|• FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2012 • CERTIFICATION OF CEO PURSUANT TO SECTION 302 • CERTIFICATION OF CFO PURSUANT TO SECTION 302 • CERTIFICATION OF CEO PURSUANT TO SECTION 906 • CERTIFICATION OF CFO PURSUANT TO SECTION 906 • XBRL INSTANCE FILE • XBRL SCHEMA FILE • XBRL CALCULATION FILE • XBRL DEFINITION FILE • XBRL LABEL FILE • XBRL PRESENTATION FILE|
For the quarterly period ended March 31, 2012
For the transition period from _________________to ________________
Commission file number 001-16339
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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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 o
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. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
Number of outstanding shares of common stock, $5.00 par value per share, as of May 7, 2012 was 7,926,458 shares
BAYLAKE CORP. AND SUBSIDIARIES
See accompanying Notes to Unaudited Consolidated Financial Statements.
See accompanying Notes to Unaudited Consolidated Financial Statements.
See accompanying Notes to Unaudited Consolidated Financial Statements.
See accompanying Notes to Unaudited Consolidated Financial Statements.
See accompanying Notes to Unaudited Consolidated Financial Statements.
See accompanying Notes to Unaudited Consolidated Financial Statements.
EARNINGS PER SHARE
ASSETS MEASURED AT FAIR VALUE ON A RECURRING
Assets measured at fair value on a recurring basis are summarized below:
The following table presents additional information about assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):
The transfers out of Level 3 during the quarter were the result of the availability of quoted prices on a portion of the securities that were Level 3 at December 31, 2011.
ASSETS MEASURED AT FAIR VALUE ON A NON-RECURRING
Assets measured at fair value on a non-recurring basis are summarized below:
Required Financial Disclosures about Fair Value of Financial Instruments
The accounting guidance for financial instruments requires disclosures of estimated fair value of certain financial instruments and the methods and significant assumptions used to estimate their fair values. Certain financial instruments and all nonfinancial instruments are excluded from the scope of this guidance. Accordingly, the fair value disclosures required by this guidance are only indicative of the value of individual financial instruments as of the dates indicated and should not be considered an indication of our fair value.
The following table presents the carrying amount and estimated fair value of certain financial instruments:
The methods and assumptions that were used to estimate the fair value of financial assets and financial liabilities that are measured at fair value on a recurring and non-recurring basis have been previously disclosed. The following methods and assumptions were used to estimate the fair value of other financial instruments for which it is practicable to estimate that value:
The carrying amount of cash approximates fair value.
(b) Federal Funds Sold
The carrying amount of federal funds sold approximates fair value.
(c) Loans Held for Sale
The fair value of loans held for sale is based on actual market quotes from third party investors.
(d) Cash Value of Life Insurance
The fair value of life insurance approximates the carrying amount, because upon liquidation of these investments, the Company would receive the cash surrender value, which equals the carrying amount.
(e) Federal Home Loan Bank Stock
It is not practical to determine the fair value of Federal Home Loan Bank (FHLB) stock due to restrictions placed on its transferability. No secondary market exists for FHLB stock. The stock is bought and sold at par by the FHLB. Management believes that the recorded value is fair value.
(f) Accrued Interest Receivable
The carrying amount of accrued interest receivable approximates fair value.
The carrying amount of demand deposits (interest-bearing and non-interest-bearing), savings deposits, and money market deposits approximates fair value. The carrying amount of variable rate time deposits, including certificates of deposit, approximates fair value. For fixed rate time deposits, fair value is based on discounted cash flows using current market interest rates.
(h) Repurchase Agreements
The carrying amount of repurchase agreements approximates fair value.
(i) Federal Home Loan Bank Advances
The carrying amount of variable rate FHLB advances approximates fair value. For fixed rate advances, fair value is based on discounted cash flows using current market interest rates.
(j) Subordinated Debentures
The carrying amount of variable rate subordinated debentures approximates fair value.
(k) Convertible Promissory Notes
The fair value of fixed rate convertible promissory notes is based on discounted cash flows using current market interest rates.
(l) Accrued Interest Payable
The carrying amount of accrued interest payable approximates fair value.
(m) Off Balance Sheet Credit Related Items-Letters of Credit
The carrying amount of the off balance sheet letters of credit approximates fair value based on managements evaluation of the factors affecting the letters of credit.
INVESTMENT SECURITY ANALYSIS
The fair value of securities available for sale and the related unrealized gains and losses as of March 31, 2012 and December 31, 2011 are as follows:
At March 31, 2012 and December 31, 2011, the mortgage-backed securities portfolio was $188.7 million, (67.6%) and $193.6 million, (68.1%), respectively, of the investment portfolios. Approximately 9.6%, or $18.2 million, of the mortgage-backed securities outstanding at March 31, 2012 were issued and guaranteed by the Government National Mortgage Association (GNMA), the Small Business Administration (SBA) or the United States Department of Veterans Affairs (VA): agencies of the United States government. An additional 67.4%, or $127.1 million, of the mortgage-backed securities outstanding at March 31, 2012 were issued by either the Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC); United States government-sponsored-agencies. Non-agency mortgage-backed securities present a level of credit risk that does not exist currently with United States government agency-backed securities, but only comprised approximately 22.9%, or $43.3 million, of the outstanding mortgage-backed securities at March 31, 2012. Management evaluates these non-agency mortgage-backed securities at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.
Securities with unrealized losses at March 31, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows (dollar amounts in thousands):
At March 31, 2012, the mortgage-backed securities category with continuous unrealized losses for twelve months or more comprises one security. The asset-backed securities category with continuous unrealized losses for twelve months or more comprises two securities.
At December 31, 2011, the mortgage-backed securities category with continuous unrealized losses for twelve months or more comprises three securities. The asset-backed securities category with continuous unrealized losses for twelve months or more comprises two securities.
Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. As part of such monitoring, the credit quality of individual securities and their issuers is assessed. Adjustments to market value that are considered temporary are recorded as a separate component of other comprehensive income, net of tax. If an impairment of a security is identified as other-than-temporary based on information available, such as the decline in the creditworthiness of the issuer, external market ratings or the anticipated or realized elimination of associated dividends, such impairments are further analyzed to determine if a credit loss exists. If there is a credit loss, it will be recorded in the consolidated statement of operations. Unrealized losses other than credit losses will continue to be recognized in other comprehensive income; net of tax. Unrealized losses reflected in the preceding tables have not been included in the results of operations because the unrealized loss was not deemed other-than-temporary. Management does not have the intent to sell the securities and has determined that it is not more likely than not that the Company will be required to sell the debt securities before their anticipated recovery and therefore, there is no other-than-temporary impairment. The losses on these securities are expected to dissipate as they approach their maturity dates and/or if interest rates decline.
Loans held for investment are summarized as follows (dollar amounts in thousands):
Loans having a carrying value of $110,949 and $105,114 are pledged as collateral for borrowings from the FHLB at March 31, 2012 and December 31, 2011, respectively.
A breakdown of the allowance for loan losses and recorded investment in loans as of and for the three months ended March 31, 2012 is as follows (dollar amounts in thousands):
A breakdown of the allowance for loan losses and recorded investment in loans as of and for the three months ended March 31, 2011 is as follows (dollar amounts in thousands):
A summary of past due loans at March 31, 2012 and December 31, 2011 is as follows (dollar amounts in thousands):
Credit Quality: Management utilizes a risk grading matrix on each of the Companys commercial loans. Loans are graded on a scale of 1 to 7. A description of the loan grades is as follows:
0001 - Excellent Risk. Borrowers of highest quality and character. Almost no risk possibility. Balance sheets are very strong with superior liquidity, excellent debt capacity and low leverage. Cash flow trends are positive and stable. Excellent ratios.
0002 - Very Good Risk. Good ratios in all areas. High quality borrower. Normally quite liquid. Differs slightly from a 0001 customer.
0003 - Strong in most categories. Possible higher levels of debt or shorter track record. Minimal attention required. Good management.
0004 - Better than Average Risk. Adequate ratios, fair liquidity, desirable customer. Proactive management. Performance trends are positive. Any deviations are limited and temporary as a historical trend.
0005 - Satisfactory Risk. Some ratios slightly weak. Overall ability to repay is adequate. Capable and generally proactive management in all critical positions. Margins and cash flow may lack stability but trends are stable to positive. Company normally profitable year to year but may experience an occasional loss.
0006 A - Weakness detected in either management, capacity to repay or balance sheet. Erratic profitability and financial performance. Loan demands more attention. Includes loans deemed to have weaknesses and less than 90 days past due.
0006 B - Have weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Bank’s collateral position at some future date. Loans rated 0006B are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. Includes loans deemed to have weaknesses and less than 90 days past due.
0007 - Well defined weaknesses and trends that jeopardize the repayment of loans. Ranging from workout to legal. Includes loans that are nonaccrual and/or 90 days and over past due.
Below is a breakdown of loans by risk grading as of March 31, 2012 (dollar amounts in thousands):
Below is a breakdown of loss by risk grading as of December 31, 2011 (dollar amounts in thousands):
Information regarding impaired loans is as follows (dollar amounts in thousands):
IMPAIRED LOANS AND ALLOCATED ALLOWANCE
Management regularly monitors impaired loan relationships. In the event facts and circumstances change, an additional PFLL may be necessary.
Nonperforming loans are as follows (dollar amounts in thousands):
During the quarter ended March 31, 2012, $8.0 million of accruing restructured loans were transferred to nonaccrual and $7.6 million of restructured loans were in compliance with their modified terms and were transferred out of the restructured loan category.
MORTGAGE SERVICING RIGHTS
During the quarter ended March 31, 2012, the entire $8.0 million of restructured loans transferred to nonaccrual status were loans that had been restructured with principal charge-offs (A/B Note Structure). Of the $7.6 million of loans transferred out of the restructured category, $5.0 million were loans that had been modified with payment schedule changes and not due to interest rate concessions. A majority of the remaining amount ($2.5 million) were loans that had been restructured with principal charge-offs (A/B Note Structure).
A summary of troubled debt restructurings as of March 31, 2012 and December 31, 2011 is as follows (dollar amounts in thousands):
Baylake Corp. is a Wisconsin corporation that is registered with the Board of Governors of the Federal Reserve (the “Federal Reserve”) as a bank holding company under the Bank Holding Company Act of 1956, as amended. Our wholly-owned banking subsidiary, Baylake Bank, is a Wisconsin state-chartered bank that provides a wide variety of loan, deposit and other banking products and services to its business, retail, and municipal customers, as well as a full range of trust, investment and cash management services. The Bank is a member of the Federal Reserve and the Federal Home Loan Bank of Chicago.
The following sets forth management’s discussion and analysis of our consolidated financial condition at March 31, 2012 and December 31, 2011 and our consolidated results of operations for the three months ended March 31, 2012 and 2011. This discussion and analysis should be read together with the consolidated financial statements and accompanying notes contained in Part I of this Form 10-Q, as well as our Annual Report on Form 10-K for the year ended December 31, 2011.
This discussion and analysis of consolidated financial condition and results of operations, and other sections of this report, may contain forward-looking statements that are based on the current expectations of management. Such expressions of expectations are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “projects,” and other such words are intended to identify such forward-looking statements. The statements contained herein and in such forward-looking statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond our control that may cause actual future results to differ materially from what may be expressed or forecasted in such forward-looking statements. Readers should not place undue expectations on any forward-looking statements. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could cause actual results to differ materially from the forward-looking statements: the factors described under “Risk Factors” in Item 1A of this Quarterly Report on Form 10-Q and of our Annual Report on Form 10-K for the year ended December 31, 2011, which are incorporated herein by reference, and other risks that may be identified or discussed in this Form 10-Q.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The Dodd-Frank Act resulted in sweeping changes in the regulation of financial institutions aimed at strengthening safety and soundness for the financial services sector. We expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.
Critical Accounting Policies
In the course of our normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in our consolidated financial statements. The following is a summary of what management believes are our critical accounting policies.
Allowance for Loan Losses: The ALL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALL requires the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on our consolidated balance sheet. Loan losses are charged off against the ALL while recoveries of amounts previously charged off are credited to the ALL. A PFLL is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The ALL consists of specific reserves on certain impaired loans and general reserves for non-impaired loans. Specific reserves reflect estimated losses on impaired loans from analyses developed through specific credit allocations for individual loans. The specific credit allocations are based on regular analyses of all impaired non-homogenous loans. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based on our historical loss experience which is updated quarterly. The general reserve portion of the ALL also includes consideration of certain qualitative factors such as (i) changes in the nature, volume and terms of loans, (ii) changes in lending personnel, (iii) changes in the quality of the loan review function, (iv) changes in nature and volume of past-due, nonaccrual and/or classified loans, (v) changes in concentration of credit risk, (vi) changes in economic and industry conditions, (vii) changes in legal and regulatory requirements, (viii) unemployment and inflation statistics, and (ix) changes in underlying collateral values.
There are many factors affecting the ALL, some are quantitative while others require qualitative judgment. The process for determining the ALL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional PFLL could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged-off or for which an actual loss is realized.
As an integral part of their examination process, various regulatory agencies review the ALL as well. Such agencies may require that changes in the ALL be recognized when such regulatory credit evaluations differ from those of management based on information available to the regulators at the time of their examinations.
Provision for Impairment of Standby Letters of Credit: The provision for losses on standby letters of credit represents management’s estimate of probable incurred losses with respect to off-balance sheet standby letters of credit which are used to support our customers’ business arrangements with an unrelated third party. In the event of further impairment, a provision for impairment of standby letters of credit is charged to operations based on management’s periodic evaluation of the factors affecting the standby letters of credit.
Foreclosed Properties: Foreclosed properties acquired through or in lieu of loan foreclosure are initially recorded at the lower of carrying cost or fair value less estimated costs to sell, establishing a new cost basis. Fair value is determined using a variety of market information including but not limited to appraisals, professional market assessments and real estate tax assessment information. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Costs incurred after acquisition are expensed.
Income Tax Accounting: The assessment of income tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of our operations and reported earnings. We believe that the net deferred income tax asset on our March 31, 2012 balance sheet is recoverable, and the income tax liabilities are adequate and fairly stated in the consolidated financial statements.
Goodwill: Goodwill represents the excess of the cost of businesses acquired over fair value of net identifiable assets at the date of acquisition. Goodwill is not amortized but is subject to impairment tests on an annual basis or more frequently if deemed appropriate. Goodwill is subject to a periodic assessment by applying a fair value test based upon a two-step method. The first step of the process compares the fair value of the reporting unit with its carrying value, including any goodwill. During 2011, we, with the assistance of a third party valuation firm determined an estimated cash fair value of our common stock. Consideration was given to our nature and history, the competitive and economic outlook for our trade area and for the banking industry in general, our book value and financial condition, our future earnings and dividend paying capacity, the size of the block valued, and the prevailing market prices of bank stocks. The following valuation methodologies were considered: (i) net asset value – defined as our net worth, (ii) market value – defined as the price at which knowledgeable buyers and sellers would agree to buy and sell our common stock, and (iii) investment value – defined as an estimate of the present value of the future benefits, usually earnings, cash flow, or dividends, that will accrue to our common stock. When consideration was given to the three valuation methodologies, as well as all other relevant valuation variables and factors, the fully-diluted cash fair value range of our common shares was considered to be in excess of the book value. Since the valuation range obtained from that firm exceeded our carrying value including goodwill, we did not fail step one of the impairment test established under generally accepted accounting principles and, therefore, no goodwill impairment was recognized. If the carrying amount would have exceeded fair value, we would have performed the second step to measure the amount of impairment loss. Based on the valuation obtained as of September 30, 2011, our valuation exceeded our carrying value by a range of 23% to 33%. As of March 31, 2012, there are no conditions that would require goodwill impairment to be reevaluated.
Results of Operations
The following table sets forth our results of operations and related summary information for the three month periods ended March 31, 2012 and 2011.
SUMMARY RESULTS OF OPERATIONS
(Dollar amounts in thousands, except per share data)
Net income of $1.3 million for the three months ended March 31, 2012 increased from a net income of $0.7 million for the comparable period in 2011. Net interest income increased $0.3 million for the quarter ended March 31, 2012 versus the comparable quarter last year, resulting from a $0.6 million reduction in interest expense partially offset by a $0.3 million reduction in interest income. A PFLL of $1.8 million was charged to operations for the first quarter of 2012, which is $0.5 million higher than the $1.3 million PFLL taken during the comparable quarter of 2011. Noninterest income increased by $0.4 million in the first quarter of 2012 versus the comparable quarter of 2011, primarily due to an increase of $0.6 million in net gains on the sale of securities. Noninterest expense decreased $0.9 million between the periods primarily due to reductions in FDIC insurance expense and expenses related to the operation of other real estate.
Net Interest Income:
Net interest income is the largest component of our operating income and represents the difference between interest earned on loans, investments and other interest-earning assets offset by the interest expense attributable to the deposits and borrowings that fund such assets. Interest rate fluctuations, together with changes in the volume and types of interest-earning assets and interest-bearing liabilities, combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of earned interest income. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable.
Net interest income on a tax-equivalent basis was $8.6 million for the three months ended March 31, 2012 compared to $8.3 million for the same period in 2011. The increase for the first quarter of 2012 resulted primarily from a decrease in interest expense in funding costs on interest-bearing liabilities, partially offset by a decrease in interest income on interest-earning assets. Positively impacting net interest income was a $10.7 million increase in average noninterest-bearing demand deposits, from $87.8 million during the first quarter of 2011 to $98.5 million for the comparable period in 2012.
Interest rate spread is the difference between the interest rate earned on average interest-earning assets and the rate paid on average interest-bearing liabilities. Interest rate spread decreased 4 bps to 3.42% for the first quarter of 2012 compared to the same period in 2011, resulting primarily from a 35 bps decrease in the yield on earning assets from 4.68% to 4.33%, partially offset by a 30 bps decrease in the cost of interest-bearing liabilities from 1.22% to 0.92%. We continue to be positively impacted by the interest rate floors on a large number of loans on our balance sheet, which has resulted in the recognition of a greater amount of interest income than would have been recognized had the floors not existed.
Net interest margin represents net interest income expressed as an annualized percentage of average interest-earning assets. Net interest margin exceeds the interest rate spread because of the use of noninterest-bearing sources of funds (demand deposits and equity capital) to fund a portion of earning assets. Net interest margin for the first quarter of 2012 was 3.51%, down 5 bps from 3.56% for the comparable period in 2011.
For the three months ended March 31, 2012, average interest-earning assets increased $39.6 million from the same period in 2011. Increases in average federal funds sold and interest-bearing due from financial institutions balances of $10.0 million (26.5%) and in taxable securities of $23.7 million (10.3%) accounted for a majority of the increase.
NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS (Dollar amounts in thousands)
RATE/VOLUME ANALYSIS (1)
(Dollar amounts in thousands)
Three months ended March 31, 2012 compared to the three months ended March 31, 2011:
Our management’s ability to employ overall assets for the production of interest income can be measured by the ratio of average interest-earning assets to average total assets. This ratio was 91.5% and 90.2% for the first quarter of 2012 and 2011, respectively.
Provision for Loan Losses:
The PFLL is the periodic cost of providing an allowance for probable and inherent losses in our loan portfolio. The ALL consists of specific and general components. Our internal risk system is used to identify loans that meet the criteria for being “impaired” as defined in the accounting guidance. The specific component relates to loans that are individually classified as impaired and where expected cash flows are less than carrying value. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. These qualitative factors include: 1) changes in the nature, volume and terms of loans, 2) changes in lending personnel, 3) changes in the quality of the loan review function, 4) changes in nature and volume of past-due, nonaccrual and/or classified loans, 5) changes in concentration of credit risk, 6) changes in economic and industry conditions, 7) changes in legal and regulatory requirements, 8) unemployment and inflation statistics, and 9) changes in underlying collateral values.
The PFLL for the quarter ended March 31, 2012 was $1.8 million compared to $1.3 million for the first quarter of 2011. New impairments of $1.5 million on loans not previously identified, with associated loan balances of $7.8 million, were recorded during the first quarter of 2012. Included in those amounts is an impairment of $1.3 million on loan balances of $4.8 million on a credit relationship in the hospitality industry. Collateral for the related loans consists of three hotel properties in the Green Bay region.
Net loan charge-offs for the first three months of 2012 and 2011 were $1.1 million and $0.7 million, respectively. A charge-off of $0.6 million was recorded on a loan transferred to foreclosed properties during the first quarter of 2012. The loan was a nonperforming loan at December 31, 2011 with no allocation for loan losses. An additional charge-off of $0.2 million was recorded on a $3.2 million credit relationship for advances made for the payment of real estate taxes to protect our security interest in the collateral securing the loan. This credit was transferred to nonperforming loans during the first quarter of 2012. Net annualized charge-offs to average loans were 0.72% for the first three months of 2012 compared to 0.45% for the same period in 2011. For the three months ended March 31, 2012, nonperforming loans increased by $2.9 million (14.8%) to $22.5 million from $19.6 million at December 31, 2011. Refer to the “Financial Condition - Risk Management and the Allowance for Loan Losses” and “Financial Condition - Nonperforming Loans, Potential Problem Loans and Foreclosed Properties” sections below for more information related to nonperforming loans. Our management believes that the ALL at March 31, 2012 and the related PFLL charged to earnings for the quarter and three months ended March 31, 2012 are appropriate in light of the present condition of the loan portfolio and the amount and quality of the collateral supporting nonperforming loans. We continue to monitor nonperforming loan relationships and will make additional PFLLs, as necessary, if the facts and circumstances change. In addition, a decline in the quality of our loan portfolio as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the ALL. If there are significant charge-offs against the ALL, or we otherwise determine that the ALL is inadequate or our estimates are different than our regulators’ estimates, we will need to make additional PFLLs in the future.
The following table reflects the various components of noninterest income for the three month periods ended March 31, 2012 and 2011, respectively.
(Dollar amounts in thousands)
Noninterest income increased $0.4 million (16.5%) for the three months ended March 31, 2012 versus the comparable period in 2011. The gain resulted when securities were sold primarily to provide additional cash for potential business opportunities being considered and secondarily, to take advantage of opportunities to restructure a portion of the investment portfolio. These gains were realized to enhance our cash position as we explore potential strategic business opportunities. Partially offsetting the increase is a reduction of $0.1 million in financial services income due to reduced brokerage activity when compared to the similar period one year ago.
The following table reflects the various components of noninterest expense for the three months ended March 31, 2012 and 2011, respectively.
(Dollar amounts in thousands)
Total noninterest expense decreased $0.9 million (10.1%) for the three months ended March 31, 2012 compared to the same period in 2011. The noninterest expense to average assets ratio was 2.9% for the three months ended March 31, 2012 compared to 3.4% for the same period in 2011.
Net overhead expense is total noninterest expense less total noninterest income. The net overhead expense to average assets ratio was at 1.8% for the three months ended March 31, 2012 compared to 1.9% for the three months ended March 31, 2011. The efficiency ratio represents total noninterest expense as a percentage of the sum of net interest income on a fully taxable equivalent basis and total noninterest income (excluding net gains on the sale of securities and premises and equipment). A lower efficiency ratio indicates a more efficient operation. The efficiency ratio improved to 71.6% for the three months ended March 31, 2012 from 80.9% for the comparable period last year. This is primarily due to a decrease of $0.9 million in noninterest expense, of which $0.4 million was related to the operation of foreclosed properties and $0.4 million was related to a decrease in FDIC insurance premiums.
Expenses related to the operation of foreclosed properties held for sale by the Bank decreased $0.4 million to $0.6 million for the three-month period ended March 31, 2012 compared to $1.0 million for the same period in 2011. The decrease consists of a $0.2 million decrease in write-downs due to the revaluation of properties held and a $0.3 million decrease in net operating expenses, partially offset by a $0.1 million decrease in the net gain on sale of foreclosed properties. We continue to evaluate all foreclosed property values and attempt to reduce the holding periods of these properties and, as a result, the related holding costs, to the extent possible. Such expenses include but are not limited to insurance, maintenance, real estate taxes, management fees, utilities and legal fees. A majority of the properties have updated valuations within the last twelve months.
Salaries and employee benefits decreased $0.1 million (2.8%) to $4.4 million for the three months ended March 31, 2012 compared to $4.5 million for the three months ended March 31, 2011. The number of full-time equivalent employees (FTEs) decreased from 304 at March 31, 2011 to 296 at March 31, 2012. Commission expense for commissioned salespersons, including financial advisors and mortgage originators, may impact future salary expense based on the levels of production attained.
Included in noninterest expense are FDIC insurance premiums of $0.4 million for the three months ended March 31, 2012 compared to $0.7 million for the same period a year ago. On February 7, 2011, the FDIC finalized a rule to change the assessment base upon which it calculates its premiums from total domestic deposits to average total assets minus average tangible equity, as required in the Dodd-Frank Act. The new base began in the second quarter of 2011, with the premium payable in September 2011. The result of the change has been a reduction in FDIC assessments.
We recorded an income tax expense of $0.5 million for the three months ended March 31, 2012 versus a nominal tax benefit for the same period in 2011. The increase in tax expense is primarily attributable to a $1.2 million year-over-year increase in pre-tax income.
We maintain significant net deferred income tax assets for deductible temporary tax differences, such as allowance for loan losses, nonaccrual loan interest, and foreclosed property valuations as well as net operating loss carry forwards. Our determination of the amount of our deferred income tax assets to be realized is highly subjective and is based on several factors, including projected future income, income tax planning strategies, and federal and state income tax rules and regulations. At March 31, 2012, we determined that no valuation allowance was required to be taken against our deferred income tax assets other than a valuation allowance to reduce our state net operating loss carry forwards to an amount which we believe the benefit will more likely than not be realized. We continue to assess the amount of tax benefits we may realize.
During the second quarter of 2011, the IRS began an audit of our 2009 federal income tax return primarily in response to our net operating loss carry back claim. In January 2012, we reached a tentative settlement agreement with the IRS to finalize the audit. We expect the audit to be finalized sometime during 2012.
The following table reflects the composition (mix) of the loan portfolio:
LOAN PORTFOLIO ANALYSIS
(Dollar amounts in thousands)
Net loans at March 31, 2012 increased $5.3 million (0.9%) from $620.4 million at December 31, 2011 to $625.7 million at March 31, 2012. The increase is primarily due to an increase of $6.4 million (7.1%) in first lien 1-4 family residential loans.
Risk Management and the Allowance for Loan Losses:
The loan portfolio is our primary asset subject to credit risk. To address this credit risk, we maintain an ALL for probable and inherent credit losses through periodic charges to our earnings. These charges are shown in our consolidated statements of operations as PFLL. See “Provision for Loan Losses” earlier in this Report. We attempt to control, monitor and minimize credit risk through the use of prudent lending standards, a thorough review of potential borrowers prior to lending and ongoing and timely review of payment performance. Asset quality administration, including early identification of loans performing in a substandard manner, as well as timely and active resolution of problems, further enhances management of credit risk and minimization of loan losses. Any losses that occur and that are charged off against the ALL are periodically reviewed with specific efforts focused on achieving maximum recovery of both principal and interest.
The ALL at March 31, 2012 was $11.3 million, compared to $10.6 million at December 31, 2011. On a quarterly basis, management reviews the adequacy of the ALL. The analysis of the ALL consists of three components: (i) specific reserves established for expected losses relating to impaired loans for which the recorded investment in the loans exceeds its fair value; (ii) general reserves based on historical loan loss experience for significant loan classes; and (iii) general reserves based on qualitative factors such as concentrations and changes in portfolio mix and volume. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized.
On a regular basis, loan officers review all commercial credit relationships. The loan officers grade commercial credits and the loan review function validates the grades assigned. In the event that the loan review function downgrades a loan, it is included in the ALL analysis process at the lower grade. This grading system is in compliance with regulatory classifications. At least quarterly, all commercial loans that have been deemed impaired are evaluated. In compliance with accounting guidance for impaired loans, the fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the market price of the loan or, if the loan is collateral dependent, the fair value of the underlying collateral less the estimated costs to sell. This evaluation may include obtaining supplemental market data and/or routine site visits to offer support to the evaluation process. A specific reserve is then allocated to the loans based on this assessment. Specific reserves are reviewed by the Chief Credit Officer (“CCO”) and management familiar with the credits.
We have two other major components of the ALL that do not pertain to specific loans: “General Reserves – Historical” and “General Reserves – Other.” We determine General Reserves – Historical based on our historical recorded charge-offs of loans in particular classes, analyzed as a group. We determine General Reserves – Other by taking into account such factors as the concentration of loans in a particular industry or geographic area and adjustments for economic indicators. By nature, our general reserve changes with our fluid lending environment and the overall economic environment in which we lend. As such, we are continually attempting to enhance this portion of the allocation process to reflect anticipated losses in our portfolio driven by these changing factors. Economic statistics, specifically unemployment and inflation rates for national, state and local markets are monitored and factored into the allocation to address repayment risk. Further identification and management of portfolio concentration risks, both by loan class and by specific markets is reflected in the general allocation component.
Nonperforming Loans, Potential Problem Loans and Foreclosed Properties:
Management encourages early identification of nonaccrual and problem loans in order to minimize the risk of loss. Nonperforming loans are defined as nonaccrual loans, loans 90 days or more past due but still accruing, and nonaccrual loans restructured in a troubled debt restructuring that haven’t shown a sufficient period of performance with the restructured terms. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collection of principal or interest on loans, it is the practice of management to place such loans on nonaccrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest or earlier as deemed appropriate. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on nonaccrual loans are used to reduce principal rather than recorded as interest income. Restructuring a loan typically involves the granting of some concession to the borrower involving a loan modification, such as payment schedule or interest rate changes. Restructured loans may involve loans that have had a charge-off taken against the loan to reduce the carrying amount of the loan to fair market value as determined pursuant to accounting guidance for troubled debt restructurings.
(Dollar amounts in thousands)
Restructured nonaccrual loans at December 31, 2011 were $4.3 million. During the first quarter of 2012, $8.0 million of restructured loans were transferred from the accruing category to the nonaccruing category. These loans were in the hospitality industry and satisfactory repayment plans could not be reached with the borrowers for future payments. At December 31, 2011, these loans were current and in compliance with the restructured loan terms. In addition, a loan in the amount of $3.8 million was transferred to foreclosed properties and a portion of the loan, $0.6 million, was charged off.
Restructured loans accruing at December 31, 2011 were $22.0 million. As previously mentioned, $8.0 million of accruing restructured loans were transferred to nonaccrual during the first quarter of 2012. In addition, $7.6 million of restructured loans were in compliance with their modified terms for a period deemed sufficient and were therefore transferred out of the restructured loan category. This reduced the accruing restructured loans to $6.5 million at March 31, 2012.
Nonperforming loans increased $2.9 million (14.7%) from December 31, 2011 to March 31, 2012 primarily due to the transfer of $8.0 million of restructured loans from the accruing category to the nonaccruing category during the first quarter of 2012. The collateral for the loans consists of four commercial properties in the hospitality industry. The nonperforming loan relationships are secured primarily by commercial or residential real estate and, secondarily, by personal guarantees from principals of the respective borrowers. Partially offsetting the increase was a decrease of $4.4 million related to a property transferred to foreclosed properties, with a portion of the loan being charged-off in the amount of $0.6 million.
Loan balances with a risk grading of 0006B or 0007 have decreased by $5.2 million since December 31, 2011. Loans in these categories are existing or potential problem loans that require management’s close attention. The decline in these troubled assets continues to be an indication of improvement in the quality of the loan portfolio. As additional evidence of the continued improvement in the overall quality of the loan portfolio, loan balances with a risk grading of 0005 or better have risen to $524.9 million as of March 31, 2012, representing 82.4% of the total loan portfolio. Loan balances with a risk grading of 0005 or better totaled $512.9 million as of December 31, 2011, representing 81.3% of the total loan portfolio.
The following table presents an analysis of our past due loans excluding nonaccrual loans:
PAST DUE LOANS (EXCLUDING NONACCRUALS)
30-89 DAYS PAST DUE
(Dollar amounts in thousands)
As indicated above, loan balances 30 to 89 days past due have increased by $2.3 million since December 31, 2011. Compared to March 31, 2011, loan balances 30 to 89 days past due have decreased $3.9 million.
Information regarding foreclosed properties is as follows:
(Dollar amounts in thousands)
Changes in the valuation allowance for losses on foreclosed properties were as follows:
The investment portfolio is intended to provide us with adequate liquidity, flexibility in asset/liability management and an increase in our earning potential.
At March 31, 2012, the investment portfolio (comprising investment securities available for sale) decreased $5.2 million (1.9%) to $279.1 million compared to $284.3 million at December 31, 2011. At March 31, 2012, the investment portfolio represented 26.1% of total assets compared to 26.2% at December 31, 2011. For the three months ended March 31, 2012, principal payments of $16.1 million and $17.1 million were received on maturing investments and the sale of investments, respectively, and a gain of $0.7 million was recognized. The gain resulted when securities were sold primarily to provide additional cash for potential business opportunities being considered and secondarily, to take advantage of opportunities to restructure a portion of the investment portfolio. We purchased $26.9 million of securities for a net cash increase of $6.3 million.
We closely monitor securities we hold in our investment portfolio that remain in an unrealized loss position for greater than twelve months. Total gross unrealized losses on these securities are $0.9 million at March 31, 2012, representing 62.9% of total gross unrealized securities losses and 0.3% of the total investment portfolio. Based on an in-depth analysis of the specific instruments, which may include ratings from external rating agencies and/or brokers, as well as the creditworthiness of the related issuers, including their ability to continue payments under the terms of the security agreements, no unrealized losses were deemed to be other-than-temporary. Additionally, we do not have the intent to sell the securities and it is not more likely than not that we will be required to sell these securities before their anticipated recovery. If at any point in time any losses are considered other-than-temporary, we would be required to recognize other-than-temporary impairment. This would require us to assess the cash flows expected to be collected from the security. The difference between the present value of the cash flows expected to be collected and the amortized cost basis would result in a credit loss for the amount of the impairment. This amount would reduce our earnings. The remaining portion of the impairment related to factors other than credit loss would be recognized through other comprehensive income (loss). At March 31, 2012 and December 31, 2011, we did not hold securities of any one issuer, other than one of the following agencies or corporations of the United States government: the Federal National Mortgage Association (“FNMA”), Government National Mortgage Association (“GNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”), or United States Department of Veterans Affairs (“VA”), in an amount greater than 10% of stockholders’ equity. As of March 31, 2012, the highest concentration of loans underlying mortgage-backed securities issued in any state was issued in California, representing approximately 23.4% of the total amount invested in mortgage-backed securities.
Total deposits at March 31, 2012 decreased $6.9 million (0.8%) to $858.3 million from $865.2 million at December 31, 2011. This decrease was a result of an $11.2 million (3.7%) decrease in time deposits from $303.5 million at December 31, 2011 to $292.3 million at March 31, 2012 and a $6.9 million (2.8%) decrease in our non-interest bearing and interest bearing demand deposits from $251.2 million at December 31, 2011 to $244.3 million at March 31, 2012, partially offset by an increase of $11.3 million (3.6%) in our savings deposits from $310.5 million at December 31, 2011 to $321.7 million at March 31, 2012. Total interest-bearing deposits decreased $9.2 million (1.2%) while non-interest-bearing deposits increased $2.3 million (2.2%) from December 31, 2011 to March 31, 2012.
Emphasis has been, and will continue to be, placed on generating additional core deposits in 2012 through competitive pricing of deposit products and through our existing branch delivery systems. We will also attempt to attract and retain core deposit accounts through new product offerings and quality customer service. If liquidity concerns arise, we have alternative sources of funds such as lines of credit with correspondent banks and borrowing arrangements with the Federal Home Loan Bank and through the discount window at the Federal Reserve.
Other Funding Sources:
Securities sold under agreements to repurchase decreased $14.3 million (30.0%) from $47.6 million at December 31, 2011 to $33.3 million at March 31, 2012. We did not have any federal funds purchased at either March 31, 2012 or December 31, 2011.
FHLB advances were $55.0 million at March 31, 2012, consistent with the balance at December 31, 2011. The availability of deposits also determines the amount of funds we need to borrow in order to fund loan demand.
Long Term Debt:
In March 2006, we issued $16.1 million of variable rate, trust preferred securities (“TruPS”) and $0.5 million of trust common securities through Baylake Capital Trust II (the “Trust”) that adjust quarterly at a rate equal to 1.35% over the three month LIBOR. At March 31, 2012, the interest rate on these securities was 1.82%. These securities were issued to replace trust preferred securities issued in 2001 through Baylake Capital Trust I. For bank regulatory purposes, these securities are considered Tier 1 capital.
The Trust’s ability to pay amounts due on the TruPS is solely dependent upon us making payment on the related subordinated debentures (“Debentures”) to the Trust. Under the terms of the Debentures, we would be precluded from paying dividends on our common stock if we were in default under the Debentures, if we exercised our right to defer payment of interest on the Debentures or if certain related defaults occurred. After discussion with our regulators during the first quarter of 2011, we exercised our right to defer payment of interest on the Debentures beginning with the March 30, 2011 interest payment, even though we had sufficient cash to make the interest payment. Our payments due June 29, 2011 and September 29, 2011 were also deferred. The expense related to the interest payment was recorded with a corresponding liability for the interest payment amount. In December of 2011, we made all payments due under the agreement, including the deferred payments. At March 31, 2012, we are current on all interest payments.
During 2009 and 2010, we completed several separate closings of a private placement of Convertible Notes. The Convertible Notes were offered and sold in reliance on the exemption from registration under Section 4(2) of the Securities Act of 1933 and Rule 506 promulgated there under. The total amount of the Convertible Notes outstanding as of the date of this report is $9.45 million.
The Convertible Notes accrue interest at a fixed rate of 10% per annum upon issuance and until maturity or earlier conversion or redemption. Interest is payable quarterly, in arrears, on January 1, April 1, July 1, and October 1, of each year. The Convertible Notes are convertible into shares of our common stock at a conversion ratio of one share of common stock for each $5.00 in aggregate principal amount held on the record date of the conversion subject to certain adjustments as described in the Convertible Notes. Prior to October 1, 2014, each holder of the Convertible Notes may convert up to 100% (at the discretion of the holder) of the original principal amount into shares of our common stock at the conversion ratio. On October 1, 2014, one-half of the original principal amounts are mandatorily convertible into common stock at the conversion ratio if voluntary conversion has not occurred. The principal amount of any Convertible Note that has not been converted will be payable at maturity on June 30, 2017. To date, none of the notes have been converted.
We use a variety of financial instruments in the normal course of business to meet the financial needs of our customers. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, and forward commitments to sell residential mortgage loans. Please refer to our Annual Report on Form 10-K for the year ended December 31, 2011 for quantitative and qualitative disclosures about our fixed and determinable contractual obligations. Contractual obligations disclosed in the 2011 Annual Report on Form 10-K have not materially changed since that Report was filed.
The following table summarizes our significant contractual obligations and commitments at March 31, 2012:
(Dollar amounts in thousands)
Off- Balance Sheet Arrangements:
The following is a summary of our off-balance sheet commitments, all of which were lending-related commitments:
LENDING RELATED COMMITMENTS
(Dollar amounts in thousands)
Subsequent to March 31, 2012, one of the properties securing a standby letter of credit for which a valuation reserve had been established was sold. The purchaser of the property assumed the existing obligations and the valuation reserve was eliminated. No additional provision for impairment was necessary.
Liquidity management refers to our ability to ensure that cash is available on a timely basis to meet loan demand and depositors’ needs and to service other liabilities as they become due without undue cost or risk and without causing a disruption to normal operating activities. We and the Bank have different liquidity considerations.
Our primary sources of funds are dividends from the Bank and net proceeds from borrowings and the offerings of subordinated debentures and convertible promissory notes. We may also undertake offerings of debt and issue our common stock if and when we deem it prudent to do so, subject to regulatory approval. We generally manage our liquidity position in order to provide funds necessary to meet interest obligations of our trust preferred securities and convertible notes, pay dividends to our shareholders, subject to regulatory restrictions, and repurchase shares. Such restrictions, which govern all state chartered banks, preclude the payment of dividends without the prior written consent of the WDFI if dividends declared and paid by such bank in either of the two immediately preceding years exceeded that bank’s net income for those years. In consultation with our federal and state regulators, our Board of Directors elected to forego the dividend to our shareholders beginning in the first quarter of 2008. In January 2012, we requested advance approval to declare a $0.01 per share dividend. We received the approval and the dividend was paid on February 10, 2012.
The Bank meets its cash flow needs by having funding sources available to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity is derived from deposit growth, payments on and maturities of loans, payments on and maturities of the investment portfolio, access to other funding sources, marketability of certain assets, the ability to use loan and investment portfolios as collateral for secured borrowings and a strong capital position.
Maturing investments have historically been a primary source of liquidity. For the three months ended March 31, 2012, principal payments totaling $16.1 million were received on maturing investments. In addition, we received proceeds of $17.1 million from the sale of investments and we purchased $26.9 million in investments in the same period. Approximately 9.6%, or $18.2 million, of the mortgage-backed securities outstanding at March 31, 2012 were issued and guaranteed by GNMA, the SBA or the VA, agencies of the United States government. An additional 67.4%, or $127.1 million, of the mortgage-backed securities outstanding at March 31, 2012 were issued by either FNMA or FHLMC, United States government-sponsored-agencies. Non-agency mortgage-backed securities present a level of credit risk that does not exist currently with United States government agency-backed securities, but only comprised approximately 22.9%, or $43.3 million, of the outstanding mortgage-backed securities at March 31, 2012. Management evaluates these non-agency mortgage-backed securities at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. These securities tend to be highly marketable.
During February 2012, proceeds of $2.1 million were received from the FHLB under their excess FHLB stock repurchase program that was implemented in 2011.
Deposit decreases, reflected as a financing activity in the March 31, 2012 Unaudited Consolidated Statements of Cash Flows, resulted in $6.9 million of cash outflow during the first three months of 2012. Deposit growth is normally the most stable source of liquidity, although brokered deposits, which are inherently less stable than locally-generated core deposits, are sometimes used. Our reliance on brokered deposits decreased $0.6 million from $46.7 million at December 31, 2011 to $46.1 million at March 31, 2012. If at any point in the future we fall below the “well capitalized” regulatory capital threshold, it will become more difficult for us to obtain brokered deposits. Also affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause a need to develop alternative sources of funds, which may not be as liquid and potentially a more costly alternative.
The scheduled payments and maturities of loans can provide a source of additional liquidity. There are $214.5 million, or 33.6% of total loans, maturing within one year of March 31, 2012. Factors affecting liquidity relative to loans are loan origination volumes, loan prepayment rates and the maturity structure of existing loans. The liquidity position is influenced by changes in interest rates, economic conditions and competition. Conversely, loan demand creates a need for liquidity that may cause us to acquire other sources of funding, some of which could be more difficult to find and more costly to secure.
Within the classification of short-term borrowings at March 31, 2012, securities sold under agreements to repurchase totaled $33.3 million compared to $47.6 million at the end of 2011. Securities sold under agreements to repurchase are obtained from a base of business customers. Short-term and long-term borrowings from the FHLB are another source of funds, totaling $55.0 million at March 31, 2012 and December 31, 2011.
In 2012, we will continue to focus on attracting and retaining core deposit accounts and expanding customer deposit relationships by emphasizing customer service and convenience and new product offerings, and competitive pricing. In the event that core deposit growth goals are not accomplished, we will continue to look at other wholesale sources of funds. In addition, we may acquire additional brokered deposits as funding for short-term liquidity needs. Short-term liquidity needs will also be addressed by growth in short-term borrowings, maturing federal funds sold and portfolio investments, and loan maturities and prepayments.
In assessing liquidity, historical information such as seasonality, local economic cycles and the economy in general are considered along with our current financial position and projections. We believe that in the current economic environment our liquidity position is adequate. To our knowledge, there are no known trends nor any known demands, commitments, events or uncertainties that will result or are reasonably likely to result in material increases or decreases in our liquidity.
Stockholders’ equity at March 31, 2012 and December 31, 2011 was $86.4 million and $84.4 million, respectively, reflecting an increase of $2.0 million (2.3%) during the first three months of 2012. The increase in stockholders’ equity was primarily related to our net income of $1.3 million and an increase in comprehensive income of $0.7 million (as a result of an increase in unrealized gains on available for sale securities). The ratio of stockholders’ equity to assets was 8.1% and 7.8% at March 31, 2012 and December 31, 2011, respectively.
No cash dividends were declared during 2011. In January 2012, we declared a $0.01 per share dividend. Subsequent to March 31, 2012, we declared a $0.01 per share dividend payable June 1, 2012. Our ability to pay dividends is subject to various factors including, among other things, sufficient earnings, available capital, board discretion and regulatory compliance. In order to pay dividends, pursuant to the Written Agreement, advance approval from the WDFI as well as the Federal Reserve Board is required. There is no assurance that we will continue to receive such approval if sought.
We regularly review the adequacy of our capital to ensure that sufficient capital is available for our current and future needs and it is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management.
The Federal Reserve has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8% of which at least half must comprise core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banks and bank holding companies must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a minimum ratio of 4% or 5%, depending on their rating. Failure to meet minimum capital requirements can initiate certain mandatory, as well as possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements. At March 31, 2012, we maintained capital in excess of the minimum ratios required to be categorized as “well capitalized” under the regulatory framework for the prompt corrective action categorization. There are no conditions or events since that date that we believe have changed our category. To be “well capitalized” under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.
Total capital to Risk-weighted Asset ratios for the previous four quarters are as follows:
Effective December 29, 2010, we and the Bank entered into the Written Agreement with the Federal Reserve Bank and WDFI, the terms of which are detailed in Note 15 to our consolidated financial statements included in Part 1, Item 1 of this Report.
As of the date of this filing, we and the Bank have complied with all terms of the Written Agreement. Specific steps taken include, but are not limited to:
Our senior management, primarily through our Chief Executive Officer, has established a regular dialogue with our lead examiner. These open communication lines provide timely feedback to us and the Bank on proposed action plans and keep our regulators updated on progress we have made.
A strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share and to provide depositor and investor confidence. We believe our capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. We actively review our capital strategies to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements.
The following tables present our and the Bank’s capital ratios as of March 31, 2012 and December 31, 2011:
Our primary market risk exposure is interest rate risk. Interest rate risk is the risk that our earnings and capital will be adversely affected by changes in interest rates. Historically, we have not used derivatives to mitigate our interest rate risk.
Our earnings are derived from the operations of our direct and indirect subsidiaries with particular reliance on net interest income, calculated as the difference between interest earned on loans and investments and the interest expense paid on deposits and other interest-bearing liabilities, including advances from FHLB and other subordinated debentures. Like other financial institutions, our interest income and interest expense are affected by general economic conditions and by the policies of regulatory authorities, including the monetary policies of the Federal Reserve. Changes in the economic environment may influence, among other matters, the growth rate of loans and deposits, the quality of the loan portfolio and loan and deposit pricing. Fluctuations in interest rates are not predictable or controllable.
As of March 31, 2012, we were in compliance with our management policies with respect to interest rate risk. We have not experienced any material changes to our market risk position since December 31, 2011, as described in our 2011 Annual Report on Form 10-K.
Our overall interest rate sensitivity is demonstrated by net interest income shock analysis which measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 100 bp to 200 bp increases and decreases in market interest rates. The table below presents our projected changes in net interest income for the various rate shock levels at March 31, 2012.
(Dollar amounts in thousands)
As shown above, at March 31, 2012, the effect of an immediate 200 bp increase in interest rates would have decreased our net interest income by $1.0 million or 3.0%. The effect of an immediate 200 bp reduction in rates would have decreased our net interest income by $1.8 million or 5.6%. However, a 200 bp reduction in rates is not realistic given the low interest rate environment that currently exists. An interest rate floor of zero is used rather than assuming a negative interest rate.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the relative levels of market interest rates and loan prepayments, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from the assumptions used in preparing the analyses. Further, the computations do not contemplate any actions we may undertake in response to changes in interest rates.
Disclosures Controls and Procedures: Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of March 31, 2012. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Internal Control Over Financial Reporting
There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
We and our subsidiaries may be involved from time to time in various routine legal proceedings incidental to our respective businesses. Neither we nor any of our subsidiaries are currently engaged in any legal proceedings that are expected to have a material adverse effect on our results of operations or financial position.
See “Risk Factors” in Item 1A of our annual report on Form 10-K for the year ended December 31, 2011. There have been no material changes to the risk factors since then.
During the quarter ended March 31, 2012, we did not sell any equity securities which were not registered under the Securities Act of 1933, as amended, or repurchase any of our equity securities.
We have several limitations on our ability to pay dividends. The Federal Reserve has adopted regulations that deal with the measure of capitalization for bank holding companies. The Federal Reserve has also issued a policy statement on the payment of cash dividends by bank holding companies, wherein the Federal Reserve has stated that a bank holding company experiencing earnings weaknesses should not pay cash dividends exceeding its net income or which could only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.
Our ability to pay dividends on our common stock is largely dependent upon the Bank’s ability to pay dividends on its stock held by us. The Bank’s ability to pay dividends is restricted by both state and federal laws and regulations. The Bank is subject to policies and regulations issued by the Federal Reserve, as the Bank’s primary federal regulator, and the Division of Banking of the WDFI, which, in part, establish minimum acceptable capital requirements for banks, thereby limiting the ability of such banks to pay dividends. In addition, Wisconsin law provides that state chartered banks may declare and pay dividends out of undivided profits but only after provision has been made for all expenses, losses, required reserves, taxes and interest accrued or due from the bank.
Our and the Bank’s payment of dividends in some circumstances may require the written consent of the Federal Reserve or the WDFI. Currently, the terms of the Written Agreement prohibit us and the Bank from declaring or paying any dividends without the prior written approval of the Federal Reserve Bank and, as to the Bank, the WDFI. We anticipate that this prior approval requirement will remain in place until the Written Agreement is lifted by the Federal Reserve Bank and the WDFI.
The following exhibits are furnished herewith:
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.