within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitability may be adversely affected. For more information regarding the Company’s exposure to interest rate risk, see Part II, Item 7A of this Form 10-K.
Attraction and Retention of Key Personnel
Our success depends upon the continued service of our senior management team and upon our ability to attract and retain qualified financial services personnel. Competition for qualified employees is intense. In our experience, it can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out our strategy. If we lose the services of our key personnel, or are unable to attract additional qualified personnel, our business, financial condition, results of operations and cash flows could be materially adversely affected.
A key component of employee retention is providing a fair compensation base combined with the opportunity for additional compensation for above average performance. In this regard, the Company and the Bank use two incentive programs. The Company uses a stock award program to recognize and incent officers of the Bank. Under the long-term incentive compensation plan, restricted stock awards may be granted to officers. The amount of shares to be granted each year is determined by the Board Compensation Committee and may vary each year in its amount of shares and the number of recipients. The Compensation Committee determines the number of shares to be awarded overall and to the Chief Executive Officer (“CEO”). The CEO then makes recommendations to the committee as to the recipients of the remaining shares. The full Board of Directors approves the action of the Committee. Since the plan’s inception in 2005, all granted stock awards have utilized a three year cliff vesting feature. This is viewed as a retention aid as the awards may be forfeited should an officer leave employment during the vested period.
A second incentive program of the Bank is based on cash compensation of which almost all employees participate (excluding commission based employees and other employees paid for specific higher paid positions, such as peak time.) A discussion of executive officer pay is incorporated within the proxy and as such, this discussion will pertain to all other employees. Non-officer employees are paid a cash incentive based on the projected overall performance of the Bank in terms of Return of Average Assets (“ROA”). The Compensation Committee determines the target performance levels on which the percentage of pay will be based. The Committee takes into account the five and ten year trend of ROA along with budget forecasted for the next year and the Bank’s past year performance. The Committee also considers the predicted banking environment under which the Bank will be operating. Non-officers receive incentive pay in December of the same year based on the year-to-date base compensation through the last pay received in November.
Officers, other than executive, receive incentive pay based on additional criterion. The officers are rewarded based on overall ROA of the Bank along with individual pre-established goals. Officers, therefore, have incentive pay at risk for individual performance. The individualized goals are recommended by each officer’s supervisor and are approved by an incentive committee of the Bank. The goals are designed to improve the performance of the Bank while also limiting the risk of a short-term performance focus. For example, a lending officer may be given two goals of which one is to grow loans within specific targets and another is tied to a specific level of past dues and charge-offs. The second goal limits the ability to be rewarded for growth at all costs along with the specific target levels within the growth goal itself. Officers in a support
department may be given goals which create efficiencies, ensure compliance with procedures, or generate new fee or product opportunities. An average of four goals were given to each officer in 2009. Officers are paid cash incentives based on the year end ROA of the Bank and receive it within the first quarter of the following year. Should the ROA be forecasted to be positive but below the base target set by the Board, the officers are paid an incentive under the same basis and timing as non-officers disclosed above.
The percentages of base pay on which the incentive is calculated graduates higher as does the responsibility level of the employee and their ability to impact the financial performance of the Bank. These percentages are recommended by management to the Compensation Committee and Board for approval. The cash incentive plan along with its targets and goals are subject to modification at the Compensation Committee and Board’s discretion throughout each year.
Dividend Payout Restrictions
We currently pay a quarterly dividend on our common shares. However, there is no assurance that we will be able to pay dividends in the future. Dividends are subject to determination and declaration by our board of directors, which takes into account many factors. The declaration of dividends by us on our common stock is subject to the discretion of our board and to applicable state and federal regulatory limitations. The Company’s ability to pay dividends on its common stock depends on its receipt of dividends from the Bank. The Bank is subject to restrictions and limitations in the amount and timing of the dividends it may pay to the Company.
Anti-Takeover Provisions
Provisions of our Articles of Incorporation and Ohio law could have the effect of discouraging takeover attempts which certain stockholders might deem to be in their interest. These anti-takeover provisions may make us a less attractive target for a takeover bid or merger, potentially depriving shareholders of an opportunity to sell their shares of common stock at a premium over prevailing market prices as a result of a takeover bid or merger.
Operational Risks
We are subject to certain operational risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.
Limited Trading Market
Our common stock is not listed on any exchange or The NASDAQ Stock Market. Our stock is currently quoted in the over-the-counter markets.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our principal office is located in Archbold, Ohio.
The Bank operates from the facilities at 307 North Defiance Street. In addition, the Bank owns the property from 200 to 208 Ditto Street, Archbold, Ohio, which it uses for Bank parking and a community mini-park area. The Bank owns real estate at two locations, 207 Ditto Street and 209 Ditto Street in Archbold, Ohio upon which the bank built a commercial building to be used for storage, and a parking lot for company vehicles and employee parking. The Bank also owns real estate across from the main facilities to provide for parking.
The Bank occupies an Operations Center at 622 Clydes Way in Archbold, Ohio to accommodate our growth over the years. The bank owns a parking lot in downtown Montpelier which had been provided for customer use. The bank owns a property at 204 Washington Street, St Joe, Indiana at which an ATM is located.
The Bank owns all of its office locations, with the exception of Angola, Indiana. The Angola office location is leased. Current locations of retail banking services are:
All but one of of the above locations have drive-up service facilities and an ATM.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no material pending legal proceedings, other than ordinary routine proceedings incidental to the business of the Bank or the Company, to which we are a party or of which any of our properties are the subject.
PART II.
ITEM 4.
ITEM 4. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is not listed on the NASDAQ stock market or any other stock exchange. While there is no established public trading market for our common stock, our shares are currently dually-quoted by various market makers on the Pink Sheets and the Over the Counter Bulletin Board, which are both over-the-counter quotation services for participant broker-dealers.
There are market makers that set a price for our stock; however, private sales continue to occur. The high and low sale prices were from sales of which we have been made aware by researching daily on Bloomberg.com. The high and low sale prices known to our management are as follows:
The Company utilizes Registrar and Transfer Company as its transfer agent.
As of January 27, 2010 there were 2,052 record holders of our common stock.
Below is a line-graph presentation comparing the cumulative total shareholder returns for the Corporation, an index for NASDAQ Stock Market (U.S. Companies) comprised of all domestic common shares traded on the NASDAQ National Market System and the NASDAQ Bank Index for the five-year period ended December 31, 2009. The chart compares the value of $100 invested in the Corporation and each of the indices and assumes investment on December 31, 2004 with all dividends reinvested.
The Board of Directors recognizes that the market price of stock is influenced by many factors, only one of which is performance. The stock price performance shown on the graph is not necessarily indicative of future performance.
Year 2004 as the Base
Dividends are declared and paid quarterly. Per share dividends declared for the years ended 2009 and 2008 are as follows:
The ability of the Company to pay dividends is limited by the dividend that the Company receives from the Bank. The Bank may pay as dividends to the Company its retained earnings during the current year and its prior two years. Currently, such limitation on the payment of dividends from the Bank to the Company does not materially restrict the Company’s ability to pay dividends to its shareholders.
Dividends declared during 2009 were $0.72 per share totaling $3.41 million, 5.88 percent higher than 2008 declared dividends of $0.68 per share. During 2009, the Company purchased 28,907 shares and awarded 10,000 restricted shares to 49 employees under its long term incentive plan. 350 shares were forfeited during 2009. At year end 2009, the Company held 437,551 shares in Treasury stock and 27,775 in unearned stock awards. The Company purchased 171,889 shares throughout 2008. 10,000 shares were awarded to 51 employees in 2008. 245 restricted shares were forfeited during 2008. At December 31, 2008, the Company held 418,294 shares in Treasury stock and 23,575 in unearned stock awards. The Company continues to have a strong capital base and to maintain regulatory capital ratios that are significantly above the defined regulatory capital ratios. On December 18, 2009, the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 200,000 shares of its outstanding common stock commencing January 1, 2010 and ending December 31, 2010.
ISSUER PURCHASES OF EQUITY SECURITIES
Reclassification
Certain amounts in the 2008 and 2007 consolidated financial statements have been reclassified to conform with the 2009 presentation.
SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA
Summary of Consolidated Statement of Income - UNAUDITED
*
Based on weighted average number of shares outstanding
ITEM 6.
ITEM 6.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Critical Accounting Policy and Estimates
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires Management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event.
All significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the notes to the consolidated financial statements and in the management discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates and judgments underlying those amounts, management has identified the determination of the Allowance for Loan and Lease Losses (ALLL) and the valuation of its Mortgage Servicing Rights as the accounting areas that requires the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.
The ALLL represents management’s estimate of credit losses inherent in the Bank’s loan portfolio at the report date. The estimate is a composite of a variety of factors including past experience, collateral value, and the general economy. ALLL includes a specific portion, a formula driven portion, and a general nonspecific portion. The collection and ultimate recovery of the book value of the collateral, in most cases, is beyond our control.
The Company is also required to estimate the value of its Mortgage Servicing Rights. The Company recognizes as separate assets rights to service fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee. Mortgage servicing assets are initially recorded at cost, based upon pricing multiples as determined by the purchaser, when the loans are sold. Mortgage servicing assets are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income using the level yield method. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. The valuation is completed by an independent third party.
The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.
For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.
2009 in Review
2009 proved to be a tough year in which businesses had to operate. This was especially true in banking as negative press continued throughout the year and all banks were painted with the same brush. Increased FDIC assessments along with a special mid-year assessment impacted the bottom line with over $1.2 million additional expense recorded for 2009 as compared to 2008. This increased level of cost is forecasted to continue as the Bank has prepaid over $3.5 million for the next three years. While funds were available for the prepayment, it still represents a cost in terms of lost opportunity for earnings on the $3.5 million.
The Bank was not hit with the cost of failures in just our own industry, but rather from almost all industries as charge-offs and watch list loans increased also. Much of our lenders’ time was spent working delinquencies and the one bright spot of the low rate environment, refinancing mortgages. Fortunately, many of our customers were able to refinance their mortgages to lower rates and payments even though their house values had declined. The financial impact of both these scenarios will be further discussed in the material changes in operations to follow.
The Bank launched a new product offering in March 2008: Reward Checking. The product is a free checking account which pays a high rate of interest to customers who agree to three qualifications each statement cycle. The three qualifications enable the Bank to deliver the high interest rate as they create efficiencies or increase non-interest revenue to the Bank. As will be shown later, the success of this product grew throughout 2009 and is the reason for the increase in interest bearing liabilities. It has been extremely well received by customers and embraced by the Bank’s employees. It has exceeded expectations at this point and continues to be the product of choice for a new checking customer. At year end 2009, it had the highest balance at over $49 million within the business and consumer checking portfolio. The Bank looks forward to further development of the product line in 2010 with the introduction of KASASA™. KASASA is the first national brand of the most innovative checking accounts available today. KASASA is a new word that was created to capture consumers’ attention and awaken them to a new way of banking. These accounts are designed to be the first and only accounts that actually take an interest in their accountholders by paying them to use their account with what interests them most. More discussion will be focused on this product with the tables to follow.
The Company is proud of its results for 2009. Increased regulatory demands and high unemployment in the communities we serve impacted the level of profitability; however, the Company has remained in the black throughout the year. Using the Bank Holding Company and Uniform Bank Performance Report compiled by the Federal Reserve system as a reference, the Company was seven times more profitable than its national peer and the Bank twice its peers as of end of third quarter 2009.
Material Changes in Results of Operations
The discussion now turns to more financial based results and trends as a result of 2009 operations. In comparing line items of the consolidated statement of income for years ended 2007 through 2009, it is easily seen where the Company has been spending its time and the impact of the recession. Decreasing interest income and expense are obvious large factors on the profitability of the Company for 2009; however, that discussion can be found in the net interest income section. This discussion will focus on the significant non-interest items that impacted the operations of the Company.
Looking at the positive items first; overall, non-interest income shows a trend of improvement. A modest improvement of $94 thousand in 2008 over 2007 was followed by a more significant gain of over $1.3 million in 2009 as compared to 2008. Accounting for over $1 million of the gain was the revenue generated from mortgage loan activity through establishing mortgage servicing rights and gain on the sale of loans into the secondary market. As mentioned earlier, our loan officers and supporting departments were very busy in 2009 handling refinance activity for mortgages. It was a much needed, but unexpected source of increased revenue.
The second largest increase to non-interest income was derived from increased debit card usage. As the Bank receives interchange revenue from each “swipe” of the card, usage increased thereby increasing revenue over $126.5 thousand in 2009 over 2008. 2008’s increase was $218.5 thousand over 2007. Both increases are attributed to the growth and popularity of the Bank’s Reward checking product. One of the criteria for the payment of high interest on the account is utilizing the debit card at least twelve times per statement cycle. The Bank’s Reward Checking customers average 25 transactions per statement, surpassing the 9 transactions average of our Free Checking customers. The additional revenue from debit card usage offsets the interest expense, creating a win-win situation for the customers and the Bank. In 2010, this revenue stream will be further enhanced with the addition of KASASA. All of the KASASA products will have a debit card usage qualification; however, interest income will not be the customer win for all accounts. Customers may choose to receive credit towards iTunes downloads or donate earnings to charity.
One additional non-interest income item to mention is overdraft and return check fee income. This revenue source decreased 6.5%, or $176 thousand, during 2009 even though the number of checking accounts increased 4.16% and the portfolio year end balance was $23.6 million higher in 2009 than 2008. Overdraft fees had been higher in 2008 than in 2007; however 2008’s income fee was lower than in 2007. 2008 was higher due to the volume of checking accounts added from the Knisely acquisition. The average overdraft fee paid per account was $6.77 less in 2008 than in 2007. This revenue source is under intense regulatory review and proposed changes are predicted to decrease this line item by as much as 30% in 2010.
Service charge income remained virtually unchanged from 2008 even with the increase in accounts. Most of the new accounts added either don’t have service fee charges and/or the balances are high enough to offset any charges. Both the OD and return check and service charge income from checking accounts are included in the customer service fees line item on the income statement.
Lastly, the Bank was able to take advantage of the ability to book some gains on the sale of securities. This opportunity presented itself in the first and last quarter of 2009. The Bank did not sacrifice long term profitability for short term gains as the yields of the portfolio were not negatively impacted by the sales. The discussion on causes for changes to yields follows in the interest section. The Bank did recognize a loss of just over $50 thousand on an equity security of a Banker’s Bank. The entity had been taken over by the FDIC with its assets and deposits being bought by another financial institution.
Overall, non-interest expense increased 8.6% or $1.8 million in 2009 over 2008. This has proved to be an increasing trend as 2008 was 13.9% over 2007, or $2.6 million higher. The causes behind the increases; however, are different. The largest factor behind the 2009 increase was FDIC assessment, which was broken out as its own line item on the statement of income due to its significance. Of the $1.8 million increase in 2009 non-interest expense, $1.2 million is attributed to the cost of FDIC insurance.
Also mentioned previously was the mortgage refinancing activity of 2009. A correlating expense to that activity is the amortization of mortgage servicing rights. The income was discussed previously; the amortization is the offset to the income recognized. This increase occurred in both 2008 and 2009. Income is recorded when the mortgage loan is first sold with servicing retained and is therefore recognized within one year. The amortization, however, is calculated over the life of the loan and accelerated when paid off early. An increase in this expense can be driven by two activities: an increase in the number of sold loans and/or by the acceleration of the expense from payoff and refinance activity. The best picture of the bottom line impact is achieved by netting the income with the expense each year. 2007 had net income from mortgage servicing rights of $95 thousand, 2008 had net income of $77 thousand, and 2009 had net income of $225 thousand. Of course, the value (or income) of the mortgage servicing right when sold also impacts the net position. The reason for 2009’s larger net position is due to the increase in the number of loans being serviced; thereby new rights are being established without having been offset by accelerated expense. This is evidenced by the year end number of loans and balances being up significantly. As of December 31 of each year, there were 3,571 loans serviced with outstanding balances of $267.8 million for 2009, 3,190 loans with balances of $233.9 million for 2008, and 3,178 loans with balances of $235.2 million for 2007. Returning to the expense only portion, expense for 2009 was $563 thousand higher than
expense for 2008 and $676 thousand higher than 2007. As seen above, the increased expense was offset by a higher increase in income.
During the first part of 2009, some of the Bank’s lending officers were also very busy in auto loan financing. This activity was spurred by government and auto manufacturer incentives along with large banks exiting the market in the first half of the year. The consumer loan portfolio grew by 26%, or almost $6 million. This increased activity offset the increased salary expense as deferred costs from these loans are recorded as a deduction to the salary expense when the loans are made. While salaries and wages decreased in 2009 as compared to 2008, it was this component that made it possible. Base salary expense increased just over $400 thousand with the deferred costs offsetting with a $50 thousand increase for 2009. In 2008, as compared to 2007, base salary increased by $835 thousand, but was offset by a $98 thousand increase in deferred costs. The increases in base salary have been driven by additional offices being opened and increase in revenue generating positions, such as additional staff in the Bank’s financial planning division.
Employee benefits ended 2009 at $185 less than (or basically even) 2008’s and again it was for different reasons than the fluctuation of $214 thousand between 2008 and 2007. Employees group insurance costs were up $224 for 2009 over 2008 and 2008 costs were $51 thousand lower than 2007. The Bank is partially self-insured and fluctuations to costs are therefore caused by fluctuations in claims made by employees. In 2008, the Bank offered a Health Savings Account (HSA) option, along with offering its traditional medical plans. 70% of employees chose the HSA high deductible plan. Both options were available in 2009 and the decision was made to implement the HSA plan only bank-wide for 2010. The increase in medical expense was offset by a decrease of $201.5 thousand in miscellaneous personnel expense and in the BOLI retirement expense for 2009 as compared to 2008. Miscellaneous personnel expense includes such items as employee outings and the use of employment and executive search agencies. Bank Owned Life Insurance (BOLI) retirement expense represents the yearly cost to fund the liability of post retirement officers upon which the Bank has an insurance policy of which the Bank is the beneficiary. The total of these two expenses increased $216 thousand in 2008 as compared to 2007 and as stated previously was opposite of the movement in 2009 as compared to 2008.
Occupancy expense increased $84 thousand over 2008 with the largest impact stemming from the costs associated with holding Other Real Estate Owned (OREO). The balance in OREO increased from $426.7 thousand as of December 31, 2008 to $1.4 million as of December 31, 2009. The largest expense increase in occupancy was real estate taxes, which was driven by the additional holding of OREO and had increased $82.9 thousand. The larger increase of $465 thousand in occupancy expense in 2008 over 2007 was based on the increase in the number of offices and a decrease in the amount of building rent received from the Bank’s brokerage division, FM Investments. The building rent received in 2009 was just 2% higher than in 2008, therefore it was not a factor in the increase for 2009.
As is often the case, an increase in technology costs is offset by efficiencies or cost savings found elsewhere on the statements of income. During 2008, the increase in furniture and equipment was caused by the increase in the number of offices and a new telephone system. The phone system utilizes the Bank’s wide area data network, or VOIP (Voice Over Internet Protocol). The depreciation cost of which is offset by a reduction in long distance and line usage. In 2009, the increase in the furniture and equipment line item of $61 thousand over 2008 comes mainly from an increase in the expense of maintenance contracts. The majority of software utilized by the Bank includes an annual maintenance cost. This cost accounts for over 85% of the line item increase. It is an area that is closely monitored; however, not easily contained. Generally, to have additional revenue generated or expense decreased from new efficiencies, an additional expense will be incurred in furniture and equipment.
A positive reduction in data processing expense of $98 thousand occurred in 2009. This decrease is not attributable to just one vendor, but rather a negotiation with multiple vendors. This reduction is hoped to begin a trend of declining costs as the Bank plans to switch service providers in February 2010 at a cost savings. The pricing on many services, however, is based on number of accounts and the Bank fully expects those to increase with the KASASA additions and an improving economy.
It was mentioned earlier that much of the lenders’ time was spent on mortgage refinancing and collections. The collection expense is included in the general and administrative expense. The collection expense increase of $92 thousand in 2008 as compared to 2007 has been followed by an additional $251 thousand increase in 2009 over 2008. A more positive comparison is the reduction by just under $74 thousand in 2009 of the expense associated with miscellaneous NSF (non-sufficient funds) and return checks. 2008 had seen an increase of $137 thousand over 2007 in this area where often the issue stems from fraudulent activity attempted on our customer accounts. This is often a reflection of a tough economy and the Bank worked hard to educate our customers and create an awareness to stop the losses. There are always a few that slip through the cracks but it is a credit to the Bank’s front line personnel that a decrease to the expense took place.
The largest cost increase to the Bank in 2009 was the Provision for Loan Losses. A tough economic environment existed for most businesses in our primary market area during 2007 through 2009. In 2009, the provision expense was $1.8 million higher than 2008 and $2.7 million over 2007. Gross charge-offs were $3.3 million for 2009, as compared to 2008’s $2.6 million and 2007’s $1.6 million. Recoveries were $242, $348, and $732 thousand for 2009, 2008, and 2007, respectively. Unfortunately, 2009 had the highest charge-off and lowest recovery amounts, making the net charge-offs the highest at $3 million. 2008 had a net charge-off position of $2.2 million and 2007 had a position of less than $1 million. 2008 was impacted by mostly agricultural business and 2009 activity was mainly commercial driven. Further analysis by loan type is presented in the discussion of the allowance for credit losses.
Overall, the Company is proud to have another solid, positive year of performance during tough times. The Bank remains well capitalized and focused on how best to weather the economic climate. Some positive signs are beginning to show in our markets; however, the heavy burden of regulation is not easily overcome. FDIC assessments will be a way of life for the next three years. The Company forecasts moderate expansion while seeking opportunities to improve earnings and lower costs.
Net Interest Income
The net interest margin improved during 2009 as the Bank was able to adjust the majority of its deposit liabilities by a larger percentage down than which the loans were pricing down. A decrease occurred in both interest income and interest expense for the second straight year, however, the $4.2 million decrease in deposit interest expense alone outpaced the $2.7 million decrease in all interest income. Net interest income was $2.2 million higher than 2008 and 2008 was $2.0 million higher than 2007. As a percentage, net interest income was 17.7% higher than 2007, while the average balance on earning assets was only 5% higher for the same time period.
The following table presents net interest income, interest spread and net interest margin for the three years 2007 through 2009, comparing average outstanding balances of earning assets and interest bearing liabilities with the associated interest income and expense. The table also shows their corresponding average rates of interest earned and paid. The tax-exempt asset yields have been tax affected to reflect a marginal corporate tax rate of 34%. Average outstanding loan balances include non-performing loans and mortgage loans held for sale. Average outstanding security balances are computed based on carrying values including unrealized gains and losses on available-for-sale securities.
As the charts indicate, the Company experienced significant increased growth on an average basis for year 2008 compared to 2007 at 9.54%. 2009 had an increase of average assets of 3.13%. Interest earning assets average balance increased during all periods. The biggest component of the interest earning assets was loans. The decrease on yields is more pronounced on the other earning assets. Specifically, the largest fluctuation is in short-term funds, Federal Funds Sold. In 2007, the yield on Federal Funds was 4.67%, 2008 was 2.90%, and in 2009 it was 0.38%.
While the loan portfolio size has remained fairly constant in 2009, the yield, or income, generated has decreased for the second straight year. This is due to the low interest rate environment, with the lending prime rate within 26 basis points of the Company’s net interest spread. Spread is the difference between what the Company earns on its assets and pays on its liabilities. It is on this spread that the Company must fund its operations and generate profit. When the asset yield decreases, so must the cost of funds to maintain profitability. It becomes increasingly challenging as the asset yield gets closer to the prime lending rate, or the break-even point, of operations. To mitigate the low rate environment, the Bank placed rate floors on most variable loans during 2009, which were typically 125 basis points over the current prime rate. This protected the Bank during a flat rate environment. The challenge will come when rates start to rise and the Bank will be affected by the index spreads also placed on the loans. An increased prime rate will not directly correlate to an increased yield on loans.
Overall, the tax equivalent yield on interest earning assets decreased to 5.52% for 2009 compared to 6.03% and 6.81% for 2008 and 2007 respectively. The percentage of interest earning assets to total assets increased slightly in 2009 over 2008 and remained above 90% at a respectable 93.55% for 2009.
As stated previously, the decreased yield on the assets was fortunately outpaced by the decreased cost of funds. The average balances for interest bearing liabilities increased only $17.4 million compared to 2008 and $83.5 million as compared to 2007. While the balance increased, the costs on those funds were significantly lower. The average cost for 2009 was 2.00% compared to 2008’s 2.82% and 2007’s 3.77%. The balances in non-interest bearing liabilities also increased during the last three years.
As with the yields on assets, the largest fluctuation in the cost of funds is in the shorter term liabilities, savings deposits. The cost on savings decreased 66% while on time deposits the cost decreased 38%. The Bank has focused on increasing its core deposit base to lessen the dependency on higher cost time deposits. The Bank has also attempted to increase the duration of the time deposits; however, customers have maintained a short-term, twelve month focus.
As stated previously, the charts show the improvement of the net interest margin from 2008 to 2009. A slight tightening occurred during 2008. Net interest spread increased 17 basis points during 2008 and 30 basis points during 2009. Net interest margin dropped 2 basis points in 2008 compared to 2007 and a 19 basis point increase from 2008 to 2009. Competition played a major role in the pressure applied on these margins along with the fluctuating rate environment and the slope of the yield curve during 2007 through 2009. The ability to grow loans was directly impacted by the ability to aggressively price the loans and finding borrowers wishing to borrow. The continued decrease in the prime lending rate and deterioration of the economy made any improvement in interest income very difficult. The two biggest factors in the decrease of interest expense in the liabilities were the volume of other time deposits that re-priced to a significantly lower rate during 2008 and 2009 and the large drop in the Federal Funds rate which directly impacted the Federal funds purchased and securities sold under agreement to repurchase. The acquisition had a major impact on the average balances in 2008 as compared to 2007.
The yield on Tax-Exempt investments securities shown in the following charts were computed on a tax equivalent basis. The yield on Loans has been tax adjusted for the portion of tax-exempt IDB loans included in the total. Total Interest Earning Assets is therefore also reflecting a tax equivalent yield in both line items, also with the Net Interest Spread and Margin. The adjustments were based on a 34% tax rate.
(1)
For purposes of these computations, non-accruing loans are included in the daily average outstanding loan amounts.
The primary source of the Company’s traditional banking revenue is net interest income. Net interest income is the difference between interest income on interest earning assets, such as loans and securities, and interest expense on liabilities used to fund those assets, such as interest bearing deposits and other borrowings. Net interest income is affected by changes in both interest rates and the amount and composition of earning assets and liabilities. The change in net interest income is most often measured as a result of two statistics - interest spread and net interest margin. The difference between the yields on earning assets and the rates paid for interest bearing liabilities supporting those funds represents the interest spread. Because non-interest bearing sources of funds such as demand deposits and stockholders’ equity also support earning assets, the net interest margin exceeds the interest spread.
The following tables show changes in interest income, interest expense and net interest resulting from changes in volume and rate variances for major categories of earnings assets and interest bearing liabilities.
Interest rates began to drop at the end of third quarter 2007 and continued that course throughout 2008. With the increase in average balances during 2008, the significant increase in interest was to be expected due to change in volume. The difference in the two comparisons is the amount of change due to interest rates remaining low through the two periods. What did remain the same in the two comparisons is that the change in interest expense outpaced the change in interest income. In the early part of 2007, the Bank employed a strategy to keep time deposit “specials” to shorter terms (12 to 15 months). As rates continued to decline in 2008 and remain low throughout 2009, this strategy accomplished its goal of significantly lowering the cost of time deposits during 2008 and 2009. The strategy currently is to extend the maturities of “specials” to over 24 months to prepare for rising rates. The other strategy employed during 2008 and 2009 was to increase core deposits by offering innovative products focused on customer needs: higher interest rates. In exchange for a high interest-bearing checking account, customers were asked to utilize services that benefited both the Bank and themselves. Smaller time deposit rate shoppers had an option to perhaps change their behavior of banking or those deposits were allowed to run off. The new core deposit products were indeed embraced by our customers and have helped to reach the deposit portfolio mix the Bank was after. The improved net interest margin played a large role in offsetting the increased operating costs of credit.
Allowance for Credit Losses
The Company segregates its Allowance for Loan and Lease Losses (ALLL) into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).
The ACL increased during 2009 as compared to 2008 as net charge-offs and past due loans had increased during 2009. The increase takes into account the high level of nonaccruals and watch list loans and the extended time period it may involve for resolution. $3.3 million in loans were charged off in 2009 compared to $2.6 million for 2008 and $1.6 million for 2007. The Company increased the allowance for credit losses for 2007 as $301 thousand of the increase was the allowance that came across from the acquisition. The allowance stands at $6.2 million for 2009 compared to $5.7 million for 2008 and $6.1 million for 2007. Provision expense was up $1.8 million for 2009 and $916 thousand for 2008, bringing the total expense to $3.6 million for 2009 compared to $1.8 million for 2008 and $871 thousand for 2007. The AULC remained almost equal to 2008, ending at $156 thousand for 2007, increased to $225 thousand for 2008, and ended 2009 at $227 thousand. Historical factors along with current economic conditions are part of the calculation to determine the adequacy of the allowance.
Non-interest Income
Non-interest income of $7.8 million is an increase of $982 thousand over 2008, while 2008 and 2007 were within $94 thousand of each other at $6.5 and $6.4 million, respectively. The largest fluctuations in non-interest income were impacted with the residential mortgage loan activity and sale of securities. Both of these were opportunities created from the low interest rate environment and may not be repeated in 2010.
Non-interest Expense
The increase of $1.8 million in non-interest expense for 2009 as compared to 2008 was mainly the increased FDIC assessment cost of $1.2 million and the $563 thousand of mortgage servicing rights amortization. The FDIC is a result of funding the insurance reserve for the increased number of failed banks the last two years and this cost will continue for the next few years to come. The mortgage servicing rights amortization came from the same residential mortgage activity as did the income; however, it was limited to the refinancing portion.
The difference in 2008 and 2007 was for entirely different reasons. Salaries and wages increased in 2008 as compared to 2007. Full time equivalent numbers of employees for December 2008 compared to September 2007 increased by seventeen with the addition of new offices. The incentive paid based on performance for
2008 was lower than 2007 as the overall performance of the Bank was lower. Employee benefits were lower as the Bank’s cost for medical insurance decreased during 2008 with lower claims and 401(k) expense was lower due to performance. This impact was discussed earlier.
Federal Income Taxes
Effective tax rates were 27.26%, 26.71%, and 26.78%, for 2009, 2008, and 2007, respectively. The effect of tax-exempt interest from holding tax-exempt securities and Industrial Development Bonds (IDBs) was $629, $654, and $650 thousand for 2009, 2008, and 2007, respectively.
Financial Condition
Average earning assets increased $21.4 million during 2009 over 2008 and were higher by $83.2 million as compared to 2007. The main cause of fluctuation was caused by the acquisition and repositioning the balance sheet. Average interest bearing liabilities increased $17.4 million over 2008 and $83.5 million from 2007. The increase in 2009 over 2008 was due to the success of the Reward Checking product to attract funds into the savings deposit bucket. The increase in 2008 over 2007 was from the acquisition and to fund the increase in loans.
Securities
Security balances as of December 31 are summarized below:
The following table sets forth (dollars in thousands) the maturities of investment securities as of December 31, 2009 and the weighted average yields of such securities calculated on the basis of cost and effective yields weighted for the scheduled maturity of each security. Tax-equivalent adjustments, using a thirty-four percent rate have been made in yields on obligations of state and political subdivisions. Stocks of domestic corporations have not been included.
As of December 31, 2009 the Bank did not hold a large block of any one investment security, except for U.S. Government agencies. The Bank also holds stock in the Federal Home Loan Bank of Cincinnati at a cost of $4.2 million. This is required in order to obtain Federal Home Loan Bank Loans. The Bank also acquired stock in the Federal Home Loan Bank of Indianapolis at a cost of $231.4 thousand and Banker’s Bancorp, Inc at a cost of $50.8 thousand through its acquisition of Knisely Bank. There were no borrowings at the time of acquisition associated with Federal Home Loan Bank of Indianapolis. The value of the stock in Banker’s Bancorp, Inc was written down to zero at the end of 2009 as the institution was taken over by its regulators. The Bank also owns stock of Farmer Mac with a carrying value of $27.4 thousand which is required to participate loans in the program.
Loan Portfolio
The Bank’s various loan portfolios are subject to varying levels of credit risk. Management mitigates these risks through portfolio diversification and through standardization of lending policies and procedures.
The following table shows the Bank’s loan portfolio by category of loan as of December 31st of each year, including loans held for sale:
The following table shows the maturity of loans as of December 31, 2009:
The following table presents the total of loans due after one year which has 1) predetermined interest rates and 2) floating or adjustable interest rates:
The following table summarizes the Company’s non-accrual and past due loans as of December 31 for each of the last five years:
Although loans may be classified as non-performing, some pay on a regular basis, many continue to pay interest irregularly or at less than original contractual rates. Interest income that would have been recorded under the original terms of these loans was $2.0 million for 2009, $1.4 for 2008, and $313 thousand for 2007. Any collections of interest on non-accrual loans are included in interest income when collected unless it is on an impaired loan with a specific allocation. A collection of interest on an impaired loan with a specific allocation is applied to the loan balance to decrease the allocation needed. Total interest collections amounted to $290 thousand for 2009, $332 thousand for 2008, and $161 thousand for 2007. $6 thousand of interest collected in 2009 was applied to reduce the specific allocations, $20 thousand of interest collected in 2008 was applied to reduce the specific allocations, and $40 thousand of the interest collected in 2007 was applied to reduce the specific allocations for 2007.
Loans are placed on non-accrual status in the event that the loan is in past due status for more than 90 days or payment in full of principal and interest is not expected. The $14.1 million of non-accrual loans as of
December 31, 2009 are secured. The loss of interest of $2 million on these non-accruals has significantly impacted the yield on loans.
As of December 31, 2009 the Bank has $25.6 million of loans which it considers to be potential problem loans in that the borrowers are experiencing financial difficulties. These loans are subject to constant management attention and are reviewed at least monthly.
The amount of the potential problem loans was considered in management’s review of the loan loss reserve required at December 31, 2009.
In extending credit to families, businesses and governments, banks accept a measure of risk against which an allowance for possible loan loss is established by way of expense charges to earnings. This expense, used to enlarge a bank’s allowance for loan losses, is determined by management based on a detailed monthly review of the risk factors affecting the loan portfolio, including general economic conditions, changes in the portfolio mix, past due loan-loss experience and the financial condition of the bank’s borrowers.
As of December 31, 2009, the Bank had loans outstanding to individuals and firms engaged in the various fields of agriculture in the amount of $59.8 million with an additional $41 million in agricultural real estate loans. The ratio of this segment of loans to the total loan portfolio is not considered unusual for a bank engaged in and servicing rural communities.
ALLL is evaluated based on an assessment of the losses inherent in the loan portfolio. This assessment results in an allowance consisting of two components, allocated and unallocated.
Management considers several different risk assessments in determining ALLL. The allocated component of ALLL reflects expected losses resulting from an analysis of individual loans, developed through specific credit allocations for individual loans and historical loss experience for each loan category. For those loans where the internal credit rating is at or below a predetermined classification and management can reasonably estimate the loss that will be sustained based upon collateral, the borrowers operating activity and economic conditions in which the borrower operates, a specific allocation is made. For those borrowers that are not currently behind in their payment, but for which management believes based on economic conditions and operating activities of the borrower, the possibility exists for future collection problems, a reserve is established. The amount of reserve allocated to each loan portfolio is based on past loss experiences and the different levels of risk within each loan portfolio. The historical loan loss portion is determined using a historical loss analysis by loan category.
The unallocated portion of the reserve for loan losses is determined based on management’s assessment of general economic conditions as well as specific economic factors in the Bank’s marketing area. This assessment inherently involves a higher degree of uncertainty. It represents estimated inherent but undetected losses within the portfolio that are probable due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition and other current risk factors that may not have yet manifested themselves in the Bank’s historical loss factors used to determine the allocated component of the allowance.
Actual charge-off of loan balances is based upon periodic evaluations of the loan portfolio by management. These evaluations consider several factors, including, but not limited to, general economic conditions, financial condition of the borrower, and collateral.
As presented below, charge-offs increased to $3.3 million for 2009, and the provision was $3.6 million. An additional $301 thousand is showing in the provision line for 2007 which represents ALLL that was carried over from the acquisition. The Commercial and Industrial portfolio was the only segment in a net recovery for 2008 and 2007, however it had the largest net charge-off position in 2009. The negative provision of 2005 was necessary to decrease the allowance because of the overall decrease of the loan portfolio and the improved asset quality position. The decrease in the total allowance for credit losses for 2006 was due to the continued improvement in the asset quality position and reassessment of the risk existent in the
unfunded loan commitments. The improvement in the ratio of net charge offs to average loans outstanding is evidence of the improved asset quality during that period. The increase in net charge-offs and past due loans along with the loan growth were the reasons for the increase in the ALLL for 2007. The decrease in the ALLL for 2008 was due to the large level of charge-offs taken. With the charge-offs going higher in 2009, it became prudent to increase the ALLL for 2009. The increase provides for the high level of non-accrual and watch list loans and recognizes the extended time period with which it has taken to achieve resolution and/or collection of these loans.
The following table presents a reconciliation of the allowance for credit losses:
Allocation of ALLL per Loan Category in terms of dollars and percentage of loans in each category to total loans is as follows:
Deposits
The amount of outstanding time certificates of deposits and other time deposits in amounts of $100,000 or more by maturity as of December 31, 2009 are as follows:
The following table presents the average amount of and average rate paid on each deposit category:
Liquidity
Maintaining sufficient funds to meet depositor and borrower needs on a daily basis continues to be among our management’s top priorities. This is accomplished not only by the immediately liquid resources of cash, due from banks and federal funds sold, but also by the Bank’s available for sale securities portfolio. The average aggregate balance of these assets was $216 million for 2009, compared to $220 million for 2008, and $196 million for 2007. This represented 26.3 percent, 28.0 percent, and 26.9 percent of total average assets, respectively. Of the almost $208 million of debt securities in the company’s portfolio as of December 31, 2009, $51 million or 24.6 percent of the portfolio is expected to mature in 2010. Taking into consideration possible calls of the debt securities, the amount climbs to $104.2 million or 50.3 percent of the portfolio becomes a source of funds. The availability of the funds may be reduced by the need to utilize securities for pledging purposes on public deposits. This liquidity provides the opportunity to fund loan growth without having to over aggressively price deposits.
Historically, the primary source of liquidity has been core deposits that include non-interest bearing and interest bearing demand deposits, savings, money market accounts and time deposits of individuals. Core deposits increased as of year end balances in 2009, in all categories. Overall deposits increased an average of $29.3 million during 2009 compared to 2008’s increase over 2007 of $53.4 million in average deposits. These represent changes of 4.8 percent and 9.5 percent in average total deposits, respectively. The Bank also utilized Federal Funds purchased at times during 2009. The average balance for 2009 was $5 thousand.
Again, historically, the primary use of new funds is placing the funds back into the community through loans for the acquisition of new homes, consumer products and for business development. The use of new funds for loans is measured by the loan to deposit ratio. The Company’s average loan to deposit ratio for 2009 was 85.95 percent, 2008 was 87.81percent, and 2007 was 88.82 percent. The lower ratio in 2009 was due to the success of the deposit gathering function and the residential mortgage loans being sold in the secondary market. The lower ratio in 2008 is due to the lower loan to deposit ratio of the acquisition and utilizing excess funds to grow loans. 2007 represented the increased loan growth outpacing deposit growth. The Company’s goal is for this ratio to be higher with loan growth the driver; however, this was difficult to achieve in 2009 with borrowers taking a conservative approach to increasing their liabilities.
Short-term debt such as federal funds purchased and securities sold under agreement to repurchase also provides the Company with liquidity. Short-term debt for both federal funds purchased and securities sold under agreement to repurchase amounted to $43.3 million at the end of 2009 compared to $48.2 million at the end of 2008 and to $41.3 million at the end of 2007. Though no federal funds were purchased at year end, the Bank does have arrangements with correspondent Banks that can be utilized when necessary. Following is a table showing the daily securities sold under agreement to repurchase activity for 2009, 2008, and 2007. These accounts are used to provide a sweep product to the Bank’s commercial customers. The decrease in balances during 2009 was due to business’ discontinuing the sweep as the cost of fees were higher than the interest benefit on lower balance accounts. These funds may return in the future when short-term rates increase.
Other borrowings are also a source of funds. Other borrowings consist of loans from the Federal Home Loan Bank of Cincinnati. These funds are then used to provide fixed rate mortgage loans secured by homes in our community. Borrowings from this source decreased by $11.4 million to $34.2 million at December 31, 2009. This compares to increased borrowings during 2008 of $13.8 million to $45.6 million at December 31, 2008 and increased borrowings during 2007 of $8.6 million to $31.8 million to end at December 31, 2007. The increased borrowings in 2008 and 2007 were used to fund loan growth and were a cheaper source of funds than certificate of deposits. The decreased borrowings were payoffs of matured notes in 2009. Sufficient funds were available to fund growth so new advances were not needed in 2009.
Asset/Liability Management
The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities. It involves the management of the balance sheet mix, maturities, re-pricing characteristics and pricing components to provide an adequate and stable net interest margin with an acceptable level of risk. Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates.
Changes in net income, other than those related to volume arise when interest rates on assets re-price in a time frame or interest rate environment that is different from that of the re-pricing period for liabilities. Changes in net interest income also arise from changes in the mix of interest-earning assets and interest-bearing liabilities.
Historically, the Bank has maintained liquidity through cash flows generated in the normal course of business, loan repayments, maturing earning assets, the acquisition of new deposits, and borrowings. The Bank’s asset and liability management program is designed to maximize net interest income over the long term while taking into consideration both credit and interest rate risk. Interest rate sensitivity varies with different types of interest-earning assets and interest-bearing liabilities. Overnight federal funds on which rates change daily and loans that are tied to the market rate differ considerably from long-term investment securities and fixed rate loans. Similarly, time deposits over $100,000 and money market certificates are much more interest rate sensitive than passbook savings accounts. The Bank utilizes shock analysis to examine the amount of exposure an instant rate change of 100, 200, and 300 basis points in both increasing and decreasing directions would have on the financials. Acceptable ranges of earnings and equity at risk are established and decisions are made to maintain those levels based on the shock results.
Impact of Inflation And Changing Prices
The consolidated financial statements and notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Unlike most industrial companies, nearly all the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and service.
Contractual Obligations
Contractual Obligations of the Company totaled $405.3 million as of December 31, 2009. Time deposits represent contractual agreements for certificates of deposits held by its customers. Long term debt represents the borrowings with the Federal Home Loan Bank and is further defined in Note 4 and 9 of the Consolidated Financial Statements.
Capital Resources
Stockholders’ equity was $93.6 million as of December 31, 2009 compared to $90.5 million at December 31, 2008. Dividends declared during 2009 were $0.72 per share totaling $3.41 million, 5.88 percent higher than 2008’s declared dividends of $0.68 per share. During 2009, the Company purchased 28,907 shares and awarded 10,000 restricted shares to 49 employees under its long term incentive plan. 350 shares were forfeited during 2009. At year end 2009, the Company held 437,551 shares in Treasury stock and 27,775 in unearned stock awards. The Company purchased 171,889 shares throughout 2008. 10,000 shares were awarded to 51 employees in 2008. 245 restricted shares were forfeited during 2008. At December 31, 2008, the Company held 418,294 shares in Treasury stock and 23,575 in unearned stock awards. The Company continues to have a strong capital base and to maintain regulatory capital ratios that are significantly above the defined regulatory capital ratios. On December 18, 2009, the Company announced the authorization by its Board of Directors for the Company’s repurchase, either on the open market, or in privately negotiated transactions, of up to 200,000 shares of its outstanding common stock commencing January 01, 2010 and ending December 31, 2010.
At December 31, 2009, The Farmers & Merchants State Bank and Farmers & Merchants Bancorp, Inc had total risk-based capital ratios of 14.10% and 14.14%, respectively. Core capital to risk-based asset ratios of 10.85% and 13.19% are well in excess of regulatory guidelines. The Bank’s leverage ratio of 8.5% is also substantially in excess of regulatory guidelines as is the Company’s at 10.3%.
The Company’s subsidiaries are restricted by regulations from making dividend distributions in excess of certain prescribed amounts.
ITEM 6A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk
Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which we are subject is interest rate risk. The majority of our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading such as loans, available for sale securities, interest bearing deposits, short term borrowings and long term borrowings. Interest rate risk occurs when interest bearing assets and liabilities reprice at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.
Interest rate risk is managed within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates. Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities
management strategies are unsuccessful, our profitability may be adversely affected. The Company employs a sensitivity analysis utilizing interest rate shocks to help in this analysis.
The shocks presented below assume an immediate change of rate in the percentages and directions shown:
The shock chart currently shows a tightening in net interest margin over the next twelve months in a rising rate environment. It shows expansion of net interest margin should rates fall. Both directional changes are well within risk exposure guidelines. The effect of the rate shocks may be mitigated to the extent that not all lines of business are directly tied to an external index.
ITEM 7.
ITEM 7. FINANCIAL STATEMENTS
Index To Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheet at December 31, 2009 and 2008
Consolidated Statements of Income for the years ended December 31, 2009, 2008 and 2007
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2009, 2008 and 2007
Consolidated Statements of Cash Flow for the years ended December 31, 2009, 2008 and 2007
Notes to Consolidated Financial Statements
Plante & Moran, PLLC
SUITE 600
65 E. State St.
Columbus, OH 43215
Tel: 614.849.3000
Fax: 614.221.3535
plantemoran.com
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders
Farmers & Merchants Bancorp, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Farmers & Merchants Bancorp, Inc. and Subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2009. We also have audited the Company’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 the accompanying financial statements. Our responsibility is to express an opinion on these financial statements and an opinion on the company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the 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 (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Farmers & Merchants Bancorp, Inc. and Subsidiaries as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Farmers & Merchants Bancorp, Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
February 24, 2010
Columbus, Ohio
Farmers & Merchants Bancorp, Inc and Subsidiaries
See Notes to Consolidated Financial Statements
Farmers & Merchants Bancorp, Inc and Subsidiaries
See Notes to Consolidated Financial Statements
Farmers & Merchants Bancorp, Inc. and Subsidiaries
See notes to Consolidated Financial Statements
Farmers & Merchants Bancorp, Inc and Subsidiaries
See Notes to Consolidated Financial Statements
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 1 - Summary of Significant Accounting Policies
Nature of Operations
The Farmers & Merchants Bancorp, Inc. (the Company) through its bank subsidiary, The Farmers & Merchants State Bank (the Bank) provides a variety of financial services to individuals and small businesses through its offices in Northwest Ohio and Northeast Indiana.
Consolidation Policy
The consolidated financial statements include the accounts of Farmers & Merchants Bancorp, Inc. and its wholly-owned subsidiaries, The Farmers & Merchants State Bank (the Bank), a commercial banking institution, and the Farmers & Merchants Life Insurance Company, a reinsurance company for life, accident and health insurance for the Bank’s consumer credits. The Farmers & Merchants Life Insurance Company was dissolved during 2007 with the Bank no longer offering the insurance product to its non-residential real estate consumers. The Bank continues to offer credit insurance related products to our residential real estate customers; however, it is through an unrelated third party vendor. All significant inter-company balances and transactions have been eliminated.
Use of 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 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. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of mortgage servicing rights. Actual results could differ from those estimates.
The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral.
The Bank’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions in the agricultural industry.
While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.
Cash and Cash Equivalents
For purposes of the consolidated statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. This includes cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are purchased and sold for one day periods.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 1 - Summary of Significant Accounting Policies (Continued)
Restrictions on Cash and Amounts Due from Banks
The Bank is required to maintain average balances on hand with the Federal Reserve Bank. The aggregate reserve was $4.0 million for December 31, 2009 and it was $3.0 million for December 31, 2008.
The Company and its subsidiaries maintain cash balances with high quality credit institutions. At times such balances may be in excess of the federally insured limits.
Securities
Debt securities are classified as available-for-sale. Securities available-for-sale are carried at fair value with unrealized gains and losses reported in other comprehensive income. Realized gains and losses on securities available for sale are included in other income (expense) and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income. Gains and losses on sales of securities are determined on the specific-identification method.
Declines in the fair value of securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment 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. The related write-downs are included in earnings as realized losses.
Other Securities
Other Securities consists of Federal Home Loan Bank of Cincinnati and Indianapolis stock, Bankers Bank stock, and Farmer Mac stock. These stocks are carried at cost and are held to enable the Bank to conduct business with the entities. The Federal Home Loan Banks sell and purchase their stock at par; therefore cost approximates market value. The Federal Home Loan Bank of Cincinnati stock is held as collateral security for all indebtedness of the Bank to the Federal Home Loan Bank.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at the amount of unpaid principal, reduced by unearned discounts and deferred loan fees and costs, as well as, by the allowance for loan losses. Interest income is accrued on a daily basis based on the principal outstanding.
Generally, a loan is classified as nonaccrual and the accrual of interest income is generally discontinued when a loan becomes ninety days past due as to principal or interest and these loans are placed on a “cash basis” for purposes of income recognition. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to cover the principal and accrued interest, and the loan is in the process of collection. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest receivable is charged against income.
Loan origination and commitment fees and certain direct loan origination costs are deferred and amortized as a net adjustment to the related loan’s yield. The Bank is generally amortizing these costs over the contractual life of such loans.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 1 - Summary of Significant Accounting Policies (Continued)
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses charged to income. Loans deemed to be uncollectable and changes in the allowance relating to loans are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based on management’s periodic review of the collectability of the loans in light of historical experiences, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are subject to revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. The unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and agricultural loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer loans for impairment disclosures.
Loans Held for Sale
Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 1 - Summary of Significant Accounting Policies (Continued)
Servicing Assets
Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest expense in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in operating income as loan payments are received. Costs of servicing loans are charged to expense as incurred.
Goodwill and other Intangible Assets
Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified.
Other intangible assets consist of core deposit intangible assets arising from business acquisitions. They are initially measured at fair value and then are amortized on a straight line method over their estimated useful lives.
Off Balance Sheet Instruments
In the ordinary course of business, the Bank has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.
Bank Premises and Equipment
Land is carried at cost. Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is based on the estimated useful lives of the various properties and is computed using straight line and accelerated methods. Costs for maintenance and repairs are charged to operations as incurred. Gains and losses on dispositions are included in current operations.
Federal Income Tax
Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the various temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
Earnings Per Share
Basic earnings per share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Basic and dilutive earnings per share are the same as the restricted stock grants are primarily anti-dilutive.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 1 - Summary of Significant Accounting Policies (Continued)
Comprehensive Income
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet. Such items, along with net income, are components of comprehensive income.
The components of other comprehensive income and related tax effects are as follows:
Other securities, not classified as available for sale, had a realized loss of $51 thousand for 2009 and a $15 thousand gain in 2008. Those amounts are not included in the above table.
Post Retirement Liability
In September 2006, the accounting for deferred compensation and postretirement benefit aspects of endorsement split-dollar life insurance arrangements was changed. Effective in 2008, liability and related compensation costs are recognized for endorsement split-dollar life insurance policies that provide a benefit to an employee extending to postretirement periods. This accounting pronouncement was applied as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of January 01, 2008 approximating $152,000.
Reclassification
Certain amounts in the 2008 and 2007 consolidated financial statements have been reclassified to conform with the 2009 presentation.
Note 2 - Business Combination
On December 31, 2007, the Bank acquired 100% of the outstanding shares of Knisely Bank. Knisely Bank was merged with and into the Bank, and the Knisely Bank offices now operate as branches of the Bank. The merger enabled the Company to increase its market share in a community contiguous to its existing markets.
The aggregate acquisition cost of Knisely Bank was $10.4 million, which was all paid in cash. Direct acquisition costs approximated $222 thousand. The acquisition cost in excess of the net assets and identifiable intangible assets acquired, has been recorded as goodwill of $4 million. Goodwill that is deductible for tax purposes is approximately $3.85 million.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 2 - Business Combination (Continued)
In connection with the acquisition, the Company recognized core deposit intangible assets of $1.1 million, which are being amortized on a straight line basis over the estimated remaining economic useful life of the deposits of 7 years. There was no amortization of the core deposit intangibles for the year ended December 31, 2007, but $157,000 was amortized in 2008 and 2009. Amortization of the core deposit intangibles remaining is scheduled to be as follows:
Note 3 - Securities
The amortized cost and fair value of securities, with gross unrealized gains and losses, follows:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 3 - Securities (Continued)
Information pertaining to securities with gross unrealized losses at December 31, 2009 and 2008, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:
Unrealized losses on securities have not been recognized into income because the issuers’ bonds are of high credit quality, the Bank has the intent and ability to hold the securities for the foreseeable future, and the decline in fair value is primarily due to increased market interest rates. The fair value is expected to recover as the bonds approach the maturity date.
The gross realized gains and losses for the years ended December 31, are presented below:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 3 - Securities (Continued)
The amortized cost and fair value of debt securities at December 31, 2009, by contractual maturity, 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.
Investments with a carrying value and fair value of $167.3 million at December 31, 2009 and $155.9 million at December 31, 2008 were pledged to secure public deposits and securities sold under repurchase agreements.
Other securities include Federal Home Loan Bank of Cincinnati and Indianapolis stock, Bankers Bank stock, and Farmer Mac stock. Bankers Bank was written down to a carrying value of zero in December 2009 at a loss of $51 thousand.
Note 4 - Loans
Loans at December 31 are summarized below:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 4 - Loans (Continued)
The following is a maturity schedule by major category of loans:
The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of December 31, 2009:
As of December 31, 2009, one to four family residential mortgage loans amounting to $73.1 million and $72.1 million, respectively, have been pledged as security for loans the Bank has received from the Federal Home Loan Bank.
The following is an analysis of the allowance for credit losses:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 4 - Loans (Continued)
The Company segregates its Allowance for Loan and Lease Losses (ALLL) into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).
The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses.
The following is a summary of information pertaining to impaired loans:
No additional funds are committed to be advanced in connection with impaired loans.
Note 5 - Premises and Equipment
The major categories of banking premises and equipment and accumulated depreciation at December 31 are summarized below:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 6 - Servicing
Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of loans serviced for others were $267 and $251 million at December 31, 2009 and 2008, respectively.
The balance of capitalized servicing rights included in other assets at December 31, 2009 and 2008, was $2.2 and $2.0 million, respectively. The capitalized addition of servicing rights is included in net gain on sale of loans on the consolidated statement of income. The capitalized additions are as shown in the table following.
The fair market value of the capitalized servicing rights as of December 31, 2009 and 2008 was $3.0 million and $2.7 million, respectively. The valuations were completed by stratifying the loans into like groups based on loan type, term and new versus seasoned. Impairment was measured by estimating the fair value of each stratum, taking into consideration an estimated level of prepayment based upon current market conditions. An average constant prepayment rate of 11.3 and 7.7 were utilized for 2009 and 2008, respectively. All stratums showed positive values compared to carrying value using a discount yield of 7.75% for 2009 and 8.0% for 2008.
The following summarizes mortgage servicing rights capitalized and amortized during each year:
Note 7 - Deposits
Time deposits at December 31 consist of the following:
At December 31, 2009 the scheduled maturities for time deposits are as follows:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 8 - Securities Sold Under Agreement to Repurchase
The Bank’s policy requires qualifying securities to be used as collateral for the underlying repurchase agreements. As of December 31, 2009 and 2008 securities with a book value of $55.9 million and $58.5 million, respectively, were underlying the repurchase agreements and were under the Bank’s control.
Note 9 - Federal Home Loan Bank Advances
Long term debt consists of various loans from the Federal Home Loan Bank. Repayment structures vary, ranging from monthly installments, annual payments or upon maturity. Interest payments are due monthly with interest rates on the loans varying from 2.70% to 7.05%. Total borrowings were $34.1 million and $45.6 million for 2009 and 2008, respectively. Notes are secured by a blanket lien on the one to four family residential mortgage loan portfolios (Note 4).
The following is a schedule by years of future minimum principal payments:
Note 10 - Federal Income Taxes
The components of income tax expense for the years ended December 31 are as follows:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 10 - Federal Income Taxes (Continued)
The following is a reconciliation of the statutory federal income tax rate to the effective tax rate:
Deferred tax assets and liabilities at December 31 are comprised of the following:
Note 11 - Employee Benefit Plan
The Bank has established a 401(k) profit sharing plan, which allows eligible employees to save at a minimum one percent of eligible compensation on a pre-tax basis, subject to certain Internal Revenue Service limitations. The Bank will match 50% of employee 401(k) contributions up to four percent of total eligible compensation. In addition, the Bank may make a discretionary contribution from time to time. A participant is 100% vested in the participant’s deferral contributions and employer matching contributions. A six-year vesting schedule applies to employer discretionary contributions. Contributions to the 401(k) profit sharing plan for both the employer matching contribution and the discretionary contribution were $570, $524, and $575 thousand for 2009, 2008 and 2007, respectively.
The Company has a Long-Term Stock Incentive Plan under which 10,000 shares of restricted stock were issued to 49 and 51 employees during 2009 and 2008, respectively. 8,760 shares were issued to 46 employees during 2007. Under the plan, the shares vest 100% in three years. Due to employee termination, there were 350 and 245 shares forfeited during 2009 and 2008, respectively, 740 shares forfeited during 2007. During 2009, 5,450 shares awarded in 2006 were vested 100%. 36 employees were still employed and received the stock. During 2007, 600 shares had vesting accelerated and were paid to a retiring officer. Compensation expense applicable to the restricted stock totaled $190, $155, and $104 thousand for the year ending December 31, 2009, 2008 and 2007, respectively.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 12 - Related Party Transactions
In the ordinary course of business, the Bank has granted loans to senior officers and directors and their affiliated companies amounting to $9.5 and $11.3 million at December 31, 2009 and 2008, respectively. Loans made during 2009 were $67 thousand and repayments were $1.8 million. The difference in related borrowings amounted to $7.6 million, net reduction. Deposits of directors, executive officers and companies in which they have a direct or indirect ownership as of December 31, 2009 and 2008 amounted to $2.4 million and $4.8 million, respectively.
There was one director added to the Board during 2009. In 2008, one director retired from the Board and one was appointed. An executive officer was hired also during the year of 2008.
Note 13 - Off Balance Sheet Activities
Credit Related Financial Instruments
The Bank is a party to credit related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing need of its customer. These financial instruments include commitments to extend credit, Standby Letters of Credit, and Commercial Letters of Credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance-sheet instruments. The allowance for credit losses as it relates to unfunded loan commitments (AULC) is included under other liabilities. The AULC as of December 31, 2009 and 2008 was $227 thousand and $226 thousand, respectively. At December 31, 2009 and 2008, the following financial instruments were outstanding whose contract amounts represent credit risk:
Commitments to extend credit, credit card arrangements and Standby Letters of Credit all include exposure to some credit loss in the event of nonperformance of the customer. The Bank’s credit policies and procedures for credit commitments and financial guarantees are the same as those for extensions of credit that are recorded in the financial statements. Due to the fact that these instruments have fixed maturity dates, and because many of them expire without being drawn upon, they generally do not present any significant liquidity risk to the Bank.
Collateral Requirements
To reduce credit risk related to the use of credit-related financial instruments, the Bank might deem it necessary to obtain collateral. The amount and nature of the collateral obtained is based on the Bank’s credit evaluation of the customer. Collateral held varies but may include cash, securities, accounts receivable, inventory, property, plant, and real estate.
Legal Contingencies
Various legal claims also arise from time to time in the normal course of business, which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 14 - Minimum Regulatory Capital Requirements
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off balance-sheet items as calculated under regulatory accounting practices.
The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of: total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). Management believes, as of December 31, 2009, that the Bank meets all the capital adequacy requirements to which it is subject.
As of December 31, 2009 the most recent notification from the FDIC indicated the Bank was categorized as well capitalized under the regulatory framework for prompt corrective action. To remain categorized as well capitalized, the Bank will have to maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as disclosed in the table to follow. There are no conditions or events since the most recent notification that management believes have changed the Bank’s prompt corrective action category.
The Company and the Bank’s actual and required capital amounts and ratios as of December 31, 2009 and 2008 are as follows:
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 14 - Minimum Regulatory Capital Requirements (Continued)
Note 15 - Restrictions of Dividends & Inter-company Borrowings
The Bank is restricted as to the amount of dividends that can be paid. Dividends declared by the Bank that exceed the net income for the current year plus retained income for the preceding two years must be approved by federal and state regulatory agencies. Under this formula dividends of $3.6 million may be paid without prior regulatory approval. Regardless of formal regulatory restrictions, the Bank may not pay dividends that would result in its capital levels being reduced below the minimum requirements shown above. Under current Federal Reserve regulations, the Bank is limited as to the amount and type of loans it may make to the Company and its non-bank subsidiary. These loans are subject to qualifying collateral requirements on which the amount of the loan may be based.
Note 16 - Fair Value of Financial Instruments
Fair values of financial instruments are management’s estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.
The following assumptions and methods were used in estimating the fair value for financial instruments:
Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest-bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 16 - Fair Value of Financial Instruments (Continued)
Securities and Other Securities
Fair values for securities, excluding Federal Home Loan Bank stock and Federal Reserve Bank stock, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying value of Federal Home Loan Bank and Federal Reserve Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank and the Federal Reserve Bank.
Loans
Most commercial and real estate mortgage loans are made on a variable rate basis. For those variable-rate loans that re-price frequently, and with no significant change in credit risk, fair values are based on carrying values. The fair values of the fixed rate and all other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.
Deposits
The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Borrowings
Short-term borrowings are carried at cost that approximates fair value. Other long-term debt was generally valued using a discounted cash flow analysis with a discounted rate based on current incremental borrowing rates for similar types of arrangements, or if not available, based on an approach similar to that used for loans and deposits.
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate their fair values.
Dividends Payable
The carrying amounts of dividends payable approximate their fair values and are generally paid within forty days of declaration.
Off Balance Sheet Financial Instruments
Fair values for off-balance-sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of December 31, 2009 and 2008, are reflected below.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 16 - Fair Value of Financial Instruments (Continued)
Fair Value Measurements
The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis at December 31, 2009 and 2008, and the valuation techniques used by the Company to determine those fair values.
In general, fair values determined by Level 1inputs use quoted prices in active markets for identical assets or liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.
Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.
Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability.
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 16 - Fair Value of Financial Instruments (Continued)
Disclosures concerning assets and liabilities measured at fair value are as follows:
Assets and Liabilities Measured at Fair Value on a Recurring Basis at December 31, 2009 and December 31, 2008:
The Company did not have any assets or liabilities measured at fair value that were categorized as Level 3 during the period. All of the Company’s available for sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2.
The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At December 31, 2009 and 2008, such assets consist primarily of impaired loans. The Company has established the fair values of these assets using Level 3 inputs, specifically discounted cash flow projections.
Impaired loans accounted for under FAS 114 categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).
At December 31, 2009 and 2008, impaired loans categorized as Level 3 were $12.2 and $11.7 million, respectively. The change in fair value of impaired loans of $353 and $466 thousand for 2009 and 2008, respectively, is accounted for in the allowance for loan losses (see Note 4).
Other real estate is reported at either the fair value of the real estate, minus the estimated costs to sell the asset, or the cost of the asset. The determination of the fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset’s fair value or estimated selling costs.
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 16 - Fair Value of Financial Instruments (Continued)
The Company also has other assets, which under certain conditions, are subject to measurement at fair value. These assets include loans held for sale, bank owned life insurance, and mortgage servicing rights. The Company estimated the fair values of these assets utilizing Level 3 inputs, including, the discounted present value of expected future cash flows. At December 31, 2009, the Company estimates that there is no impairment of these assets and therefore, no impairment charge to other expense was required to adjust these assets to their estimated fair values.
Note 17 - Condensed Financial Statements of Parent Company
Balance Sheet
Statement of Income
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 17 - Condensed Financial Statements of Parent Company (Continued)
Statements of Cashflows
Farmers & Merchants Bancorp, Inc and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2009, 2008, and 2007
Note 18 - Quarterly Financial Data
(000s omitted except per share data)
ITEM 8.
ITEM 8. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTING AND FINANCIAL DISCLOSURE
No disagreements exist on accounting and financial disclosures or related matter.
ITEM 8A. CONTROLS AND PROCEDURES
Management Report Regarding Disclosure Controls and Procedures
The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of December 31, 2009, pursuant to Exchange Act 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2009, in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings.
MANAGEMENT REPORT REGARDING INTERNAL CONTROL AND
COMPLIANCE WITH DESIGNATED LAWS AND REGULATIONS
Management of Farmers & Merchants Bancorp, Inc. and Subsidiaries is responsible for preparing the Bank’s annual financial statements. Management is also responsible for establishing and maintaining internal control over financial reporting presented in conformity with both generally accepted accounting principles and regulatory reporting in conformity with the Federal Financial Institutions Examination Council Instructions for Consolidated Reports of Condition and Income (call report instructions). The Bank’s internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.
There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
It is also management’s responsibility to ensure satisfactory compliance with all designated laws and regulations and in particular, those laws and regulations concerning loans to insiders. The federal laws concerning loans to insiders are codified at 12 USC 375a and 375b, and the federal regulations are set forth at 12 CFR 23.5, 31, and 215.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2009. The registered public accounting firm that audited the financial statements included in this annual report has issued an attestation report on the Company’s internal control over financial reporting which can be found under Item 8 of this form 10-K.
There was no change in the company’s internal control over financial reporting that occurred during the Company’s fiscal quarter ended December 31, 2009 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 8B. OTHER INFORMATION
None.
PART III
ITEM 9.
ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
BOARD OF DIRECTORS
The information called for herein is presented below:
Directors are elected annually at the annual meeting of shareholders
Ms. Latta was appointed to the Board of Directors of the Company and The Farmers & Merchants State Bank on January 16, 2009.
David P. Rupp, Jr. is an attorney with membership in the law firm of Plassman, Rupp, Short & Hagans of Archbold, Ohio. The law firm has been retained by the Corporation, and its subsidiaries, during the past twenty years and is to be retained currently.
EXECUTIVE OFFICERS
Any remaining information required by Item 401 of Regulation S-K is presented in the proxy statement to be furnished in connection with the solicitation of proxies on behalf of the Board of Directors of the Registrant for use at its Annual Meeting to be held on April 15, 2010, and is incorporated herein by reference. The information called for under Item 405 of Regulation S-K regarding compliance with Section 16(a) and called for under Item 407(d)(5) regarding the existence of a Financial Expert on the Audit Committee of the Company’s Board of Directors is presented in the proxy statement to be furnished in connection with the solicitation of proxies on behalf of the Board of Directors of the Registrant for use at its Annual Meeting to be held on April 15, 2010, and is incorporated herein by reference.
The Board of Directors of the Company adopted a Code of Business Conduct and Ethics (the “Code”) at its meeting on February 13, 2004. While the Sarbanes-Oxley Act of 2002 mandates the adoption of a code of ethics for the most senior executive officers of all public companies, the Code adopted by the Corporation’s Board of Directors is broader in the activities covered and applies to all officers, directors and employees of the Corporation and the Bank, including the chief executive officer, chief financial officer, principal accounting officer and other senior officers performing accounting, auditing, financial management or similar functions. The administration of the Code has been delegated to the Audit Committee of the Board of Directors, a Committee comprised entirely of “independent directors.” The Code addresses topics such as compliance with laws and regulations, honest and ethical conduct, conflicts of interest, confidentiality and protection of Corporation assets, fair dealing and accurate and timely periodic reports, and also provides for enforcement mechanisms. The Board and management of the Corporation intends to continue to monitor not only the developing legal requirements in this area, but also the best practices of comparable companies, to assure that the Corporation maintains sound corporate governance practices in the future.
A copy of the Corporation’s Code is available on the website of the Bank (www.fm-bank.com). In addition, a copy of the Code is available to any shareholder free of charge upon request. Shareholders desiring a copy of the Code should address written requests to Mr. Paul S. Siebenmorgen, President, Chief Executive Officer and Treasurer of Farmers & Merchants Bancorp, Inc., 307North Defiance Street, Archbold, Ohio 43502, and are asked to mark Code of Business Conduct and Ethics on the outside of the envelope containing the request.
The information called for herein is presented in the proxy statement to be furnished in connection with the solicitation of proxies on behalf of the Board of Directors of the Registrant for use at its Annual Meeting to be held on April 15, 2010, and is incorporated herein by reference.
ITEM 11.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 12.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for herein is presented in the proxy statement to be furnished in connection with the solicitation of proxies on behalf of the Board of Directors of the Registrant for use at its Annual Meeting to be held on April 15, 2010, and is incorporated herein by reference.
ITEM 13.
ITEM 13. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information called for by this Item is presented in the proxy statement to be furnished in connection with the solicitation of proxies on behalf of the Board of Directors of the Registrant for use at its Annual Meeting to be held on April 15, 2010, and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS AND FINANCIAL STATEMENTS SCHEDULES
a. The Following documents are filed as part of this report.
(1)
Financial Statements (included in this 10-K under Item 8) Report of Independent Accountants Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Changes in Shareholders’ Equity Consolidated Statements of Cash Flows Note to Consolidated Financial Statements
(2)
Financial Statement Schedules Five Year Summary of Operations
ITEM 14. EXHIBITS AND FINANCIAL STATEMENTS SCHEDULES (Continued)
FARMERS & MERCHANTS BANCORP, INC
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, hereunto duly authorized
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.