ITEM 1 BUSINESS
United Bancorp, Inc. (the “Company” or “United”) is a Michigan corporation headquartered in Ann Arbor, Michigan and serves as the holding company for United Bank & Trust (“UBT” or “the Bank”), a Michigan-chartered bank organized over 115 years ago. The Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) under the Bank Holding Company Act of 1956, as amended (the “Bank Holding Company Act”). The Company has corporate power to engage in activities permitted to business corporations under the Michigan Business Corporation Act, subject to the limitations of the Bank Holding Company Act and regulations of the Federal Reserve System. In general, the Bank Holding Company Act and regulations restrict the Company with respect to its own activities and activities of any subsidiaries to the business of banking or other activities that are closely related to the business of banking. At December 31, 2011, the Company had total assets of approximately $885.0 million, total deposits of approximately $764.9 million, and total shareholders’ equity of approximately $93.8 million. For more information about the Company’s financial condition and results of operations, see the consolidated financial statements and related notes filed as part of this report.
The Company has four primary lines of business under one operating segment of commercial banking: banking services, residential mortgage, wealth management and structured finance. During the year ended December 31, 2011, our net interest income accounted for approximately 63.6% of our operating revenues and our noninterest income accounted for approximately 36.4% of our operating revenues.
The Company was formed in 1985 to acquire all of the capital stock of UBT. The Company provides services through the Bank's system of sixteen banking offices, one trust office, one loan production office and twenty automated teller machines, located in Washtenaw, Lenawee, Livingston and Monroe Counties, Michigan. United’s corporate headquarters are located in Ann Arbor, which is located in Washtenaw County, Michigan. The employment base of Washtenaw County is centered around health care, education and automotive high technology. Economic stability is provided to a great extent by the University of Michigan, which is a major employer and is not as economically sensitive to the fluctuations of the automotive industry. The services and public sectors account for a substantial percentage of total industry employment, in a large part due to the University of Michigan and the University of Michigan Medical Center.
The Bank offers a full range of services to individuals, corporations, fiduciaries and other institutions. Banking services include checking accounts, NOW accounts, savings accounts, time deposit accounts, money market deposit accounts, safe deposit facilities and money transfers. Lending operations provide real estate loans, secured and unsecured business and personal loans, consumer installment loans, credit card and check-credit loans, home equity loans, accounts receivable and inventory financing, and construction financing. We offer our customers a full array of conventional residential mortgage products, including purchase, refinance and construction loans. The Bank offers a full complement of online services, including internet banking and bill payment.
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The Bank maintains correspondent bank relationships with a small number of larger banks, which involve check clearing operations, securities safekeeping, transfer of funds, loan participation, purchase and sale of federal funds and other similar services.
Our mortgage company, United Mortgage Company, offers our customers a full array of conventional residential mortgage products, including purchase, refinance and construction loans. Due to our local decision making and fully-functional back office, we have consistently been the most active originator of mortgage loans in our market area. United Mortgage Company was the leading residential mortgage lender in Lenawee and Washtenaw Counties for 2010.
The Bank’s Wealth Management Group is a key focus of the Company’s growth and diversification strategy. The Wealth Management Group offers a variety of investment services to individuals, corporations and governmental entities, including services as trustee for personal, pension, and employee benefit trusts. The department provides trust services, financial planning services, investment services, custody services, pension paying agent services and acts as the personal representative for estates. These products help to diversify the Company's sources of income. The Bank offers nondeposit investment products through licensed representatives in its banking offices, and sells credit and life insurance products.
The Bank operates United Structured Finance Company (“USFC”). USFC is a division of the Bank that was established in 2007, and operates as a finance company that offers simple, effective financing solutions to small businesses and commercial property owners, primarily by utilizing various government guaranteed loan programs and other off-balance sheet finance solutions through secondary market sources. The loans generated by USFC are typically sold on the secondary market, to the extent allowed by the applicable SBA programs. Gains on the sale of those loans are included in income from loan sales and servicing. USFC revenue provides additional diversity to the Company's income stream, and provides additional financing alternatives to clients of the Bank as well as non-bank clients. For the twelve months ended September 30, 2011 and 2010, United Structured Finance Company was the leading SBA lender in each of Lenawee, Washtenaw and Livingston Counties. For 2011, USFC was the third largest SBA 7A lender in Michigan, based on loan volume.
Supervision and Regulation
General
The Company and the Bank are extensively regulated and are subject to a comprehensive regulatory framework that imposes restrictions on their activities, minimum capital requirements, lending and deposit restrictions, and numerous other requirements. This system of regulation is primarily intended for the protection of depositors, federal deposit insurance funds and the banking system as a whole, rather than for the protection of shareholders and creditors. Many of these laws and regulations have undergone significant change in recent years and are likely to change in the future. Future legislative or regulatory change, or changes in enforcement practices or court rulings, may have a significant and potentially adverse impact on the Company's operations and financial condition.
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The Company
The Company is subject to supervision and regulation by the Federal Reserve System. Its activities are generally limited to owning or controlling banks and engaging in such other activities as the Federal Reserve System may determine to be closely related to banking. Prior approval of the Federal Reserve System, and in some cases various other government agencies, is required for the Company to acquire control of any additional bank holding companies, banks or other operating subsidiaries. The Company is subject to periodic examination by the Federal Reserve System, and is required to file with the Federal Reserve System periodic reports of its operations and such additional information as the Federal Reserve System may require.
The Company is a legal entity separate and distinct from the Bank. There are legal limitations on the extent to which the Bank may lend or otherwise supply funds to the Company. Payment of dividends to the Company by the Bank, the Company's principal source of funds, is subject to various state and federal regulatory limitations. Under the Michigan Banking Code of 1999, the Bank's ability to pay dividends to the Company is subject to the following restrictions:
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A bank may not declare or pay a dividend if a bank's surplus would be less than 20% of its capital after payment of the dividend.
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A bank may not declare a dividend except out of net income then on hand after deducting its losses and bad debts.
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A bank may not declare or pay a dividend until cumulative dividends on preferred stock, if any, are paid in full.
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A bank may not pay a dividend from capital or surplus.
Federal law generally prohibits a bank from making any capital distribution (including payment of a dividend) or paying any management fee to its parent company if the depository institution would thereafter be undercapitalized. The Federal Deposit Insurance Corporation (“FDIC”) may prevent an insured bank from paying dividends if the bank is in default of payment of any assessment due to the FDIC. In addition, the FDIC may prohibit the payment of dividends by a bank if such payment is determined, by reason of the financial conditions of the bank, to be an unsafe and unsound banking practice. UBT is a party to a memorandum of understanding with the FDIC and the Michigan Office of Financial and Insurance Regulation (“OFIR”), described below under “Recent Developments - Memorandum of Understanding,” which requires the Bank not to declare or pay any dividends without the prior consent of the FDIC and OFIR. In addition, the Federal Reserve Bank of Chicago (the “Reserve Bank”) has restricted the Company from declaration or payment of common or preferred stock dividends without prior written approval of the Reserve Bank.
Additional information on restrictions on payment of dividends by the Company and the Bank may be found under Item 5 of this report and under Note 15 on Page A-63 hereof, all of which information is incorporated here by reference.
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Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank. In addition, if OFIR deems a Bank's capital to be impaired, OFIR may require the Bank to restore its capital by a special assessment on the Company as the Bank's only shareholder. If the Company fails to pay any assessment, the Company's directors would be required, under Michigan law, to sell the shares of the Bank's stock owned by the Company to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the Bank's capital.
The Federal Reserve Board and the FDIC have established guidelines for risk-based capital by bank holding companies and banks. These guidelines establish a risk-adjusted ratio relating capital to risk-weighted assets and off-balance-sheet exposures. These capital guidelines primarily define the components of capital, categorize assets into different risk classes, and include certain off-balance-sheet items in the calculation of capital requirements.
The FDIC Improvement Act of 1991 established a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, federal banking regulators have established five capital categories - well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, in which all institutions are placed. The federal banking agencies have also specified by regulation the relevant capital levels for each of the categories.
Federal banking regulators are required to take specified mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Subject to a narrow exception, the banking regulator must generally appoint a receiver or conservator for an institution that is critically undercapitalized. An institution in any of the under-capitalized categories is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. An undercapitalized institution is also generally prohibited from paying any dividends, increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.
Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and other restrictions on its business. In addition, such a bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless the bank could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time. The capital ratios of the Company and the Bank exceed the regulatory guidelines for an institution to be categorized as “well-capitalized” and the ratios required by the Bank’s memorandum of understanding. Information in Note 18 on Page A-70 and A-71 hereof provides additional information regarding the Company's and the Bank’s capital ratios, and is incorporated here by reference.
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The Bank
The Bank is chartered under Michigan law and is subject to regulation by OFIR. Michigan banking laws place restrictions on various aspects of banking, including permitted activities, loan interest rates, branching, payment of dividends, and capital and surplus requirements.
Substantially all of the deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a matrix that takes into account a bank's capital level and supervisory rating. In addition, the Bank pays Financing Corporation (“FICO”) assessments related to outstanding FICO bonds to the FDIC as collection agent. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings and Loan Insurance Corporation. FICO assessments will continue in the future for the Bank.
The Bank is subject to a number of federal and state laws and regulations, which have a material impact on its business. These include, among others, minimum capital requirements, state usury laws, state laws relating to fiduciaries, the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Expedited Funds Availability Act, the Community Reinvestment Act, the Real Estate Settlement Procedures Act, the USA PATRIOT Act, The Bank Secrecy Act, Office of Foreign Assets Control regulations, electronic funds transfer laws, redlining laws, predatory lending laws, antitrust laws, environmental laws, money laundering laws and privacy laws. The instruments of monetary policy of authorities, such as the Federal Reserve System, may influence the growth and distribution of bank loans, investments and deposits, and may also affect interest rates on loans and deposits. These policies may have a significant effect on the operating results of banks.
Bank holding companies may acquire banks and other bank holding companies located in any state in the United States without regard to geographic restrictions or reciprocity requirements imposed by state banking law. Banks may also establish interstate branch networks through acquisitions of and mergers with other banks. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.
Michigan banking laws do not significantly restrict interstate banking. The Michigan Banking Code of 1999 permits, in appropriate circumstances and with the approval of the OFIR, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan. A Michigan bank holding
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company may acquire a non-Michigan bank and a non-Michigan bank holding company may acquire a Michigan bank.
Recent Developments
Memorandum of Understanding
On January 15, 2010, UBT entered into a Memorandum of Understanding with the FDIC and the Michigan Office of Financial and Insurance Regulation (“OFIR”). On January 11, 2011, the Bank entered into a revised Memorandum of Understanding (“MOU”) with substantially the same requirements as the MOU dated January 15, 2010. The MOU is not a “written agreement” for purposes of Section 8 of the Federal Deposit Insurance Act. The MOU documents an understanding among UBT, the FDIC and OFIR, that, among other things, (i) UBT will not declare or pay any dividend to the Company without the prior consent of the FDIC and OFIR; and (ii) UBT will have and maintain its Tier 1 capital ratio at a minimum of 9% for the duration of the MOU, and will maintain its ratio of total capital to risk-weighted assets at a minimum of 12% for the duration of the MOU.
Board Leadership
James C. Lawson was elected as Chairman of the Board following the 2011 Annual Meeting of Shareholders. Mr. Lawson has a diverse background in the formation and operation of a successful business, and has served as a Director of the Company since 1986. Lawson replaced David S. Hickman, who retired as Chairman of the Board of Directors as a result of reaching mandatory retirement age. Director James D. Buhr was elected as Vice Chairman of the Board, replacing Mr. Lawson in that role.
Competition
The banking business in the Company's service area is highly competitive. In their markets, the Bank competes with a number of community banks and subsidiaries of large multi-state, multi-bank holding companies. In addition, the Bank faces competition from credit unions, savings associations, finance companies, loan production offices and other financial services companies. The principal methods of competition that we face are price (interest rates paid on deposits, interest rates charged on borrowings and fees charged for services) and service (convenience and quality of services rendered to customers).
The Company believes that the market perceives a competitive benefit to an independent, locally controlled commercial bank. Much of the Company's competition comes from affiliates of organizations controlled from outside the area.
Employees
On December 31, 2011, the Company and its subsidiary employed 244 full-time and 38 part-time employees. This compares to 231 full-time and 43 part-time employees at December 31, 2010.
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Accounting Standards
Information regarding accounting standards adopted by the Company is included in Note 1 beginning on Page A-36, and is incorporated here by reference.
Available Information
You can find more information about us at our website, located at www.ubat.com. Our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available as soon as reasonably practicable after such forms have been filed with or furnished to the Securities and Exchange Commission (the “SEC”) free of charge on our website through a link to the SEC website.
SELECTED STATISTICAL INFORMATION
Additional statistical information describing our business appears in the following pages and in Management's Discussion and Analysis of Financial Condition and Results of Operations and in our consolidated financial statements and related notes contained in this report.
I
DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL:
The information required by these sections is contained on Pages A-1 through A-18, and is incorporated here by reference.
II INVESTMENT PORTFOLIO
(A) Book Value of Investment Securities
The book value of investment securities as of December 31, 2011, 2010 and 2009 are as follows, in thousands of dollars:
(B) Carrying Values and Yields of Investment Securities
The following table reflects the carrying values and yields of the Company's investment securities portfolio as of December 31, 2011. Average yields are based on amortized costs and the average yield on tax exempt securities of states and political subdivisions is adjusted to a taxable equivalent basis, assuming a 34% marginal tax rate.
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As of December 31, 2011, the Company's securities portfolio contains no concentrations by any single issuer of securities greater than 10% of shareholders' equity. As of December 31, 2011, the Company’s securities portfolio contained no securities of issuers outside of the United States. Additional information concerning the Company's securities portfolio is included on Pages A-7 and A-8 and in Note 3 on Pages A-43 through A-45, and is incorporated here by reference.
III LOAN PORTFOLIO
(A) Types of Loans
The tables below show loans outstanding (net of unearned interest) at December 31, and the percentage makeup of the portfolios. All loans are domestic and contain no concentrations by industry or customer.
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(B) Maturities and Sensitivities of Loans to Changes in Interest Rates
The following table presents the maturity of total loans outstanding, other than residential mortgages and personal loans, as of December 31, 2011, according to scheduled repayments of principal.
(C) Risk Elements
Nonaccrual, Past Due and Restructured Loans
Information regarding nonaccrual, past due and restructured loans is shown in the table below as of December 31, 2007 through 2011.
The following shows the effect on interest revenue of nonaccrual and troubled debt restructured loans as of December 31, 2011, in thousands of dollars:
Additional information concerning nonperforming loans, the Company's nonaccrual policy, and loan concentrations is provided on Pages A-10 through A-14, in Note 1 on Pages A-36 through A-42, Note 4 on Page A-45 and Note 5 on Pages A-45 through A-57, and is incorporated here by reference.
At December 31, 2011, the Bank had two loans, other than those disclosed above, for a total of $516,000, which cause management to have serious doubts as to the ability of the borrowers to
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comply with the present loan repayment terms. These loans were included on the Bank’s “watch list” and were classified as impaired; however, payments were current as of the date of this report.
(D) Other Interest Bearing Assets
As of December 31, 2011, other than $3,657,000 in other real estate, there were no other interest bearing assets that would be required to be disclosed under Item III, Parts (C)(1) or (C)(2) of Industry Guide 3 if such assets were loans.
IV SUMMARY OF LOAN LOSS EXPERIENCE
(A) Changes in Allowance for Loan Losses
The table below summarizes changes in the allowance for loan losses for the years 2007 through 2011.
The allowance for loan losses is maintained at a level believed adequate by management to absorb losses inherent in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic
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conditions, volume, amount and composition of the loan portfolio, and other relevant factors. The provision charged to earnings was $12,150,000 in 2011, $21,530,000 in 2010 and $25,770,000 in 2009.
(B) Allocation of Allowance for Loan Losses
The following table presents the portion of the allowance for loan losses applicable to each loan category as of December 31. A table showing the percent of loans in each category to total loans is included in Section III (A), above.
Information regarding the Company’s allocation methods used is provided in Note 5 on Pages A-44 and A-46, and is incorporated here by reference.
V DEPOSITS
The information concerning average balances of deposits and the weighted-average rates paid thereon is included on Page A-18 and maturities of time deposits is provided in Note 9 on Page A-59, and is incorporated here by reference. There were no foreign deposits.
As of December 31, 2011, outstanding time certificates of deposit in amounts of $100,000 or more were scheduled to mature as shown below.
VI RETURN ON EQUITY AND ASSETS
Various ratios required by this section and other ratios commonly used in analyzing bank holding company financial statements are included in Item 6 on Page 33, and are incorporated here by reference.
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VII SHORT-TERM BORROWINGS
All of the information that the Company is required to disclose under this section is contained in Note 10 on Page A-59, and is incorporated here by reference. The Company is not required to disclose any additional information, as for all reporting periods there were no categories of short-term borrowings for which the average balance outstanding during the period was 30% or more of shareholders' equity at the end of the period.
ITEM 1A
ITEM 1A RISK FACTORS
Risks Related To Our Business
Our results of operations have improved in 2011 compared to 2010 and 2009, but we may incur additional losses during 2012.
We were profitable in the fourth quarter and full year of 2011, but had a total consolidated net loss during the three-year period from 2009 through 2011 of $11.6 million. There is no assurance that the Company's results of operations will be profitable in the short term or at all. We have recorded provisions for loan losses of $12.2 million for the year ended December 31, 2011, $21.5 million for the year ended December 31, 2010 and $25.8 million for the year ended December 31, 2009. In light of the current economic environment, significant additional provisions for loan losses may be necessary to supplement the allowance for loan losses in the future. As a result, we may incur significant additional credit costs in 2012 or beyond, which could adversely impact our financial condition, results of operations, and the value of our common stock.
If our nonperforming assets increase, our earnings will be adversely affected.
At December 31, 2011, our nonperforming assets (which consist of non-accruing loans, loans 90 days or more past due, and other real estate owned) totaled $29.5 million, or 3.33% of total assets. At December 31, 2010 and December 31, 2009, our nonperforming assets were $33.5 million and $34.5 million, respectively, or 3.89% and 3.79% of total assets, respectively. Our nonperforming assets adversely affect our net income in various ways:
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We do not record interest income on nonaccrual loans or other real estate owned.
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We must provide for probable loan losses through a current period charge to the provision for loan losses.
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Non-interest expense increases when we must write down the value of properties in our other real estate owned portfolio to reflect changing market values.
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There are legal fees associated with the resolution of problem assets, as well as carrying costs, such as taxes, insurance, and maintenance fees related to our other real estate owned.
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The resolution of non-performing assets requires the active involvement of management, which can distract them from more profitable activity.
If additional borrowers become delinquent and do not pay their loans and we are unable to successfully manage our nonperforming assets, our losses and troubled assets could increase significantly, which could have a material adverse effect on our results of operations and financial condition.
The economic conditions in the State of Michigan could have a material adverse effect on our results of operations and financial condition.
Our success depends primarily on the general economic conditions in the State of Michigan and the specific local markets in which we operate. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers primarily in the Lenawee, Monroe and Washtenaw Counties, Michigan. The local economic conditions in these areas have a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities, financial, or credit markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on our results of operations and financial condition.
Difficult market conditions have adversely affected the financial services industry.
The capital and credit markets have been experiencing unprecedented volatility and disruption for an extended period of time. Dramatic declines in the housing market, falling home prices, increased foreclosures and unemployment have negatively impacted the credit performance of mortgage loans and construction and development loans, and resulted in significant write-downs of asset values by financial institutions. These write-downs have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions.
This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and commercial borrowers and lack of confidence in the financial markets has adversely affected our business, results of operations and financial condition. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience adverse effects, which may be material, on our ability to access capital and on our business, results of operations and financial condition.
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We are subject to lending risk, which could materially adversely affect our results of operations and financial condition.
There are inherent risks associated with our lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where we operate. Increases in interest rates or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans, which could have a material adverse effect on our results of operations and financial condition.
Business loans may expose us to greater financial and credit risk than other loans.
Our business loan portfolio, including commercial mortgages, was approximately $335.1 million at December 31, 2011, comprising approximately 59.5% of our loan portfolio. Business loans generally carry larger loan balances and can involve a greater degree of financial and credit risk than other loans. Any significant failure to pay on time by our customers would hurt our earnings. The increased financial and credit risk associated with these types of loans are a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the size of loan balances, the effects of general economic conditions on income-producing properties and the increased difficulty of evaluating and monitoring these types of loans.
We have significant exposure to risks associated with commercial and residential real estate.
A substantial portion of our loan portfolio consists of commercial and residential real estate-related loans, including real estate development, construction and residential and commercial mortgage loans. As of December 31, 2011, we had approximately $229.5 million of commercial real estate loans outstanding, which represented approximately 40.7% of our loan portfolio. As of that same date, we had approximately $83.1 million in residential real estate loans outstanding, or approximately 14.7% of our loan portfolio, and approximately $39.7 million in construction and development loans outstanding, or approximately 7.0% of our loan portfolio. Consequently, real estate-related credit risks are a significant concern for us. The adverse consequences from real estate-related credit risks tend to be cyclical and are often driven by national economic developments that are not controllable or entirely foreseeable by us or our borrowers. General difficulties in our real estate markets have recently contributed to significant increases in our non-performing loans, charge-offs, and decreases in our income.
Our construction and development lending exposes us to significant risks and has resulted in a disproportionate amount of the increase in our provision for loan losses in recent periods.
Our construction and development loan portfolio includes residential and non-residential construction and development loans. Our residential construction and development portfolio consists mainly of loans for the construction, development, and improvement of residential lots, homes, and subdivisions. Our non-residential construction and development portfolio consists mainly of loans for the construction and development of office buildings and other non-residential commercial properties. This type of lending is generally considered to have more complex credit risks than traditional single-family residential lending because the principal is
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concentrated in a limited number of loans with repayment dependent on the successful completion and sale of the related real estate project. Consequently, these loans are often more sensitive to adverse conditions in the real estate market or the general economy than other real estate loans. These loans are generally less predictable and more difficult to evaluate and monitor and collateral may be difficult to dispose of in a market decline. Additionally, we may experience significant construction loan losses because independent appraisers or project engineers inaccurately estimate the cost and value of construction loan projects.
Construction and development loans have contributed disproportionately to the increase in our provisions for loan losses in recent periods. As of December 31, 2011, we had approximately $39.7 million in construction and development loans outstanding, or approximately 7.0% of our loan portfolio. Approximately $2.6 million, or 15.8%, of our net charge-offs during 2011 and approximately $5.6 million, or 34.4%, of our net charge-offs during 2010 was attributable to construction and development loans. Further deterioration in our construction and development loan portfolio could result in additional increases in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.
Environmental liability associated with commercial lending could result in losses.
In the course of our business, we may acquire, through foreclosure, properties securing loans we have originated or purchased that are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, we might be required to remove these substances from the affected properties at our sole cost and expense. The cost of this removal could substantially exceed the value of affected properties. We may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have an adverse effect on our business, results of operations and financial condition.
Our allowance for loan losses may not be adequate to cover actual future losses.
We maintain an allowance for loan losses to cover probable incurred loan losses. Every loan we make carries a certain risk of non-repayment, and we make various assumptions and judgments about the collectibility of our loan portfolio including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of customers relative to their financial obligations with us.
The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control, and these losses may exceed current estimates. We cannot fully predict the amount or timing of losses or whether the loss allowance will be adequate in the future. If our assumptions prove to be incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in additions to the allowance for loan losses. In addition, bank regulatory agencies periodically review the Company's allowance for loan losses and may require an
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increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different from those of management. Excessive loan losses and significant additions to our allowance for loan losses could have a material adverse impact on our financial condition and results of operations.
As of December 31, 2011 and 2010, our allowance for loan losses was $20.6 million and $25.2 million, respectively. As of the same dates, the ratio of our allowance for loan losses to total nonperforming loans was 80.0% and 86.0% respectively. Nonperforming loans include nonaccrual loans and accruing loans past due 90 days or more and exclude accruing restructured loans. As of the same dates, total accruing restructured loans were $21.8 million and $17.3 million, respectively.
We operate in a highly competitive industry and market area, which may adversely affect our profitability.
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include a number of community banks, subsidiaries of large multi-state and multi-bank holding companies, credit unions, savings associations and various finance companies and loan production offices. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking.
We compete with these institutions both in attracting deposits and in making loans. Price competition for loans might result in us originating fewer loans, or earning less on our loans, and price competition for deposits might result in a decrease in our total deposits or higher rates on our deposits. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Due to their size, many competitors may be able to achieve economies of scale and may offer a broader range of products and services as well as better pricing for those products and services than we can.
The Dodd-Frank Act enacted in 2010 may adversely impact the Company's results of operations, financial condition or liquidity.
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), was signed into law by President Obama. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection (the “BCFP”), and will require the BCFP and other federal agencies to implement many new and significant rules and regulations. At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact our business. Compliance with these new laws and regulations has resulted and is expected to result in additional costs, which could be significant and could adversely impact our results of operations, financial condition or liquidity.
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Legislative or regulatory changes or actions, or significant litigation, could adversely impact us or the businesses in which we are engaged.
The financial services industry is extensively regulated. We are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of our operations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds, and not to benefit our shareholders. The impact of changes to laws and regulations or other actions by regulatory agencies may negatively impact us or our ability to increase the value of our business. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution's allowance for loan losses. Future regulatory changes or accounting pronouncements may increase our regulatory capital requirements or adversely affect our regulatory capital levels. Additionally, actions by regulatory agencies or significant litigation against us could require us to devote significant time and resources to defending our business and may lead to penalties that materially affect us and our shareholders.
We may face increasing pressure from historical purchasers of our residential mortgage loans to repurchase those loans or reimburse purchasers for losses related to those loans.
We generally sell the fixed rate long-term residential mortgage loans we originate on the secondary market and retain adjustable rate mortgage loans for our portfolios. In response to the financial crisis, we believe that purchasers of residential mortgage loans, such as government sponsored entities, are increasing their efforts to seek to require sellers of residential mortgage loans to either repurchase loans previously sold or reimburse purchasers for losses related to loans previously sold when losses are incurred on a loan previously sold due to actual or alleged failure to strictly conform to the purchaser's purchase criteria. As a result, we may face increasing pressure from historical purchasers of our residential mortgage loans to repurchase those loans or reimburse purchasers for losses related to those loans and we may face increasing expenses to defend against such claims. If we are required in the future to repurchase loans previously sold, reimburse purchasers for losses related to loans previously sold, or if we incur increasing expenses to defend against such claims, our financial condition and results of operations would be negatively affected.
We are subject to risks related to the prepayments of loans, which may negatively impact our business.
Generally, our customers may prepay the principal amount of their outstanding loans at any time. The speed at which prepayments occur, and the size of prepayments, are within customers' discretion. If customers prepay the principal amount of their loans, and we are unable to lend those funds to other borrowers or invest the funds at the same or higher interest rates, our interest income will be reduced. A significant reduction in interest income could have an adverse effect impact on our results of operations and financial condition.
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Changes in interest rates may negatively affect our earnings and the value of our assets.
Our earnings and cash flows depend substantially upon our net interest income. Net interest income is the difference between interest income earned on interest-earnings assets, such as loans and investment securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds. Interest rates are sensitive to many factors that are beyond our control, including general economic conditions, competition and policies of various governmental and regulatory agencies and, in particular, the policies of the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investment securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect: (i) our ability to originate loans and obtain deposits; (ii) the fair value of our financial assets and liabilities, including our securities portfolio; and (iii) the average duration of our interest-earning assets. This also includes the risk that interest-earning assets may be more responsive to changes in interest rates than interest-bearing liabilities, or vice versa (repricing risk), the risk that the individual interest rates or rates indices underlying various interest-earning assets and interest-bearing liabilities may not change in the same degree over a given time period (basis risk), and the risk of changing interest rate relationships across the spectrum of interest-earning asset and interest-bearing liability maturities (yield curve risk), including a prolonged flat or inverted yield curve environment. Any substantial, unexpected, prolonged change in market interest rates could have a material adverse affect on our financial condition and results of operations.
We are subject to liquidity risk in our operations, which could adversely affect our ability to fund various obligations.
Liquidity risk is the possibility of being unable to meet obligations as they come due, capitalize on growth opportunities as they arise, or pay regular dividends because of an inability to liquidate assets or obtain adequate funding on a timely basis, at a reasonable cost and within acceptable risk tolerances. Liquidity is required to fund various obligations, including credit obligations to borrowers, mortgage originations, withdrawals by depositors, repayment of debt, dividends to shareholders, operating expenses and capital expenditures. Liquidity is derived primarily from retail deposit growth and retention, principal and interest payments on loans and investment securities, net cash provided from operations and access to other funding sources. Liquidity is essential to our business.
We must maintain sufficient funds to respond to the needs of depositors and borrowers. An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or regulatory action that limits or eliminates our access to alternate funding sources. Our ability to borrow could also be impaired by factors that are nonspecific to us, such as severe disruption of the financial markets or negative expectations about the prospects for the financial services industry as a whole, as evidenced by recent turmoil in the domestic and worldwide credit markets.
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The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral that we hold cannot be realized upon or is liquidated at prices insufficient to recover the full amount of the loan. We cannot assure you that any such losses would not materially and adversely affect our business, financial condition or results of operations.
A substantial decline in the value of our Federal Home Loan Bank of Indianapolis common stock may adversely affect our financial condition.
We own common stock of the Federal Home Loan Bank of Indianapolis (the “FHLB”), in order to qualify for membership in the Federal Home Loan Bank system, which enables us to borrow funds under the Federal Home Loan Bank advance program. The carrying value of our FHLB common stock was approximately $2.6 million as of December 31, 2011.
Published reports indicate that certain member banks of the Federal Home Loan Bank system may be subject to asset quality risks that could result in materially lower regulatory capital levels. In December 2008, certain member banks of the Federal Home Loan Bank system (including the FHLB) suspended dividend payments and the repurchase of capital stock until further notice. FHLB has subsequently reinstated dividend payments. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLB, could be substantially diminished or reduced to zero. Consequently, given that there is no market for our FHLB common stock, we believe that there is a risk that our investment could be deemed other-than-temporarily impaired at some time in the future. If this occurs, it may adversely affect our results of operations and financial condition. If the FHLB were to cease operations, or if we were required to write-off our investment in the FHLB, our business, financial condition, liquidity, capital and results of operations may be materially adversely affected.
Impairment of investment securities, other intangible assets, or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations.
In assessing the impairment of investment securities, we consider the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuers, whether the market decline was affected by macroeconomic conditions and whether we have the intent to sell the debt security or will be required to sell the debt security before its anticipated maturity.
Under current accounting standards, goodwill and certain other intangible assets with indeterminate lives are no longer amortized but, instead, are assessed for impairment periodically or when impairment indicators are present. As of March 31, 2009, the Company determined that
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the full amount of the goodwill carried on its financial statements was impaired and, accordingly, a goodwill impairment charge was taken in the first quarter of 2009 for the entire book value of goodwill of $3.5 million.
Deferred tax assets are only recognized to the extent it is more likely than not they will be realized. Should our management determine it is not more likely than not that the deferred tax assets will be realized, a valuation allowance with a charge to earnings would be reflected in the period. At December 31, 2011, the Company's net deferred tax asset was $9.9 million, of which $5.7 million was disallowed for regulatory capital purposes. Based on the levels of taxable income in prior years, the significant improvement in operating results in 2011 compared to 2010 and 2009, and the Company’s expectation of a return to sustained profitability in future years as a result of strong core earnings, management has determined that no valuation allowance was required at December 31, 2011. If the Company is required in the future to take a valuation allowance with respect to its deferred tax asset, its financial condition, results of operations and regulatory capital levels would be negatively affected.
An “ownership change” for purposes of Section 382 of the Internal Revenue Code may materially impair our ability to use our deferred tax assets.
Our ability to use our deferred tax assets to offset future taxable income will be limited if we experience an “ownership change” as defined in Section 382 of the Internal Revenue Code. In general, an ownership change will occur if there is a cumulative increase in our ownership by “5-percent shareholders” (as defined in the Code) that exceeds 50 percentage points over a rolling three-year period. A corporation that experiences an ownership change will generally be subject to an annual limitation on the use of its pre-ownership change deferred tax assets equal to the equity value of the corporation immediately before the ownership change, multiplied by the long-term tax-exempt rate.
In the event an “ownership change” was to occur, we could realize a permanent loss of a portion of our U.S. federal deferred tax assets and lose certain built-in losses that have not been recognized for tax purposes. The amount of the permanent loss would depend on the size of the annual limitation (which is a function of our market capitalization at the time of an “ownership change” and the then prevailing long-term tax exempt rate) and the remaining carry forward period (U.S. federal net operating losses generally may be carried forward for a period of 20 years). The resulting loss could have a material adverse effect on our results of operations and financial condition and could also decrease the Bank's regulatory capital. We performed an evaluation of potential impairment at December 31, 2011, and determined that if an “ownership change” had occurred on December 31, 2011, we would have had no impairment of our net deferred tax asset.
If we are required to take a valuation allowance with respect to our mortgage servicing rights, our financial condition and results of operations would be negatively affected.
At December 31, 2011, our mortgage servicing rights had a book value of $5.4 million and a fair value of approximately $7.3 million. Because of the current interest rate environment and the increasing rate and speed of mortgage refinancings, it is possible that we may have to take a valuation allowance with respect to our mortgage servicing rights in the future. If we are required
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in the future to take a valuation allowance with respect to our mortgage servicing rights, our financial condition and results of operations would be negatively affected.
We may be required to pay additional insurance premiums to the FDIC, which could negatively impact earnings.
Recent insured institution failures, as well as deterioration in banking and economic conditions, have significantly increased FDIC loss provisions, resulting in a decline in the designated reserve ratio to historical lows. The reserve ratio may continue to decline over the next several years. In addition, the limit on FDIC coverage has been permanently increased to $250,000. These developments have caused our FDIC premiums to increase in recent periods.
Further, depending upon any future losses that the FDIC insurance fund may suffer, there can be no assurance that there will not be additional premium increases in order to replenish the fund. The FDIC may need to set a higher base rate schedule or impose special assessments due to future financial institution failures and updated failure and loss projections. Potentially higher FDIC assessment rates than those currently projected could have an adverse impact on our results of operations.
We depend upon the accuracy and completeness of information about customers.
In deciding whether to extend credit to customers, we may rely on information provided to us by our customers, including financial statements and other financial information. We may also rely on representations of customers as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. Our financial condition and results of operations could be negatively impacted to the extent that we extend credit in reliance on financial statements that do not comply with generally accepted accounting principles or that are misleading or other information provided by customers that is false or misleading.
We hold general obligation municipal bonds in our investment securities portfolio. If one or more issuers of these bonds were to become insolvent and default on its obligations under the bonds, it could have a negative effect on our financial condition and results of operations.
Some experts have raised concerns about the financial difficulties that municipalities are experiencing and the potential for many municipalities to become insolvent. Municipal bonds held by us totaled $21.0 million at December 31, 2011, and were issued by different municipalities. The municipal portfolio contains a small level of geographic risk, as approximately 2.0% of the investment portfolio is issued by political subdivisions located within Lenawee County, Michigan and 2.7% in Washtenaw County, Michigan. We believe the overall credit quality of the municipalities to be good and expect the municipal bonds to continue to perform in accordance with their terms. However, there can be no assurance that the financial conditions of these municipalities will not be materially and adversely affected by future economic conditions. If one or more of the issuers of these bonds were to become insolvent and default on their obligations under the bonds, it could have a negative effect on our financial condition and results of operations.
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We may be a defendant in a variety of litigation and other actions, which may have a material adverse effect on our financial condition and results of operations.
We may be involved from time to time in a variety of litigation arising out of our business. Our insurance may not cover all claims that may be asserted against us, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation or cause us to incur unexpected expenses, which could be material in amount. Should the ultimate expenses, judgments or settlements in any litigation exceed our insurance coverage, they could have a material adverse effect on our financial condition and results of operations. In addition, we may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms, if at all.
We may face risks related to future expansion and acquisitions or mergers, which include substantial acquisition costs, an inability to effectively integrate an acquired business into our operations, lower than anticipated profit levels and economic dilution to shareholders.
We may seek to acquire other financial institutions or parts of those institutions and may engage in de novo branch expansion in the future. We may incur substantial costs to expand. An expansion may not result in the levels of profits we anticipate. Integration efforts for any future mergers or acquisitions may not be successful, which could have a material adverse effect on our results of operations and financial condition. Also, we may issue equity securities, including our common stock and securities convertible into shares of our common stock, in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders.
Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of computer systems or otherwise, or failure or interruption of the Company's communication or information systems, could severely harm the Company’s business.
As part of the its business, the Corporation collects, processes and retains sensitive and confidential client and customer information on behalf of the Company and other third parties. Despite the security measures the Company has in place for its facilities and systems, and the security measures of its third party service providers, the Company may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors or other similar events.
The Company relies heavily on communications and information systems to conduct its business. Any failure or interruption of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems. In addition, customers could lose access to their accounts and be unable to conduct financial transactions during a period of failure or interruption of these systems.
Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information, whether by the Company or by its vendors, or failure or interruption of the Company's communication or information systems, could severely damage the Company’s reputation, expose it to risks of regulatory scrutiny, litigation and liability, disrupt
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the Company’s operations, or result in a loss of customer business, the occurrence of any of which could have a material adverse effect on the Company’s business.
We may not be able to effectively adapt to technological change, which could adversely affect our profitability.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers, all of which could adversely affect our profitability.
Our controls and procedures may fail or be circumvented, which could have a material adverse effect on our business, results of operations and financial condition.
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
A failure to fully comply with our memorandum of understanding could subject us to regulatory actions.
The Bank is a party to a Memorandum of Understanding, which documents an understanding among the Bank, the FDIC and OFIR. See the information under “Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources” on Page A-26 of this report, which information is incorporated here by reference. Failure to comply with the terms of the Memorandum of Understanding could result in enforcement orders or penalties from our regulators, under the terms of which we could, among other things, become subject to restrictions on our ability to develop any new business, as well as restrictions on our existing business, and we could be required to raise additional capital, dispose of certain assets and liabilities within a prescribed period of time, or both. The terms of any such enforcement order or action could have a material negative effect on our business, operations, financial condition, results of operations or the value of our common stock.
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If we cannot raise additional capital when needed, our ability to further expand our operations through organic growth and acquisitions could be materially impaired.
We are required by federal and state regulatory authorities to maintain specified levels of capital to support our operations. We may need to raise additional capital to support our current level of assets or our growth. Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. We cannot assure that we will be able to raise additional capital in the future on terms acceptable to us or at all. If we cannot raise additional capital when needed, our ability to maintain our current level of assets or to expand our operations through organic growth and acquisitions could be materially limited. Additional information on the capital requirements applicable to the Bank may be found under “Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources” on Page A-26 and A-27, and is incorporated here by reference.
Loss of our Chief Executive Officer or other executive officers could adversely affect our business.
Our success is dependent upon the continued service and skills of our executive officers and senior management. If we lose the services of these key personnel, it could adversely affect our business because of their skills, years of industry experience and the difficulty of promptly finding qualified replacement personnel. The services of Robert K. Chapman, our President and Chief Executive Officer, would be particularly difficult to replace.
Risks Associated with Our Stock
Our participation in U.S. Treasury's TARP Capital Purchase Program restricts our ability to pay dividends to common shareholders, restricts our ability to repurchase shares of common stock, and could have other negative effects.
On January 16, 2009, we sold to the United States Department of the Treasury $20,600,000 of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A, which will pay cumulative dividends at a rate of 5% for the first five years and 9% thereafter. We also issued to Treasury a 10-year Warrant to purchase 311,492 shares of our common stock at an exercise price of $9.92 per share. We will have the right to redeem the preferred stock at any time after three years. The payment of dividends on the TARP CPP preferred stock will reduce the amount of earnings available to pay dividends to common shareholders. This could negatively affect our ability to pay dividends on our common stock.
Under the TARP CPP, we are subject to restrictions on the payment of dividends to common shareholders and the repurchase of common stock. We may not pay any dividends on our common stock unless we are current on our dividend payments on the TARP CPP preferred stock. If we fail to pay in full dividends on the TARP CPP preferred stock for six dividend periods, whether consecutive or not, the holder of the TARP CPP preferred stock would have the right to elect two directors to our board of directors. This right would terminate only upon us declaring and paying in full all accrued and unpaid dividends for all past dividend periods,
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including the latest completed dividend period. This right could reduce the level of influence existing common shareholders have in our management policies.
If Treasury (or a subsequent holder) exercised the Warrant and purchased shares of common stock, each common shareholder's percentage of ownership of us would be smaller. As a result, each shareholder might have less influence in our management policies than before exercise of the Warrant. This could also have an adverse effect on the market price of our common stock.
Unless we are able to redeem the TARP CPP preferred stock before January 16, 2014, the cost of this capital will increase on that date, from 5% (approximately $1,030,000 annually) to 9% (approximately $1,854,000 annually). Depending on our financial condition at the time, this increase in dividends on the TARP CPP preferred stock could have a negative effect on our capacity to pay common stock dividends.
Additional restrictions and requirements may be imposed by the Treasury or Congress on us at a later date. These restrictions may apply to us retroactively and their imposition is outside of our control.
Our ability to pay dividends is limited and we may be unable to pay future dividends.
We have suspended payment of dividends on our common stock in order to preserve capital. Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of the Bank to pay dividends to the Company is limited by its obligations to maintain sufficient capital and by other general restrictions on dividends that are applicable to banks. If the Company or the Bank does not satisfy these regulatory requirements, we would be unable to pay dividends on our common stock. Additional information on restrictions on payment of dividends by the Company and the Banks may be found in Item 1 of this report under "Supervision and Regulation," Item 5 of this report, and under Note 15 on Page A-63, all of which information is incorporated here by reference.
The market price of our common stock can be volatile, which may make it more difficult to resell our common stock at a desired time and price.
Stock price volatility may make it more difficult for a shareholder to resell our common stock when a shareholder wants to and at prices a shareholder finds attractive or at all. Our stock price can fluctuate significantly in response to a variety of factors. General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause our stock price to decrease regardless of operating results.
Our common stock trading volume may not provide adequate liquidity for our shareholders.
Our common stock is quoted on the OTC Bulletin Board. The average daily trading volume for our common stock is far less than larger financial institutions. Due to this relatively low trading volume, significant sales of our common stock, or the expectation of these sales, may place significant downward pressure on the market price of our common stock. We may apply for listing of our common stock on the NASDAQ Stock Market or another securities exchange in the
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future. No assurance can be given that our application will be approved or that we will meet applicable initial listing standards in the future. No assurance can be given that an active trading market in our common stock will develop in the foreseeable future or can be maintained.
We may issue additional shares of our common stock in the future, which could dilute a shareholder's ownership of common stock.
Our articles of incorporation authorize our board of directors, without shareholder approval, to, among other things, issue additional shares of common or preferred stock. The issuance of any additional shares of common or preferred stock could be dilutive to a shareholder's ownership of our common stock. To the extent that we issue options or warrants to purchase common stock in the future and the options or warrants are exercised, our shareholders may experience further dilution. Holders of shares of our common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series and, therefore, shareholders may not be permitted to invest in future issuances of our common or preferred stock. We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations, and the terms of our MOU impose heightened capital requirements on us. Accordingly, regulatory requirements and/or further deterioration in our asset quality may require us to sell common stock to raise capital under circumstances and at prices which result in substantial dilution.
We may issue debt and equity securities that are senior to our common stock as to distributions and in liquidation, which could negatively affect the value of our common stock.
In the future, we may increase our capital resources by entering into debt or debt-like financing or issuing debt or equity securities, which could include issuances of senior notes, subordinated notes, preferred stock or common stock. In the event of our liquidation, our lenders and holders of our debt or preferred securities would receive a distribution of our available assets before distributions to the holders of our common stock. Our decision to incur debt and issue securities in future offerings will depend on market conditions and other factors beyond its control. We cannot predict or estimate the amount, timing or nature of its future offerings and debt financings. Future offerings could reduce the value of shares of our common stock and dilute a shareholder's interest in us.
Our common stock is not insured by any governmental entity.
Our common stock is not a deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental entity. Investment in our common stock is subject to risk, including possible loss.
Anti-takeover provisions could negatively impact our shareholders.
Our articles of incorporation and the laws of Michigan include provisions which are designed to provide our board of directors with time to consider whether a hostile takeover offer is in the best interests of us and our shareholders. These provisions could discourage potential acquisition proposals and could delay or prevent a change in control. The provisions also could diminish the opportunities for a holder of our common stock to participate in tender offers, including tender
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offers at a price above the then-current price for our common stock. These provisions could also prevent transactions in which our shareholders might otherwise receive a premium for their shares over then-current market prices, and may limit the ability of our shareholders to approve transactions that they may deem to be in their best interests.
If an entity holds as little as a 5% interest in our outstanding securities, that entity could, under certain circumstances, be subject to regulation as a “bank holding company.”
Any entity, including a “group” composed of natural persons, owning or controlling with the power to vote 25% or more of our outstanding securities, or 5% or more if the holder otherwise exercises a “controlling influence” over us, may be subject to regulation as a “bank holding company” in accordance with the Bank Holding Company Act of 1956, as amended (the “BHC Act”). In addition, (i) any bank holding company or foreign bank with a U.S. presence may be required to obtain the approval of the Federal Reserve Board under the BHC Act to acquire or retain 5% or more of our outstanding securities and (ii) any person not otherwise defined as a company by the BHC Act and its implementing regulations may be required to obtain the approval of the Federal Reserve Board under the Change in Bank Control Act of 1978, as amended, to acquire or retain 10% or more of our outstanding securities. Becoming a bank holding company imposes statutory and regulatory restrictions and obligations, such as providing managerial and financial strength for its bank subsidiaries. Regulation as a bank holding company could require the holder to divest all or a portion of the holder's investment in our securities or those nonbanking investments that may be deemed impermissible or incompatible with bank holding company status, such as a material investment in a company unrelated to banking.
ITEM 1B
ITEM 1B UNRESOLVED STAFF COMMENTS
None
ITEM 2
ITEM 2 PROPERTIES
The Company’s executive offices are located in Ann Arbor, MI. The Company and the Bank operate twenty properties in Washtenaw, Lenawee, Livingston and Monroe Counties in Michigan. Six of the properties are leased, and all others are owned. Sixteen properties include banking offices, and all but two of the banking offices offer drive-up banking services. All banking offices also offer ATM service. In addition to banking offices, United operates one loan production office in Brighton, and administrative and support facilities at the Hickman Financial Center, support and training facilities at the Downing Center, a Wealth Management office, and additional training facilities, all in Tecumseh.
ITEM 3
ITEM 3 LEGAL PROCEEDINGS
As of the date of this report, there are no material pending legal proceedings other than routine litigation incidental to the business of banking, to which the Company or its subsidiaries are a party or of which any of our properties are the subject. As of the date of this report, neither the Company nor its subsidiaries are involved in any proceedings to which any director, principal officer, affiliate thereof, or person who owns of record or beneficially more than five percent
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(5%) of the outstanding stock of the Company, or any associate of the foregoing, is a party or has a material interest adverse to the Company.
ITEM 4
ITEM 4 MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5
ITEM 5
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCK-HOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
MARKET FOR COMMON STOCK
The following table shows the high and low bid prices of common stock of the Company for each quarter of 2011 and 2010 as quoted on the OTC Bulletin Board, under the symbol of “UBMI” and cash dividends declared for each quarter of 2011 and 2010. The quoted bid prices reflect inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. They also do not include private transactions not involving brokers or dealers. The Company had 1,236 shareholders of record as of December 31, 2011.
The board of directors of the Company suspended payment of cash dividends on its shares of common stock in the second quarter of 2009. The board believes that it is in the Company’s best interest to preserve capital given the financial market and economic conditions in Michigan and the United States.
Banking laws and regulations restrict the amount the Bank can transfer to the Company in the form of cash dividends and loans. Those restrictions are discussed in Note 15 on Page A-50, which discussion is incorporated here by reference. In addition, under the CPP, the Company is subject to restrictions on the declaration and payment of dividends to common shareholders. These restrictions are discussed in Part I, Item 1 of this report and Note 15 on Page A-63 which discussion is incorporated here by reference. See also, the risk factor on Page 27 of this report entitled “Our participation in U.S. Treasury's TARP Capital Purchase Program restricts our
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ability to pay dividends to common shareholders, restricts our ability to repurchase shares of common stock, and could have other negative effects,” which is incorporated here by reference.
The following table provides information regarding equity compensation plans approved by shareholders as of December 31, 2011.
The Company has no equity compensation plans not approved by shareholders.
ITEM 6
ITEM 6
SELECTED FINANCIAL DATA
The following table shows summarized historical consolidated financial data for the Company. The table is unaudited. The information in the table is derived from the Company's audited financial statements for 2007 through 2011. This information is only a summary. You should read it in conjunction with the consolidated financial statements, related notes, Management's Discussion and Analysis of Financial Condition and Results of Operations, and other information included in this report. Information is unaudited; in thousands, except per share data.
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ITEM 7
ITEM 7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item is contained on Pages A-1 through A-29, and is incorporated by reference here.
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ITEM 7A
ITEM 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8
ITEM 8
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Supplementary financial information required by this item is contained in Note 22 on Page A-74 and A-75, and is incorporated by reference here.
Our consolidated financial statements and related notes are contained on Pages A-30 through A-75 hereof, and are incorporated by reference here.
ITEM 9
ITEM 9
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A
CONTROLS AND PROCEDURES
(a)
Our management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”). Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report (the “Evaluation Date”), and have concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms.
(b)
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined under Rule 13a-15(f) of the Exchange Act. The Company's internal control over financial reporting system was designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our board of directors, management and other personnel, to provide
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reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and 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.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's internal control over financial reporting as of the Evaluation Date, and has concluded that, as of the Evaluation Date, the Company's internal control over financial reporting was effective. Management identified no material weakness in the Company's internal control over financial reporting as of the Evaluation Date. In making this evaluation, management used the criteria set forth by the Committee of Sponsoring Organizations of Treadway Commission in “Internal Control - Integrated Framework.”
/s/ Robert K. Chapman
/s/ Randal J. Rabe
Robert K. Chapman
Randal J. Rabe
President and Chief Executive Officer
Executive Vice President and Chief Financial Officer
(c)
There has been no change in the Company's internal control over financial reporting that occurred during the fiscal quarter ended December 31, 2011 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
ITEM 9B
ITEM 9B
OTHER INFORMATION
None.
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PART III
ITEM 10
ITEM 10
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The Company has adopted a Code of Business Conduct and Ethics (the “Code”) that applies to all co-workers, officers and directors of the Company and its subsidiaries. The Code is designed to deter wrongdoing and to promote:
•
Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
•
Full, fair, accurate, timely and understandable disclosure in reports and documents that the Company files with, or submits to, the Commission and in other public communications made by the registrant;
•
Compliance with applicable governmental laws, rules and regulations;
•
Prompt internal reporting of violations of the Code to an appropriate person or persons identified in the Code; and
•
Accountability for adherence to the Code.
A copy of the Code is posted on our website at www.ubat.com.
The information required by this item, other than as set forth above, is contained under the heading “Directors and Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company's definitive Proxy Statement in connection with its 2012 Annual Meeting of Shareholders and is incorporated here by reference
ITEM 11
ITEM 11
EXECUTIVE COMPENSATION
The information required by this item is contained under the heading “Compensation of Directors and Executive Officers” and “Compensation Committee Interlocks and Insider Participation” in the Company's definitive Proxy Statement in connection with its 2012 Annual Meeting of Shareholders and is incorporated here by reference.
ITEM 12
ITEM 12
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is contained under the headings “Compensation of Directors and Executive Officers - Equity Compensation Plan Information,” “Security Ownership of Certain Beneficial Owners,” and “Security Ownership of Management,” in the Company's definitive Proxy Statement in connection with its 2012 Annual Meeting of Shareholders and is incorporated here by reference.
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ITEM 13
ITEM 13
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is contained under the headings “Directors and Executive Officers,” and “Directors, Executive Officers, Principal Shareholders and their Related Interests - Transactions with the Bank” in the Company's definitive Proxy Statement in connection with its 2012 Annual Meeting of Shareholders and in Note 14 on Page A-61 and is incorporated here by reference.
ITEM 14
ITEM 14
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is contained under the heading “Relationship With Independent Public Accountants” in the Company's definitive Proxy Statement in connection with its 2012 Annual Meeting of Shareholders and is incorporated here by reference.
PART IV
ITEM 15
ITEM 15
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
1.
The index to financial statements is included in Item 8 on Page 34 of this report, and is incorporated here by reference.
2.
Financial statement schedules are not applicable.
(b)
The exhibits filed in response to Item 601 of Regulation S-K are listed in the Exhibit Index, which is incorporated here by reference.
(c)
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
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UNITED BANCORP, INC.
Management's Discussion and Analysis of
Financial Condition and Results of Operations
and
Consolidated Financial Statements
Nature of Business
United Bancorp, Inc. (the "Company" or “United”) is a Michigan bank holding company headquartered in Ann Arbor, Michigan. The Company, through its subsidiary bank, United Bank & Trust ("UBT" or the “Bank”), offers a full range of financial services through a system of sixteen banking offices located in Lenawee, Monroe and Washtenaw Counties and one loan production office in Livingston County. The Bank is 100% owner of United Mortgage Company. United Structured Finance Company (“USFC”) is a DBA of the Bank’s structured finance group. While the Company's chief decision makers monitor the revenue streams of the Company’s various products and services, operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all of the Company's financial services operations are considered by management to be aggregated in one reportable operating segment - commercial banking.
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Management's Discussion and Analysis of Financial Condition and Results of Operations
This discussion provides information about the consolidated financial condition and results of operations of the Company and the Bank.
Background
We are a Michigan corporation headquartered in Ann Arbor, Michigan and serve as the holding company for UBT, a Michigan-chartered bank organized over 115 years ago. We are registered as a bank holding company under the Bank Holding Company Act of 1956. At December 31, 2011, we had total assets of approximately $885.0 million, deposits of approximately $764.9 million, and total shareholders' equity of approximately $93.8 million. Our common stock is quoted on the OTC Bulletin Board under the symbol "UBMI."
We have four primary lines of business under one operating segment of commercial banking: banking services, residential mortgage, wealth management and structured finance. Subject to our overall business strategy, each line of business is encouraged to be entrepreneurial in how it develops and implements its business. We believe that these four lines of business provide us with a diverse and strong core revenue stream that is unmatched by our community bank competitors and positions us well for future revenue growth and profitability. During the twelve month period ended December 31, 2011, our non-interest income equaled 36.4% of our operating revenues and for each of the last five years ended December 31, 2011 approximated 33.7% of our operating revenues. This diverse revenue stream has enabled us to recognize a pre-tax, pre-provision return on average assets of 1.44% for the twelve month period ended December 31, 2011. Our average pre-tax, pre-provision return on average assets over the last five years ended December 31, 2011 was approximately 1.70%. The presentation of pre-tax, pre-provision return on average assets is not consistent with, or intended to replace, presentation under generally accepted accounting principles. For additional information about our pre-tax, pre-provision income and pre-tax, pre-provision return on average assets, please see "Earnings Summary and Key Ratios” under “Results of Operations” on Page A-17 and A-19.
Our Bank offers a full range of services to individuals, corporations, fiduciaries and other institutions. Banking services include checking accounts, NOW accounts, savings accounts, time deposit accounts, money market deposit accounts, safe deposit facilities and money transfers. Lending operations provide real estate loans, secured and unsecured business and personal loans, consumer installment loans, credit card and check-credit loans, home equity loans, accounts receivable and inventory financing, and construction financing. The Bank offers a full complement of online services, including internet banking and bill payment. In 2011, the Bank opened its first loan production office in neighboring Livingston County, Michigan.
Our mortgage company, United Mortgage Company, offers our customers a full array of conventional residential mortgage products, including purchase, refinance and construction loans. Due to our local decision making and fully-functional back office, we have consistently been the most active originator of mortgage loans in our market area. United Mortgage Company was the leading residential mortgage lender in Lenawee and Washtenaw Counties for 2010. Information for 2011 is not yet available.
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Our Wealth Management Group is a key focus of our growth and diversification strategy and offers a variety of investment services to individuals, corporations and governmental entities. Our Wealth Management Group generated 29.5% of our noninterest income for the twelve months ended December 31, 2011.
Our structured finance group, United Structured Finance Company, offers simple, effective financing solutions to small businesses and commercial property owners, primarily by utilizing various government guaranteed loan programs and other off-balance sheet finance solutions through secondary market sources. For the twelve months ended September 30, 2011 and 2010, United Structured Finance Company was the leading SBA lender in each of Lenawee, Washtenaw and Livingston Counties. For the twelve months ended September 30, 2011, USFC was the third largest SBA 7A lender in Michigan, based on loan volume.
Economic Trends
Our primary market area is Washtenaw, Livingston, Lenawee, and Monroe Counties in Michigan, and generally encompasses the Ann Arbor metropolitan area, which we believe is our primary area for future organic growth.
Michigan had the eleventh highest seasonally-adjusted unemployment rate in the United States at November 20111, improving from the fourth highest as of December 2010.2 The Michigan seasonally-adjusted unemployment rate of 9.3%3 for December 2011 was the lowest monthly rate since September 2008.4 University of Michigan economists estimate that Michigan will see employment growth for 2011 of 63,000 total net jobs when final numbers are available, just two years after losing 245,000 jobs during 2009. Michigan lost just 12,900 jobs in all of 2010, representing a significant decrease from the monthly average loss of 16,500 in 2008 and 17,000 in 2009, to an average monthly decline of 1,100 jobs in 2010. 5
Washtenaw County had the lowest unadjusted unemployment rate in the state at 5.2% for November 2011.6 Washtenaw County had a population of approximately 345,000 for 20107 and had a median household income of approximately $54,900 for 2009, which was the fourth highest in the state.8
The economic base of Washtenaw County has a substantial reliance on health care, education and automotive high technology. Economic stability is provided to a great extent by the University of Michigan, which is a major employer and is not as economically sensitive to the fluctuations of the automotive industry. The services and public sectors account for a substantial percentage of total employment, in large part due to the University of Michigan and the University of Michigan Medical Center.
1U.S. Bureau of Labor Statistics, Local Area Unemployment Statistics, Unemployment Rates for November 2011.
2 U.S. Bureau of Labor Statistics, Local Area Unemployment Statistics, Unemployment Rates for December 2010.
3 Michigan Labor Market Information, Data Explorer - Unemployment Statistics, Statewide, Adjusted (Monthly Historical).
4 Id..
5 University of Michigan News Service, Michigan's Economy Will Continue to Add Jobs, November 18, 2011.
6 Michigan Labor Market Information, Data Explorer - Unemployment Statistics, by County (November, 2011).
7 Michigan State Senate, Senate Fiscal Agency, Michigan Population by County.
8 Michigan Labor Market Information, Data Explorer - Income (2009 Annual).
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Livingston County had an unadjusted unemployment rate of 7.6% for November 2011.9 The county had a population of approximately 181,000 for 201010 and had a median household income of approximately $68,500 for 2009, which was the highest in the state.11 Approximately 35 percent of the land in Livingston County is used for farming, and a large portion of the population works outside the county. Manufacturing in the county is dominated by auto-related sectors. 12 Of the 171 counties in Michigan and Ohio, Livingston County is projected to have the highest market growth potential over the next five years.13
The economic base of Lenawee and Monroe Counties is primarily agricultural and light manufacturing, with their manufacturing sectors exhibiting moderate dependence on the automotive industry. Lenawee County had a population of approximately 100,000 for 201014 and a median household income of approximately $46,700 for 2009.15 Monroe County had a population of approximately 152,000 for 201016 and a median household income of approximately $53,200 for 2009.17 Lenawee County had an unadjusted unemployment rate of 8.5% for November 201118 and Monroe County had an unadjusted unemployment rate of 7.5% for that same month.19
Market Developments
Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act") was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection ("CFPB"), and will require the CFPB and other federal agencies to implement many new and significant rules and regulations. The act is categorized into 16 titles and requires regulators to create rules, conduct studies, and issue periodic reports. The rulemaking phase began shortly after enactment. Implementation is occurring in stages, and widespread and complex changes are expected.The Dodd-Frank Act contains more than 300 provisions that expressly indicate that rulemaking is either required or permitted.20 At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact the Company's business. Compliance with these new laws and regulations will likely result in additional costs, which could be significant and could adversely impact the Company's results of operations, financial condition or liquidity.
9 Michigan Labor Market Information, Data Explorer - Unemployment Statistics, by County (November 2011).
10 Michigan State Senate, Senate Fiscal Agency, Michigan Population by County.
11 Michigan Labor Market Information, Data Explorer - Income (2009 Annual).
12 Economic Development Council of Livingston County, Michigan www.livingstonedc.com.
13 BankIntelligence.com.
14 U.S. Census Bureau, Population Finder (Lenawee County).
15 Michigan Labor Market Information, Data Explorer - Income (2009 Annual).
16 U.S. Census Bureau, Population Finder (Monroe County).
17 Michigan Labor Market Information, Data Explorer - Income (2009 Annual).
18 Michigan Labor Market Information, Data Explorer -Unemployment Statistics (November 2011).
19 Id.
20 Navigating Dodd-Frank: An Implementation Update and Resource Guide; SRC Insights: First Quarter 2011; Federal Reserve Bank of Philadelphia
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Deposit Insurance
In 2011, the FDIC changed the assessment base for FDIC insurance assessments from adjusted domestic deposits to a bank’s average consolidated total assets minus average tangible equity, as required by the Dodd-Frank Act.21 The new measurement defines tangible equity as Tier 1 capital. Since the new base is larger than the current base, the FDIC lowered assessment rates to between 2.5 and 9 basis points on the broader base for banks in the lowest risk category, and 30 to 45 basis points for banks in the highest risk category. Initial assessment rates were determined by combining supervisory ratings with financial ratios. Under the new rule, the Bank pays 20% to 35% less in FDIC assessments than under the prior methodology, at similar risk ratings and balance sheet size. Those reductions were realized in 2011 beginning with the assessment for the second quarter of 2011 and payable at the end of September 2011.
As a result of provisions of the Dodd-Frank Act, all funds in a "noninterest-bearing transaction account" are insured in full by the FDIC from December 31, 2010, through December 31, 2012. This temporary unlimited coverage is in addition to, and separate from, the general FDIC deposit insurance coverage of up to $250,000 available to depositors. The increase in maximum deposit insurance coverage to $250,000 was made permanent under the Dodd-Frank Act.
Other Developments
Memorandum of Understanding
On January 15, 2010, UBT entered into a Memorandum of Understanding with the Federal Deposit Insurance Corporation (“FDIC”) and the Michigan Office of Financial and Insurance Regulation (“OFIR”). On January 11, 2011, we entered into a revised Memorandum of Understanding (“MOU”) with substantially the same requirements as the MOU dated January 15, 2010. The MOU is not a “written agreement” for purposes of Section 8 of the Federal Deposit Insurance Act. The MOU documents an understanding among UBT, the FDIC and OFIR, that, among other things, (i) UBT will not declare or pay any dividend to the Company without the prior consent of the FDIC and OFIR; and (ii) UBT will have and maintain its Tier 1 capital ratio at a minimum of 9% for the duration of the MOU, and will maintain its ratio of total capital to risk-weighted assets at a minimum of 12% for the duration of the MOU.
Board Leadership
James C. Lawson was elected as Chairman of the Board following the 2011 Annual Meeting of Shareholders. Mr. Lawson has a diverse background in the formation and operation of a successful business, and has served as a Director of the Company since 1986. Lawson succeeded David S. Hickman, who reached mandatory Board retirement age in 2011. Director James D. Buhr was elected as Vice Chairman of the Board following the 2011 Annual Meeting of Shareholders.
21 FDIC Notice of Proposed Rulemaking and Request for Comment, November 9, 2010
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Capital Management
In December, 2010, the Company closed its public offering of 7,583,800 shares of common stock. The net proceeds to the Company, after deducting underwriting discounts and commissions and offering expenses, were approximately $17.1 million. The Company has contributed $12.0 million of the net proceeds of the offering to the capital of the Bank to increase the Bank's capital and regulatory capital ratios. As a result of the additional capital, the Bank was in compliance with the capital requirements of its MOU with the FDIC and OFIR at December 31, 2011 and 2010. At December 31, 2011 the Bank’s Tier 1 capital ratio was 9.20%, and its ratio of total capital to risk-weighted assets was 15.49%.
Executive Summary
The Company achieved consolidated net income of $917,000 for the twelve months ended December 31, 2011, improving from a full year loss of $3.7 million in 2010. While the Company’s provision for loan losses has declined significantly from 2010 levels, net interest margin has also declined as a result of continued low interest rates and continued elevated levels of liquidity. In addition, while credit quality continues to improve, expenses relating to collection and disposition of troubled assets have increased.
The Company’s return on average assets for the twelve month period ended December 31, 2011 was 0.10%, compared to -0.42% for the same period of 2010. Return on average shareholders’ equity of 0.98% for the twelve months ended December 31, 2011 was up from -4.66% for the same period of 2010.
Net interest income for 2011 was 3.3% lower than achieved in 2010, in spite of an increase in average earning assets. At the same time, the Company’s net interest margin has declined in part as a result of a 40.1% increase in average balances of investments in 2011 compared to 2010, continued declines in loan balances, increased deposit balances and elevated levels of short-term liquid assets, and in spite of a relatively large increase in non-interest bearing deposits.
Noninterest income improved by $913,000, or 5.6%, in 2011 as compared to 2010. Most categories of noninterest income contributed to this improvement, while deposit service charges continued the decline noted over the past two years, with a decrease of 10.0% in 2011 compared to 2010. That followed a decline of 19.8% for 2010 compared to 2009.
Total noninterest expenses increased by 6.5% for all of 2011 compared to 2010. Substantial decreases in FDIC insurance premiums and modest decreases in occupancy and equipment expense were more than offset by increases in most other noninterest expense categories.
The Company’s provision for loan losses for the twelve months ended December 31, 2011 of $12.2 million was down 43.6% from $21.5 million for the same period of 2010. This significantly reduced level of provision for loan losses is a result of a decline in nonperforming loans, a reduction in nonperforming asset formation, and a slowdown in loan rating downgrades during 2011.
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Total consolidated assets of the Company were $885.0 million at December 31, 2011, up 2.7% from $861.7 million at December 31, 2010. Gross portfolio loans have continued to decline in 2011 as a result of stagnant loan demand, charge-offs and the Company’s effective use of loan sales and servicing to mitigate credit and interest rate risk. The Company generally sells its fixed rate long-term residential mortgages on the secondary market, and retains adjustable rate mortgages in its loan portfolio. While the Company’s portfolio loans have declined by $28.3 million, or 4.8%, since December 31, 2010, the balance of loans serviced for others has increased by $80.1 million, or 12.2%, over the same period.
The Company continued to hold elevated levels of investments, federal funds sold and cash equivalents in order to protect the balance sheet during this prolonged period of economic uncertainty. United’s balances in federal funds sold and other short-term investments were $91.8 million at December 31, 2011, compared to $95.6 million at December 31, 2010. Balances of securities held for sale increased by $48.7 million, or 39.1% during the same period.
United experienced significant growth in balances of non-interest bearing deposits during 2011, while interest-bearing deposits were up modestly during the same period. Total deposits increased by $30.9 million, or 4.2%, from December 31, 2010 to December 31, 2011. The majority of the Bank’s deposits are derived from core client sources, relating to long-term relationships with local individual, business and public clients. Public clients include local government and municipal bodies, hospitals, universities and other educational institutions. As a result of its strong core funding, the Company’s cost of deposits was 0.83% for all of 2011, down from 1.13% for 2010.
The Company’s ongoing proactive efforts to resolve nonperforming loans have contributed to the Company’s improving credit quality trends in 2011. Within the Company’s loan portfolio, $25.8 million of loans were considered nonperforming at December 31, 2011, compared to $29.2 million as of December 31, 2010. Total nonperforming loans as a percent of total portfolio loans improved from 4.94% at the end of 2010 to 4.57% at December 31, 2011. For purposes of this presentation, nonperforming loans consist of nonaccrual loans and accruing loans that are past due 90 days or more and exclude accruing restructured loans. Balances of accruing restructured loans at December 31, 2011 and 2010 were $21.8 million and $17.3 million, respectively.
The Company’s ratio of allowance for loan losses to total loans at December 31, 2011 was 3.66%, and covered 80.0% of nonperforming loans, compared to 4.25%, and 86.0%, respectively, at December 31, 2010. The Company’s allowance for loan losses decreased by $4.5 million, or 18.0%, from December 31, 2010 to December 31, 2011. Net charge-offs of $16.7 million for 2011 were 1.8% above the $16.4 million charged off in 2010.
Financial Condition
Securities
Balances in the securities portfolio increased in recent periods, generally reflecting deposit growth in excess of loan growth. The makeup of the Company’s investment portfolio evolves with the changing price and risk structure, and liquidity needs of the Company. The table below
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reflects the carrying value of various categories of investment securities of the Company, along with the percentage composition of the portfolio by type as of the end of 2011 and 2010.
Investments in U.S. Treasury and agency securities are considered to possess low credit risk. Obligations of U.S. government agency mortgage-backed securities possess a somewhat higher interest rate risk due to certain prepayment risks. The municipal portfolio contains a small level of geographic risk, as approximately 2.0% of the investment portfolio is issued by political subdivisions located within Lenawee County, Michigan and 2.7% in Washtenaw County, Michigan. The Company's portfolio contains no mortgage-backed securities or structured notes that the Company believes to be “high risk.” The Bank’s investment in local municipal issues also reflects our commitment to the development of the local area through support of its local political subdivisions. The Company has no investments in securities of issuers outside of the United States.
Management believes that the unrealized gains and losses within the investment portfolio are temporary, since they are a result of market changes, rather than a reflection of credit quality. Management has no specific intent to sell any securities, although the entire investment portfolio is classified as available for sale. The following chart summarizes net unrealized gains (losses) in each category of the portfolio at the end of 2011 and 2010.
FHLB Stock
The Bank is a member of the Federal Home Loan Bank of Indianapolis (“FHLBI”) and holds a $2.6 million investment in stock of the FHLBI. The investment is carried at par value, as there is not an active market for FHLBI stock. If total Federal Home Loan Bank gross unrealized losses were deemed “other than temporary” for accounting purposes, this would significantly impair the Federal Home Loan Bank capital levels and the resulting value of FHLBI stock. The FHLBI reported a profit of $74.3 million for the first nine months of 201122, and continues to pay dividends on its stock. The Company regularly reviews the credit quality of FHLBI stock for
22 Federal Home Loan Bank of Indianapolis, Form 10-Q for the third quarter of 2011
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impairment, and determined that no impairment of FHLBI stock was necessary as of December 31, 2011.
Loans
As a full service lender, the Bank offers a variety of loan products in its markets. Portfolio loan balances declined by 4.8% in 2011, with the declines across all major categories of the portfolio. Personal loans on the Company's balance sheet included home equity lines of credit, direct and indirect loans for automobiles, boats and recreational vehicles, and other items for personal use. Personal loan balances declined by 3.7% for the year. Business loan balances were down 5.4% during 2011, following a decline of 9.7% in 2010. The decline in loans to commercial enterprises reflects a continued stagnation in demand, primarily relating to the current economic conditions, as well as write-downs, charge-offs and payoffs.
The Bank generally sells its production of fixed-rate mortgages on the secondary market, and retains high credit quality mortgage loans that are not otherwise eligible to be sold on the secondary market and shorter-term adjustable rate mortgages in its portfolio. As a result, the mix of mortgage production for any given year will have an impact on the amount of mortgages held in the portfolio of the Bank. Refinancing activity has resulted in a decline in residential mortgage balances on the Bank's portfolio of 3.4% in 2011 and 0.5% in 2010.
The Bank’s loan portfolio includes $7.4 million of purchased participations in business loans originated by other institutions. These participations represent 1.4% of total portfolio loans. Of those participation loans, 75.5% of the outstanding balances are the result of participations purchased from other Michigan banks.
Outstanding balances of loans for construction and development declined by approximately $1.8 million, or 4.4%, during 2011. The change in balances reflects an increase in the amount of individual construction loan volume, combined with the shift of some construction loans to permanent financing and the payoff or charge-off of a number of construction and development loans. Residential construction loans generally convert to residential mortgages to be retained in the Bank's portfolios or to be sold in the secondary market, while commercial construction loans generally will be converted to commercial mortgages.
The following table shows the balances of each of the various categories of loans of the Company, along with the percentage of the total portfolio, as of the end of 2011 and 2010.
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Credit Quality
Nonperforming Assets. The Company actively monitors delinquencies, nonperforming assets and potential problem loans. The accrual of interest income is discontinued when a loan becomes 90 days past due unless the loan is both well secured and in the process of collection, or the borrower's capacity to repay the loan and the collateral value appears sufficient. The chart below shows the amount of nonperforming assets by category at December 31, 2011 and 2010.
Total nonaccrual loans have decreased by $2.9 million, or 10.1% since the end of 2010, while accruing loans past due ninetydays or more have decreased by $552,000, or 94.7% for the same period. The change in nonaccrual loans principally reflects the payoff or charge-off of some nonperforming loans, net of the migration of some loans to nonaccrual status. Subsequent payments on nonaccrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Nonaccrual loans are returned to accrual status when, in the judgment of management, the financial position of the borrower indicates there is no longer any reasonable doubt as to the timely collection of interest or principal. The Company requires a period of satisfactory performance of not less than six months before returning a nonaccrual loan to accrual status.
Total nonperforming loans have decreased by $3.5 million, or 11.8%, since December 31, 2010. Total nonperforming loans as a percent of total portfolio loans were 4.57% at December 31, 2011, down from 4.94% at December 31, 2010, while the allowance coverage of nonperforming loans decreased from 86.0% at December 31, 2010 to 80.0% at December 31, 2011. Loan
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workout and collection efforts continue with all delinquent clients, in an effort to bring them back to performing status.
Other assets owned includes other real estate owned and other repossessed assets, which may include automobiles, boats and other personal property. Holdings of other assets owned decreased by 14.7% since the end of 2010, as the Bank continued to sell assets while others have been added to its totals. At December 31, 2011, other real estate owned included 42 properties that were acquired through foreclosure or in lieu of foreclosure. The properties included 26 commercial properties, seven of which were the result of out-of-state loan participations, and sixteen residential properties. All properties are for sale. Other repossessed assets at December 31, 2011 consisted of one automobile.
The following table reflects the changes in other assets owned during 2011.
Troubled Debt Restructurings. In the course of working with borrowers, the Bank may choose to restructure the contractual terms of certain loans. In this scenario, the Bank attempts to work out an alternative payment schedule with the borrower in order to optimize collectability of the loan. Any loans that are modified are reviewed by the Bank to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two. If such efforts by the Bank do not result in a satisfactory arrangement, the loan is referred to legal counsel, at which time foreclosure proceedings are initiated. At any time prior to a sale of the property at foreclosure, the Bank may terminate foreclosure proceedings if the borrower is able to work-out a satisfactory payment plan.
It is the Bank’s policy to have any restructured loans which are on nonaccrual status prior to being restructured remain on nonaccrual status until six months of satisfactory borrower performance, at which time management would consider its return to accrual status. The balance of nonaccrual restructured loans, which is included in nonaccrual loans, was $10.7 million at December 31, 2011 and $8.5 million at December 31, 2010. If the restructured loan is on accrual status prior to being restructured, it is reviewed to determine if the restructured loan should remain on accrual status. The balance of accruing restructured loans was $21.8 million at December 31, 2011 and $17.3 million at December 31, 2010.
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Loans that are considered TDRs are classified as performing, unless they are on nonaccrual status or greater than ninety days delinquent as of the end of the most recent quarter. All TDRs are considered impaired by the Company. When it is determined that the borrower has met the six month satisfactory performance period (or six payments) under modified terms and the restructuring agreement specified an interest rate greater than or equal to an acceptable rate for a comparable new loan, the loan is considered to be performing. On a quarterly basis, the Company individually reviews all TDR loans to determine if a loan meets both of these criteria.
Accruing restructured loans at December 31, 2011 are comprised of two categories of loans on which interest is being accrued under their restructured terms, and the loans are current or less than ninety days past due. The first category consists of $18.6 million of commercial loans, primarily comprised of business loans that have been temporarily modified as interest-only loans, generally for a period of up to one year, without a sufficient corresponding increase in the interest rate. Within this category are $8.2 million of construction and land development ("CLD") loans that have been renewed as interest only, generally for a period of up to one year, to assist the borrower.
The Bank does not generally forgive principal or interest on restructured loans. However, when a loan is restructured, principal is generally received on a delayed basis as compared to the original repayment schedule. CLD loans that are restructured are generally modified to require interest-only for a period of time. The Bank does not generally reduce interest rates on restructured commercial loans. The average yield on modified commercial loans was 5.38%, compared to 5.54% earned on the entire commercial loan portfolio in the fourth quarter of 2011.
The second category included in accruing restructured loans consists of residential mortgage and home equity loans whose terms have been restructured at less than market terms and include rate modifications, extension of maturity, and forbearance. This category consists of fifteen loans for a total of $3.2 million at December 31, 2011. The average yield on modified residential mortgage and home equity loans was 3.96%, compared to 5.71% earned on the entire residential mortgage loan portfolio in the fourth quarter of 2011. The Company has no personal loans other than the loans described in the paragraph above that are classified as troubled debt restructurings.
As a result of adopting the amendments in Accounting Standards Update ("ASU") No. 2011-02, the Company reassessed all restructurings that occurred on or after the beginning of the current fiscal year (January 1, 2011) to determine whether they are now considered troubled debt restructurings. The Company identified as TDRs certain loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying those loans as TDRs, the Company identified them as impaired under the guidance in Accounting Standards Codification ("ASC") 310-10-35. The amendments in ASU No. 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those loans newly identified as impaired. At the end of the first interim period of adoption (September 30, 2011), the recorded investment in loans for which the allowance was previously measured under a general allowance methodology and are now impaired under ASC 310-10-35 was $4.0 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss, was $1.5 million.
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In addition, the Company performed its quarterly evaluation of the specific reserves on all of its loans previously identified as TDRs at December 31, 2011. Where current appraisals were previously performed in the fourth quarter of 2010, properties were re-appraised during the fourth quarter of 2011. In addition, the Company utilized collateral values to estimate the fair value of certain TDR loans. All of the Company’s accruing TDRs are performing in accordance with their modified terms and have demonstrated the necessary performance for the accrual of interest.
The following table compares the recorded investment in accruing TDR loans and their specific reserve amount, as of December 31, 2011 and 2010.
Impaired Loans. A loan is classified as impaired when it is probable that the Bank will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the loan agreement. Within the Bank’s loan portfolio, $52.0 million of impaired loans have been identified as of December 31, 2011, up from $48.8 million as of December 31, 2010. The specific allowance for impaired loans was $9.0 million at December 31, 2011, compared to $9.2 million at December 31, 2010. The ultimate amount of the impairment and the potential losses to the Company may be substantially higher or lower than estimated, depending on the realizable value of the collateral. The level of the provision made in connection with impaired loans reflects the amount management believes to be necessary to maintain the allowance for loan losses at an adequate level, based upon the Bank’s current analysis of losses inherent in its loan portfolios.
Business loans carry the largest balances per loan, and any single loss would be proportionally larger than losses in other portfolios. In addition to internal loan rating systems and active monitoring of loan trends, the Bank uses an independent loan review firm to assess the quality of its business loan portfolio. Interest payments received on impaired loans are recorded as interest income unless collection of the remaining recorded investment is doubtful, at which time payments received are recorded as reductions to principal.
CLD loans include residential and non-residential construction and land development loans. The residential CLD loan portfolio consists mainly of loans for the construction, development, and improvement of residential lots, homes, and subdivisions. The non-residential CLD loan portfolio consists mainly of loans for the construction and development of office buildings and other non-residential commercial properties. This type of lending is generally considered to have more complex credit risks than traditional single-family residential lending because the principal is concentrated in a limited number of loans with repayment dependent on the successful completion and sales of the related real estate project. Consequently, these loans are often more sensitive to adverse conditions in the real estate market or the general economy than other real estate loans. These loans are generally less predictable and more difficult to evaluate and monitor and collateral may be difficult to dispose of in a market decline.
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The Bank’s portfolio of residential mortgages consists of loans to finance 1-4 family residences, second homes, vacation homes, and residential investment properties. In the second quarter of 2010, the Company began recognizing losses on specific residential mortgage loans in the process of foreclosure at an earlier point in the foreclosure process, in accordance with regulatory guidance.
The personal loan portfolio consists of direct and indirect installment, home equity and unsecured revolving line of credit loans. Installment loans consist primarily of home equity loans and loans for consumer durable goods, principally automobiles. Indirect personal loans, which make up a small percent of the personal loans, consist of loans for automobiles, boats and manufactured housing.
Allowance for Loan Losses. The Company’s allowance for loan losses has decreased by $3.7 million in the fourth quarter of 2011 and by $4.5 million over the twelve months ended December 31, 2011. A number of factors caused the decline in the fourth quarter and full year of 2011. Net charge-offs for the fourth quarter of 2011 were $4.0 million, most of which represented specific reserves which had been provided for in previous quarters.
As discussed in Note 5 of the Notes to Consolidated Financial Statements, the Company’s allowance for loan losses for loans evaluated collectively for impairment decreased by $3.7 million as a result of a change in allocation methodology as of September 30, 2011. The impact of the decrease in the allowance due to the new methodology was largely offset by an increase in the specific reserve associated with the Company’s troubled debt restructurings of $3.2 million during 2011, which included the impact of adopting the amendments in ASU No. 2011-02.
The allowance as a percent of total loans decreased from 4.25% at December 31, 2010 to 3.66% at December 31, 2011. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred credit losses in the loan portfolio. Management’s determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, amount and composition of the loan portfolio, and other factors management believes to be relevant.
Further information concerning credit quality is contained in Note 5 of the Notes to Consolidated Financial Statements, which information is incorporated here by reference.
Deposits
United internally funds its operations through a large, stable base of core deposits that provides cost-effective funding for its lending operations. The majority of deposits are derived from core client sources, relating to long term relationships with local individual, business and public clients. Public clients include local governments and municipal bodies, hospitals, universities and other educational institutions. At December 31, 2011, core deposits accounted for 98.8% of total deposits, as compared to 97.3% at December 31, 2010. For this presentation, core deposits consist of total deposits less national certificates of deposit and brokered deposits. Core deposits include deposits held through the Certificate of Deposit Account Registry Service® (“CDARS”) as they represent deposits originated in the Bank’s market area.
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The table below shows the change in the various categories of the deposit portfolio for the reported periods.
Total deposits grew by $30.9, or 4.2%, in the twelve months ended December 31, 2011, compared to a decline of $48.8 million, or 6.2%, in the twelve months ended December 31, 2010. The Bank’s noninterest bearing deposits increased by 23.1% during 2011, while interest bearing deposits grew by 0.8%. As part of its capital ratio improvement initiatives, United generally did not replace maturing wholesale deposits in 2011 or 2010. The Bank utilizes purchased or brokered deposits for interest rate risk management purposes, but does not support its growth through the use of those products. In addition, the Bank participates in the CDARS program, which allows it to provide competitive CD products while maintaining FDIC insurance for clients with larger balances. The Bank's deposit rates are consistently competitive with other banks in its market areas.
Noninterest bearing deposits made up 18.2% of total deposits at December 31, 2011, compared to 15.4% at December 31, 2010. The table below shows the makeup of the Company’s deposits at December 31, 2011 and 2010.
Cash Equivalents and Borrowed Funds
The Company maintains correspondent accounts with a number of other banks for various purposes. In addition, cash sufficient to meet the operating needs of its banking offices is maintained at its lowest practical levels. The Bank is also a participant in the federal funds market, either as a borrower or seller. Federal funds are generally borrowed or sold for one-day periods. The Bank maintains interest-bearing deposit accounts with the Federal Reserve Bank and the FHLBI, as alternatives to federal funds.
The Bank also has the ability to utilize short term advances from the FHLBI and borrowings at the discount window of the Federal Reserve Bank as additional short-term funding sources. Federal funds and equivalents were used during 2011 and 2010, while short term advances and discount window borrowings were not utilized during either year.
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At December 31, 2010, the Company’s balance sheet included short-term borrowings representing the secured borrowing portion of SBA 7a loans held for sale, as a result of adoption of ASU 2009-16 in 2010. Qualifying loans were carried as loans held for sale, while the sold portion of the loans was carried as secured borrowing for a 90-day period. In the first quarter of 2011, the Company modified its SBA 7a loan sales contract to eliminate a 90-day warranty period to the purchaser of the loans, eliminating the requirement to record a liability for the sold portion of the loans, and the Company’s balance sheet included no short-term borrowings related to SBA loans at December 31, 2011.
The Company periodically finds it advantageous to utilize longer-term borrowings from the FHLBI. These long-term borrowings, as detailed in Note 11 of the Notes to Consolidated Financial Statements, serve to provide a balance to some of the interest rate risk inherent in the Company's balance sheet. Additional information regarding borrowed funds is found in the Liquidity section below.
Results of Operations
Earnings Summary and Key Ratios
The Company achieved consolidated net income of $917,000 for 2011, improving from a loss of $3.7 million in 2010. Net interest income for 2011 was 3.3% lower than in 2010, as investments increased while average loan balances declined. At the same time, the Company’s net interest margin continued to decline as a result of a decline in loan balances and continued elevated levels of investments and short-term liquid assets, and in spite of a relatively large increase in non-interest bearing deposits. The Company’s return on average assets for 2011 was 0.10%, compared to -0.42% for 2010 and -1.00% for 2009. Return on average shareholders’ equity for 2011 was 0.98%, compared to -4.66% for 2010 and -10.47% for 2009.
Total noninterest income for the twelve months ended December 31, 2011 improved by $913,000, or 5.6%, as compared to the same period of 2010. Most categories of noninterest income contributed to this improvement, while deposit service charges continued the decline noted over the past two years. Noninterest income represented 36.4% of the Company’s total revenues for 2011, compared to 34.4% for 2010.
Noninterest expense for the twelve month period ended December 31, 2011 was up 6.5% compared to the same period of 2011. The largest dollar amount of increase for 2011 was in salaries and employee benefits. Expenses relating to ORE properties, and attorney and other professional fees reflect costs related to the Company’s credit quality concerns, and expenses in those categories increased in the twelve months ended December 31, 2011 compared to the same period of 2010. Those items are discussed in more detail later in this discussion.
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The following table shows the trends of the major components of earnings and related ratios for the five most recent quarters.
In an attempt to evaluate the trends of net interest income, noninterest income and noninterest expense, the Company calculates pre-tax, pre-provision income (“PTPP Income”) and pre-tax, pre-provision return on average assets (“PTPP ROA”). PTPP Income adjusts net income before federal income tax by the amount of the Company’s provision for loan losses, which is excluded because its level is elevated and volatile in times of economic stress. PTPP ROA measures PTPP Income as a percent of average assets. While this information is not consistent with, or intended to replace, presentation under generally accepted accounting principles, it is presented here for comparison. Management believes that PTPP Income and PTPP ROA are useful and consistent measures of the Company’s earning capacity, as these financial measures enable investors and others to assess the Company’s ability to generate capital to cover losses through a credit cycle, particularly in times of economic stress.
United’s PTPP ROA for the twelve month period ended December 31, 2011 of 1.44% was down from 1.70% for the twelve month period ended December 31, 2010. The Company’s relatively strong PTPP Income has been achieved through a substantial core funding base which has resulted in a comparatively strong net interest margin, a diversity of noninterest income sources and expansion of our markets. The reduction in PTPP ROA in 2011 was in part a result of increases in noninterest expenses relating to collection and disposition of troubled assets.
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The table below shows the calculation and trend of PTPP Income and PTPP ROA for the twelve month periods ended December 31, 2011, 2010 and 2009.
Net Interest Income
Declining interest rates over the past few years have significantly reduced the Company’s yield on earning assets, but have also resulted in a reduction in its cost of funds. Interest income decreased 9.1% in 2011 compared to 2010, while interest expense decreased 29.6% for 2011 compared to 2010, resulting in a reduction in net interest income of 3.3% for 2011 compared to 2010. Net interest margin for all of 2011 was 3.64%, compared to 3.79% for 2010. The Company’s net interest margin has continued to trend downward year over year, as a result of a decline in loan balances and continued elevated levels of investments and short-term liquid assets, and in spite of a relatively large increase in non-interest bearing deposits.
Tax-equivalent yields on earning assets declined from 4.83% for 2010 to 4.37% for 2011, for a reduction of 46 basis points. The Company's average cost of funds decreased by 32 basis points, and tax-equivalent spread declined from 3.56% for 2010 to 3.42% for all of 2011. The following table provides a summary of the various components of net interest income, as well as the results of changes in average balance sheet makeup that have resulted in the changes in spread and net interest margin for 2011, 2010 and 2009.
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Provision for Loan Losses
The Company’s provision for loan losses for 2011 was $12.2 million, down 43.6% from $21.5 million for 2010. This significantly reduced level of provision for loan losses is a result of a decline in nonperforming loans, a reduction in nonperforming asset formation, and a slowdown in loan rating downgrades. For 2011, the Company’s net charge offs exceeded its provision for loan losses by $4.5 million, as the Company realized losses for which it had previously provided for in its allowance for loan losses.
In addition, as discussed in Note 5 of the Notes to Consolidated Financial Statements, the Company’s allowance for loan losses for loans evaluated collectively for impairment decreased by $3.7 million as a result of a change in allocation methodology as of September 30, 2011. The impact of the decrease in the allowance (and provision for loan losses) due to the new methodology was largely offset by an increase in the specific reserve associated with the Company’s troubled debt restructurings of $3.2 million during 2011, which included the impact of adopting the amendments in ASU No. 2011-02.
While the local real estate markets and the economy in general have experienced some signs of stabilization, the loan portfolio of the Bank is affected by loans to a number of residential real estate developers that continue to struggle to meet their financial obligations. Loans in the Bank's residential land development and construction portfolios are secured by unimproved and improved land, residential lots, and single-family homes and condominium units. In addition, loans secured by commercial real estate are continuing to experience stresses resulting from the current economic conditions.
Generally, lot sales by the developers/borrowers continue to take place at a greatly reduced pace and at reduced prices. As home sales volumes have declined, income of residential developers, contractors and other real estate-dependent borrowers has also been reduced. The Bank has continued to closely monitor the impact of economic circumstances on its lending clients, and is working with these clients to minimize losses. Additional information regarding the provision for loan losses is included in the “Credit Quality” discussion above.
Noninterest Income
Total noninterest income increase by 5.6% in 2011, following a decline of 3.6% in 2010 compared with 2009. The following table summarizes changes in noninterest income by category for the twelve month periods ended December 31, 2011, 2010 and 2009.
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Service charges on deposit accounts were down 10.0% in 2011 following a decrease of 19.8% in 2010 over 2009. This continuing decline is in spite of the Company's 23.1% growth of noninterest bearing deposit account balances over the twelve months ended December 31, 2011. No significant changes to service charge structure were implemented in 2011 or 2010, and substantially all of the decline in service charges in 2010 and 2011 was due to a reduction in NSF and overdraft fees collected in part as a result of changes in banking regulations governing collection of these fees, effective in mid-2010.
The Wealth Management Group of UBT provides a relatively large component of the Company's noninterest income, and in 2011, was responsible for the largest dollars of increase in the Company’s total noninterest income. Wealth Management income includes trust fee income and income from the sale of nondeposit investment products within the Bank’s offices. Wealth Management income improved by 12.4% in 2011 compared to 2010, following an increase of 11.0% in 2010 compared to 2009. Market values of assets managed by the Wealth Management Group have continued to recover in the past two years as financial markets have rebounded, resulting in improvement in fee income.
The Bank generally markets its production of fixed rate long-term residential mortgages in the secondary market, and retains adjustable rate mortgages for its portfolio. The Company maintains a portfolio of sold residential real estate mortgages that it services, and this servicing provides ongoing income for the life of the loans. Loans serviced consist primarily of residential mortgages sold on the secondary market. The Bank also originates, sells and services SBA loans through its structured finance group, United Structured Finance Company (“USFC”). The guaranteed portion of SBA loans originated by USFC is typically sold on the secondary market, and gains on the sale of those loans contribute to income from loan sales and servicing.
Income from loan sales and servicing increased by 1.3% in 2011 compared to 2010, following a decrease of 5.1% in 2010 compared to 2009. The decrease from 2009 to 2010 was due in part to a positive valuation adjustment to loan servicing rights of $520,000 in 2009, and the Company had no servicing rights valuation adjustment in 2010 or 2011. The loan servicing rights valuation adjustment in 2009 was a reflection of a slowing of prepay speeds in the industry. The following table shows the breakdown of income from loan sales and servicing between residential mortgages and USFC.
ATM, debit and credit card fee income provides a steady source of noninterest income for the Company. The Bank operates twenty ATMs throughout its market areas, and Bank clients are active users of debit cards. The Bank receives ongoing fee income from credit card referrals and operation of its credit card merchant business. Fee income in these areas improved by 12.2% in 2011 compared to 2010, following a reduction in 2010 compared to 2009. That decrease
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reflected changes made in its provider of credit card services for the Bank late in 2009. Expenses relating to production of that fee income were also reduced, with a net benefit to the Bank.
Other income includes income from various fee-based banking services, such as sale of official checks, wire transfer fees, safe deposit box income, sweep account and other fees, income from bank-owned life insurance, as well as gains on the sale of assets, which generally represent gains realized on the sale of other real estate owned. Gains on the sale of ORE property was $301,000 in 2011, compared to $41,000 in 2010.Total other income was up 22.4% in 2011 compared to 2010, following an increase of 0.6% from 2009 to 2010
Noninterest Expense
Total noninterest expense for the twelve month period ended December 31, 2011 was up 6.5% compared to the same period of 2011, following a decrease of 12.4% in 2010 compared to 2009. The following table summarizes changes in the Company's noninterest expense by category for 2011, 2010 and 2009.
Salaries and employee benefits, which are the Company’s largest single area of expense, increased by 10.2% in 2011 compared to 2010, following a decrease of 3.8% in 2010 compared to 2009. The increase in 2011 reflects, in part, the reinstatement of the Company’s match portion of its 401(k) effective January 1, 2011, increased health and life insurance premiums, and continued higher levels of commissions and other compensation costs related to the generation of wealth management income and income from loan sales and servicing. In addition, the Company has increased its staffing levels modestly to accommodate its future anticipated growth, and salary increases were reinstated effective April 1, 2011. However, the Company did not pay or accrue any cash bonus or other payout to executive officers or non-commissioned employees under our bonus plans in 2010 or 2011.
Occupancy and equipment expenses decreased by 3.7% in 2011 compared to 2010, following a decrease of 0.9% in 2010 compared to 2009. This decrease in 2011 compared to 2010 is primarily a result of reduced costs of software and depreciation of furniture and equipment.
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The increase in external data processing costs in 2011 compared to 2010 reflects in part conversion expenses in the third quarter of 2011 relating to the conversion of the Wealth Management Group to a different processing provider. Advertising and marketing expenses for 2011 were up 2.5% compared to 2010, following an increase of 0.8% in 2010 compared to 2009.
Attorney, accounting and other professional fees were up 7.5% in 2011 compared to 2010, following an increase of 32.0% for 2010 compared to 2009. While much of the increase in both years represents attorney and appraisal fees related to the Bank’s credit issues, the Company also incurred data processing conversion costs during the second and third quarters of 2010 relating to the consolidation of the Company’s subsidiary banks, which resulted in the large increase in 2010 compared to 2009.
Expenses related to ORE property included write-downs of the value and losses on the sale of property held as ORE, along with costs to maintain and carry those properties. Expenses in this category increased by 18.9% in the twelve months ended December 31, 2011 compared to the same period of 2010, following a decrease of 5.5% from 2009 to 2010. Deterioration in the value of certain of these properties resulted in write-downs and losses on the sale of properties of $1.0 million in 2011, $873,000 for 2010, and $1.2 million for 2009. Assets were written down to their estimated fair value less costs to sell, as a result of a decline in prevailing real estate prices and the Bank’s experience with increased foreclosures resulting from the weakened economy.
As a result of an evaluation of the value of its goodwill, United took an impairment charge of $3.47 million during the first quarter of 2009. Additional information regarding the 2009 goodwill impairment charge is included in Note 8 of the Notes to the Consolidated Financial Statements, which information is incorporated here by reference.
Other expenses were up 14.4% in 2011 compared to 2010, with most of the increase in this category resulting from unreimbursed fraud losses on debit cards and losses related to serviced loans. That increase followed a decline of 5.0% in 2010 compared to 2009.
Federal Income Tax
The following chart shows the effective federal tax rates of the Company for the past three years.
The effective tax rates for 2010 and 2009 were a calculated benefit based upon a pre-tax loss. For 2011, 2010 and 2009, the differences between the effective rates and the Company’s expected tax rate were primarily due to the benefit from tax-exempt income.
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At December 31, 2011, the Company had net operating losses of $7.6 million that are being carried forward to reduce future taxable income. The carryforwards expire in 2030 and 2031. As of December 31, 2011, the Company had low income housing and alternative minimum tax credits available to offset future federal income taxes. The low income housing credits expire in 2028 through 2031, and the alternative minimum tax credits have no expiration date.
The Company’s net deferred tax asset was $9.9 million at December 31, 2011. A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. Based upon analysis of the evidence (both negative and positive), management has determined that no valuation allowance was required at December 31, 2011 or 2010. See Note 13 of the Notes to Consolidated Financial Statements for further discussion.
Liquidity, Funds Management and Market Risk
Liquidity
The Company maintains correspondent accounts with a number of other banks for various purposes. In addition, cash sufficient to meet the operating needs of its banking offices is maintained at its lowest practical levels. At times, the Bank is a participant in the federal funds market, either as a borrower or seller. Federal funds are generally borrowed or sold for one-day periods. In 2011 and 2010, the Bank generally utilized short-term interest-bearing balances with banks as an alternative to federal funds sold.
The Company’s balances in federal funds sold and short-term interest-bearing balances with banks were $91.8 million at December 31, 2011, down from $95.6 million at December 31, 2010. The 4.0% decrease has resulted from increases in investments, along with planned decreases in wholesale funding that exceeded reductions in loan balances, as United did not replace maturing FHLB advances or wholesale deposits in 2011. The Company continued to maintain high levels of liquidity, with investments, federal funds and cash equivalents held to improve the liquidity of the balance sheet during this period of economic uncertainty, and the Company expects to maintain higher than normal levels of liquidity until economic conditions improve and more attractive investment opportunities emerge.
The Bank also has the ability to utilize short-term advances from the FHLBI and borrowings at the discount window of the Federal Reserve Bank as additional short-term funding sources. Short-term advances and discount window borrowings were not utilized during 2011 or 2010.
At December 31, 2010, the Company’s balance sheet included short-term borrowings representing the secured borrowing portion of SBA 7a loans held for sale, as a result of adoption of ASU 2009-16 in 2010. In the first quarter of 2011, the Company eliminated the 90-day warranty period to borrowers in its sales contracts for SBA 7a loans, and there were no short-term borrowings on the books of the Company at December 31, 2011.
The Company periodically finds it advantageous to utilize longer term borrowings from the FHLBI. Theselong-term borrowings serve primarily to provide a balance to some of the interest rate risk inherent in the Company's balance sheet. During 2011, the Bank procured no new
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advances and repaid $6.3 million in matured borrowings and scheduled principal payments, resulting in a decrease in total FHLBI borrowings outstanding for the year. Information concerning available lines is contained in Note 10 of the Notes to Consolidated Financial Statements.
Funds Management and Market Risk
The composition of the Company’s balance sheet consists of investments in interest earning assets (loans and investment securities) that are funded by interest bearing liabilities (deposits and borrowings). These financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk.
Policies of the Company place strong emphasis on stabilizing net interest margin while managing interest rate, liquidity and market risks, with the goal of providing a sustained level of satisfactory earnings. The Funds Management, Investment and Loan policies provide direction for the flow of funds necessary to supply the needs of depositors and borrowers. Management of interest sensitive assets and liabilities is also necessary to reduce interest rate risk during times of fluctuating interest rates.
Interest rate risk is the exposure of the Company’s financial condition to adverse movements in interest rates. It results from differences in the maturities or timing of interest adjustments of the Company’s assets, liabilities and off-balance-sheet instruments; from changes in the slope of the yield curve; from imperfect correlations in the adjustment of interest rates earned and paid on different financial instruments with otherwise similar repricing characteristics; and from interest rate related options embedded in the Company’s products such as prepayment and early withdrawal options.
A number of measures are used to monitor and manage interest rate risk, including interest sensitivity and income simulation analyses. An interest sensitivity model is the primary tool used to assess this risk, with supplemental information supplied by an income simulation model. The simulation model is used to estimate the effect that specific interest rate changes would have on twelve months of pretax net interest income assuming an immediate and sustained up or down parallel change in interest rates of 300 basis points. Key assumptions in the models include prepayment speeds on mortgage related assets; cash flows and maturities of financial instruments; changes in market conditions, loan volumes and pricing; and management’s determination of core deposit sensitivity. These assumptions are inherently uncertain and, as a result, the models cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results may differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions.
The Funds Management Committee is also responsible for evaluating and anticipating various risks other than interest rate risk. Those risks include prepayment risk, pricing for credit risk and liquidity risk. The Committee is made up of senior members of management, and continually monitors the makeup of interest sensitive assets and liabilities to assure appropriate liquidity,
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maintain interest margins and to protect earnings in the face of changing interest rates and other economic factors.
The Funds Management policy provides for a level of interest sensitivity that, management believes, allows the Company to take advantage of opportunities within the market relating to liquidity and interest rate risk, allowing flexibility without subjecting the Company to undue exposure to risk. In addition, other measures are used to evaluate and project the anticipated results of management's decisions.
We conducted multiple simulations as of December 31, 2011, in which it was assumed that changes in market interest rates occurred ranging from up 400 basis points to down 200 basis points in equal quarterly installments over the next twelve months. The following table reflects the suggested impact on net interest income over the next twelve months in comparison to estimated net interest income based on our balance sheet structure, including the balances and interest rates associated with our specific loans, securities, deposits and borrowed funds as of December 31, 2011. The resulting estimates are within our policy parameters established to manage and monitor interest rate risk.
In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including the growth, composition and levels of loans, deposits and other earnings assets and interest-bearing liabilities, level of nonperforming assets, economic and competitive conditions, potential changes in lending, investing and deposit gathering strategies, client preferences and other factors.
Capital Resources
The common stock of the Company is quoted on the OTC Bulletin Board under the symbol “UBMI.” As was the case with much of the financial services industry, the stock of the Company continued to experience significant price declines during 2011 and 2010. In December 2010, the Company closed its public offering of 7,583,800 shares of common stock. The net proceeds to the Company, after deducting underwriting discounts and commissions and offering expenses, were approximately $17.1 million. Since the public offering, the Company has contributed $12 million to the capital of the Bank to increase the Bank's capital and regulatory capital ratios.
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UBT is party to an MOU as described under “Other Developments - Memorandum of Understanding” on Page A-5 hereof. The Bank has continued to maintain its ratio of total capital to risk-weighted assets above the prescribed minimum level of 12%. The Bank did not reach the Tier 1 capital ratio level required to comply with the timeframe provided in the January 15, 2010 memorandum of understanding, but was in compliance with the minimum Tier 1 capital ratio at December 31, 2011. At December 31, 2011, the Bank’s Tier 1 capital ratio was 9.20%, and its ratio of total capital to risk-weighted assets was 15.49%.
Current capital ratios for the Company and the Bank are shown in Note 18 of the Notes to Consolidated Financial Statements. At December 31, 2011, the Company’s Tier 1 capital ratio was 9.87%, its ratio of total capital to risk-weighted assets was 16.53% and its tangible common equity ratio was 8.29%. As a result of a small amount of net income in 2011, book value per share of the Company’s common stock increased from $5.72 at the end of 2010 to $5.78 at December 31, 2011.
Contractual Obligations
The following table details the Company's known contractual obligations at December 31, 2011, in thousands of dollars:
Critical Accounting Policies
Generally accepted accounting principles are complex and require management to apply significant judgments to various accounting, reporting and disclosure matters. The Company's management must use assumptions and estimates to apply these principles where actual measurement is not possible or practical. For a complete discussion of the Company's significant accounting policies, see "Notes to the Consolidated Financial Statements" on pages A-34 to A-73 of the Company's Annual Report on Form 10-K for the year ended December 31, 2011. Certain policies are considered critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements.
Allowance for Loan Losses
The allowance for loan losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for credit losses each quarter based on changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently
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subjective, as it requires the use of significant management estimates. Many factors can affect management’s estimates of incurred losses, including volatility of default probabilities, credit rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs.
The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s observable market price, the collateral value for collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate.
Regardless of the extent of the Company’s analysis of client performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a client’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or client-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company’s evaluation of imprecision risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment.
Loan Servicing Rights
Loan servicing rights (“LSRs”) associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for LSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of LSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the LSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets.
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Deferred Tax Assets
Deferred tax assets are only recognized to the extent it is more likely than not they will be realized. Should our management determine it is not more likely than not that the deferred tax assets will be realized, a valuation allowance with a charge to earnings would be reflected in the period. If the Company is required in the future to take a valuation allowance with respect to its deferred tax asset, its financial condition, results of operations and regulatory capital levels would be negatively affected.
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Report of Independent Registered Public Accounting Firm
Audit Committee, Board of Directors and Stockholders
United Bancorp, Inc.
Ann Arbor, Michigan
We have audited the accompanying consolidated balance sheets of United Bancorp, Inc. (Company) as of December 31, 2011 and 2010, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2011. The Company's management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing auditing procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits also 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. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of United Bancorp, Inc. as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.
/s/ BKD LLP
Indianapolis, Indiana
February 24, 2012
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Notes to Consolidated Financial Statements
United Bancorp, Inc. and Subsidiaries
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Basis of Presentation
The consolidated financial statements include the accounts of United Bancorp, Inc. and its wholly owned subsidiary, United Bank & Trust (“UBT” or “the Bank”) after elimination of significant intercompany transactions and accounts. The Company is engaged 100% in the business of commercial and retail banking, including trust and investment services, with operations conducted through its offices located in Lenawee, Washtenaw, Livingston and Monroe Counties in southeastern Michigan. These counties are the source of substantially all of the Company's deposit, loan, trust and investment activities.
Effective April 1, 2010, the Company completed the consolidation of its subsidiary banks, United Bank & Trust and United Bank & Trust - Washtenaw. Under the consolidation, United Bank & Trust - Washtenaw was consolidated and merged with and into United Bank & Trust, and the consolidated bank operates under the charter and name of United Bank & Trust.
Use of Estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period as well as affecting the disclosures provided. Actual results could differ from those estimates. The allowance for loan losses, loan servicing rights and the fair values of financial instruments are particularly subject to change.
Securities
Securities available for sale consist of bonds and notes that might be sold prior to maturity. Securities classified as available for sale are reported at their fair values and the related net unrealized holding gain or loss is reported in other comprehensive income. Premiums and discounts on securities are recognized in interest income using the interest method over the period to maturity. Realized gains or losses are based upon the amortized cost of the specific securities sold.
Loans Held for Sale
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or market value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and the allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Loans are placed on nonaccrual status at ninety days or more past due and interest is considered a loss, unless the loan is well-secured and in the process of collection.
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Allowance for Loan Losses
The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred credit losses in the loan portfolio. The allowance is increased by provisions for loan losses charged to income. Loan losses are charged against the allowance when management believes a loan is uncollectible. Subsequent recoveries, if any, are credited to the allowance. This policy applies to each of the Company’s portfolio segments.
The Company’s established methodology for evaluating the adequacy of the allowance for loan losses considers both components of the allowance; (1) specific allowances allocated to loans evaluated individually for impairment under the Accounting Standards Codification (“ASC”) Section 310-10-35 of the Financial Accounting Standards Board (“FASB”), and (2) allowances calculated for pools of loans evaluated collectively for impairment under FASB ASC Subtopic 450-20. Until the third quarter of 2011, the Company’s past loan loss experience was determined by evaluating the average charge-offs over the most recent eight quarters. Effective September 30, 2011, the Company changed its allocation methodology as described in detail below.
For the quarter ended September 30, 2011, the Company changed its methodology for evaluating the adequacy of the allowance for loan losses by revising and enhancing the methodology for loans evaluated collectively for impairment. Under its new methodology, the Company revised and further disaggregated its pools of loans evaluated collectively for impairment. Similar to the prior methodology, pools are analyzed by general loan types, and further analyzed by collateral types, where appropriate. However, under the new methodology, pools are further disaggregated by internal credit risk ratings for commercial loans, commercial mortgages and construction loans and by delinquency status for residential mortgages, consumer loans and all other loan types.
Allowance allocations for each pool are determined through a migration analysis based on activity for the period beginning March 2008. The analysis computes loss rates based on a probability of default (“PD”) and loss given default (“LGD”). Allowance allocations were previously computed based on weighted average charge-off rates as opposed to the use of credit migration matrices, which computes PDs and LGDs based on historical losses as loans migrate through the various risk rating or delinquency categories. The March 2008 date was selected in an effort to capture sufficient data points to provide a meaningful migration analysis using available data in comparable formats.
Under both the current and previous methodologies, loss rates are adjusted to consider qualitative factors such as economic conditions and trends, among others. However, under the new methodology, the Company applies a more detailed analysis of qualitative factors that are assessed on a quarterly basis based upon gradings specific to the Company, as well as regional economic metrics. As of September 30, 2011, the allowance for loan losses for loans evaluated collectively for impairment decreased from $15.6 million under the Company’s prior methodology to $11.9 million under the new methodology.
Loan impairment is reported when full payment under the loan terms is not expected. Impaired loans are carried at the present value of estimated future cash flows using the loan's existing rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations require an increase in the allowance for loan losses, that
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increase is recorded as a component of the provision for loan losses. Loans are evaluated for impairment when payments are delayed or when the internal grading system indicates a substandard or doubtful classification. This policy applies to each class of the Company’s loan portfolio.
Impairment is evaluated in total for smaller-balance loans of similar nature, such as residential mortgage, consumer, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When credit analysis of borrower operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, including loans to the borrower by United Bank & Trust (the “Bank”), the loan is evaluated for impairment. Often this is associated with a delay or shortfall of payments of thirty days or more. Loans are generally moved to nonaccrual status when ninety days or more past due or in bankruptcy. These loans are often also considered impaired. Impaired loans are charged off, in part or in full, when deemed uncollectible. This typically occurs when the loan is 120 or more days past due, unless the loan is both well-secured and in the process of collection. This policy applies to each class of the Company’s loan portfolio.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation. The provisions for depreciation are computed principally by the straight-line method, based on useful lives of ten to forty years for premises and three to eight years for equipment.
Other Real Estate Owned
Other real estate consists of properties acquired through foreclosure or acceptance of a deed in lieu of foreclosure and property acquired for possible future expansion. Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value, less estimated selling costs, at the date of foreclosure establishing a new cost basis. After foreclosure, valuations are periodically performed and the real estate is carried at the lower of cost basis or fair value, less estimated selling costs. The historical average holding period for such properties is less than eighteen months. As of December 31, 2011 and 2010, other real estate owned totaled $3,657,000 and $4,278,000, and is included in other assets on the consolidated balance sheets.
Servicing Rights
Servicing rights are recognized as assets for the allocated value of retained servicing on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates, remaining loan terms and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance.
Long-term Assets
Long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are written down to their fair value.
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Income Tax
The Company records income tax expense based on the amount of taxes due on its tax return plus deferred taxes computed based on the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, using enacted tax rates, adjusted for allowances made for uncertainty regarding the realization of deferred tax assets. The Company has no uncertain tax positions as defined by the Tax Position Topic of the FASB Accounting Standards Codification (“FASB ASC”) Topic 740-10-05.
The Company recognizes interest and penalties on income taxes as a component of income tax expense. The Company files consolidated income tax returns with its subsidiaries. With a few exceptions, the Company is no longer subject to U.S. federal, state and local or non-U.S. income tax examinations by tax authorities for years before 2010.
Earnings (Loss) Per Share
Amounts reported as earnings or loss per share are based on income or loss available to common shareholders divided by weighted average shares outstanding. Income or loss available to common shareholders is calculated by subtracting dividends on preferred stock and the accretion of discount on preferred stock from net income or loss. Weighted average shares outstanding include the weighted average number of common shares outstanding plus the weighted average number of contingently issuable shares associated with the Directors' and Senior Management Group's deferred stock plans.
Stock Based Compensation
At December 31, 2011, the Company has a stock-based employee compensation plan, which is described more fully in Note 16. The Company’s disclosure regarding this plan is in accordance with the fair value recognition provisions of FASB ASC Topic 718-10.
Statements of Cash Flows
For purposes of this Statement, cash and cash equivalents include cash on hand, demand balances with banks, and federal funds sold. Federal funds are generally sold for one-day periods. The Company reports net cash flows for client loan and deposit transactions, deposits made with other financial institutions, and short-term borrowings with an original maturity of ninety days or less.
Comprehensive Income (Loss)
Comprehensive income (loss) consists of net income or loss and other comprehensive income (loss). Other comprehensive income (loss) includes net unrealized gains and losses on securities available for sale, net of tax, which are also recognized as separate components of shareholders' equity.
Industry Segment
The Company and its subsidiary are primarily organized to operate in the banking industry. Substantially all revenues and services are derived from banking products and services in southeastern Michigan. While the Company's chief decision makers monitor various products and services, operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all of the Company's banking operations are considered by management to be aggregated in one business segment.
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Recently Issued Accounting Standards
ASU No. 2011-02; A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“TDR”). In April 2011, FASB issued ASU No. 2011-02, intended to provide additional guidance to assist creditors in determining whether a restructuring of a receivable meets the criteria to be considered a troubled debt restructuring. The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011, and are to be applied retrospectively to the beginning of the annual period of adoption. As a result of applying these amendments, an entity may identify receivables that are newly considered impaired. The Company adopted the methodologies prescribed by this ASU effective with its third quarter 2011 financial statements.
ASU No. 2011-03; Reconsideration of Effective Control for Repurchase Agreements. In April 2011, FASB issued ASU No. 2011-03. The amendments in this ASU remove from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. The amendments in this ASU also eliminate the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets.
The guidance in this ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance is to be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company will adopt the methodologies prescribed by this ASU by the date required, and does not anticipate that the ASU will have a material effect on its financial position or results of operations.
ASU No. 2011-04; Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. In May 2011, FASB issued ASU No. 2011-04. The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs.
The amendments in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. The Company will adopt the methodologies prescribed by this ASU by the date required, and does not anticipate that the ASU will have a material effect on its financial position or results of operations.
ASU No. 2011-05 and ASU 2011-12; Amendments to Topic 220, Comprehensive Income. In June 2011, FASB issued ASU No. 2011-05. Under the amendments in this ASU, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This ASU eliminates the option to present the
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components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in this ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.
The amendments in this ASU should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted, because compliance with the amendments is already permitted. The amendments do not require any transition disclosures. The Company adopted the methodologies prescribed by this ASU effective with its third quarter financial statements.
In December, 2011, FASB issued ASU 2011-12, which included additional information to supersede certain pending paragraphs in Accounting Standards Update No. 2011-05 to effectively defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. The amendments will be temporary to allow the Board time to redeliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private, and non-profit entities.
Accounting Standards Update No. 2011-09-Compensation-Retirement Benefits-Multiemployer Plans (Subtopic 715-80); On September 21, 2011, FASB issued ASU 2011-09. The amendments in this update require additional disclosures about an employer's participation in a multiemployer plan. For public entities, the amendments in this Update are effective for annual periods for fiscal years ending after December 15, 2011, with early adoption permitted. The amendments should be applied retrospectively for all prior periods presented. The Company does not participate in multiemployer plans as defined by the ASU, and does not anticipate that adoption of this ASU will have an impact on its financial position or results of operations.
Accounting Standards Update No. 2011-10-Property, Plant, and Equipment (Topic 360); On December 14, 2011, FASB issued ASU 2011-10. The objective of the amendments in this Update is to resolve the diversity in practice about whether the guidance in Subtopic 360-20, Property, Plant, and Equipment-Real Estate Sales, applies to a parent that ceases to have a controlling financial interest (as described in Subtopic 810-10, Consolidation-Overall) in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt. This Update does not address whether the guidance in Subtopic 360-20 would apply to other circumstances when a parent ceases to have a controlling financial interest in a subsidiary that is in substance real estate.
The amendments in this Update should be applied on a prospective basis to deconsolidation events occurring after the effective date. Prior periods should not be adjusted even if the reporting entity has continuing involvement with previously derecognized in substance real estate entities. Early adoption is permitted. The Company does not anticipate that adoption of this ASU will have an impact on its financial position or results of operations.
Accounting Standards Update No. 2011-11-Balance Sheet (Topic 210). In December 2011, FASB issued ASU 2011-11. The objective of this Update is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting
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arrangements on an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this Update. The amendments require enhanced disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45.
An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company will adopt the methodologies prescribed by this ASU by the date required, and does not anticipate that the ASU will have a material effect on its financial position or results of operations.
Current Economic Conditions
The current protracted economic decline continues to present financial institutions with circumstances and challenges that in many cases have resulted in large and unanticipated declines in the fair values of investments and other assets, constraints on liquidity and capital and significant credit quality problems, including severe volatility in the valuation of real estate and other collateral supporting loans. The financial statements have been prepared using values and information currently available to the Company.
At December 31, 2011, the Company held $2.6 million in commercial real estate and $269.3 million in loans collateralized by commercial and development real estate. Due to national, state and local economic conditions, values for commercial and development real estate have declined significantly, and the market for these properties is depressed.
Given the volatility of current economic conditions, the values of assets and liabilities recorded in the financial statements could change rapidly, resulting in material future adjustments in asset values, the allowance for loan losses, capital that could negatively impact the Company’s ability to meet regulatory capital requirements and maintain sufficient liquidity.
NOTE 2 - RESTRICTIONS ON CASH AND DEMAND BALANCES IN OTHER BANKS
The Bank is subject to average reserve and clearing balance requirements in the form of cash on hand or balances due from the Federal Reserve Bank. The amount of reserve and clearing balances required at December 31, 2011 were $473,000. These reserve balances vary depending on the level of client deposits in the Bank.
The Company considers all liquid investments with original maturities of three months or less to be cash equivalents. At December 31, 2011 and 2010, cash equivalents consisted primarily of interest-bearing balances with banks.
As a result of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, all funds in a “noninterest-bearing transaction account” are insured in full by the Federal Deposit Insurance Corporation from December 31, 2010, through December 31, 2012. This temporary unlimited coverage is in addition to, and separate from, the general FDIC deposit insurance
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coverage of up to $250,000 available to depositors. The financial institution holding the Company’s cash accounts is insured by the FDIC. At December 31, 2011, the Company’s cash accounts did not exceed federally insured limits. At December 31, 2011, the Company had cash balances of $91,673,000 at the FRB and FHLB that did not have FDIC insurance coverage.
NOTE 3 - SECURITIES
Balances of securities by category are shown below, as of December 31, 2011 and 2010:
The following table shows the gross unrealized loss and fair value of the Company's investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2011 and 2010.
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Unrealized losses within the investment portfolio are determined to be temporary. The Company has performed an evaluation of its investments for other than temporary impairment, and no losses were recognized during 2011 or 2010. Loss from other than temporary impairment for 2009 consisted of write-down of one equity security that was deemed to be impaired.
The unrealized losses on the Company’s investments in direct obligations of U.S. government agencies were caused by interest rate changes. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Company does not intend to sell the investments and it is not more likely than not the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2011.
The unrealized losses on the Company’s investment in residential mortgage-backed securities were caused by interest rate changes. The Company expects to recover the amortized cost basis over the term of the securities. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2011.
The entire investment portfolio is classified as available for sale. However, management has no specific intent to sell any securities, and management believes that it is more likely than not that the Company will not have to sell any security before recovery of its cost basis. Sales activities for securities for the years indicated are shown in the following table. All sales were of securities identified as available for sale.
The fair value of securities available for sale by contractual maturity as of December 31, 2011 is shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Asset-backed securities are included in the “Due in one year or less” category.
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Securities carried at $3,060,000 and $4,857,000 as of December 31, 2011 and 2010, respectively, were pledged to secure deposits of public funds, funds borrowed, repurchase agreements, and for other purposes as required by law.
NOTE 4 - LOANS
The following table shows total loans outstanding at December 31 and the percentage change in balances from the prior year. All loans are domestic and contain no significant concentrations by industry or client.
NOTE 5 - ALLOWANCE FOR LOAN LOSSES AND CREDIT RISK
The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred credit losses in the loan portfolio. The allowance is increased by provisions for loan losses charged to income. Loan losses are charged against the allowance when management believes a loan is uncollectible. Subsequent recoveries, if any, are credited to the allowance. This policy applies to each of the Company’s portfolio segments.
The Company’s established methodology for evaluating the adequacy of the allowance for loan losses considers both components of the allowance; (1) specific allowances allocated to loans evaluated individually for impairment under the Accounting Standards Codification (“ASC”) Section 310-10-35 of the Financial Accounting Standards Board (“FASB”), and (2) allowances calculated for pools of loans evaluated collectively for impairment under FASB ASC Subtopic 450-20.
Prior to the fourth quarter of 2009, the Company determined its past loan loss experience by using a rolling twelve quarter historical approach. Beginning in the fourth quarter of 2009, the Company began using a rolling eight quarter historical approach. The change in methodology was implemented as management believed this shorter period was more reflective of the current
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economic conditions at that time and that the collectively-evaluated allowance could be better estimated by using a shorter loss period rather than a longer loss period combined with a larger emphasis on estimating additional qualitative and environment factors. The impact of the change in methodology increased the allowance for loan losses in the fourth quarter of 2009 by approximately $235,000.
For the quarter ended September 30, 2011, the Company changed its methodology for evaluating the adequacy of the allowance for loan losses by revising and enhancing the methodology for loans evaluated collectively for impairment. Under its new methodology, the Company revised and further disaggregated its pools of loans evaluated collectively for impairment. Similar to the prior methodology, pools are analyzed by general loan types, and further analyzed by collateral types, where appropriate. However, under the new methodology, pools are further disaggregated by internal credit risk ratings for commercial loans, commercial mortgages and construction loans and by delinquency status for residential mortgages, consumer loans and all other loan types.
Allowance allocations for each pool are determined through a migration analysis based on activity for the period beginning March 2008. The analysis computes loss rates based on a probability of default (“PD”) and loss given default (“LGD”). Allowance allocations were previously computed based on weighted average charge-off rates as opposed to the use of credit migration matrices, which computes PDs and LGDs based on historical losses as loans migrate through the various risk rating or delinquency categories. The March 2008 date was selected in an effort to capture sufficient data points to provide a meaningful migration analysis using available data in comparable formats.
Under both the current and previous methodologies, loss rates are adjusted to consider qualitative factors such as economic conditions and trends, among others. However, under the new methodology, the Company applies a more detailed analysis of qualitative factors that are assessed on a quarterly basis based upon gradings specific to the Company, as well as regional economic metrics. As of September 30, 2011, the allowance for loan losses for loans evaluated collectively for impairment decreased from $15.6 million under the Company’s prior methodology to $11.9 million under the new methodology.
Loan impairment is reported when full payment under the loan terms is not expected. Impaired loans are carried at the present value of estimated future cash flows using the loan's existing rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations require an increase in the allowance for loan losses, that increase is recorded as a component of the provision for loan losses. Loans are evaluated for impairment when payments are delayed or when the internal grading system indicates a substandard or doubtful classification. This policy applies to each class of the Company’s loan portfolio.
Impairment is evaluated in total for smaller-balance loans of similar nature, such as residential mortgage, consumer, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When credit analysis of borrower operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, including
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loans to the borrower by United Bank & Trust (the “Bank”), the loan is evaluated for impairment. Often this is associated with a delay or shortfall of payments of thirty days or more.
Loans are generally moved to nonaccrual status when ninety days or more past due or in bankruptcy. These loans are often also considered impaired. Impaired loans are charged off, in part or in full, when deemed uncollectible. This typically occurs when the loan is 120 or more days past due, unless the loan is both well-secured and in the process of collection. This policy applies to each class of the Company’s loan portfolio.
An analysis of the allowance for loan losses for the twelve-month periods ended December 31, 2011, 2010 and 2009 follows:
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Credit Exposure and Quality Indicators
The Company categorizes commercial and tax-exempt loans into risk categories based on relevant information about the ability of borrowers to service their debt, such as current financial information, management capacity, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed during the loan approval process and is updated as circumstances warrant. The risk characteristics of each loan portfolio segment are as follows:
Business and Commercial Mortgages. The Business and Commercial Mortgages segment consists of commercial and industrial loans and commercial real estate loans. Commercial and industrial loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and may include a personal guarantee. Some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.
Commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal
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amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The characteristics of properties securing the Company’s commercial real estate portfolio are diverse, but with geographic location almost entirely in the Company’s market area. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. In general, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.
Construction and Land Development. Construction and Land Development (“CLD”) loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. CLD loans are generally based on estimates of costs and value associated with the complete project. These estimates may be inaccurate. CLD loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.
Consumer. Consumer loans consist of two segments - residential mortgage loans and personal loans. For residential mortgage loans that are secured by 1-4 family residences and are generally owner occupied, the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and personal loans are secured by personal assets, such as automobiles or recreational vehicles. Some personal loans are unsecured, such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas, such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.
Internal Risk Categories
Commercial and tax-exempt loans that are analyzed individually are assigned one of eight internal risk categories. Categories 1-4 are considered to be Pass-rated loans. Other risk category definitions for individually-analyzed commercial and tax-exempt loans are as follows:
Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Bank’s credit position at some future date.
Substandard. Loans classified as substandard are inadequately protected by the current net
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worth and paying capacity of the obligor or of the collateral securing the loans, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.
Loss. Loans classified as loss are regarded as uncollectible and should be charged off.
Consumer loans are not rated on the above-listed risk categories, but are classified by their payment activity, either as performing, accruing restructured, delinquent less than 90 days, or nonperforming.
Quality indicators for portfolio loans as of December 31, 2011 and 2010 based on the Bank’s internal risk categories are detailed in the following tables.
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Loan totals in the classifications above are based on categories of loans as classified within the Bank’s regulatory reporting. As a result, they may differ from totals of similar classifications in Note 4 and in the tables above.
Loan Portfolio Aging Analysis
The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified due date. Schedules detailing the loan portfolio aging analysis as of December 31, 2011 and 2010 follow.
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Impaired Loans
Information regarding impaired loans as of December 31, 2011 and 2010 follows. Data for December 31, 2010 has been modified from presentation in previous periods to match the current period presentation:
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Included in the above impaired loan totals were $21.8 million and $17.3 million of loan modifications meeting the definition of a troubled debt restructuring that were accruing interest and performing in accordance with their agreements at December 31, 2011 and 2010, respectively. Substantially all of the interest income recognized in the tables above was recorded on a cash basis.
Interest payments received on impaired loans are recorded as interest income unless collection of the remaining recorded investment is doubtful, at which time payments received are recorded as reductions to principal. Subsequent payments on nonaccrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Nonaccrual loans are returned to accrual status when, in the judgment of management, the financial position of the borrower indicates there is no longer any reasonable doubt as to the timely collection of interest or principal. The Company requires a period of satisfactory performance of not less than six months before returning a nonaccrual loan to accrual status. These policies apply to each class of the Company’s loan portfolio.
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Troubled Debt Restructurings
In the course of working with borrowers, the Bank may choose to restructure the contractual terms of certain loans. In this scenario, the Bank attempts to work out an alternative payment schedule with the borrower in order to optimize collectability of the loan. Any loans that are modified are reviewed by the Bank to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two. If such efforts by the Bank do not result in a satisfactory arrangement, the loan is referred to legal counsel, at which time foreclosure proceedings are initiated. At any time prior to a sale of the property at foreclosure, the Bank may terminate foreclosure proceedings if the borrower is able to work out a satisfactory payment plan.
It is the Bank’s policy to have any restructured loans which are on nonaccrual status prior to being restructured remain on nonaccrual status until six months of satisfactory borrower performance, at which time management would consider its return to accrual status. The balance of nonaccrual restructured loans, which is included in nonaccrual loans, was $10.7 million at December 31, 2011 and $8.5 million at December 31, 2010. If the restructured loan is on accrual status prior to being restructured, it is reviewed to determine if the restructured loan should remain on accrual status. The balance of accruing restructured loans was $21.8 million at December 31, 2011 and $17.3 million at December 31, 2010.
Loans that are considered TDRs are classified as performing, unless they are on nonaccrual status or greater than 90 days delinquent as of the end of the most recent quarter. All TDRs are considered impaired by the Company. When it is determined that the borrower has met the six month satisfactory performance period (or six payments) under modified terms and the restructuring agreement specified an interest rate greater than or equal to an acceptable rate for a comparable new loan, the loan is considered to be performing. On a quarterly basis, the Company individually reviews all TDR loans to determine if a loan meets both of these criteria.
Accruing restructured loans at December 31, 2011 are comprised of two categories of loans on which interest is being accrued under their restructured terms, and the loans are current or less than ninety days past due. The first category consists of $18.6 million of commercial loans, primarily comprised of business loans that have been temporarily modified as interest-only loans, generally for a period of up to one year, without a sufficient corresponding increase in the interest rate. Within this category are $8.2 million of CLD loans that have been renewed as interest only, generally for a period of up to one year, to assist the borrower.
The Bank does not generally forgive principal or interest on restructured loans. However, when a loan is restructured, principal is generally received on a delayed basis as compared to the original repayment schedule. CLD loans that are restructured are generally modified to require interest-only for a period of time. The Bank does not generally reduce interest rates on restructured commercial loans. The average yield on modified commercial loans was 5.38%, compared to 5.54% earned on the entire commercial loan portfolio in the fourth quarter of 2011.
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The second category included in accruing restructured loans consists of residential mortgage and home equity loans whose terms have been restructured at less than market terms and include rate modifications, extension of maturity, and forbearance. This category consists of fifteen loans for a total of $3.2 million at December 31, 2011. The average yield on modified residential mortgage and home equity loans was 3.96%, compared to 5.71% earned on the entire residential mortgage loan portfolio in the fourth quarter of 2011.
The Company has no personal loans other than the loans described in the paragraph above that are classified as troubled debt restructurings.
With regard to determination of the amount of the allowance for loan losses, all restructured loans are considered to be impaired. As a result, the determination of the amount of impaired loans for each portfolio segment within troubled debt restructurings is the same as detailed previously above.
The following tables present information regarding troubled debt restructurings for the years ended December 31, 2011 and 2010.
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As a result of adopting the amendments in ASU No. 2011-02, the Company reassessed all restructurings that occurred on or after the beginning of the current fiscal year (January 1, 2011) to determine whether they are now considered troubled debt restructurings. The Company identified as TDRs certain loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying those loans as TDRs, the Company identified them as impaired under the guidance in ASC 310-10-35. The amendments in ASU No. 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those loans newly identified as impaired. At the end of the first interim period of adoption (September 30, 2011), the recorded investment in loans for which the allowance was previously measured under a general allowance methodology and are now impaired under ASC 310-10-35 was $4.0 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss, was $1.5 million.
NOTE 6 - LOAN SERVICING
Loans serviced for others are not included in the accompanying consolidated financial statements. The unpaid principal balance of loans serviced for others was $735,108,000 and $655,054,000 at December 31, 2011 and 2010, respectively. The balance of loans serviced for others related to servicing rights that have been capitalized was $732,591,000 and $651,629,000 at December 31, 2011 and 2010, respectively.
Unamortized cost of loan servicing rights included in accrued interest receivable and other assets on the consolidated balance sheet, for the years ended December 31 was as follows:
The fair value of servicing rights was as follows at December 31:
NOTE 7 - PREMISES AND EQUIPMENT
Depreciation expense was approximately $1,124,000 in 2011, $1,251,000 in 2010 and $1,387,000 in 2009. Premises and equipment as of December 31 consisted of the following:
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The Company has a small number of non-cancellable operating leases, primarily for banking facilities that expire over the next fifteen years. The leases generally contain renewal options for periods ranging from one to five years. Rental expense for these leases was $1.2 million for the year ended December 31, 2011 and $1.1 million for the years ended December 31, 2010 and 2009, respectively.
Future minimum lease payments under operating leases are shown in the table below:
NOTE 8 - GOODWILL
In 2009, management performed an impairment evaluation to identify potential impairment of goodwill carried by the Company’s subsidiary banks. As a result of the impairment evaluation, a goodwill impairment charge was taken in the first quarter of 2009 for the Company’s entire book value of goodwill of $3.469 million. This non-cash charge was recorded as a component of noninterest expense. The goodwill on the books of the banks originally resulted from the acquisition of various banking offices between 1992 and 1999.
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NOTE 9 - DEPOSITS
Information relating to maturities of time deposits as of December 31 is summarized below:
NOTE 10 - SHORT TERM BORROWINGS
The Company has several credit facilities in place for short term borrowing which are used on occasion as a source of liquidity. These facilities consist of borrowing authority totaling $7.0 million from correspondent banks to purchase federal funds on a daily basis. There were no fed funds purchased outstanding at December 31, 2011 and 2010.
The Company’s balance sheet includes short-term borrowings of $1.234 million at December 31, 2010, representing the secured borrowing portion of SBA 7a loans held for sale, as a result of adoption of ASU 2009-16 in 2010. In the first quarter of 2011, the Company modified its SBA 7a loan sales contract to eliminate a 90-day warranty period to the purchaser of the loans, eliminating the requirement to record a liability for the sold portion of the loans, and the Company’s balance sheet included no short term borrowings related to SBA loans at December 31, 2011.
The Bank may also enter into sales of securities under agreements to repurchase ("repurchase agreements"). These agreements generally mature within one to 120 days from the transaction date. U.S. Treasury, agency and other securities involved with the agreements are recorded as assets and are generally held in safekeeping by correspondent banks. Repurchase agreements are offered principally to certain clients as an investment alternative to deposit products. There were no balances outstanding at any time during 2011 or 2010.
NOTE 11 - OTHER BORROWINGS
The Bank carried fixed rate, non-callable advances from the Federal Home Loan Bank of Indianapolis totaling $24.0 million and $30.3 million at December 31, 2011 and 2010, respectively. As of December 31, 2011, the rates on the advances ranged from 2.74% to 5.36% with a weighted average rate of 3.43%.
Advances are primarily collateralized by residential mortgage loans under a blanket security agreement. Additional coverage is provided by Other Real Estate Related (“ORER”) and Community Financial Institution (“CFI”) collateral. The unpaid principal balance of the loans pledged as collateral required is between 155% and 250%, depending on the type of collateral
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and was $150.3 million at year-end 2011. Interest payments are made monthly, with principal due annually and at maturity. If principal payments are paid prior to maturity, advances are subject to a prepayment penalty.
Maturities and scheduled principal payments for other borrowings over the next five years as of December 31 are shown below.
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet financing needs of its clients. These financial instruments include commitments to make loans, unused lines of credit, and letters of credit. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Bank follows the same credit policy to make such commitments as is followed for loans and investments recorded in the consolidated financial statements. The Bank's commitments to extend credit are agreements at predetermined terms, as long as the client continues to meet specified criteria, with fixed expiration dates or termination clauses.
The following table shows the commitments to make loans and the unused lines of credit available to clients at December 31:
Commitments to make loans generally expire within thirty to ninety days, while unused lines of credit expire at the maturity date of the individual loans. At December 31, 2011, the rates for amounts in the fixed rate category ranged from 3.25% to 7.00%.
In 2001, United Bank & Trust entered into a limited partnership agreement to purchase tax credits awarded from the construction, ownership and management of an affordable housing project and a residual interest in the real estate. As of December 31, 2011 and 2010, the total
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recorded investment including the obligation to make additional future investments were $900,000 and $1,014,000 respectively, and was included in other assets. As of December 31, 2011 and 2010, the obligation of UBT to the limited partnership was $457,000 and $664,000, respectively, which was reported in other liabilities. While UBT is a 99% partner, the investment is accounted for on the equity method as UBT is a limited partner and has no control over the operation and management of the partnership or the affordable housing project.
NOTE 13 - FEDERAL INCOME TAX
Income tax benefit consists of the following for the years ended December 31:
The Company’s effective tax rates were a calculated benefit based upon pre-tax losses, resulting in a tax benefit for each year presented.
The components of deferred tax assets and liabilities at December 31 are as follows:
At December 31, 2011, the Company had net operating losses of $7.6 million that are being carried forward to reduce future taxable income. The carryforwards expire in 2030 and 2031. As of December 31, 2011, the Company had approximately $947,000 of low income housing and alternative minimum tax credits available to offset future federal income taxes. The low income
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housing credits expire in 2028 through 2031, and the alternative minimum tax credits have no expiration date.
The Company’s net deferred tax asset is included in the category “Accrued interest receivable and other assets” on the balance sheet. The Company’s net deferred tax asset was $9.9 million at December 31, 2011. A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. The following lists the evidence considered in determining whether a valuation allowance was necessary for deferred tax assets:
Negative Evidence
·
As a result of cumulative losses over the past few years, the Company has a tax Net Operating Loss (“NOL”) of $7.6 million as of December 31, 2011
Positive Evidence
·
The Company had many years of consistently profitable operations before 2009;
·
The Company’s NOL carry-forward position of $7.6 million at December 31, 2011 is not large in comparison to historical profitability (taxable income of $41.6 million from 2004 to 2008);
·
The Company can carry forward losses for twenty years;
·
The Company’s pre-tax loss has been reduced from $14.5 million in 2009 to $6.6 million in 2010. The Company generated a pre-tax profit of $0.5 million in 2011;
·
The Company’s 2009-2010 losses were due to a goodwill impairment of $3.5 million in 2009 along with high provision for loan losses, which have been reduced from $25.8 million in 2009 to $21.5 million in 2010, and $12.2 in 2011;
·
Management expects a return to sustained profitability in future years as a result of strong core earnings and continued reduction in loan losses.
·
Available tax planning strategies, including:
o
Sale and leaseback of premises
o
Sale of mortgage servicing rights
o
Sale of municipal securities
Based upon our analysis of the evidence (both negative and positive), management has determined that no valuation allowance was required at December 31, 2011 or 2010.
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Reconciliation between total federal income tax and the amount computed through the use of the federal statutory tax rate for the years ended is as follows:
NOTE 14 - RELATED PARTY TRANSACTIONS
Certain directors and executive officers of the Company and the Bank, including their immediate families and companies in which they are principal owners, are clients of the Bank. Loans to these parties did not, in the judgment of management, involve more than normal credit risk or present other unfavorable features. The aggregate amount of these loans at December 31, 2010 was $1,677,000. That balance was adjusted to exclude directors and officers that were not with the Company at the end of 2011. During 2011, new and newly reportable loans to such related parties amounted to $804,000 and repayments amounted to $1,318,000, resulting in a balance at December 31, 2011 of $1,164,000. Related party deposits totaled $1,315,000 and $1,046,000 at December 31, 2011 and 2010, respectively. The balance of deposits at December 31, 2010 was adjusted to exclude directors and officers that were not with the Company at the end of 2011
NOTE 15 - RESTRICTIONS ON SUBSIDIARY DIVIDENDS, LOANS OR ADVANCES
Banking laws and regulations restrict the amount the Bank can transfer to the Company in the form of cash dividends and loans. Under the Memorandum of Understanding described in Note 18, United Bank & Trust may not declare or pay any dividends without prior approval of its regulators. It is not the intent of management to pay dividends in amounts that would reduce the capital of the Bank to a level below that which is considered prudent by management and in accordance with the guidelines of regulatory authorities.
NOTE 16 - EMPLOYEE BENEFIT PLANS
Employee Savings Plan
The Company maintains a 401(k) employee savings plan ("plan") which is available to substantially all employees. Individual employees may make contributions to the plan up to 100% of their compensation up to a maximum of $16,500 for 2011, 2010 and 2009. Prior to July, 2009, the Company offered discretionary matching of funds for a percentage of the employee contribution, plus an amount based on Company earnings. In July 1, 2009, the Company discontinued its profit sharing and employer matching contributions to the plan, and had no expense for the plan for 2010. The Company reinstated matching contributions beginning January 1, 2011, but did not make profit sharing contributions in 2011. The expense for the plan
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for 2011 and 2009 was $459,000 and $238,000, respectively. The plan offers employees the option of purchasing Company stock with the match portion of their 401(k) contribution, and shares available to employees within the plan are purchased on the open market.
Director Retainer Stock Plan
The Company maintains a deferred compensation plan designated as the Director Retainer Stock Plan ("Director Plan"). The plan provides eligible directors of the Company and the Bank with a means of deferring payment of retainers and certain fees payable to them for Board service. Under the Director Plan, any retainers or fees elected to be deferred under the plan by an eligible director ultimately will be payable in common stock at the time of payment.
Senior Management Bonus Deferral Stock Plan
The Company maintains a deferred compensation plan designated as the Senior Management Bonus Deferral Stock Plan ("Management Plan"). The Management Plan has essentially the same purposes as the Director Plan discussed above and permits eligible employees of the Company and its affiliates to elect cash bonus deferrals and, after employment termination, to receive payouts in whole or in part in the form of common stock on terms substantially similar to those of the Director Plan.
Stock Options and Other Equity Awards
The Company has stock based compensation plans as described below. The Company has recorded approximately $138,000, $92,000 and $150,000 in compensation expense related to stock based compensation plans for the periods ended December 31, 2011, 2010 and 2009, respectively. The Company has a policy of issuing authorized but unissued shares to satisfy exercises of stock options or stock only stock appreciation rights.
Stock Incentive Plan
The Company’s Stock Incentive Plan of 2010 (the "Incentive Plan") permits the grant and award of stock options, stock appreciation rights, restricted stock, restricted stock units, stock awards and other stock-based and stock-related awards (collectively referred to as "incentive awards") to directors, consultative board members, officers and other key employees of the Company and its subsidiaries.
The following table shows activity for the twelve months ended December 31, 2011 for the Company’s Incentive Plan:
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As of December 31, 2011, unrecognized compensation expense related to the Incentive Plan totaled $160,225. Costs for SOSARs are recognized over approximately three years. The compensation costs for RSUs are based on an expected level of achievement of performance targets as determined at the time of each grant, and are expected to be recognized over three years. Compensation costs for restricted stock grants will be recognized over two years.
The fair value of restricted stock grants is considered to be the market price of Company stock at the grant date. The fair value of RSU grants is considered to be the market price of Company stock at the grant date, adjusted for an estimated probability of achieving performance targets.
The fair value of each SOSAR grant is estimated on the grant date using the Black-Scholes option pricing model. Fair value of 2011 grants is based on the weighted-average assumptions shown in the table below.
At December 31, 2011, the SOSARs outstanding had no intrinsic value. Intrinsic value was determined by calculating the difference between the Company's closing stock price on December 31, 2011 and the exercise price of the SOSARs, multiplied by the number of in-the-money units held by each holder, assuming all option holders had exercised their SOSARs on December 31, 2011. The weighted-average period over which nonvested SOSARs are expected to be recognized is 1.18 years.
Stock Option Plan
Through December 31, 2009, the Company granted stock options under its 2005 Stock Option Plan (the "2005 Plan"), which is a non-qualified stock option plan as defined under Internal Revenue Service regulations. The shares of stock that are subject to options are the authorized and unissued shares of common stock of the Company. Under the 2005 Plan, directors and management of the Company and subsidiaries were given the right to purchase stock of the Company at the then-current market price at the time the option was granted. The options have a three-year vesting period, and with certain exceptions, expire at the end of ten years, three years after retirement or ninety days after other separation from the Company. The 2005 Plan expired effective January 1, 2010, and no additional options may be granted under the plan. The following summarizes year to date option activity for the 2005 Plan:
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The table below provides information regarding stock options outstanding under the 2005 Plan at December 31, 2011.
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the weighted-average assumptions shown below. No figures are shown for 2011 or 2010, as there were no options granted during those years:
As of the end of 2011, unrecognized compensation expense related to the stock options granted under the 2005 Plan totaled $8,782 and is expected to be recognized over six months.
At December 31, 2011, the total outstanding stock options granted under the 2005 Plan had no intrinsic value. Intrinsic value was determined by calculating the difference between the Company's closing stock price on December 31, 2011 and the exercise price of each option, multiplied by the number of in-the-money stock options held by each holder, assuming all holders had exercised their stock options on December 31, 2011.
NOTE 17 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair Value Measurements. The Fair Value Measurements Topic of the FASB Accounting Standards Codification (“FASB ASC”) defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FASB ASC Topic 820-10-20 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Topic 820-10-55 establishes a fair value hierarchy that emphasizes use of observable inputs and minimizes use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
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Level 1
Quoted prices in active markets for identical assets or liabilities
Level 2
Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities
Level 3
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities
Following is a description of the inputs and valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying consolidated balance sheets, as well as the general classification of those instruments under the valuation hierarchy.
Available-for-sale Securities
Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Level 2 securities include U.S. Government agency securities, mortgage backed securities, obligations of states and municipalities, and certain corporate securities. Matrix pricing is a mathematical technique widely used in the banking industry to value investment securities without relying exclusively on quoted prices for specific investment securities, but rather, relying on the investment securities’ relationship to other benchmark quoted investment securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy. The Company has no Level 3 securities.
The following table presents the fair value measurements of assets recognized in the accompanying consolidated balance sheets measured at fair value on a recurring basis and the level within the FASB ASC fair value hierarchy in which the fair value measurements fall at December 31, 2011 and 2010:
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Following is a description of the valuation methodologies used for instruments measured at fair value on a non-recurring basis and recognized in the accompanying balance sheets, as well as the general classification of those instruments under the valuation hierarchy.
Impaired Loans (Collateral Dependent)
Loans for which it is believed to be probable that the Company will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral-dependent loans. If the impaired loan is identified as collateral dependent, the fair value of collateral method of measuring the amount of impairment is utilized.
The Company’s practice is to obtain new or updated appraisals on the loans subject to the initial impairment review and to generally update on an annual basis thereafter. The Company discounts the appraisal amount as necessary for selling costs and past due real estate taxes. If a new or updated appraisal is not available at the time of a loan’s impairment review, the Company typically applies a discount to the value of a previous appraisal to reflect the property's current estimated value if there is believed to be deterioration in either (i) the physical or economic aspects of the subject property or (ii) any market conditions. The results of the impairment review results in an increase in the allowance for loan loss or in a partial charge-off of the loan, if warranted. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.
The following table presents the fair value measurements of assets recognized in the accompanying consolidated balance sheets measured at fair value on a non-recurring basis and the level within the FASB ASC fair value hierarchy in which the fair value measurements fall at December 31, 2011 and 2010:
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The carrying amounts and estimated fair value of principal financial assets and liabilities were as follows:
Estimated fair values require subjective judgments and are approximate. The above estimates of fair value are not necessarily representative of amounts that could be realized in actual market transactions, or of the underlying value of the Company. Changes in the following methodologies and assumptions could significantly affect the estimated fair value:
Cash and cash equivalents, FHLB stock, loans held for sale, accrued interest receivable and accrued interest payable - The carrying amounts are reasonable estimates of the fair values of these instruments at the respective balance sheet dates.
Net portfolio loans - The carrying amount is a reasonable estimate of fair value for personal loans for which rates adjust quarterly or more frequently, and for business and tax-exempt loans that are prime related and for which rates adjust immediately or quarterly. The fair value of all other loans is estimated by discounting future cash flows using current rates for loans with similar characteristics and maturities. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns.
Total deposits - With the exception of certificates of deposit, the carrying value is deemed to be the fair value due to the demand nature of the deposits. The fair value of fixed maturity certificates of deposit is estimated by discounting future cash flows using the current rates paid on certificates of deposit with similar maturities.
Short Term Borrowings - The carrying amounts are reasonable estimates of the fair values of these instruments at the respective balance sheet dates.
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FHLB Advances - The fair value is estimated by discounting future cash flows using current rates on advances with similar maturities.
Off-balance-sheet financial instruments - Commitments to extend credit, standby letters of credit and undisbursed loans are deemed to have no material fair value as such commitments are generally fulfilled at current market rates.
NOTE 18 - REGULATORY CAPITAL REQUIREMENTS
The Company and 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 discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum ratios of Total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets.
On January 15, 2010, UBT entered into a Memorandum of Understanding with the Federal Deposit Insurance Corporation (“FDIC”) and the Michigan Office of Financial and Insurance Regulation (“OFIR”). On January 11, 2011, we entered into a revised Memorandum of Understanding (“MOU”) with substantially the same requirements as the MOU dated January 15, 2010. The MOU is not a “written agreement” for purposes of Section 8 of the Federal Deposit Insurance Act. The MOU documents an understanding among UBT, the FDIC and OFIR, that, among other things, (i) UBT will not declare or pay any dividend to the Company without the prior consent of the FDIC and OFIR; and (ii) UBT will have and maintain its Tier 1 capital ratio at a minimum of 9% for the duration of the MOU, and will maintain its ratio of total capital to risk-weighted assets at a minimum of 12% for the duration of the MOU.
In December 2010, the Company closed its public offering of common stock. The net proceeds to the Company, after deducting underwriting discounts and commissions and offering expenses, were approximately $17.1 million. The Company has contributed $12.0 million of the net proceeds of the offering to the capital of the Bank to increase the Bank's capital and regulatory capital ratios. As a result of the additional capital, the Bank was in compliance with the capital requirements of its MOU with the FDIC and OFIR at December 31, 2011 and 2010 At December 31, 2011, the Bank’s Tier 1 leverage capital ratio was 9.20%, and its ratio of total capital to risk-weighted assets was 15.49%.
The following table shows information about the Company's and the Banks' capital levels compared to regulatory requirements at year-end 2011 and 2010.
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NOTE 19 - EARNINGS (LOSS) PER SHARE
A reconciliation of basic and diluted earnings and loss per share follows:
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There was no dilutive effect of stock warrants in 2011, 2010 or 2009. Stock options for 381,743 407,730 and 416,594 shares of common stock were not considered in computing diluted earnings per share for 2011, 2010 and 2009 because they were not dilutive.
NOTE 20 - OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income components and related taxes were as follows:
The components of accumulated other comprehensive income included in shareholders’ equity at December 31, 2011 and, 2010 were as follows:
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NOTE 21 - PARENT COMPANY ONLY FINANCIAL INFORMATION
The condensed financial information for United Bancorp, Inc. is summarized below.
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NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Quarterly financial information is summarized below:
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NOTE 23 - CAPITAL PURCHASE PROGRAM
On January 16, 2009, the Company entered into a Letter Agreement (“Purchase Agreement”) with the U.S. Department of the Treasury (“Treasury”), pursuant to which United issued and sold (a) 20,600 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“Preferred Stock”) for an aggregate purchase price of $20,600,000 and (b) a 10-year warrant (“Warrant”) to purchase 311,492 shares of our common stock at an aggregate exercise price of $3,090,000.
The Preferred Stock qualifies as Tier I capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. The Preferred Stock is non-voting except with respect to certain matters affecting the rights of the holders, and may be redeemed by United after three years. The Warrant has a ten year term and is immediately exercisable with an exercise price of $9.92 per share of the Company’s common stock. Pursuant to the Purchase Agreement, Treasury has agreed not to exercise voting power with respect to any shares of United common stock issued upon exercise of the Warrant.
In the Purchase Agreement, the Company agreed that, until such time as Treasury ceases to own any debt or equity securities of the Company acquired pursuant to the Purchase Agreement, United will take all necessary action to ensure that its benefit plans with respect to its senior executive officers comply with Section 111(b) of the Emergency Economic Stabilization Act of 2008 (“EESA”) as implemented by any guidance or regulation under EESA that has been issued and is in effect as of the date of issuance of the Preferred Stock and the Warrant, and has agreed to not adopt any benefit plans with respect to, or which cover, its senior executive officers that do not comply with the EESA, and the applicable executives have consented to the foregoing.
As a result of issuance of the Preferred Stock on January 16, 2009, the ability of United to declare or pay dividends on, or purchase, redeem or otherwise acquire for consideration, shares of its common stock will be subject to restrictions. The Company may not pay any dividends on its common stock unless the Company is current on its dividend payments on the TARP CPP preferred stock. As of December 31, 2010 and 2011, the Company was current on its dividend payments on the TARP CPP preferred stock.
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NOTE 24 - LEGAL PROCEEDINGS
A class action lawsuit was filed against the Bank in early 2011that alleges the Bank violated the Electronic Funds Transfer Act (“EFTA”), 15 U.S.C. §1693 et seq., by allegedly failing to provide adequate notice of automated teller machines (“ATMs”) fees at the Bank’s ATMs. The plaintiff is seeking class certification of the lawsuit, statutory damages, payment of costs of the lawsuit and payment of reasonable attorneys' fees. This case is in the discovery stage, and the class has not been certified. The Company is unable to determine potential liability in this case. Although the Bank intends to vigorously defend the lawsuit, the likelihood of an unfavorable outcome is neither probable nor remote, and as such, no conclusion can be made at this time. The Bank believes this complaint is a routine legal proceeding occurring in the ordinary course of its business as an operator of ATMs. The Company believes that this lawsuit is without merit, but that disclosure of the potential liability is prudent.
Other than the above-referenced matter, the Company is involved in routine legal proceedings occurring in the ordinary course of its business, which, in the aggregate, are believed to be immaterial to the financial condition of the Company.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
United Bancorp, Inc.
By
/s/ Robert K. Chapman
February 24, 2012
Robert K. Chapman,
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities and on the dates indicated.
/s/ Robert K. Chapman
Director, President and Chief Executive Officer (Principal Executive Officer)
February 24, 2012
Robert K. Chapman
/s/ Randal J. Rabe
Executive Vice President and Chief Financial Officer (Principal Financial Officer)
February 24, 2012
Randal J. Rabe
Director
February 24, 2012
Stephanie H. Boyse*
Director
February 24, 2012
James D. Buhr *
Director
February 24, 2012
Kenneth W. Crawford *
Director
February 24, 2012
John H. Foss*
Director
February 24, 2012
Norman G. Herbert*
Chairman of the Board
February 24, 2012
James C. Lawson*
Director
February 24, 2012
Len M. Middleton*
*By
/s/ Robert K. Chapman
Robert K. Chapman,
Attorney-in-Fact
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EXHIBIT INDEX
Exhibit
Description
2.1
Agreement of Consolidation. Previously filed with the Commission on January 15, 2010 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 2.1. Incorporated here by reference.
3.1
Restated Articles of Incorporation of United Bancorp, Inc. Previously filed with the Commission on October 1, 2010 in United Bancorp, Inc.'s Form S-1 Registration Statement, Exhibit 3.1. Incorporated here by reference.
3.2
Amended and Restated Bylaws of United Bancorp, Inc. Previously filed with the Commission on December 9, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 3.1. Incorporated here by reference.
3.3
Certificate of Designations for Fixed Rate Cumulative Perpetual Preferred Stock, Series A. Previously filed with the Commission on January 16, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 3.1. Incorporated here by reference.
4.1
Restated Articles of Incorporation of United Bancorp, Inc. Exhibit 3.1 is incorporated here by reference.
4.2
Amended and Restated Bylaws of United Bancorp, Inc. Exhibit 3.2 is incorporated here by reference.
4.3
Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A. Previously filed with the Commission on January 16, 2009 in the United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 4.1. Incorporated here by reference.
4.4
Warrant, dated January 16, 2009, issued to the United States Department of the Treasury. Previously filed with the Commission on January 16, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 4.2. Incorporated here by reference.
4.5
Certificate of Designations for Fixed Rate Cumulative Perpetual Preferred Stock, Series A. Exhibit 3.3 is incorporated here by reference.
10.1*
United Bancorp, Inc. Amended and Restated Director Retainer Stock Plan (as amended through October 20, 2011). Previously filed with the Commission on November 21, 2011 in United Bancorp, Inc.'s Quarterly Report on Form 10-Q/A, Exhibit 10.1. Incorporated here by reference.
10.2*
United Bancorp, Inc. Senior Management Bonus Deferral Stock Plan (as amended through October 20, 2011). Previously filed with the Commission on November 21, 2011 in United Bancorp, Inc.'s Quarterly Report on Form 10-Q/A, Exhibit 10.2. Incorporated here by reference.
10.3*
United Bancorp, Inc. Stock Incentive Plan of 2010 (as amended through October 20, 2011). Previously filed with the Commission on November 21, 2011 in United Bancorp, Inc.'s Quarterly Report on Form 10-Q/A, Exhibit 10.3. Incorporated here by reference.
10.4*
United Bancorp, Inc. 1999 Stock Option Plan. Previously filed with the Commission on February 27, 2009 in United Bancorp, Inc.'s Annual Report on Form 10-K, Exhibit 10.3. Incorporated here by reference.
10.5*
United Bancorp, Inc. 2005 Stock Option Plan. Previously filed with the Commission on September 21, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.3. Incorporated here by reference.
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10.6*
Form of Employment Contract, effective as of June 1, 2009. Previously filed with the Commission on June 2, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.1. Incorporated here by reference.
10.7
Letter Agreement, dated January 16, 2009, between United Bancorp, Inc. and the United States Department of the Treasury. Previously filed with the Commission on January 16, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.1. Incorporated here by reference.
10.8
Form of Waiver. Previously filed with the Commission on January 16, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.2. Incorporated here by reference.
10.9*
Form of Consent and Amendments to Benefit Plans. Previously filed with the Commission on January 16, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.3. Incorporated here by reference.
10.10*
2009 Management Committee Incentive Compensation Plan. Previously filed with the Commission on September 21, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.1. Incorporated here by reference.
10.11*
Form of 2005 United Bancorp, Inc. Stock Option Plan Award Agreement. Previously filed with the Commission on September 21, 2009 in United Bancorp, Inc.'s Current Report on Form 8-K, Exhibit 10.4. Incorporated here by reference.
21.
Subsidiaries of United Bancorp, Inc. Previously filed with the Commission on October 1, 2010 in United Bancorp., Inc.'s Form S1 Registration Statement, Exhibit 21. Incorporated here by reference.
23.
Consent of Independent Registered Public Accounting Firm.
24.
Powers of Attorney.
31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification pursuant to 18 U.S.C. Section 1350.
99.1
Certification of the Principal Executive Officer Pursuant to Section 111 of the Emergency Economic Stabilization Act of 2008.
99.2
Certification of the Principal Financial Officer Pursuant to Section 111 of the Emergency Economic Stabilization Act of 2008.
* These documents are management contracts or compensation plans or arrangements required to be filed as exhibits to this Form 10-K.
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