XNAS:BKMU Bank Mutual Corp Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

xQuarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended June 30, 2012

 

OR

 

¨Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission File Number: 000-31207

 

BANK MUTUAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Wisconsin   39-2004336
(State or other jurisdiction of   (IRS Employer Identification No.)
incorporation or organization)    

 

4949 West Brown Deer Road

Milwaukee, Wisconsin 53223

(414) 354-1500

 

(Address, including Zip Code, and telephone number,

including area code, of registrant’s principal executive offices)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.

 

Yes     x                No     ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)

 

Yes     x               No     ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. 

 

Large accelerated filer ¨   Accelerated filer x
Non-accelerated filer ¨   Small reporting company ¨

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes     ¨               No     x

 

The number of shares outstanding of the issuer’s common stock, $0.01 par value per share, was 46,326,484 shares, at August 7, 2012.

 

 
 

 

BANK MUTUAL CORPORATION

 

FORM 10-Q QUARTERLY REPORT

 

Table of Contents

 

Item   Page
     
PART I    
     
Item l. Financial Statements  
     
  Unaudited Condensed Consolidated Statements of Financial Condition as of June 30, 2012, and December 31, 2011 3
     
  Unaudited Condensed Consolidated Statements of Income  for the three and six months ended June 30, 2012 and 2011 4
     
  Unaudited Condensed Consolidated Statements of Total Comprehensive Income for the three and six months ended June 30, 2012 and 2011 6
     
  Unaudited Condensed Consolidated Statements of Equity for the three and six months ended June 30, 2012 and 2011 7
     
  Unaudited Condensed Consolidated Statements of Cash Flows  for the three and six months ended June 30, 2012 and 2011 8
     
  Notes to Unaudited Condensed Consolidated Financial Statements 10
     
Item 2. Management's Discussion and Analysis of Financial  Condition and Results of Operations 34
     
Item 3. Quantitative and Qualitative Disclosures about Market Risk 52
     
Item 4. Controls and Procedures 56
     
PART II    
     
Item 1A. Risk Factors 57
     
Item 6. Exhibits 57
     
SIGNATURES   58

 

2
 

 

PART I

 

Item 1. Financial Statements

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Financial Condition

 

   June 30   December 31 
   2012   2011 
  (Dollars in thousands) 
Assets        
Cash and due from banks  $33,809   $52,306 
Interest-earning deposits   171,424    68,629 
Cash and cash equivalents   205,233    120,935 
Mortgage-related securities available-for-sale, at fair value   687,619    781,770 
Mortgage-related securities held-to-maturity, at amortized cost (fair value of $160,377  in 2012)   158,556     
Loans held-for-sale, net   11,072    19,192 
Loans receivable (net of allowance for loan losses of $26,029 in 2012 and $27,928 in 2011)   1,348,573    1,319,636 
Foreclosed properties and repossessed assets   16,460    24,724 
Mortgage servicing rights, net   7,263    7,401 
Other assets   200,176    224,826 
           
Total assets  $2,634,952   $2,498,484 
           
Liabilities and equity          
           
Liabilities:          
Deposit liabilities  $1,983,179   $2,021,663 
Borrowings   311,414    153,091 
Advance payments by borrowers for taxes and insurance   22,261    3,192 
Other liabilities   45,741    51,842 
Total liabilities   2,362,595    2,229,788 
Equity:          
Preferred stock–$0.01 par value:          
Authorized–20,000,000 shares in 2012 and 2011
Issued and outstanding–none in 2012 and 2011
        
Common stock–$0.01 par value:          
Authorized–200,000,000 shares in 2012 and 2011
Issued–78,783,849 shares in 2012 and 2011
          
Outstanding–46,326,484 shares in 2012 and 46,228,984 in 2011   788    788 
Additional paid-in capital   489,186    490,159 
Retained earnings   142,350    140,793 
Accumulated other comprehensive loss   (3,454)   (5,379)
Treasury stock–32,457,365 shares in 2012 and 32,554,865 in 2011   (359,409)   (360,590)
Total shareholders’ equity   269,461    265,771 
Non-controlling interest in real estate partnership   2,896    2,925 
Total equity including non-controlling interest   272,357    268,696 
           
Total liabilities and equity  $2,634,952   $2,498,484 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

3
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Income

 

   Three Months Ended
June 30
 
   2012   2011 
   (Dollars in thousands, 
except per share data)
 
Interest income:          
Loans  $16,205   $17,546 
Mortgage-related securities   4,792    4,033 
Interest-earning deposits   59    46 
Investment securities   23    1,281 
Total interest income   21,079    22,906 
Interest expense:          
Deposit liabilities   3,868    5,010 
Borrowings   2,357    1,790 
Advance payments by borrowers for taxes and insurance   1    1 
Total interest expense   6,226    6,801 
Net interest income   14,853    16,105 
Provision for loan losses   1,730    805 
Net interest income after provision for loan losses   13,123    15,300 
Non-interest income:          
Service charges on deposits   1,664    1,559 
Brokerage and insurance commissions   964    832 
Loan related fees and servicing revenue, net   (1,395)   333 
Gain on loan sales activities, net   3,551    520 
Gain on investments, net   543     
Other-than-temporary impairment (“OTTI”) losses:          
Total OTTI losses   (909)   (1,299)
Non-credit portion of OTTI losses   573    910 
Net OTTI losses   (336)   (389)
Increase in cash surrender value of life insurance   524    539 
Other non-interest income   1,419    1,365 
Total non-interest income   6,934    4,759 
Non-interest expense:          
Compensation, payroll taxes, and other employee benefits   10,697    9,602 
Occupancy and equipment   2,778    2,850 
Federal insurance premiums   871    746 
Advertising and marketing   471    400 
Losses and expenses on foreclosed real estate, net   970    2,696 
Other non-interest expense   2,353    2,320 
Total non-interest expense before goodwill impairment   18,140    18,614 
Goodwill impairment       52,570 
Total non-interest expense   18,140    71,184 
Income (loss) before income taxes   1,917    (51,125)
Income tax expense   601    266 
Net income (loss) before non-controlling interest   1,316    (51,391)
Net loss attributable to non-controlling interest   13    14 
Net income (loss)  $1,329   $(51,377)
           
Per share data:          
Earnings (loss) per share–basic  $0.03   $(1.12)
Earnings (loss) per share–diluted  $0.03   $(1.12)
Cash dividends per share paid  $0.01   $0.01 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

4
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Income

 

   Six Months Ended
June 30
 
   2012   2011 
   (Dollars in thousands, 
except per share data)
 
Interest income:          
Loans  $32,629   $35,419 
Mortgage-related securities   9,094    7,828 
Interest-earning deposits   100    97 
Investment securities   34    2,625 
Total interest income   41,857    45,969 
Interest expense:          
Deposit liabilities   7,924    10,479 
Borrowings   4,181    3,560 
Advance payments by borrowers for taxes and insurance   1    2 
Total interest expense   12,106    14,041 
Net interest income   29,751    31,928 
Provision for loan losses   1,781    3,985 
Net interest income after provision for loan losses   27,970    27,943 
Non-interest income:          
Service charges on deposits   3,223    3,027 
Brokerage and insurance commissions   1,545    1,446 
Loan related fees and servicing revenue, net   (1,257)   584 
Gain on loan sales activities, net   6,455    1,116 
Gain on investments, net   543    1,113 
Other-than-temporary impairment (“OTTI”) losses:          
Total OTTI losses   (909)   (1,299)
Non-credit portion of OTTI losses   573    910 
Net OTTI losses   (336)   (389)
Increase in cash surrender value of life insurance   1,050    1,085 
Other non-interest income   2,983    2,572 
Total non-interest income   14,206    10,554 
Non-interest expense:          
Compensation, payroll taxes, and other employee benefits   21,272    19,001 
Occupancy and equipment   5,732    5,849 
Federal insurance premiums   1,702    1,768 
Advertising and marketing   1,070    645 
Losses and expenses on foreclosed real estate, net   3,748    3,726 
Other non-interest expense   5,134    4,675 
Total non-interest expense before goodwill impairment   38,658    35,664 
Goodwill impairment       52,570 
Total non-interest expense   38,658    88,234 
Income (loss) before income taxes   3,518    (49,737)
Income tax expense   1,063    626 
Net income (loss) before non-controlling interest   2,455    (50,363)
Net loss attributable to non-controlling interest   29    27 
Net income (loss)  $2,484   $(50,336)
           
Per share data:          
Earnings (loss) per share–basic  $0.05   $(1.10)
Earnings (loss) per share–diluted  $0.05   $(1.10)
Cash dividends per share paid  $0.02   $0.04 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

5
 

 

Bank Mutual Corporations and Subsidiaries

Unaudited Condensed Consolidated Statements of Total Comprehensive Income

 

   Three Months Ended
June 30
 
   2012   2011 
   (Dollars in thousands) 
Net income (loss) before non-controlling interest  $1,316   $(51,391)
Other comprehensive income (loss), net of tax:          
Unrealized holding gains (losses) during the period:          
Non-credit portion of OTTI on securities available-for sale, net of of deferred income taxes of $(230) in 2012 and $(365) in 2011   (343)   (545)
Change in net unrealized gain on securities available-for-sale, net of deferred income taxes of $(64) in 2012 and $3,198 in 2011   (99)   4,776 
Reclassification adjustment for realized gains on sales of securities available-for-sale, net of income taxes of $(218) in 2012   (325)    
    (767)   4,231 
Defined benefit pension plans:          
Amortization of prior period net loss included in net periodic pension cost, net of deferred income taxes of $254 in 2012   382     
    382     
Total other comprehensive income (loss), net of tax   (385)   4,231 
Total comprehensive income (loss) before non-controlling interest   931    (47,160)
Comprehensive loss attributable to non-controlling interest   13    14 
           
Total comprehensive income (loss)  $944   $(47,146)

 

   Six Months Ended 
   June 30 
   2012   2011 
   (Dollars in thousands) 
Net income (loss) before non-controlling interest  $2,455   $(50,363)
Other comprehensive income (loss), net of tax:          
Unrealized holding gains (losses) during the period:          
Non-credit portion of OTTI on securities available-for sale, net of of deferred income taxes of $(230)in 2012 $(365) in 2011   (343)   (545)
Change in net unrealized gain on securities available-for-sale, net of deferred income taxes of $1,385 in 2012 and $3,529 in 2011   2,066    5,271 
Reclassification adjustment for realized gains on sales of securities available-for-sale, net of income taxes of $(218) in 2012 and $(446) in 2011   (325)   (667)
    1,398    4,059 
Defined benefit pension plans:          
Amortization of prior period net loss included in net periodic pension cost, net of deferred income taxes of $351 in 2012   527     
Other pension-related adjustments, net of deferred income taxes of $(41) in 2011       (62)
    527    (62)
Total other comprehensive income, net of tax   1,925    3,997 
Total comprehensive income (loss) before non-controlling interest   4,380    (46,366)
Comprehensive loss attributable to non-controlling interest   29    27 
           
Total comprehensive income (loss)  $4,409   $(46,339)

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

6
 

 

Bank Mutual Corporations and Subsidiaries 

Unaudited Condensed Consolidated Statements of Equity

 

               Accumulated       Non-Controlling     
       Additional       Other       Interest in     
   Common   Paid-In   Retained   Comprehensive   Treasury   Real Estate     
   Stock   Capital   Earnings   Income (Loss)   Stock   Partnership   Total  
   (Dollars in thousands, except per share data) 
                             
Balance at January 1, 2012  $788   $490,159   $140,793   $(5,379)  $(360,590)  $2,925   $268,696 
Net income           2,484                2,484 
Net loss attributable to non-controlling interest                       (29)   (29)
Other comprehensive income               1,925            1,925 
Issuance of management recognition plan shares       (1,181)           1,181         
Share based payments       208                    208 
Cash dividends ($0.02 per share)           (927)               (927)
                                    
Balance at June 30, 2012  $788   $489,186   $142,350   $(3,454)  $(359,409)  $2,896   $272,357 
                                    
Balance at January 1, 2011  $788   $494,377   $191,238   $(6,897)  $(366,553)  $2,925   $315,878 
Net loss           (50,336)               (50,336)
Net loss attributable to non-controlling interest                       (27)   (27)
Other comprehensive income               3,997            3,997 
Issuance of management recognition plan shares       (123)           123         
Exercise of stock options       (4,376)           5,840        1,464 
Share based payments       141                    141 
Cash dividends ($0.04 per share)           (1,956)               (1,956)
                                    
Balance at June 30, 2011  $788   $490,019   $138,946   $(2,900)  $(360,590)  $2,898   $269,161 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

7
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows

 

   Six Months Ended
June 30
 
   2012   2011 
   (Dollars in thousands) 
Operating activities:          
Net income (loss)  $2,484   $(50,336)
Adjustments to reconcile net income to net cash from operating activities:          
Net provision for loan losses   1,781    3,985 
Net loss on foreclosed real estate   3,072    2,867 
Provision for depreciation   1,266    1,300 
Goodwill impairment       52,570 
Net OTTI losses   336    389 
Amortization of mortgage servicing rights   2,022    993 
Increase (decrease) in valuation allowance on MSRs   975    (6)
Net premium amortization on securities   2,291    1,198 
Loans originated for sale   (248,148)   (54,826)
Proceeds from loan sales   259,864    79,498 
Net gain on loan sales activities   (6,455)   (1,116)
Net gain on sale of investments   (543)   (1,113)
Other, net   (3,325)   (6,157)
Net cash provided by operating activities   15,620    29,246 
Investing activities:          
Proceeds from maturities of investment securities available-for-sale       150,825 
Proceeds from sale of investment securities       21,950 
Purchases of mortgage-related securities available-for-sale   (51,374)   (287,696)
Principal repayments on mortgage-related securities available-for-sale   124,946    49,686 
Proceeds from sales of mortgage-related securities available-for-sale   20,938     
Purchases of mortgage-related securities held-to-maturity   (158,915)    
Principal repayments on mortgage-related securities held-to-maturity   250     
Proceeds from redemption of FHLB of Chicago stock   21,653     
Net increase in loans receivable   (36,197)   (13,873)
Proceeds from sale of foreclosed properties   10,671    3,822 
Net purchases of premises and equipment   (1,275)   (866)
Net cash used by investing activities   (69,303)   (76,152)
           
         (continued) 

  

8
 

 

Bank Mutual Corporation and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows (Continued)

 

   Six Months Ended
June 30
 
   2012   2011 
   (Dollars in thousands) 
Financing activities:          
Net decrease in deposit liabilities   (38,484)   (70,273)
Proceeds from long-term borrowings   158,935     
Repayments of borrowings   (612)   (543)
Net increase in advance payments by borrowers for taxes and insurance   19,069    17,722 
Cash dividends   (927)   (1,956)
Other, net       1,465 
Net cash provided (used) by financing activities   137,981    (53,585)
Increase (decrease) in cash and cash equivalents   84,298    (100,491)
Cash and cash equivalents at beginning of period   120,935    232,832 
Cash and cash equivalents at end of period  $205,233   $132,341 
           
Supplemental information:          
Cash paid in period for:          
Interest on deposit liabilities and borrowings  $11,996   $15,836 
Income taxes   162     
Non-cash transactions:          
Loans  transferred to foreclosed properties and repossessed assets   5,479    19,622 
Increase in due to brokers for security purchases       40,694 

 

Refer to Notes to Unaudited Condensed Consolidated Financial Statements

 

9
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

1. Basis of Presentation

 

The Unaudited Condensed Consolidated Financial Statements include the accounts of Bank Mutual Corporation (the “Company”), its wholly-owned subsidiary Bank Mutual (the “Bank”), and the Bank’s subsidiaries.

 

The accompanying Unaudited Condensed Consolidated Financial Statements have been prepared in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information, Rule 10-01 of Regulation S-X, and the instructions to Form 10-Q. The financial statements do not include all of the information and footnotes required by GAAP for complete financial information. However, in the opinion of management, all adjustments (consisting of normal recurring entries) necessary for a fair presentation of operations, cash flows, and financial position have been included in the accompanying financial statements. This report should be read in conjunction with the Company’s 2011 Annual Report on Form 10-K. Operating results for the three and six months ended June 30, 2012, are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

 

In April 2011 the Financial Accounting Standards Board (“FASB”) issued new accounting guidance related to a creditor’s determination of whether a loan restructuring is a troubled debt restructuring. The new guidance was effective for the first interim period beginning on or after June 15, 2011, which was the third quarter of 2011 for the Company. The Company's adoption of this new guidance did not have a material impact on its financial condition, results of operations, or liquidity, although it did affect the matters that are disclosed in the financial statements.

 

During the second quarter of 2011 the FASB issued new accounting guidelines related to (i) accounting for repurchase agreements, (ii) certain fair value measurements of assets, liability, and instruments classified in shareholders’ equity, and (iii) presentation of net income, other comprehensive income, and total comprehensive income (certain aspects the adoption of which were deferred indefinitely in the fourth quarter of 2011). These new guidelines were effective for the first interim period beginning on or after December 15, 2011, which was the first quarter of 2012 for the Company. The Company's adoption of these guidelines did not have a material impact on its financial condition, results of operations, or liquidity. However, the new guidelines did affect the matters that are disclosed in the financial statements.

 

During the fourth quarter of 2011 the FASB issued new accounting guidelines related to (i) the determination of whether a parent should derecognize the in-substance real estate of a subsidiary that is in-substance real estate when the parent ceases to have a controlling financial interest in the subsidiary and (ii) the disclosure of both gross information and net information about instruments eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting agreement. Item (i) will be effective for interim and fiscal periods beginning on or after June 15, 2012, which for the Company will be the third quarter of 2012. Item (ii) will be effective for interim and fiscal periods beginning on or after January 1, 2013, which for the Company will be the first quarter of 2013. The Company's adoption of these guidelines is not expected to have a material impact on its financial condition, results of operations, or liquidity. However, the new guidelines may affect matters that will be disclosed in the financial statements.

 

The Company describes all of its critical and/or significant accounting policies, judgments, and estimates in Note 1 of its Audited Consolidated Financial Statements contained in its 2011 Annual Report on Form 10-K. Particular attention should be paid to the Company’s allowance for losses on loans, which requires significant management judgments and/or estimates because of the inherent uncertainties surrounding this area and/or the subjective nature of the area. Information regarding the impact loss allowances have had on the Company's financial condition and results of operations for the three and six months ended June 30, 2012 and 2011, can be found in Note 3, “Loans Receivable,” below.

 

Significant judgments and/or estimates are also made in accounting for the Company’s net deferred income taxes and other-than-temporary impairment (“OTTI”) of its mortgage-related securities. Management evaluates the Company’s net deferred tax asset on an on-going basis to determine if a valuation allowance is required. In the judgment of management there was no need for a valuation allowance against the Company’s net deferred tax asset as of June 30, 2012. Information regarding the impact OTTI has had on the Company’s financial condition and results of operations for the three and six months ended June 30, 2012 and 2011, can be found in Note 2, “Securities Available-for-Sale,” below.

 

10
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts) 

 

2. Mortgage-Related Securities Available-for-Sale and Held-to-Maturity

 

The amortized cost and fair value of mortgage-related securities available-for-sale and held-to-maturity are as follows:

 

   June 30, 2012 
       Gross   Gross   Estimated 
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Securities available-for-sale:                    
Federal Home Loan Mortgage Corporation  $431,012   $9,686       $440,698 
Federal National Mortgage Association   188,969    2,990   $(70)   191,889 
Government National Mortgage Association   39    7        46 
Private-label CMOs   57,551    479    (3,044)   54,986 
Total available-for-sale  $677,571   $13,162   $(3,114)  $687,619 
Securities held-to-maturity:                    
Federal National Mortgage Association  $158,556   $1,889   $(68)  $160,377 
Total held-to-maturity  $158,556   $1,889   $(68)  $160,377 

 

   December 31, 2011 
       Gross   Gross   Estimated 
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Securities available-for-sale:                    
Federal Home Loan Mortgage Corporation  $537,935   $11,009       $548,944 
Federal National Mortgage Association   167,601    2,476   $(57)   170,020 
Government National Mortgage Association   767    10        777 
Private-label CMOs   67,754    540   $(6,265)   62,029 
Total available-for-sale  $774,057   $14,035   $(6,322)  $781,770 

 

11
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

2. Mortgage-Related Securities Available-for-Sale and Held-to-Maturity (continued)

 

The following tables summarize mortgage-related securities available-for-sale and held-to-maturity by amount of time the securities have had a gross unrealized loss as of the dates indicated:

 

   June 30, 2012 
   Less Than 12 Months   Greater Than 12 Months         
   in an Unrealized Loss Position   in an Unrealized Loss Position   Gross   Total 
    Unrealized
Loss
Amount
    Number of
Securities
    Estimated
Fair
Value
    Unrealized
Loss
Amount
    Number of
Securities
    Estimated
Fair
Value
    Unrealized
Loss
Amount
    Estimated
Fair
Value
 
Securities available-for-sale:                                        
Federal National Mortgage Association  $70    3   $22,242               $70   $22,242 
Private-label CMOs              $3,044    16   $29,888    3,044    29,888 
Total available-for-sale  $70    3   $22,242   $3,044    16   $29,888   $3,114   $52,130 
Securities held-to-maturity:                                        
Federal National Mortgage Association  $68    1                   $68   $8,068 
Total held-to-maturity  $68    1                   $68   $8,068 

 

   December 31, 2011 
   Less Than 12 Months   Greater Than 12 Months         
   in an Unrealized Loss Position   in an Unrealized Loss Position   Gross   Total 
    Unrealized
Loss
Amount
    Number of
Securities
    Estimated
Fair
Value
    Unrealized
Loss
Amount
    Number of
Securities
    Estimated
Fair
Value
    Unrealized
Loss
Amount
    Estimated
Fair
Value
 
Securities available-for-sale:                                        
Federal National Mortgage Association  $57    1   $9,603               $57   $9,603 
Private-label CMOs   1    1    448   $6,264    20   $40,523    6,265    40,971 
Total available-for-sale  $58    2   $10,051   $6,264    20   $40,523   $6,322   $50,574 

 

Certain of the Company’s available-for-sale and held-to-maturity securities that were in an unrealized loss position at June 30, 2012, and December 31, 2011, consisted of mortgage-related securities issued by government-sponsored entities. As of those dates, the Company believed that it was probable that it would receive all future contractual cash flows related to such securities. The Company does not intend to sell the securities and it is unlikely that it will be required to sell the securities before the recovery of their amortized cost. Accordingly, the Company determined that the unrealized loss on its mortgage-related securities issued by government-sponsored entities was temporary as of June 30, 2012, and December 31, 2011.

 

Except as noted below, the Company also determined that the unrealized loss on its private-label collateralized mortgage obligations (“CMOs”) was temporary as of June 30, 2012, and December 31, 2011. The Company does not intend to sell these securities and it is unlikely that it will be required to sell these securities before the recovery of their amortized cost. The Company believes it is probable that it will receive all future contractual cash flows related to these securities. This determination was based on management’s judgment regarding the nature of the loan collateral that supports the securities, a review of the current ratings issued on the securities by various credit rating agencies, a review of the actual delinquency and/or default performance of the loan collateral that supports the securities, and recent trends in the fair market values of the securities.

 

12
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

 2. Mortgage-Related Securities Available-for-Sale and Held-to-Maturity (continued)

 

As of June 30, 2012, and December 31, 2011, the Company had private-label CMOs, with a fair value of $34,157 and $36,751 respectively, and unrealized losses of $2,698 and $5,357, respectively, that were rated less than investment grade. These private-label CMOs were analyzed using modeling techniques that considered the priority of cash flows in the CMO structure and various default and loss rate scenarios that management considered appropriate given the nature of the loan collateral. In the second quarter of 2012 the Company recognized $336 in net OTTI losses in earnings related to its investment in four private-label CMOs. The Company recognized $389 in net OTTI losses in earnings the second quarter of 2011 on three private-label CMOs. The determination of the net OTTI loss was based on modeling techniques that considered the priority of cash flows in the CMO structure and various default and loss rate scenarios that management considered appropriate given the nature of the loan collateral. The following assumptions were used in determining the amount of the credit loss in 2012: (i) prepayments speeds with a range of 5.1% to 16.5% and a weighted average rate of 9.9%, (ii) default rates with a range of 4.0% to 5.5% and a weighted average rate of 4.5%, (iii) loss severity rates with a range of 40.0% to 52.0% and a weighted average rate of 42.9%, and (iv) current credit enhancements with a range of 2.2% to 4.6% and a weighted average rate of 3.4%. The following assumptions were used in determining the amount of the credit loss in 2011: (i) prepayments speeds with a range of 6.1% to 14.9% and a weighted average rate of 11.6%, (ii) default rates with a range of 3.7% to 5.2% and a weighted average rate of 4.4%, (iii) loss severity rates with a range of 40.0% to 43.0% and a weighted average rate of 40.8%, and (iv) current credit enhancements with a range of 5.1% to 6.7% and a weighted average rate of 5.6%.

 

The following table is a summary of OTTI related to credit losses that have been recognized in earnings as of the dates indicated, as well as end of period values for securities that have experienced such losses:

 

   At or for the
Three Months Ended
June 30
   At or for the
Six Months Ended
June 30
 
   2012   2011   2012   2011 
Beginning balance of unrealized OTTI related to credit losses  $389       $389     
Additional unrealized OTTI related to credit losses for which OTTI was not previously recognized   82   $389    82   $389 
Additional unrealized OTTI related to credit losses for which OTTI was previously recognized   254        254     
Net OTTI losses recognized in earnings   336    389    336    389 
Ending balance of unrealized OTTI related to credit losses  $725   $389   $725   $389 
Adjusted cost at end of period  $9,182   $9,116   $9,182   $9,116 
Estimated fair value at end of period  $8,609   $8,206   $8,609   $8,206 

 

The three and six months ended June 30, 2012, included gross realized gains on the sale of securities of $543. There were no gross realized losses during these periods. The three and six months ended June 30, 2011, included gross realized gains on the sale of securities of zero and $1,113, respectively. There were no gross realized losses during these periods.

 

Mortgage-related securities available-for-sale with a fair value of approximately $62,215 and $91,731 at June 30, 2012, and December 31, 2011, respectively, were pledged to secure deposits, borrowings, and for other purposes as permitted or required by law.

 

13
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable

 

The following table summarizes the components of loans receivable as of the dates indicated:

 

   June 30   December 31 
   2012   2011 
Permanent mortgage loans:          
One- to four-family  $492,221   $508,503 
Multi-family   252,544    247,040 
Commercial real estate   217,812    226,195 
Total permanent mortgages   962,577    981,738 
Construction and development loans:          
One- to four-family   14,855    16,263 
Multi-family   30,382    29,409 
Commercial real estate   22,612    19,907 
Land   18,670    16,429 
Total construction and development   86,519    82,008 
Total real estate mortgage loans   1,049,096    1,063,746 
Consumer loans:          
Fixed home equity   111,130    102,561 
Home equity lines of credit   83,213    86,540 
Student   14,199    15,711 
Home improvement   23,641    24,237 
Automobile   1,648    2,228 
Other consumer   8,884    7,177 
Total consumer loans   242,715    238,454 
Commercial business loans   120,629    87,715 
Total loans receivable   1,412,440    1,389,915 
Undisbursed loan proceeds   (37,204)   (41,859)
Allowance for loan losses   (26,029)   (27,928)
Unearned loan fees and discounts   (634)   (492)
Total loans receivable, net  $1,348,573   $1,319,636 

 

The Company’s first mortgage loans and home equity loans are primarily secured by properties that are located in the Company's local lending areas in Wisconsin, Illinois, Michigan, and Minnesota. Substantially all of the Company’s non-mortgage loans have also been made to borrowers in these same lending areas.

 

At June 30, 2012, and December 31, 2011, certain one- to four-family mortgage loans, multi-family mortgage loans, and home equity loans with aggregate carrying values of approximately $415,000 and $204,000 were pledged to secure advances from the FHLB of Chicago.

 

The unpaid principal balance of loans serviced for others was $1,139,576 and $1,102,126 at June 30, 2012, and December 31, 2011, respectively. These loans are not reflected in the consolidated financial statements.

 

14
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables summarize the activity in the allowance for loan losses by loan portfolio segment for the periods indicated. The tables also summarize the allowance for loan loss and loans receivable by the nature of the impairment evaluation, either individually or collectively, at the dates indicated (the loans receivable amounts in the table are net of undisbursed loan proceeds).

 

   At or for the Six Months Ended June 30, 2012 
Allowance for loan losses:  One- to
Four-
Family
   Multi-
Family
   Commercial
Real 
Estate
   Construction
and
Development
   Consumer   Commercial
Business
   Total 
Beginning balance  $3,201   $7,442   $9,467   $4,506   $1,214   $2,098   $27,928 
Provision   809    (1,488)   983    1,173    436    (132)   1,781 
Charge-offs   (560)   (371)   (3,225)   (102)   (379)   (48)   (4,685)
Recoveries       568    414        23        1,005 
Ending balance  $3,450   $6,151   $7,639   $5,577   $1,294   $1,918   $26,029 
Loss allowance individually evaluated for impairment  $585   $1,780   $672   $2,645   $369   $129   $6,180 
Loss allowance collectively evaluated for impairment  $2,865   $4,371   $6,967   $2,932   $925   $1,789   $19,849 
                                    
Loan receivable balances at the end of the period:                                   
Loans individually evaluated for impairment  $11,704   $21,977   $29,213   $17,152   $1,546   $2,627   $84,219 
Loans collectively evaluated for impairment   470,595    230,567    188,599    42,085    241,169    118,002    1,291,017 
Total loans receivable  $482,299   $252,544   $217,812   $59,237   $242,715   $120,629   $1,375,236 

  

   At or for the Six Months Ended June 30, 2011 
Allowance for loan losses:  One- to
Four-
Family
   Multi-
Family
   Commercial
Real 
Estate
   Construction
and
Development
   Consumer   Commercial
Business
   Total 
Beginning balance  $3,726   $9,265   $21,885   $10,141   $1,427   $1,541   $47,985 
Provision   1,304    934    (35)   496    245    1,041    3,985 
Charge-offs   (2,266)   (2,981)   (5,419)   (2,472)   (463)   (379)   (13,980)
Recoveries   1    16        550    9    7    583 
Transfers       2,765    2,026    (4,791)            
Ending balance  $2,765   $9,999   $18,457   $3,924   $1,218   $2,210   $38,573 
Loss allowance individually evaluated for impairment  $342   $5,396   $12,067   $2,752   $477   $473   $21,507 
Loss allowance collectively evaluated for impairment  $2,423   $4,603   $6,390   $1,172   $741   $1,737   $17,066 
                                    
Loan receivable balances at the end of the period:                                   
Loans individually evaluated for impairment  $16,672   $33,200   $45,891   $23,565   $1,622   $6,648   $127,598 
Loans collectively evaluated for impairment   507,143    191,095    192,485    32,605    231,401    70,683    1,225,412 
Total loans receivable  $523,815   $224,295   $238,376   $56,170   $233,023   $77,331   $1,353,010 

 

During the six months ended June 30, 2012 and 2011, the Company adjusted certain factors used to determine the allowance for loan losses on loans that are collectively evaluated for impairment. Management considered these adjustments necessary and prudent in light of recent trends in real estate values, economic conditions, and unemployment. The Company estimates that these adjustments, as well as overall changes in the balance of loans to which these factors were applied, resulted in increases of $226 and $652 in the total allowances for loan losses during the six months ended June 30, 2012 and 2011, respectively. The transfers noted in the table were the result of the reclassification of certain construction loans to permanent loans as a result of the completion of construction.

 

15
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables present information regarding impaired loans that have a related allowance for loan loss and those that do not as of the dates indicated (the loans receivable amounts in the table are net of undisbursed loan proceeds).

 

   June 30, 2012 
  Loans
Receivable
Balance, Net
   Unpaid
Principal
Balance
   Related
Allowance
for Loss
   Average Loan
Receivable
Balance, Net
   Interest
Income
Recognized
 
With an allowance recorded:                     
One- to four-family  $3,025   $3,036   $585   $3,051   $30 
Multi-family   14,727    15,224    1,780    15,738     
Commercial real estate: Office   675    681    86    1,278    12 
Retail/wholesale/mixed   2,811    2,833    586    2,273    28 
Industrial/warehouse               505     
Other               320     
Total commercial real estate   3,486    3,514    672    4,376    40 
 Construction and development:                          
One- to four-family               92     
Multi-family               1,489     
Commercial real estate               918     
Land   2,975    2,993    2,645    2,591     
Total construction and development   2,975    2,993    2,645    5,090     
Consumer:                         
Home equity   280    280    265    339     
Student                    
Other   111    111    104    77     
Total consumer   391    391    369    416     
Commercial business:                         
Term loans   209    216    129    242    4 
Lines of credit               49     
Total commercial business   209    216    129    291    4 
Total with an allowance recorded  $24,813   $25,374   $6,180   $28,962   $74 
                          
With no allowance recorded:                         
One- to four-family  $8,448   $10,018       $10,105   $73 
Multi-family   3,072    3,303        4,517    26 
Commercial real estate:                         
Office   2,124    3,717        3,711    12 
Retail/wholesale/mixed   6,987    11,356        7,086    155 
Industrial/warehouse   532    631        716    9 
Other   328    619        1,303     
Total commercial real estate   9,971    16,323        12,816    176 
Construction and development:                         
One- to four-family               25     
Multi-family   114    114        38     
Commercial real estate               914     
Land   1,144    1,364        1,200    14 
Total construction and development   1,258    1,478        2,177    14 
Consumer:                         
Home equity   1,023    1,023        1,014    14 
Student                    
Other   72    72        115    3 
Total consumer   1,095    1,095        1,129    17 
Commercial business:                         
Term loans   595    644        667    22 
Lines of credit   431    532        489    4 
Total commercial business   1,026    1,176        1,156    26 
Total with no allowance recorded  $24,870   $33,393       $31,900   $332 

 

16
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

   December 31, 2011 
   Loans   Unpaid   Related   Average Loan   Interest 
   Receivable   Principal   Allowance   Receivable   Income 
Impaired loans with an allowance recorded:  Balance, Net   Balance   for Loss   Balance, Net   Recognized 
One- to four-family  $2,606   $2,606   $364   $3,916   $51 
Multi-family   19,006    19,106    2,357    23,158    851 
Commercial real estate:                         
Office   2,474    2,474    746    7,917    30 
Retail/wholesale/mixed   3,220    3,225    570    16,931    78 
Industrial/warehouse   1,250    1,250    250    1,286     
Other   959    964    318    1,175    67 
Total commercial real estate   7,903    7,913    1,884    27,309    175 
Construction and development:                         
One- to four-family                    
Multi-family   4,466    4,488    678    4,482    248 
Commercial real estate   152    153    84    1,908    11 
Land   2,993    2,995    2,434    2,944    58 
Total construction and development   7,611    7,636    3,196    9,334    317 
Consumer:                         
Home equity   413    413    327    446     
Student                    
Other   67    67    49    126     
Total consumer   480    480    376    572     
Commercial business:                         
Term loansTerm loans   164    165    83    690    15 
Lines of credit   117    117    45    324    5 
Total commercial business   281    282    128    1,014    20 
Total with an allowance recorded  $37,887   $38,023   $8,305   $65,303   $1,414 
                          
Impaired loans with no allowance recorded:                         
One- to four-family  $12,262   $13,645       $12,382   $264 
Multi-family   3,899    4,413        7,117    306 
Commercial real estate:                         
Office   6,580    8,520        2,937    375 
Retail/wholesale/mixed   8,716    15,318        7,797    712 
Industrial/warehouse   530    754        1,146    25 
Other   268    1,044        673    9 
Total commercial real estate   16,094    25,636        12,553    1,121 
Construction and development:                         
One- to four-family                    
Multi-family               20     
Commercial real estate               2,459     
Land   1,757    1,967        3,219    28 
Total construction and development   1,757    1,967        5,698    28 
Consumer:                         
Home equity   1,044    1,044        962    43 
Student                    
Other   140    140        110    4 
Total consumer   1,184    1,184        1,072    47 
Commercial business:                         
Term loans   787    896        825    44 
Lines of credit   574    699        268    40 
Total commercial business   1,361    1,595        1,094    84 
Total with no allowance recorded  $36,557   $48,440       $39,915   $1,850 

 

17
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables present information relating to the Company’s internal risk ratings of its loans receivable as of the dates indicated (all amounts in the tables are net of undisbursed loan proceeds):

 

   June 30, 2012 
   Pass   Watch   Special
Mention
   Substandard   Total 
One- to four-family  $469,535   $930   $130   $11,704   $482,299 
Multi-family   201,728    28,839        21,977    252,544 
Commercial real estate:                         
Office   49,889    4,761    18,281    5,583    78,514 
Retail/wholesale/mixed use   56,396    10,070    19,388    21,543    107,397 
Industrial/warehouse   24,904    3,269    7    1,593    29,773 
Other   1,634            494    2,128 
Total commercial real estate   132,823    18,100    37,676    29,213    217,812 
Construction and development:                         
One- to four-family   6,591                6,591 
Multi-family   8,656            12,250    20,906 
Commercial real estate   12,783    624            13,407 
Land   12,254    1,177        4,902    18,333 
Total construction/development   40,284    1,801        17,152    59,237 
Consumer:                         
Home equity   216,670            1,313    217,983 
Student   14,199                14,199 
Other   10,300            233    10,533 
Total consumer   241,169            1,546    242,715 
Commercial business:                         
Term loans   63,677    1,474    120    1,510    66,781 
Lines of credit   46,255    4,251    2,225    1,117    53,848 
Total commercial business   109,932    5,725    2,345    2,627    120,629 
Total  $1,195,471   $55,395   $40,151   $84,219   $1,375,236 

 

18
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

   December 31, 2011 
   Pass   Watch   Special
Mention
   Substandard   Total 
One- to four-family  $482,271   $4,044   $141   $16,075   $502,531 
Multi-family   196,231    18,123    8,357    24,108    246,819 
Commercial real estate:                         
Office   49,324    1,853    20,405    9,054    80,636 
Retail/wholesale/mixed use   50,108    9,376    19,870    19,849    99,203 
Industrial/warehouse   24,431    3,237    2,230    5,698    35,596 
Other   4,897    1,318    181    2,405    8,801 
Total commercial real estate   128,760    15,784    42,686    37,006    224,236 
Construction and development:                         
One- to four-family   7,704                7,704 
Multi-family   4,503            14,347    18,850 
Commercial real estate   4,411            908    5,319 
Land   11,125    299    184    4,820    16,428 
Total construction/development   27,743    299    184    20,075    48,301 
Consumer:                         
Home equity   211,834            1,505    213,339 
Student   15,711                15,711 
Other   9,214            190    9,404 
Total consumer   236,759            1,695    238,454 
Commercial business:                         
Term loans   35,433    1,342        2,823    39,598 
Lines of credit   44,291    1,729    252    1,845    48,117 
Total commercial business   79,724    3,071    252    4,668    87,715 
Total  $1,151,488   $41,321   $51,620   $103,627   $1,348,056 

 

Loans rated “pass” or “watch” are generally current on contractual loan and principal payments and comply with other contractual loan terms. Pass loans generally have no noticeable credit deficiencies or potential weaknesses. Loans rated watch, however, will typically exhibit early signs of credit deficiencies or potential weaknesses that deserve management’s close attention. Loans rated “special mention” do not currently expose the Company to a sufficient degree of risk to warrant a lower rating, but possess clear trends in credit deficiencies or potential weaknesses that deserve management’s close attention. The allowance for loan losses on loans rated pass, watch, or special mention is typically evaluated collectively for impairment using a homogenous pool approach. This approach utilizes quantitative factors developed by management from its assessment of historical loss experience, qualitative factors, and other considerations.

 

Loans rated “substandard” involve a distinct possibility that the Company could sustain some loss if deficiencies associated with the loan are not corrected. Loans rated “doubtful” indicate that full collection is highly questionable or improbable. The Company did not have any loans that were rated doubtful at June 30, 2012, or December 31, 2011. Loans rated substandard or doubtful that are also considered in management’s judgment to be impaired are generally analyzed individually to determine an appropriate allowance for loan loss. A loan rated “loss” is considered uncollectible, even if a partial recovery could be expected in the future. The Company generally charges off loans that are rated as a loss. As such, the Company did not have any loans that were rated loss at June 30, 2012, or December 31, 2011.

 

19
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3. Loans Receivable (continued)

 

The following tables contain information relating to the past due and non-accrual status of the Company’s loans receivable as of the dates indicated (all amounts in the table are net of undisbursed loan proceeds):

 

   June 30, 2012 
   Past Due Status           Total 
   30-59
Days
   60-89
Days
   > 90
Days
   Total
Past Due
   Total
Current
   Total
Loans
   Non-
Accrual
 
One- to four-family  $7,491   $4,435   $9,687   $21,613   $460,686   $482,299   $11,473 
Multi-family   1,514        7,197    8,711    243,833    252,544    17,799 
Commercial real estate:                                   
Office   782        1,954    2,736    75,778    78,514    2,799 
Retail/wholesale/mixed   3,250    497    4,176    7,923    99,474    107,397    9,798 
Industrial/warehouse           160    160    29,613    29,773    532 
Other           328    328    1,800    2,128    328 
Total commercial real estate   4,032    497    6,618    11,147    206,665    217,812    13,457 
Construction and development:                                   
One- to four-family                   6,591    6,591     
Multi-family   114            114    20,792    20,906    114 
Commercial real estate   97            97    13,310    13,407     
Land   257    2,278    1,849    4,384    13,949    18,333    4,119 
Total construction   468    2,278    1,849    4,595    54,642    59,237    4,233 
Consumer:                                   
Home equity   1,034    460    1,303    2,797    215,186    217,983    1,303 
Student   248    356    736    1,340    12,859    14,199     
Other   59    21    183    263    10,270    10,533    183 
Total consumer   1,341    837    2,222    4,400    238,315    242,715    1,486 
Commercial business:                                   
Term loans   200        705    905    65,876    66,781    804 
Lines of credit       332    111    443    53,405    53,848    431 
Total commercial   200    332    816    1,348    119,281    120,629    1,235 
Total  $15,046   $8,379   $28,389   $51,814   $1,323,422   $1,375,236   $49,683 

 

20
 

 

  

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

3.  Loans Receivable (continued)

 

   December 31, 2011 
   Past Due Status         Total 
   30-59
Days
   60-89
Days
   > 90
Days
   Total
Past Due
   Total
Current
   Total
Loans
   Non-
Accrual
 
One- to four-family  $10,713   $2,491   $12,890    26,094   $476,437   $502,531   $14,868 
Multi-family   7,692        9,949    17,640    229,179    246,819    22,905 
Commercial real estate:                                   
Office   745        3,743    4,488    76,147    80,636    9,054 
Retail/wholesale/mixed   695    154    7,214    8,063    91,139    99,203    11,936 
Industrial/warehouse   2,230        1,474    3,704    31,892    35,596    1,780 
Other           560    560    8,241    8,801    1,227 
Total commercial real estate   3,670    154    12,991    16,815    207,419    224,236    23,997 
Construction and development:                                   
One- to four-family                   7,704    7,704     
Multi-family       4,466        4,466    14,384    18,850    4,466 
Commercial real estate                   5,319    5,319    152 
Land   238    1,046    3,310    4,594    11,834    16,428    4,750 
Total construction   238    5,512    3,310    9,060    39,241    48,301    9,368 
Consumer:                                   
Home equity   1,172    439    1,457    3,067    210,271    213,339    1,457 
Student   396    310    696    1,403    14,309    15,711     
Other   137    64    202    404    9,000    9,404    207 
Total consumer   1,705    813    2,355    4,874    233,580    238,454    1,664 
Commercial business:                                   
Term loans   86    169    412    668    38,930    39,598    951 
Lines of credit   58        608    665    47,452    48,117    691 
Total commercial   144    169    1,020    1,333    86,382    87,715    1,642 
Total  $24,162   $9,139   $42,515   $75,816   $1,272,238   $1,348,056   $74,444 

 

As of June 30, 2012, and December 31, 2011, $736 and $696 in student loans, respectively, were 90-days past due, but remained on accrual status. No other loans 90-days past due were in accrual status as of either date.

 

The Company classifies a loan modification as a troubled debt restructuring (“TDR”) when it has granted a borrower experiencing financial difficulties a concession that it would otherwise not consider. Loan modifications that result in insignificant delays in the receipt of payments (generally six months or less) are not considered TDRs under the Company’s TDR policy. TDRs are relatively insignificant and/or infrequent in the Company and generally consist of loans placed in interest-only status for a short period of time or payment forbearance for greater than six months. Loans added as TDRs for the six months ended June 30, 2012 consisted of four one- to four-family residential loans totaling $459, three commercial real estate loans totaling $481, and one commercial business loan totaling $37. TDRs are evaluated for impairment and appropriate credit losses are recorded in accordance with the Company’s accounting policies.

 

21
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

4.  Mortgage Servicing Rights

 

The following table presents the activity in the Company’s mortgage servicing rights (“MSRs”) for the periods indicated:

 

   Six Months Ended June 30 
   2012   2011 
MSRs at beginning of the period  $8,269   $7,775 
Additions   2,858    603 
Amortization   (2,022)   (516)
MSRs at end of period   9,105    7,862 
Valuation allowance at end of period   (1,843)    
MSRs at end of the period, net  $7,262   $7,862 

 

The following table shows the estimated future amortization expense for MSRs for the periods indicated:

 

       Amount 
Estimate for six months ended December 31:   2012   $586 
Estimate for years ended December 31:   2013    1,148 
    2014    1,122 
    2015    1,101 
    2016    1,074 
    2017    942 
    Thereafter    1,289 
    Total   $7,262 

 

The projections of amortization expense shown above for MSRs are based on existing asset balances and the existing interest rate environment as of June 30, 2012. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates, and market conditions.

 

 5. Other Assets

 

The following table summarizes the components of other assets as of the dates indicated:

 

   June 30   December 31 
   2012   2011 
Accrued interest:          
Loans receivable  $4,581   $4,664 
Mortgage-related securities   1,927    1,851 
Interest-earning deposits   7    6 
Total accrued interest   6,515    6,521 
Premises and equipment, net   50,427    50,423 
Federal Home Loan Bank stock, at cost   24,439    46,092 
Bank owned life insurance   57,601    56,604 
Prepaid FDIC insurance premiums   4,045    5,673 
Deferred tax asset, net   35,231    37,493 
Prepaid and other assets   21,918    22,020 
Total other assets  $200,176   $224,826 

 

22
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

6.  Deposit Liabilities

 

The following table summarizes the components of deposit liabilities as of the dates indicated:

 

   June 30   December 31 
   2012   2011 
Checking accounts:          
Non-interest-bearing  $130,785   $112,211 
Interest-bearing   234,211    229,990 
Total checking accounts   364,996    342,201 
Money market accounts   423,579    432,248 
Savings accounts   221,621    204,263 
Certificates of deposit:          
Due within one year   730,933    709,362 
After one but within two years   173,802    250,613 
After two but within three years   52,928    61,291 
After three but within four years   9,152    13,301 
After four but within five years   6,168    8,384 
Total certificates of deposits   972,983    1,042,951 
Total deposit liabilities  $1,983,179   $2,021,663 

 

7. Borrowings

 

The following table summarizes borrowings as of the dates indicated:

 

   June 30, 2012   December 31, 2011 
       Weighted-       Weighted- 
       Average       Average 
   Amount   Rate   Amount   Rate 
Federal Home Loan Bank advances maturing in:                    
2012  $100,000    4.52%  $100,000    4.52%
2013   225    4.17    233    4.17 
2014                
2015   23,450    0.80         
2016   23,450    1.04         
2017 and thereafter   164,289    2.75    52,858    5.00 
Total borrowings  $311,414    3.04%  $153,091    4.69%

 

All of the Company’s advances from the Federal Home Loan Bank (“FHLB”) of Chicago are subject to prepayment penalties if voluntarily repaid by the Company prior to stated maturity.

 

The Company is required to maintain certain unencumbered mortgage loans and certain mortgage-related securities as collateral against its outstanding advances from the FHLB of Chicago. Total advances from the FHLB of Chicago are limited to the lesser of: (i) 35% of the Bank’s total assets; (ii) twenty times the capital stock of the FHLB of Chicago that is owned by the Bank; or (iii) the total of 60% of the book value of certain multi-family mortgage loans, 75% of the book value of one- to four-family mortgage loans, and 95% of certain mortgage-related securities.

 

23
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

7.  Borrowings (continued)

 

At June 30, 2012 and December 31, 2011, the Company had lines of credit with two financial institutions that totaled $10,000 as of both dates. There were no amounts outstanding on these lines of credits as of either of the dates.

 

 8.  Shareholders' Equity

 

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory actions and possible additional discretionary actions by regulators, that, if undertaken, could have a direct material effect on the Bank’s and the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

 

Quantitative measures established by federal regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total capital and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to adjusted assets (as all of these terms are defined in the applicable regulations). Management believes, as of June 30, 2012, that the Bank met or exceeded all capital adequacy requirements to which it is subject. The Company is not aware of any conditions or events which would change the Bank’s status from “well capitalized.”

 

The following table presents the Bank’s actual and required regulatory capital amounts and ratios as of the dates indicated:

 

  Actual   Required
For Capital
Adequacy Purposes
   To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
 
  Amount   Ratio   Amount   Ratio   Amount   Ratio 
As of June 30, 2012:                              
Total capital  $257,850    18.27%  $112,929    8.00%  $141,162    10.00%
(to risk-weighted assets)                              
Tier 1 capital   240,101    17.01    56,465    4.00    84,697    6.00 
(to risk-weighted assets)                              
Tier 1 capital   240,101    9.23    104,056    4.00    130,070    5.00 
(to adjusted total assets)                              
                               
As of December 31, 2011:                              
Total capital  $253,815    18.34%  $110,714    8.00%  $138,392    10.00%
(to risk-weighted assets)                              
Tier 1 capital   236,516    17.09    55,354    4.00    83,035    6.00 
(to risk-weighted assets)                              
Tier 1 capital   236,516    9.59    98,601    4.00    123,252    5.00 
(to adjusted total assets)                              

 

24
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

9.  Earnings Per Share

 

The following table summarizes the computation of basic and diluted earnings per share for the periods indicated:

 

   Three Months Ended
 June 30
   Six Months Ended
 June 30
 
   2012   2011   2012   2011 
Basic earnings (loss) per share:                    
Net income (loss)  $1,329   $(51,377)  $2,484   $(50,336)
Weighted average shares outstanding   46,184,264    46,058,361    46,184,264    45,897,411 
Vested MRP shares for period   5,459    1,745    3,532    3,489 
Basic shares outstanding   46,189,723    46,060,106    46,187,796    45,900,900 
Basic earnings (loss) per share  $0.03   $(1.12)  $0.05   $(1.10)
                     
Diluted earnings per share:                    
Net income (loss)  $1,329   $(51,377)  $2,484   $(50,336)
Weighted average shares outstanding used in basic earnings per share basic earnings per share   46,189,723    46,060,106    46,187,796    45,900,900 
Net dilutive effect of:        46,060,106           
Stock option shares                
Unvested MRP shares   6,640        6,667     
Diluted shares outstanding   46,196,363    46,060,106    46,194,463    45,900,900 
Diluted earnings (loss) per share  $0.03   $(1.12)  $0.05   $(1.10)

 

The Company had stock options for 2,675,000 shares outstanding as of June 30, 2012, and for 2,367,000 shares as of June 30, 2011, that were not included in the computation of diluted earnings per share because they were anti-dilutive. These shares had weighted average exercise prices of $8.47 and $9.50 per share as of those dates, respectively.

  

10.  Employee Benefit Plans

 

The Company has a discretionary, defined contribution savings plan (the “Savings Plan”). The Savings Plan is qualified under Sections 401 and 401(k) of the Internal Revenue Code and provides employees meeting certain minimum age and service requirements the ability to make contributions to the Savings Plan on a pretax basis. The Company then matches a percentage of the employee’s contributions. Matching contributions made by the Company were $52 and $39 during the three months ended June 30, 2012 and 2011, respectively, and $99 and $79 during the six months ended as of the same dates, respectively.

 

The Company also has a defined benefit pension plan covering employees meeting certain minimum age and service requirements and a non-qualified supplemental pension plan for certain qualifying employees. The supplemental pension plan is funded through a "rabbi trust" arrangement. The benefits are generally based on years of service and the employee’s average annual compensation for five consecutive calendar years in the last ten calendar years that produces the highest average. The Company’s funding policy for the qualified plan is to contribute annually the amount necessary to satisfy the requirements of the Employee Retirement Income Security Act of 1974.

 

25
 

  

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

10.  Employee Benefit Plans (continued)

 

The following table summarizes the qualified plan’s net periodic benefit cost for the periods indicated:

 

   Three Months Ended
June 30
   Six Months Ended
June 30
 
   2012   2011   2012   2011 
Service cost  $725   $626   $1,450   $1,252 
Interest cost   564    569    1,128    1,138 
Expected return on plan assets   (756)   (650)   (1,512)   (1,300)
Amortization of unrecognized prior service cost   440    216    880    432 
Net periodic benefit cost  $973   $761   $1,946   $1,522 

 

The net periodic benefit cost for the Company’s supplemental plan was $126 and $117 for the three months ended June 30, 2012 and 2011, respectively, and $252 and $234 for the six months ended as of the same dates, respectively. The amount in 2012 consisted of interest cost of $188, amortization of unrecognized prior service costs of $6, and service costs of $58. The amount in 2011 consisted of interest cost of $208, amortization of unrecognized prior service costs of $3, and service costs of $23.

 

The Company does not expect to make a contribution to the qualified and supplemental plans in 2012. This determination was based on a number of factors, including the results of the Actuarial Valuation Reports as of January 1, 2012.

 

11.  Stock-Based Benefit Plans

 

In 2001 the Company’s shareholders approved the 2001 Stock Incentive Plan (the “2001 Plan”), which provided for stock option awards of up to 4,150,122 shares. The 2001 Plan also provided for restricted stock ("MRP") awards of up to 1,226,977 shares. The 2001 Plan has expired, no further awards may be granted under the 2001 Plan, and no options or unvested MRP awards remain outstanding under the 2001 Plan.

 

In 2004 the Company’s shareholders approved the 2004 Stock Incentive Plan (the “2004 Plan”), which provided for stock option awards of up to 4,106,362 shares. Options granted under the 2004 Plan vest over five years and have expiration terms of ten years. The 2004 Plan also provided for MRP awards of up to 1,642,521 shares. MRP shares awarded under the 2004 Plan vest over five years. As of June 30, 2012, 520,221 MRP shares and options for 621,362 shares remain eligible for award under the 2004 Plan.

 

MRP grants are amortized to compensation expense as the Company’s employees and directors become vested in the granted shares. The amount amortized to expense was $46 and $30 for the three months ended June 30, 2012 and 2011, respectively, and $93 and $60 for the six months ended as of the same dates, respectively. Outstanding non-vested MRP grants had a fair value of $521 and an unamortized cost of $510 at June 30, 2012. The cost of these shares is expected to be recognized over a weighted-average period of 1.86 years.

 

During the three months ended June 30, 2012 and 2011, the Company recorded stock option compensation expense of $58 and $38, respectively. During the six months ended as of the same dates stock option compensation expense was $116 and 81, respectively. As of June 30, 2012, there was $803 in total unrecognized stock option compensation expense related to non-vested options. This cost is expected to be recognized over a weighted-average period of 1.94 years.

 

26
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

11.  Stock-Based Benefit Plans (continued)

 

The following table summarizes the activity in the Company’s stock options during the periods indicated:

 

  Six Months Ended June 30 
  2012   2011 
  Stock
Options
   Weighted
Average
Exercise
Price
   Stock
Options
   Weighted
Average
Exercise
Price
 
Outstanding at beginning of period   2,382,500   $9.4637    2,462,464   $9.0184 
Granted   412,500    3.3999    421,000    5.0251 
Exercised           (488,464)   3.2056 
Forfeited   (120,000)   10.6730    (28,000)   9.0664 
Outstanding at end of period   2,675,000   $8.4744    2,367,000   $9.5072 

 

The following table provides additional information regarding the Company’s outstanding options as of June 30, 2012.

 

   Remaining   Non-Vested Options   Vested Options 
   Contractual
Life in Years
   Stock
Options
   Intrinsic
Value
   Stock
Options
   Intrinsic
Value
 
Exercise Price:                          
$10.6730    1.8            1,580,000     
$12.2340    4.0            50,000     
$11.1600    5.8    6,400        25,600     
$12.0250    6.1    20,000        30,000     
$7.2200    7.8    30,000        20,000     
$4.7400    8.5    56,000        14,000     
$5.0500    8.6    310,400        77,600     
$4.3000    8.7    20,000   $2    5,000   $1 
$3.7200    9.1    17,500    12         
$3.3900    9.6    402,500    410         
$3.8000    9.8    10,000    6         
Total         872,800   $430    1,802,200   $1 
Weighted average remaining contractual life         9.0 years         2.4 years      
Weighted average exercise price        $4.4856        $10.4015      

 

 The intrinsic value of options exercised during the six months ended June 30, 2011, was $296. There were no options exercised during the six months ended June 30, 2012. The weighted average grant date fair value of non-vested options at June 30, 2012, was $1.06 per share. During the six months ended June 30, 2012, options for 412,500 shares were granted, options for 99,000 shares became vested, and there were no forfeitures of non-vested options shares.

 

The Company uses the Black-Scholes option-pricing model to estimate the fair value of granted options. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. However, the Company's stock options have characteristics significantly different from traded options and changes in the subjective input assumptions can materially affect the fair value estimate. Option valuation models such as Black-Scholes require the input of highly subjective assumptions including the expected stock price volatility, which is computed using five-years of actual price activity in the Company’s stock. The Company uses historical data of employee behavior as a basis to estimate the expected life of the options, as well as forfeitures due to employee terminations. The Company also uses its actual dividend yield at the time of the grant, as well as actual U.S. Treasury yields in effect at the time of the grant to estimate the risk-free rate. The following weighted-average assumptions were used to value 412,500 options granted during the six months ended June 30, 2012: risk free rate of 1.50%, dividend yield of 1.18%, expected stock volatility of 25%, and expected term to exercise of 7.5 years. These options had a weighted-average value of $0.86 per option using these assumptions. The following weighted-average assumptions were used to value 421,000 options granted during the six months ended June 30, 2011: risk free rate of 2.06%, dividend yield of 2.04%, expected stock volatility of 25%, and expected term to exercise of 7.5 years.

 

27
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

12.  Financial Instruments with Off-Balance Sheet Risk

 

Off-balance sheet financial instruments or obligations whose contract amounts represent credit and/or interest rate are summarized in the following table as of the dates indicated:

 

   June 30   December 31 
   2012   2011 
Unused consumer lines of credit  $153,384   $151,807 
Unused commercial lines of credit   51,973    43,518 
Commitments to extend credit:          
Fixed rate   47,838    23,793 
Adjustable rate   33,493    17,197 
Undisbursed commercial loans   2,608    870 
Standby letters of credit   1,616    410 

 

The Company sells substantially all of its long-term, fixed-rate, one- to four-family loan originations in the secondary market. The Company uses derivative instruments to manage interest rate risk associated with these activities. Specifically, the Company enters into interest rate lock commitments (“IRLCs”) with borrowers, which are considered to be derivative instruments. The Company manages its exposure to interest rate risk in IRLCs (as well as interest rate risk in its loans held-for-sale) by entering into forward commitments to sell loans to the Federal National Mortgage Association (“Fannie Mae”). Commitments to sell loans expose the Company to interest rate risk if market rates of interest decrease during the commitment period. Such forward commitments are considered to be derivative instruments. These derivatives are not designated as accounting hedges as specified in GAAP. As such, changes in the fair value of the derivative instruments are recognized currently through earnings.

 

As of June 30, 2012, and December 31, 2011, net unrealized gains of $712 and $243, respectively, were recognized in net gain on loan sales activities on the derivative instruments specified in the previous paragraph. These amounts were exclusive of net unrealized gains of $345 and $507 on loans held-for-sale as of those dates, respectively, which were also included in net gain on loan sales activities.

 

The following table summarizes the Company’s derivative assets and liabilities as of the dates indicated:

 

   June 30, 2012   December 31, 2011 
   Notional
Amount
   Fair
Value
   Notional
Amount
   Fair
Value
 
Interest rate lock commitments  $75,196   $1,720   $52,699   $1,012 
Forward commitments   70,605    (1,008)   62,025    (769)
Net unrealized gain       $712        $243 

 

The unrealized gains shown in the above table were included as a component of other assets as of the dates indicated. The unrealized losses were included in other liabilities as of the dates indicated.

 

28
 

 

 Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

13.  Fair Value Measurements

 

Fair value is 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 (exit price). The Company utilizes market data or assumptions that market participants would use in pricing its financial assets and liabilities, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. The Company primarily applies the market approach for recurring fair value measurements and endeavors to utilize the best available information. Accordingly, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The Company is able to classify fair value balances based on the observability of those inputs. Accounting guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1), the next highest priority to prices based on models, methodologies, and/or management judgments that rely on direct or indirect observable inputs (Level 2), and the lowest priority to prices derived from models, methodologies, and/or management judgments that rely on significant unobservable inputs (Level 3). There were no transfers of assets or liabilities between categories of the fair value hierarchy during the three and six months ended June 30, 2012.

 

The methods and assumptions used by the Company in estimating the fair value of its financial instruments, whether or not such fair values are recognized in the consolidated financial statements, are summarized below:

 

Cash and Cash Equivalents The carrying amounts reported in the statements of financial condition for cash and cash equivalents approximate those assets’ fair values. The Company considers the fair value of cash and cash equivalents to be Level 1 in the fair value hierarchy.

 

Mortgage-Related Securities Available-for-Sale and Held to Maturity Fair values for these securities are based on price estimates obtained from a third-party independent pricing service. This service utilizes pricing models that vary by asset class and incorporate available trade, bid, ask, and other market information of comparable instruments. For structured securities, such as CMOs, the pricing models include cash flow estimates that consider the impact of loan performance data, including, but not limited to, expectations relating to loan prepayments, default rates, and loss severities. Management has reviewed the pricing methodology used by its pricing service to verify that prices are determined in accordance with the fair value guidance specified in GAAP. The Company considers the fair value of mortgage-related securities to be Level 2 in the fair value hierarchy.

 

Loans Held-for-Sale The fair value of loans held-for-sale is based on the current market price for securities collateralized by similar loans. The Company considers the fair value of loans held for sale to be Level 2 in the fair value hierarchy.

 

Loans Receivable Loans receivable are segregated by type such as one- to four-family, multi-family, and commercial real estate mortgage loans, consumer loans, and commercial business loans. The fair value of each type is calculated by discounting scheduled cash flows through the expected maturity of the loans using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan type. The estimated maturity is based on the Company’s historical experience with prepayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. The Company considers the fair value of loans receivable to be Level 3 in the fair value hierarchy.

 

Mortgage Servicing Rights The Company estimates the fair market value of MSRs for those loans that are sold with servicing rights retained. For valuation purposes, the related loans are stratified into pools by product type and, within product type, by contractual interest rates. The fair value of the MSR pools is based upon the present value of estimated future cash flows using current market assumptions for prepayments, servicing cost, and other factors. The Company considers the fair value of MSRs to be Level 3 in the fair value hierarchy.

 

29
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

13.  Fair Value Measurements (continued)

 

The following table summarizes the significant inputs utilized by the Company to estimate the fair value of its MSRs as of June 30, 2012:

 

   Weighted-
Average
   Range 
Loan size  $127    $1-$415 
Contractual interest rate   4.25%   2.00%-7.75% 
Constant prepayment rate (“CPR”)   20.44%   13.20%-27.24% 
Remaining maturity in months   263    45-420 
Servicing fee   0.25%    
Annual servicing cost per loan (not in thousands)  $82.66     
Annual ancillary income per loan (not in thousands)  $59.75     
Discount rate   3.33%   2.875%-3.625% 

 

MSR pools with an amortized cost basis greater than fair value are carried at fair value in the Company’s financial statements. Pools determined to be impaired at June 30, 2012, had an amortized cost basis of $8,135 and a fair value of $6,292 as of that date. Accordingly, the Company recorded a valuation allowance of $1,843 as of June 30, 2012, as well as a corresponding loss of $975 during the six month period then ended, which was equal to the change in the valuation allowance during that period. Pools determined to be impaired at December 31, 2011, had an amortized cost basis of $6,812 and a fair value of $5,944 as of that date. Accordingly, the Company recorded a valuation allowance of $868 as of December 31, 2011, as well as a corresponding loss of $862 during the twelve month period then ended, which was equal to the change in the valuation allowance during that period. The company recorded a gain of $6 during the six month period ended June 30, 2011.

 

Federal Home Loan Bank Stock FHLB of Chicago stock is carried at cost, which is its redeemable (fair) value, since the market for this stock is restricted. The Company considers the fair value of FHLB of Chicago stock to be Level 2 in the fair value hierarchy.

 

Accrued Interest Receivable and Payable The carrying values of accrued interest receivable and payable approximate their fair value. The Company considers the fair value of accrued interest receivable and payable to be Level 2 in the fair value hierarchy.

 

Deposit Liabilities and Advance Payments by Borrowers for Taxes and Insurance Fair value for demand deposits equal book value. The Company considers the fair value of demand deposits to be Level 2 in the fair value hierarchy. Fair values for certificates of deposits are estimated using a discounted cash flow calculation that applies current market borrowing interest rates to a schedule of aggregated expected monthly maturities on deposits. The Company considers the fair value of certificates of deposit to be Level 3 in the fair value hierarchy. The advance payments by borrowers for taxes and insurance are equal to their carrying amounts at the reporting date. The Company considers the fair value of advance payment by borrowers to be Level 2 in the fair value hierarchy.

 

Borrowings The fair value of long-term borrowings is estimated using discounted cash flow calculations with the discount rates equal to interest rates currently being offered for borrowings with similar terms and maturities. The carrying value on short-term borrowings approximates fair value. The Company considers the fair value of borrowings to be Level 2 in the fair value hierarchy.

 

Off-Balance Sheet Financial Instruments Off-balance sheet financial instruments consist of commitments to extend credit, IRLCs, and forward commitments to sell loans. Commitments to extend credit that are not IRLCs generally carry variable rates of interest. As such, the fair value of these instruments is not material. The Company considers the fair value of these instruments to be Level 2 in the fair value hierarchy. The carrying value of IRLCs and forward commitments to sell loans, which is equal to their fair value, is the difference between the current market prices for securities collateralized by similar loans and the notional amounts of the IRLCs and forward commitments. The Company considers the fair value of IRLCs and forward commitments to sell loans to be Level 2 in the fair value hierarchy.

 

30
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

13.  Fair Value Measurements (continued)

  

The carrying values and fair values of the Company’s financial instruments are presented in the following table as of the indicated dates.

 

   June 30, 2012   December 31, 2011 
   Carrying
Value
   Fair
Value
   Carrying
Value
   Fair
Value
 
Cash and cash equivalents  $205,233   $205,233   $120,935   $120,935 
Securities available-for-sale   687,619    687,619    781,770    781,770 
Securities held-to-maturity   158,556    160,377         
Loans held-for-sale   11,072    11,072    19,192    19,192 
Loans receivable, net   1,348,573    1,319,469    1,319,636    1,284,651 
Mortgage servicing rights, net   7,263    7,415    7,401    7,577 
Federal Home Loan Bank stock   24,439    24,439    46,092    46,092 
Accrued interest receivable   6,515    6,515    6,521    6,521 
Deposit liabilities   1,983,179    1,936,128    2,021,663    1,968,842 
Borrowings   311,414    327,541    153,091    167,418 
Advance payments by borrowers   22,261    22,261    3,192    3,192 
Accrued interest payable   868    868    750    750 
Unrealized gain (loss) on off-balance-sheet items:                    
Interest rate lock commitments on loans   1,720    1,720    1,012    1,012 
Forward commitments to sell loans   (1,008)   (1,008)   (769)   (769)

 

Certain financial instruments and all nonfinancial instruments are excluded from the table, above. Accordingly, the aggregate fair value of amounts presented in the table does not represent the underlying value of the Company and is not particularly relevant to predicting the Company’s future earnings or cash flows. Furthermore, because the fair value estimates in the table are estimated under Levels 2 or 3 of the fair value hierarchy, the fair value estimates presented in the table cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument.

 

The following table segregates by fair value hierarchy (i.e., Level 1, 2, or 3) all of the Company's assets and liabilities that were accounted for at fair value on a recurring basis as of the dates indicated:

 

   At June 30, 2012 
   Level 1   Level 2   Level 3   Total 
Loans held-for-sale      $11,072       $11,072 
Mortgage-related securities available-for-sale       687,619        687,619 

 

   At December 31, 2011 
   Level 1   Level 2   Level 3   Total 
Loans held-for-sale      $19,192       $19,192 
Mortgage-related securities available-for-sale       781,770        781,770 

 

31
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts) 

 

13.  Fair Value Measurements (continued)

 

Impaired Loans For non-accrual loans greater than an established threshold and individually evaluated for impairment and all renegotiated loans, impairment is measured based on: (i) the fair value of the loan or the fair value of the collateral less estimated selling costs (collectively the “collateral value method”) or (ii) the present value of the estimated cash flows discounted at the loan’s original effective interest rate (the “discounted cash flow method”). The resulting valuation allowance, if any, is a component of the allowance for loan losses. The discounted cash flow method is a fair value measure. For the collateral value method, the Company generally obtains appraisals on a periodic basis to support the fair value of collateral underlying the loans. Appraisals are performed by independent certified and/or licensed appraisers that have been reviewed by the Company and incorporate information such as recent sales prices for comparable properties, costs of construction, and net operating income of the property or business. Selling costs are generally estimated at 10%. Appraised values may be further discounted based on management judgment regarding changes in market conditions and other factors since the time of the appraisal. A significant unobservable input in using net operating income to estimate fair value is the capitalization rate. At June 30, 2012, the range of capitalization rates utilized to determine the fair value of the underlying collateral on certain loans was 7% to 13%. The Company considers these fair values to be Level 3 in the fair value hierarchy. For those loans individually evaluated for impairment using the collateral value method, a valuation allowance of $6,180 was recorded for loans with a recorded investment of $84,219 at June 30, 2012. These amounts were $8,305 and $103,627 at December 31, 2011, respectively. Provision for loan losses related to these loans was $590 during the six months ended June 30, 2012, and $1,257 during the twelve month period ended December 31, 2011. Provision for loan losses related to impaired loans at June 30, 2011, was $1,788 for the six months ended June 30, 2011.

 

Foreclosed Properties Foreclosed properties acquired through, or in lieu of, loan foreclosure are recorded at the lower of cost or fair value less estimated costs to sell. In determining fair value, the Company generally obtains appraisals to support the fair value of foreclosed properties, as described in the previous paragraph. In certain instances, the Company may also use the selling list price, less estimated costs to sell, as the fair value of foreclosed properties. In such instances, the list price is generally less than the appraised value. The Company considers these fair values to be Level 3 in the fair value hierarchy. As of June 30, 2012, $14,984 in foreclosed properties were valued at collateral value compared to $22,655 at December 31, 2011. Losses of $1,764 and $4,639 related to these foreclosed properties were recorded during the six months ended June 30, 2012, and the twelve months ended December 31, 2011, respectively. Losses on foreclosed properties valued at collateral value at June 30, 2011, were $2,586 for the six months ended June 30, 2011. The following table summarizes foreclosed properties and repossessed assets as of the dates indicated:

 

   June 30   December 31 
   2012   2011 
One- to four-family  $3,424   $6,557 
Multi-family   146    1,162 
Commercial real estate   8,589    13,115 
Land   4,301    3,890 
   $16,460   $24,724 

 

14.  Goodwill Impairment

 

During the three months ended June 30, 2011, the Company determined that the goodwill recorded as a result of the purchase of financial institutions in 1997 and 2000 was impaired. The Company performed a goodwill impairment test during that period as a result of a number of developments including the decline in the Company’s stock price and market capitalization and Memoranda of Understanding (“MOU”) with the Office of Thrift Supervision (“OTS”). To determine the fair value of goodwill, as well as the amount of the impairment, the Company obtained a third-party independent appraisal of the Company, which consists of a single reporting unit, and its assets and liabilities. The fair value of the Company was estimated using a weighted average of three valuation methodologies, including a public market peers approach, a comparable transactions approach, and a discounted cash flow approach.

 

32
 

 

Bank Mutual Corporation and Subsidiaries

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

June 30, 2012

 

(Dollars in Thousands, Except Share and Per Share Amounts)

 

14.  Goodwill Impairment (continued)

 

A comparison of the weighted average value from these approaches to the net carrying value of the Company indicated that potential impairment existed. The weighted average value of the Company was subsequently compared to the estimated net fair value of the Company’s individual assets and liabilities. As a result of this comparison, the Company concluded that goodwill was impaired and recorded an impairment charge of $52.6 million during the three months ended June 30, 2011, which represented the total amount of the Company’s goodwill.

 

Goodwill impairment is not deductible for income tax purposes. Accordingly, the Company recorded income tax expense of $266 and $626 during the three and six months ended June 30, 2011, regardless of the fact that it incurred a net loss before income taxes in such periods. Excluding the goodwill impairment from the Company’s net loss before income taxes, the Company’s effective tax rate for those periods was 18.4% and 22.1%, respectively.

 

33
 

 

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

 

Cautionary Statement

 

This report contains or incorporates by reference various forward-looking statements concerning the Company's prospects that are based on the current expectations and beliefs of management. Forward-looking statements may contain, and are intended to be identified by, words such as “anticipate,” “believe,” “estimate,” “expect,” “objective,” “projection,” “intend,” and similar expressions or use of verbs in the future tense any discussions of periods after the date on which this report is filed are also forward-looking statements. The statements contained herein and such future statements involve or may involve certain assumptions, risks, and uncertainties, many of which are beyond the Company's control, that could cause the Company's actual results and performance to differ materially from what is stated or expected. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company: general economic conditions, including instability in credit, lending, and financial markets; declines in the real estate market, which could further affect both collateral values and loan activity; continuing relatively high unemployment and other factors which could affect borrowers’ ability to repay their loans; negative developments affecting particular borrowers, which could further adversely impact loan repayments and collection; legislative and regulatory initiatives and changes, including action taken, or that may be taken, in response to difficulties in financial markets and/or which could negatively affect the right of creditors; monetary and fiscal policies of the federal government; the effects of further regulation and consolidation within the financial services industry, including substantial changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and the transfer of regulatory authority from the Office of Thrift Supervision (“OTS”) to the Office of the Comptroller of the Currency (“OCC”) and the Federal Reserve Board (“FRB”); regulators’ increasing expectations for financial institutions’ capital levels and restrictions imposed on institutions, as to payments of dividends or otherwise, to maintain or achieve those levels, including the possible effect of the memoranda of understanding mentioned in this report and potential new regulatory capital requirements under Basel III; pending and/or potential rulemaking or other actions by the Consumer Financial Protection Bureau (“CFPB”); potential regulatory or other actions affecting the Company or the Bank; potential adverse publicity relating to any such action or other developments affecting the Company or the Bank; potential changes in Fannie Mae and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), which could impact the home mortgage market; increased competition and/or disintermediation within the financial services industry; changes in tax rates, deductions and/or policies; potential further changes in Federal Deposit Insurance Corporation (“FDIC”) premiums and other governmental assessments; changes in deposit flows; changes in the cost of funds; fluctuations in general market rates of interest and/or yields or rates on competing loans, investments, and sources of funds; demand for loan or deposit products; illiquidity of financial markets and other negative developments affecting particular investment and mortgage-related securities, which could adversely impact the fair value of and/or cash flows from such securities; changes in customers’ demand for other financial services; the Company’s potential inability to carry out business plans or strategies; changes in accounting policies or guidelines; natural disasters, acts of terrorism, or developments in the war on terrorism; the risk of failures in computer or other technology systems or data maintenance, or breaches of security relating to such systems; and the factors discussed in the Company’s filings with the Securities and Exchange Commission, particularly under Part I, Item 1A, “Risk Factors,” of the Company’s 2011 Annual Report on Form 10-K.

 

Results of Operations

 

Overview The Company’s net income was $1.3 million or $0.03 per diluted share and $2.5 million or $0.05 per diluted share for the three- and six-month periods ended June 30, 2012, respectively. These amounts compared to net losses of $51.4 million or $1.12 per diluted share and $50.3 million or $1.10 per diluted share in the same periods of 2011, respectively. The losses in the 2011 periods were caused by a $52.6 million non-cash goodwill impairment in the second quarter of that year. Excluding this impairment, the Company’s earnings during the three- and six-month periods in 2011 were $1.2 million or $0.03 per diluted share and $2.2 million or $0.05 per diluted share, respectively. The following paragraphs describe the reasons for the changes in the Company’s earnings during the three- and six-month periods ended June 30, 2012 and 2011, along with other matters affecting the Company’s operations.

 

34
 

 

Net Interest Income Net interest income decreased by $1.3 million or 7.8% and by $2.2 million or $6.8% during the three and six months ended June 30, 2012, compared to the same periods in 2011. These decreases were primarily attributable to a decline in the Company’s net interest margin, which was 2.47% and 2.56% during the three- and six-month periods of 2012, respectively, compared to 2.82% in each of the 2011 periods. These declines were primarily the result of a lower interest rate environment during the first six months of 2012 compared to the same period in 2011, which reduced the return on the Company’s earning assets more than the cost of its funding sources. This development was partially offset by the favorable impact of higher earning assets in the 2012 periods compared to the same periods of 2011. During first six months of 2012 the Company completed the purchase of $158.9 million in mortgage-related securities that were funded by $158.9 million in term advances from the FHLB of Chicago. These investments consisted of mortgage-backed securities issued and guaranteed by Fannie Mae and secured by multi-family residential loans. The securities have a weighted-average life of 7.7 years, a yield of 2.31%, and yield-maintenance fees that discourage the underlying borrowers from prepaying the loans. The term advances from the FHLB of Chicago have a weighted-average life of 5.5 years and cost of 1.47%. The purpose of this transaction was to supplement growth in the Company’s earning assets. The Company classified these securities as held-to-maturity because it has the ability and intent to hold them until they mature.

 

35
 

 

The following tables present certain details regarding the Company's average balance sheet and net interest income for the periods indicated. The tables present the average yield on interest-earning assets and the average cost of interest-bearing liabilities. The yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods shown. The average balances are derived from daily balances over the periods indicated. Interest income includes fees, which are considered adjustments to yields. Net interest spread is the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin is derived by dividing net interest income by average interest-earning assets. No tax equivalent adjustments were made since the Company does not have any tax exempt investments.

 

  Three Months Ended June 30 
  2012   2011 
      Interest   Average      Interest   Average 
  Average   Earned/   Yield/   Average   Earned/   Yield/ 
  Balance   Paid   Rate   Balance   Paid   Rate 
   (Dollars in thousands) 
Assets:                              
Interest-earning assets:                              
Loans receivable (1)  $1,378,035   $16,205    4.70%  $1,371,929   $17,546    5.12%
Mortgage-related securities   880,860    4,792    2.18    571,035    4,033    2.83 
Investment securities (2)   26,003    23    0.35    250,040    1,281    2.05 
Interest-earning deposits   117,468    59    0.20    90,236    46    0.20 
Total interest-earning assets   2,402,366    21,079    3.51    2,283,240    22,906    4.01 
Non-interest-earning assets   228,857              258,251           
Total average assets  $2,631,223             $2,541,491           
                               
Liabilities and equity:                              
Interest-bearing liabilities:                              
Regular savings deposits  $220,110    17    0.03   $220,373    22    0.04 
Money market accounts   422,707    174    0.16    400,778    448    0.45 
Interest-bearing demand accounts   224,699    11    0.02    211,438    24    0.05 
Certificates of deposit   1,006,178    3,666    1.46    1,071,785    4,516    1.69 
Total deposit liabilities   1,873,694    3,868    0.83    1,904,374    5,010    1.05 
Advance payments by borrowers for taxes and insurance   17,735    1    0.02    16,805    1    0.02 
Borrowings   303,493    2,357    3.11    176,413    1,790    4.06 
Total interest-bearing liabilities   2,194,922    6,226    1.13    2,097,592    6,801    1.30 
Non-interest-bearing liabilities:                              
Non-interest-bearing deposits   126,098              101,522           
Other non-interest-bearing liabilities   40,533              39,259           
Total non-interest-bearing liabilities   166,631              140,781           
Total liabilities   2,361,553              2,238,373           
Total equity   269,670              303,118           
Total average liabilities and equity  $2,631,223             $2,541,491           
Net interest income and net interest rate spread       $14,853    2.38%       $16,105    2.71%
                               
Net interest margin             2.47%             2.82%
Average interest-earning assets to average interest-bearing liabilities   1.09x             1.09x          

 

(1)For the purposes of these computations, non-accruing loans and loans held-for-sale are included in loans receivable.
(2)The carrying value and earnings on stock in the FHLB of Chicago is included in investment securities.

 

36
 

 

   Six Months Ended June 30 
   2012   2011 
       Interest   Average       Interest   Average 
   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Rate   Balance   Paid   Rate 
   (Dollars in thousands) 
Assets:                              
Interest-earning assets:                              
Loans receivable (1)  $1,375,669   $32,629    4.74%  $1,369,129   $35,419    5.23%
Mortgage-related securities   817,005    9,094    2.23    541,630    7,828    2.89 
Investment securities (2)   31,393    34    0.22    252,755    2,625    2.08 
Interest-earning deposits   100,845    100    0.20    98,460    97    0.20 
Total interest-earning assets   2,324,912    41,857    3.60    2,261,974    45,969    4.06 
Non-interest-earning assets   217,776              329,356           
Total average assets  $2,542,688             $2,591,330           
                               
Liabilities and equity:                              
Interest-bearing liabilities:                              
Regular savings deposits  $213,865    32    0.03   $213,789    44    0.04 
Money market accounts   422,260    372    0.18    397,545    982    0.49 
Interest-bearing demand accounts   219,620    23    0.02    202,602    47    0.05 
Certificates of deposit   1,019,664    7,497    1.47    1,078,175    9,406    1.74 
Total deposit liabilities   1,875,409    7,924    0.85    1,892,111    10,479    1.11 
Advance payments by borrowers for taxes and insurance   13,113    1    0.02    12,289    2    0.03 
Borrowings   231,081    4,181    3.62    161,543    3,560    4.41 
Total interest-bearing liabilities   2,119,603    12,106    1.14    2,065,943    14,041    1.36 
Non-interest-bearing liabilities:                              
Non-interest-bearing deposits   121,793              102,073           
Other non-interest-bearing liabilities   32,659              115,672           
Total non-interest-bearing liabilities   154,452              217,745           
Total liabilities   2,274,055              2,283,688           
Total equity   268,633              307,642           
Total average liabilities and equity  $2,542,688             $2,591,330           
Net interest income and net interest rate spread      $29,751    2.46%      $31,928    2.70%
                               
Net interest margin           2.56%            2.82%
Average interest-earning assets to average interest-bearing liabilities   1.10x            1.09x          

 

(1)For the purposes of these computations, non-accruing loans and loans held-for-sale are included in loans receivable.
(2)The carrying value and earnings on stock in the FHLB of Chicago is included in investment securities.

 

37
 

 

The following tables present the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to the change attributable to change in volume (change in volume multiplied by prior rate), the change attributable to change in rate (change in rate multiplied by prior volume), and the net change. The change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate.

 

   Three Months Ended June 30, 2012
Compared to June 30, 2011
 
   Increase (Decrease) 
   Volume   Rate   Net 
  (Dollars in thousands) 
Interest-earning assets:     
Loans receivable  $106   $(1,447)  $(1,341)
Mortgage-related securities   1,837    (1,078)   759 
Investment securities   (654)   (604)   (1,258)
Interest-earning deposits   14    (1)   13 
Total interest-earning assets   1,303    (3,130)   (1,827)
Interest-bearing liabilities:               
Savings accounts   1    (6)   (5)
Money market accounts   24    (298)   (274)
Interest-bearing demand accounts   2    (15)   (13)
Certificates of deposit   (265)   (585)   (850)
Total deposit liabilities   (238)   (904)   (1,142)
Advance payments by borrowers for taxes and insurance              
Borrowings   1,062    (495)   567 
Total interest-bearing liabilities   824    (1,399)   (575)
Net change in net interest income  $479   $(1,731)  $(1,252)

 

   Six Months Ended June 30, 2012
Compared to June 30, 2011
 
   Increase (Decrease) 
   Volume   Rate   Net 
  (Dollars in thousands) 
Interest-earning assets:    
Loans receivable  $167    (2,957)  $(2,790)
Mortgage-related securities   3,335    (2,069)   1,266 
Investment securities   (1,283)   (1,308)   (2,591)
Interest-earning deposits   2    1    3 
Total interest-earning assets   2,221    (6,333)   (4,112)
Interest-bearing liabilities:               
Savings accounts   (1)   (11)   (12)
Money market accounts   58    (668)   (610)
Interest-bearing demand accounts   4    (28)   (24)
Certificates of deposit   (489)   (1,420)   (1,909)
Total deposit liabilities   (428)   (2,127)   (2,555)
Advance payments by borrowers for taxes and insurance       (1)   (1)
Borrowings   1,339    (718)   621 
Total interest-bearing liabilities   911    (2,846)   (1,935)
Net change in net interest income  $1,310   $(3,487)  $(2,177)

 

38
 

 

Provision for Loan Losses The Company’s provision for loan losses was $1.7 million in the second quarter of 2012 compared to $805,000 in the same quarter last year. The provision for the six months ended June 30, 2012, was $1.8 million compared to $4.0 million in the same period last year. During the second quarter of 2012 the Company recorded additional loss provisions of $1.2 million against a number of smaller multi-family, commercial real estate, and business loan relationships, as well as residential and consumer loans. In addition, during the quarter the Company recorded $507,000 in additional loss provision related primarily to growth in its loan portfolio during the period.

 

During the second quarter of 2011, the Company recorded $1.8 million in additional loss provision against two unrelated loan relationships that aggregated $6.7 million. These loans were secured by office/warehouse and multi-tenant retail buildings. During the second quarter of 2011 the Company also recorded $1.5 million in loss provisions against a number of smaller multi-family, commercial real estate, and business loan relationships, as well as residential and consumer loans. Finally, the Company recorded $900,000 in additional loss provision during the quarter that reflected management’s concerns at the time related to continuing weaknesses in housing markets and increases in unemployment. The impact of these developments was substantially offset by $3.4 million in loss recaptures related to loans that were paid off or were upgraded to performing status during the second quarter of 2011.

 

On a year-to-date basis in 2012 the Company recorded additional loss provisions of $2.6 million against a number of smaller multi-family, commercial real estate, and business loan relationships, as well as residential and consumer loans. This development was partially offset by $1.2 million in loss recaptures related to non-performing loans that paid off during the period or recoveries of previously charged-off loans. Finally, during the year-to-date period the Company also recorded $226,000 in additional loss provision related primarily to growth in its loan portfolio during the period.

 

On a year-to-date basis in 2011 the Company recorded $7.4 million in loss provisions against a number of multi-family, commercial real estate, and business loan relationships, as well as certain smaller residential and consumer loans. This development was partially offset by $3.4 million in loss recaptures in the second quarter of 2011, as previously described.

 

Although the Company’s provision for loan losses was higher in the second quarter of 2012 than it was in the first quarter, such losses have generally been trending lower in recent periods. This trend is directionally consistent with recent declines in the Company’s non-performing loans and classified loans, as described below, and is consistent with trends in the banking industry. It should be noted, however, that the Company’s loan portfolio continues to be impacted by slow economic growth, persistent unemployment, and depressed real estate values. These conditions are particularly challenging for borrowers whose loans are secured by commercial real estate, multi-family real estate, and land. Although the Company’s level of non-performing loans and credit-related losses have trended lower in recent periods, such remain elevated and could continue to remain elevated for the foreseeable future. For additional discussion related to the Company’s non-performing loans, non-performing assets, classified assets, and allowance for loan losses, refer to “Financial Condition—Asset Quality,” below.

 

Non-Interest Income Total non-interest income increased by $2.2 million or 45.7% and $3.7 million or 34.6% during the three and six months ended June 30, 2012, compared to the same periods in 2011, respectively. Significant reasons for this increase are discussed in the following paragraphs.

 

Service charges on deposits increased by $105,000 or 6.7% during the three months ended June 30, 2012, compared to the same quarter in 2011. During the first six months of 2012, service charges on deposits increased by $196,000 or 6.5% compared to the same six-month period in 2011. Management attributes these improvements to an increase in the Company’s average checking accounts, which increased by $36.7 million or 12.1% during the six months ended June 30, 2012, compared to the same period in the previous year. In addition, enhancements in recent periods to the Company’s commercial deposit products and services generated increased fee revenue in the 2012 periods, particularly related to treasury management services.

 

39
 

 

Brokerage and insurance commissions were $1.0 million during the second quarter of 2012, a $132,000 or 15.9% increase from the same period in the previous year. On a year-to-date basis, this source of revenue was $1.5 million in 2012, a $99,000 or 6.9% increase from the same period in 2011. Management attributes these increases to improved sales efforts in this line of business, as well as a low interest rate environment, which encourages customers to purchase tax-deferred annuities due to higher rates of return on such products compared to deposit-related products.

 

Net loan-related fees and servicing revenue was a loss of $1.4 million during the three months ended June 30, 2012, compared to income of $333,000 in the same period of the previous year. Net loan-related fees and servicing revenue was a loss of $1.3 million during the six months ended June 30, 2012, compared to income of $584,000 in the same period of 2011. The following table presents the components of this income statement line item for the periods indicated:

 

   Three Months Ended
June 30
   Six Months Ended
 June 30
 
   2012   2011   2012   2011 
   (Dollars in thousands) 
Gross servicing fees  $747   $678   $1,440   $1,360 
Mortgage servicing rights amortization   (979)   (477)   (2,022)   (993)
Mortgage servicing rights valuation (loss) recovery   (1,296)       (975)   6 
Loan servicing revenue, net   (1,528)   201    (1,557)   373 
Other loan fee income   133    132    300    211 
Loan-related fees and servicing revenue, net  $(1,395)  $333   $(1,257)  $584 

 

Amortization of MSRs increased in the 2012 periods compared to the same periods in the prior year due to lower market interest rates for one- to four-family mortgage loans, which resulted in increased loan prepayments and faster amortization of the MSRs relative to the 2011 periods. Net loan-related fees and servicing revenue is also impacted by changes in the valuation allowance that is established against MSRs. The change in this allowance is recorded as a recovery or loss, as the case may be, in the period in which the change occurs. Lower market interest in 2012 resulted in higher prepayment expectations as of June 30, 2012, which caused increases in the MSR valuation allowance during the three- and six-month periods ended June 30, 2012. As of June 30, 2012, the Company had a valuation allowance of $1.8 million against MSRs with a gross book value of $9.1 million. As of the same date the Company serviced $1.1 billion in loans for third-party investors compared to a similar amount one year ago.

 

The valuation of MSRs, as well as the periodic amortization of MSRs, is significantly influenced by the level of market interest rates and loan prepayments. If interest rates decrease and/or prepayment expectations increase, the Company could potentially record charges to earnings related to increases in the valuation allowance on its MSRs. In addition, amortization expense could increase due to likely increases in loan prepayment activity. Alternatively, if market interest rates for one- to four-family loans increase and/or actual or expected loan prepayment expectations decrease in future periods, the Company could recover all or a portion of previously established allowance on MSRs, as well as record reduced levels of MSR amortization expense.

 

Gains on sales of loans were $3.6 million in the second quarter of 2012 compared to $520,000 in the same quarter last year. Year-to-date, gains on sales of loans were $6.5 million in 2012 compared to $1.1 million in 2011. The Company typically sells most fixed-rate, one- to four-family mortgage loans that it originates in the secondary market. During the three and six months ended June 30, 2012, sales of these loans were $110.5 million or 489% higher and $175.9 million or 219% higher than they were during the same periods of 2011, respectively. Management attributes these increases to lower market interest rates for one- to four-family mortgage loans, which encouraged borrowers to refinance higher-rate loans into lower-rate loans during the 2012 periods. Although market interest rates for one- to four-family mortgage loans remain historically low, management is not certain that gains on sales of loans can be sustained during the last half of 2012 at the levels experienced during the first half of the year.

 

40
 

 

 

The Company recorded $543,000 in gains on sales of investments in the second quarter of 2012. During this period the Company sold $20.4 million in mortgage-related securities to provide additional liquidity in anticipation of the maturity in July of a $100.0 million term advance from the FHLB of Chicago (refer to “Financial Condition—Borrowings,” below). In the first quarter of 2011 the Company recorded $1.1 million in net gains on sales of investments. In that period the Company sold a $20.8 million investment in a mutual fund that management did not expect would perform well in future periods.

 

In the second quarters of 2012 and 2011 the Company recorded $336,000 and $389,000 in net OTTI losses, respectively. These losses consisted of the credit portion of the total OTTI loss related to the Company’s investment in certain private-label CMOs rated less than investment grade. Management attributes the net OTTI losses in these periods to low real estate values for residential properties on a nationwide basis. None of the Company’s remaining private-label CMOs were deemed to be other-than-temporarily impaired as of June 30, 2012. However, the collection of the amounts due on private-label CMOs is subject to numerous factors outside of the Company’s control and a future determination of OTTI could result in additional losses being recorded through earnings in future periods. As of June 30, 2012, the Company’s total investment in private-label CMOs was $55.0 million, of which $34.2 million was rated less than investment grade (for additional discussion refer to “Financial Condition— Mortgage-Related Securities Available-for-Sale,” below).

 

Other non-interest income was $1.4 million and $3.0 million during the three months and six months ended June 30, 2012, respectively, compared to $1.4 million and $2.6 million during the same periods in 2011, respectively. The increase in the 2012 year-to-date period was due primarily to an increase in the fair value of assets held in trust for certain non-qualifying employee benefit plans, due to the effects of lower interest rates and improved equity markets.

 

Non-Interest Expense Total non-interest expense was $18.1 million and $38.7 million during three and six months ended June 30, 2012, respectively, and $71.2 million and $88.2 million during the same periods in 2011, respectively. The 2011 periods include a $52.6 million non-cash goodwill impairment that had no effect on the Company’s liquidity, operations, tangible capital, or regulatory capital. The Company determined that the value of its goodwill had become impaired in the second quarter of 2011 based on a number of factors including the decline in its stock price and market capitalization and the impact the MOU with the OTS had on the impairment valuation process (for additional discussion refer to “Note 14. Goodwill Impairment” in the Company’s Unaudited Condensed Consolidated Financial Statements). Excluding the impact of the goodwill impairment, total non-interest expense decreased by $474,000 or 2.5% during the three months ended June 30, 2012, compared to the same period in 2011, and increased by $3.0 million or 8.4% and six months ended June 30, 2012, compared to the same period in 2011. The following paragraphs discuss the components of the Company’s non-interest expense and the primary reasons for their changes during the second quarter of 2012 compared to the second quarter of 2011.

 

Compensation-related expenses increased by $1.1 million or 11.4% and by $2.3 million or 12.0% during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011, respectively. These increases were due primarily to the hiring of additional commercial relationship managers and other key personnel in recent periods, as well as normal annual merit increases. Also contributing was an increase in expenses related to stock-based compensation, certain non-qualifying employee benefit plans, and the defined-benefit pension plan. The latter development was principally caused by a decline in the interest rate used to determine the present value of the pension obligation.

 

41
 

 

Federal deposit insurance premiums increased by $125,000 or 16.8% during the second quarter of 2012 compared to the same quarter in 2011. Year-to-date, federal deposit insurance premiums decreased by $66,000 or 3.7% in 2012 compared to the same period in the prior year. The year-to-date decrease was caused by a change in how deposit insurance premiums are assessed to insured institutions. Beginning with the second quarter of 2011 the FDIC implemented a new rule that changed the deposit insurance assessment base from an insured institution’s domestic deposits (minus certain allowable exclusions) to an insured institution’s average consolidated assets (minus certain adjustments). The change in the assessment methodology benefited the Company and resulted in lower deposit insurance costs in the year-to-date comparison. However, deposit insurance costs were higher in the quarterly comparison because the Company’s average total assets were higher in the second quarter of 2012 compared to the same quarter in 2011. Refer to “Financial Condition—Overview,” below, for additional discussion.

 

Advertising and marketing-related expenses increased by $71,000 or 17.8% during the three months ended June 30, 2012, compared to the same period in the prior year. On a year-to-date basis, advertising and marketing-related expenses increased by $425,000 or 65.9% in 2012 compared to the same period in 2011. These changes were primarily caused by differences in the timing of the Company’s advertising and marketing efforts between the 2012 and 2011 periods. At this time management does not expect advertising and marketing-related expenses during the whole of 2012 to be substantially different than prior years. However, this will depend on future management decisions and there can be no assurances.

 

Net losses and expenses on foreclosed properties were $970,000 and $3.7 million during the three and six months ended June 30, 2012, respectively, compared to $2.7 million and $3.7 million in the same periods of the prior year, respectively. Net losses and expenses on foreclosed properties declined in the 2012 quarterly period due to a lower level of foreclosed properties. However, despite recent declines, the Company’s losses and expenses on foreclosed real estate remain elevated due to lower real estate values and slow economic growth in recent years. If these conditions persist, losses on foreclosed real estate could remain elevated in the near term.

 

Other non-interest expense increased by $33,000 or 1.4% and $460,000 or 9.8% during the three and six months ended June 30, 2012, compared to the same period in 2011. The year-to-date increase was primarily the result of legal, consulting, and accounting fees related to loan workout efforts and related professional services. These expenses have declined in recent months as the Company has reduced its level of non-performing loans.

 

Income Tax Expense Income tax expense was $601,000 and $266,000 during the three months ended June 30, 2012 and 2011, respectively, and was $1.1 million and $626,000 during the six months ended as of the same dates, respectively. Excluding the 2011 goodwill impairment from income (loss) before taxes, which is not deductible for income tax purposes, the Company’s effective tax rate (“ETR”) for the three months ended June 30, 2012 and 2011, was 31.3% and 18.4%, respectively. The Company’s ETR for the six-month periods in these years was 30.2% and 22.1%, respectively (again, excluding the goodwill impairment). The Company’s ETR increased in the 2012 periods because non-taxable revenue, which consists principally of earnings from bank-owned life insurance (“BOLI”), has comprised a smaller portion of pre-tax earnings in 2012 than it did in 2011.

 

Like many Wisconsin financial institutions, the Company has non-Wisconsin subsidiaries that hold and manage investment assets and loans, the income from which has not been subject to Wisconsin tax prior to 2009. The Wisconsin Department of Revenue (the “Department”) has instituted an audit program specifically aimed at financial institutions’ out-of-state investment subsidiaries. The Department has asserted the position that some or all of the income of the out-of-state subsidiaries in years prior to 2009 was taxable in Wisconsin. In 2010 the Department’s auditor issued a Notice of Proposed Audit Report to the Company which proposes to tax all of the income of its out-of-state investment subsidiaries for all periods that are still open under the statute of limitations, which includes tax years back to 1997. This is a preliminary determination made by the auditor and does not represent a formal assessment. The Company’s outside legal counsel has met with representatives of the Department to discuss, and object to, the auditor’s proposed adjustments. The Department has requested further information to support the Company’s position, which the Company has provided. The Company is awaiting a further response from the Department.

 

42
 

 

Management continues to believe that the Company has reported income and paid Wisconsin taxes in prior periods in accordance with applicable legal requirements and the Department’s long-standing interpretations of them and that the Company’s position will prevail in discussions with the Department, court proceedings, or other actions that may occur. Ultimately, however, an adverse resolution of these matters could result in additional Wisconsin tax obligations for prior periods, which could have a substantial negative impact on the Company’s earnings in the period such resolution is reached. The Company may also incur further costs in the future to address and defend these issues.

 

Financial Condition

 

Overview The Company’s total assets increased by $136.5 million or 5.5% during the six months ended June 30, 2012. During the period the Company’s held-to-maturity securities increased by $158.6 million, its interest-earning deposits, which consist principally of overnight investments, increased by $102.8 million, and its loan portfolio increased by $28.9 million. These developments were partially offset by a $94.2 million decrease in the Company’s available-for-sale securities and a $21.7 million decrease in its investment in the common stock of the FHLB of Chicago. Also during the period, the Company’s borrowings from the FHLB of Chicago increased by $158.3 million and its deposit liabilities decreased by $38.5 million. The Company’s total shareholders’ equity increased from $265.8 million at December 31, 2011, to $269.5 million at June 30, 2012. Non-performing assets decreased from $99.9 million or 4.00% of total assets at December 31, 2011, to $66.9 million or 2.54% at June 30, 2012. The following paragraphs describe these changes in greater detail, as well as other changes in the Company’s financial condition during the six months ended June 30, 2012.

 

Cash and Cash Equivalents The Company’s cash and cash equivalents increased by $84.3 million or 69.7% during the six months ended June 30, 2012. In recent months the Company increased its holdings of interest-bearing deposits, which consists principally of overnight investments, in anticipation of its repayment of a $100.0 million maturing term advance from the FHLB of Chicago in July.

 

Mortgage-Related Securities Available-for-Sale The Company’s portfolio of securities available-for-sale decreased by $94.2 million or 12.0% during the six months ended June 30, 2012. This decrease was principally caused by periodic repayments and security sales that exceeded the Company’s purchase of new securities during the period. Also contributing to the decrease was a $20.4 million sale of securities, as previously described. The Company purchased $51.4 million of CMOs issued by government-sponsored entities during the six months ended June 30, 2012.

 

Changes in the fair value of the Company’s available-for-sale securities are recorded through accumulated other comprehensive loss (net of deferred income taxes), which is a component of shareholders’ equity. The fair value adjustment on the Company’s available-for-sale securities was a net unrealized gain of $10.0 million at June 30, 2012, compared to a net unrealized gain of $7.7 million at December 31, 2011.

 

The Company maintains an investment in private-label CMOs that were purchased from 2004 to 2006 and are secured by prime residential mortgage loans. The securities were all rated “triple-A” by various credit rating agencies at the time of their purchase. However, most of the securities in the portfolio have been downgraded since their purchase.

 

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The following table presents the credit ratings, carrying values, and unrealized gains (losses) of the Company’s private-label CMO portfolio as of the dates indicated (in instances of split-ratings, each security has been classified according to its lowest rating):

 

   June 30, 2012   December 31, 2011 
   Carrying
Value
   Unrealized
Gain (Loss),
Net
   Carrying
Value
   Unrealized
Gain (Loss),
Net
 
   (Dollars in thousands) 
Credit rating:                     
AAA/Aaa  $4,184   $146   $5,386   $210 
AA/Aa   1,675    32    2,512    58 
A   4,214    13    6,951    (271)
BBB/Baa   10,756    (59)   10,428