This is Pavilion Bancorp, Inc.’s (the “Company”) 2006 Annual Report to shareholders, which contains the Company’s audited consolidated financial statements and a detailed financial review. Although attached to the Company’s proxy statement, this report is not part of the Company’s proxy statement, is not deemed to be soliciting material, and is not deemed to be filed with the Securities and Exchange Commission (the “SEC”) except to the extent that it is expressly incorporated by reference in a document filed with the SEC.
The 2006 Summary Annual Report to Shareholders accompanies the proxy statement and the 2006 Annual Report to Shareholders. This report presents information concerning the business and financial results of the Company in a format and level of detail that the Company believes shareholders will find useful and informative.
Shareholders who would like to receive additional information than that contained in this 2006 Annual Report are invited to request the Company’s Annual Report on Form 10-K. Pavilion Bancorp, Inc.’s Form 10-K Annual Report to the Securities and Exchange Commission will be provided to any shareholder without charge upon written request. Requests should be addressed to Pavilion Bancorp, Inc., Attention: Melissa Covell, 135 East Maumee Street, Adrian, Michigan 49221. You may also access our Annual Report on Form 10-K from the Company’s website: www.pavilionbancorp.com.
2006 ANNUAL REPORT
CONTENTS
| SELECTED FINANCIAL DATA | 3 | ||||
| CONSOLIDATED FINANCIAL STATEMENTS | |||||
| As of December 31, 2006 and 2005 and for twelve months ended December 31, 2006, 2005 and 2004 | |||||
| - REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM | 4 | ||||
| - CONSOLIDATED BALANCE SHEETS | 5 | ||||
| - CONSOLIDATED STATEMENTS OF INCOME | 6 | ||||
| - CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY | 7 | ||||
| - CONSOLIDATED STATEMENTS OF CASH FLOWS | 8 | ||||
| - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS | 9 | ||||
| SELECTED QUARTERLY FINANCIAL DATA | 33 | ||||
| - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION | |||||
| AND RESULTS OF OPERATIONS | 36 | ||||
| - DISCLOSURE CONTROLS AND PROCEDURES | 58 | ||||
2
SELECTED FINANCIAL DATA
(In thousands, except per share data)
| 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| At year-end: | |||||||||||||||||
| Total assets | $ | 295,023 | $ | 287,881 | $ | 259,322 | $ | 323,382 | $ | 287,286 | |||||||
| Loans receivable | $ | 246,129 | $ | 237,598 | $ | 207,159 | $ | 209,467 | $ | 184,837 | |||||||
| Deposits | $ | 235,944 | $ | 210,748 | $ | 199,992 | $ | 202,366 | $ | 189,046 | |||||||
| Shareholders' equity | $ | 27,936 | $ | 26,384 | $ | 31,857 | $ | 26,524 | $ | 25,069 | |||||||
| For the year: | |||||||||||||||||
| Total interest income | $ | 18,875 | $ | 16,130 | $ | 14,885 | $ | 15,039 | $ | 16,201 | |||||||
| Total interest expense | 7,050 | 4,449 | 2,795 | 3,252 | 4,777 | ||||||||||||
| Net interest income | 11,825 | 11,681 | 12,090 | 11,787 | 11,424 | ||||||||||||
| Provision for loan losses | 333 | 342 | 693 | 595 | 667 | ||||||||||||
| Noninterest income | 3,068 | 3,277 | 3,566 | 5,840 | 5,625 | ||||||||||||
| Noninterest expense | 11,088 | 12,075 | 11,809 | 12,110 | 11,384 | ||||||||||||
| Income before income taxes | 3,472 | 2,541 | 3,154 | 4,922 | 4,998 | ||||||||||||
| Provision for income tax | 1,071 | 603 | 1,001 | 1,563 | 1,590 | ||||||||||||
| Net income from continuing operations | 2,401 | 1,938 | 2,153 | 3,359 | 3,408 | ||||||||||||
| Discontinued operation | |||||||||||||||||
| Income (loss) from operation of discontinued component | - | - | 724 | (173 | ) | (816 | ) | ||||||||||
| Gain on sale of discontinued component | - | - | 6,990 | - | - | ||||||||||||
| Provision (benefit) for income tax | - | - | 2,735 | (49 | ) | (263 | ) | ||||||||||
| Income (loss) from discontinued operation | - | - | 4,979 | (124 | ) | (553 | ) | ||||||||||
| Net income | $ | 2,401 | $ | 1,938 | $ | 7,132 | $ | 3,235 | $ | 2,855 | |||||||
| Financial ratios: | |||||||||||||||||
| From continuing operations | |||||||||||||||||
| Return on average shareholders' equity | 8.84 | % | 6.66 | % | 7.38 | % | 13.02 | % | 14.02 | % | |||||||
| Return on average assets | 0.82 | % | 0.71 | % | 0.74 | % | 1.10 | % | 1.20 | % | |||||||
| From combined operations | |||||||||||||||||
| Return on average shareholders' equity | 8.84 | % | 6.66 | % | 24.43 | % | 12.54 | % | 11.74 | % | |||||||
| Return on average assets | 0.82 | % | 0.71 | % | 2.45 | % | 1.06 | % | 1.01 | % | |||||||
| Per share data: | |||||||||||||||||
| Cash dividends declared per share | $ | 1.07 | $ | 0.96 | $ | 1.22 | $ | 1.09 | $ | 0.82 | |||||||
| Dividend payout ratio | 32.7 | % | 38.9 | % | 14.5 | % | 28.8 | % | 25.4 | % | |||||||
| Shareholders' equity per share | $ | 38.50 | $ | 35.88 | $ | 37.38 | $ | 31.37 | $ | 30.16 | |||||||
| Average equity to average assets | 9.31 | % | 10.64 | % | 10.02 | % | 8.45 | % | 8.59 | % | |||||||
| Earnings per share from continuing operations | |||||||||||||||||
| Basic | $ | 3.27 | $ | 2.47 | $ | 2.54 | $ | 3.92 | $ | 3.85 | |||||||
| Diluted | $ | 3.26 | $ | 2.45 | $ | 2.52 | $ | 3.89 | $ | 3.83 | |||||||
| Earnings per share from discontinued operation | |||||||||||||||||
| Basic | $ | - | $ | - | $ | 5.88 | $ | (0.14 | ) | $ | (0.63 | ) | |||||
| Diluted | $ | - | $ | - | $ | 5.82 | $ | (0.14 | ) | $ | (0.62 | ) | |||||
| Net earnings per share | |||||||||||||||||
| Basic | $ | 3.27 | $ | 2.47 | $ | 8.42 | $ | 3.78 | $ | 3.23 | |||||||
| Diluted | $ | 3.26 | $ | 2.45 | $ | 8.34 | $ | 3.75 | $ | 3.21 | |||||||
All per share data has been adjusted to reflect stock splits and stock dividends, including a 5% stock dividend declared on December 19, 2003 and issued January 30, 2004.
3
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Shareholders
Pavilion Bancorp, Inc.
We have audited the accompanying balance sheets of Pavilion Bancorp, Inc. as of December 31, 2006 and 2005, and the related statements of income, shareholders’equity, and cash flows for each year in the three-year period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement preparation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Pavilion Bancorp, Inc. as of December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each year in the three-year period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
| /s/ Plante & Moran, PLLC Plante & Moran, PLLC |
Auburn Hills, Michigan
March 9, 2007
4
| (000’s omitted) | December 31, | |||||||
|---|---|---|---|---|---|---|---|---|
| ASSETS | 2006 | 2005 | ||||||
| Cash and cash equivalents | $ | 17,210 | $ | 11,308 | ||||
| Securities available for sale (Note 2) | 17,828 | 25,407 | ||||||
| Federal Home Loan Bank, Freddie Mac, FNMA stock | 2,053 | 2,795 | ||||||
| Federal Reserve Bank stock | 630 | 630 | ||||||
| Loans held for sale | 377 | 927 | ||||||
| Loans (Note 3) | 246,129 | 237,598 | ||||||
| Less: allowance for loan and lease losses (Note 4) | (2,817 | ) | (2,683 | ) | ||||
| Net loans | 243,312 | 234,915 | ||||||
| Premises and equipment - net (Note 6) | 8,175 | 6,135 | ||||||
| Accrued interest receivable | 1,930 | 1,651 | ||||||
| Mortgage servicing rights (Note 5) | 2,558 | 2,898 | ||||||
| Other assets | 950 | 1,215 | ||||||
| Total assets | $ | 295,023 | $ | 287,881 | ||||
| LIABILITIES AND SHAREHOLDERS' EQUITY | ||||||||
| LIABILITIES | ||||||||
| Deposits | ||||||||
| Noninterest bearing | $ | 46,291 | $ | 45,353 | ||||
| Interest-bearing (Note 7) | 189,653 | 165,395 | ||||||
| Total deposits | 235,944 | 210,748 | ||||||
| Federal funds purchased (Note 8) | 6,601 | 9,000 | ||||||
| Repurchase agreements (Note 8) | 7,700 | 13,663 | ||||||
| Federal Home Loan Bank advances (Note 8) | 10,885 | 16,901 | ||||||
| Accrued interest payable | 851 | 667 | ||||||
| Other liabilities | 2,341 | 2,529 | ||||||
| Subordinated debentures (Note 9) | - | 5,000 | ||||||
| Common stock in ESOP subject to repurchase obligation | ||||||||
| (Note 11) | 2,765 | 2,989 | ||||||
| Total liabilities | 267,087 | 261,497 | ||||||
| SHAREHOLDERS' EQUITY (Notes 17 and 18) | ||||||||
| Common stock and paid-in capital, no par value: | ||||||||
| 3,000,000 shares authorized; shares issued | ||||||||
| and outstanding: 725,206-2006; 735,379-2005 | 10,629 | 10,724 | ||||||
| Retained earnings | 17,409 | 15,963 | ||||||
| Accumulated other comprehensive loss | (102 | ) | (303 | ) | ||||
| Total shareholders' equity | 27,936 | 26,384 | ||||||
| Total liabilities and shareholders' equity | $ | 295,023 | $ | 287,881 | ||||
See accompanying notes to the consolidated financial statements.
5
| (000’s omitted, except per share data) | 2006 | 2005 | 2004 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Interest and dividend income | |||||||||||
| Loans receivable, including fees | $ | 17,711 | $ | 14,951 | $ | 13,914 | |||||
| Debt securities: | |||||||||||
| Taxable | 701 | 780 | 664 | ||||||||
| Tax-exempt | 95 | 135 | 120 | ||||||||
| Federal funds sold | 206 | 118 | 47 | ||||||||
| Dividend income | 162 | 146 | 140 | ||||||||
| Total interest and dividend income | 18,875 | 16,130 | 14,885 | ||||||||
| Interest expense | |||||||||||
| Deposits | 5,467 | 3,334 | 2,144 | ||||||||
| Subordinated debentures | 419 | 359 | 285 | ||||||||
| Other borrowed funds | 1,164 | 756 | 366 | ||||||||
| Total interest expense | 7,050 | 4,449 | 2,795 | ||||||||
| Net interest income | 11,825 | 11,681 | 12,090 | ||||||||
| Provision for loan losses (Note 4) | 333 | 342 | 693 | ||||||||
| Net interest income after provision for loan losses | 11,492 | 11,339 | 11,397 | ||||||||
| Noninterest income | |||||||||||
| Service charges and fees | 1,354 | 1,318 | 1,431 | ||||||||
| Net gain on sale of loans | 976 | 1,390 | 1,516 | ||||||||
| Loan servicing fees, net of amortization (Note 5) | 97 | 287 | 500 | ||||||||
| Other | 641 | 282 | 119 | ||||||||
| Total noninterest income | 3,068 | 3,277 | 3,566 | ||||||||
| Noninterest expense | |||||||||||
| Compensation and employee benefits (Note 11) | 6,217 | 7,194 | 7,209 | ||||||||
| Occupancy and equipment | 1,502 | 1,449 | 1,417 | ||||||||
| Postage and delivery | 297 | 300 | 305 | ||||||||
| Professional services | 536 | 673 | 301 | ||||||||
| Outside services | 1,171 | 1,038 | 1,026 | ||||||||
| Marketing and advertising | 166 | 272 | 342 | ||||||||
| Loan and collection | 298 | 343 | 322 | ||||||||
| Director and shareholders (Note 12) | 184 | 191 | 175 | ||||||||
| Other | 717 | 615 | 712 | ||||||||
| Total noninterest expense | 11,088 | 12,075 | 11,809 | ||||||||
| Income from continuing operations before income taxes | 3,472 | 2,541 | 3,154 | ||||||||
| Income taxes from continuing operations (Note 10) | 1,071 | 603 | 1,001 | ||||||||
| Income from continuing operations | 2,401 | 1,938 | 2,153 | ||||||||
| Discontinued operation: | |||||||||||
| Income (loss) from discontinued operation, | |||||||||||
| net of income taxes of $0, $0, and $162 | - | - | 562 | ||||||||
| Gain on sale of discontinued component, net of | |||||||||||
| income tax expense of $0, $0, and $2,573 | - | - | 4,417 | ||||||||
| Income (loss) from discontinued operation | - | - | 4,979 | ||||||||
| Net income | $ | 2,401 | $ | 1,938 | $ | 7,132 | |||||
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Earnings per share from continuing operations | |||||||||||
| Basic | $ | 3.27 | $ | 2.47 | $ | 2.54 | |||||
| Diluted | $ | 3.26 | $ | 2.45 | $ | 2.52 | |||||
| Earnings per share from discontinued operation | |||||||||||
| Basic | $ | - | $ | - | $ | 5.88 | |||||
| Diluted | $ | - | $ | - | $ | 5.82 | |||||
| Net earnings per share | |||||||||||
| Basic | $ | 3.27 | $ | 2.47 | $ | 8.42 | |||||
| Diluted | $ | 3.26 | $ | 2.45 | $ | 8.34 | |||||
See accompanying notes to the consolidated financial statements.
6
| (000’s omitted) | Common Stock Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income (Loss) | Total Shareholders' Equity | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Balance January 1, 2004 | $ | 10,675 | $ | 15,616 | $ | 233 | $ | 26,524 | ||||||
| Comprehensive income: | ||||||||||||||
| Net income | - | 7,132 | - | 7,132 | ||||||||||
| Unrealized gains (losses) on securities | - | - | (423 | ) | ||||||||||
| Tax effect | - | - | 144 | |||||||||||
| Total other comprehensive income | - | - | (279 | ) | (279 | ) | ||||||||
| Total comprehensive income | - | - | 6,853 | |||||||||||
| Change in common stock subject to repurchase | (745 | ) | - | - | (745 | ) | ||||||||
| Retirement of stock | (1 | ) | - | - | (1 | ) | ||||||||
| Stock option expense | 43 | - | - | 43 | ||||||||||
| Stock options exercised | 218 | - | - | 218 | ||||||||||
| Cash dividends - $1.22 per share | - | (1,035 | ) | - | (1,035 | ) | ||||||||
| Balance December 31, 2004 | 10,190 | 21,713 | (46 | ) | 31,857 | |||||||||
| Comprehensive income: | ||||||||||||||
| Net income | - | 1,938 | - | 1,938 | ||||||||||
| Unrealized gains (losses) on securities | - | - | (389 | ) | ||||||||||
| Tax effect | - | - | 132 | |||||||||||
| Total other comprehensive income | - | - | (257 | ) | (257 | ) | ||||||||
| Total comprehensive income | - | - | 1,681 | |||||||||||
| Change in common stock subject to repurchase | 1,555 | - | - | 1,555 | ||||||||||
| Stock repurchase and retirement | (1,566 | ) | (6,952 | ) | - | (8,518 | ) | |||||||
| Stock option expense | 16 | - | - | 16 | ||||||||||
| Stock options exercised | 529 | - | - | 529 | ||||||||||
| Cash dividends - $0.96 per share | - | (736 | ) | - | (736 | ) | ||||||||
| Balance December 31, 2005 | 10,724 | 15,963 | (303 | ) | 26,384 | |||||||||
| Comprehensive income: | ||||||||||||||
| Net income | - | 2,401 | - | 2,401 | ||||||||||
| Unrealized gains (losses) on securities | - | - | 305 | |||||||||||
| Tax effect | - | - | (104 | ) | ||||||||||
| Total other comprehensive income | - | - | 201 | 201 | ||||||||||
| Total comprehensive income | - | - | 2,602 | |||||||||||
| Change in common stock subject to repurchase | (87 | ) | - | - | (87 | ) | ||||||||
| Retirement of stock | (77 | ) | (173 | ) | - | (250 | ) | |||||||
| Issuance of stock | 10 | 10 | ||||||||||||
| Stock option expense | 22 | - | - | 22 | ||||||||||
| Stock options exercised | 37 | - | - | 37 | ||||||||||
| Cash dividends - $1.07 per share | - | (782 | ) | - | (782 | ) | ||||||||
| Balance December 31, 2006 | $ | 10,629 | $ | 17,409 | $ | (102 | ) | $ | 27,936 | |||||
See accompanying notes to the consolidated financial statements.
7
| (000’s omitted) | 2006 | 2005 | 2004 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Cash flows from operating activities | |||||||||||
| Net income | $ | 2,401 | $ | 1,938 | $ | 7,132 | |||||
| Adjustments to reconcile net income to | |||||||||||
| net cash from operating activities | |||||||||||
| Depreciation | 715 | 688 | 579 | ||||||||
| Stock option expense | 22 | 16 | 43 | ||||||||
| Stock award expense | 10 | - | - | ||||||||
| Provision for loan losses | 333 | 342 | 693 | ||||||||
| Gain on sale of discontinued operation | - | - | (6,990 | ) | |||||||
| Deferred income tax (benefit) provision | (304 | ) | (161 | ) | 483 | ||||||
| Amortization on investment securities available for sale | 21 | 34 | 188 | ||||||||
| Net loss on disposal of assets | 9 | 89 | - | ||||||||
| Amortization of mortgage servicing rights | 858 | 663 | 444 | ||||||||
| Origination of mortgage loans held for sale | (42,407 | ) | (60,122 | ) | (85,788 | ) | |||||
| Proceeds from sales of mortgage loans held for sale | 43,415 | 60,173 | 86,884 | ||||||||
| Net gains on sale of mortgage loans | (976 | ) | (1,390 | ) | (1,207 | ) | |||||
| Net change in: | |||||||||||
| Deferred loan origination fees | (14 | ) | (17 | ) | - | ||||||
| Accrued interest receivable and other assets | (430 | ) | (63 | ) | 396 | ||||||
| Accrued interest payable and other liabilities | 119 | (1,684 | ) | (6,921 | ) | ||||||
| Net cash provided by (used in) operating activities | 3,772 | 506 | (4,064 | ) | |||||||
| Cash flows from investing activities | |||||||||||
| Proceeds from: | |||||||||||
| Maturities, calls and principal payments on | |||||||||||
| securities available for sale | 7,861 | 5,233 | 8,349 | ||||||||
| Sales of securities available for sale | 990 | - | - | ||||||||
| Federal Home Loan Bank stock | 742 | - | - | ||||||||
| Federal Reserve Bank stock | - | - | 21 | ||||||||
| Proceeds from the disposition of premises and equipment | 1 | 161 | 511 | ||||||||
| Proceeds from sale of discontinued operation | - | - | 15,101 | ||||||||
| Purchases of: | |||||||||||
| Securities available for sale | (996 | ) | (3,165 | ) | (16,410 | ) | |||||
| Federal Home Loan Bank stock | - | (57 | ) | (137 | ) | ||||||
| Federal Reserve Bank stock | - | (270 | ) | - | |||||||
| Premises and equipment, net | (2,756 | ) | (1,346 | ) | (1,407 | ) | |||||
| Net (increase) decrease in loans | (8,348 | ) | (30,348 | ) | 1,726 | ||||||
| Recoveries on loans charged-off | 47 | 67 | 82 | ||||||||
| Net cash (used in) provided by investing activities | (2,459 | ) | (29,725 | ) | 7,836 | ||||||
| Cash flows from financing activities | |||||||||||
| Net change in deposits | 25,196 | 10,756 | (2,374 | ) | |||||||
| Net change in short term borrowings | (8,362 | ) | 18,731 | 682 | |||||||
| Redemption of subordinated debentures | (5,000 | ) | - | - | |||||||
| Proceeds from FHLB advances | 40,400 | 16,800 | 2,000 | ||||||||
| Repayment of FHLB advances | (46,416 | ) | (8,485 | ) | (635 | ) | |||||
| Redemption of ESOP/401k shares | (311 | ) | - | - | |||||||
| Repurchase and retirement of common stock | (250 | ) | (8,518 | ) | - | ||||||
| Stock options exercised | 37 | 529 | 218 | ||||||||
| Dividends paid | (705 | ) | (986 | ) | (1,035 | ) | |||||
| Net cash provided by (used in) financing activities | 4,589 | 28,827 | (1,144 | ) | |||||||
| Net change in cash and cash equivalents | 5,902 | (392 | ) | 2,628 | |||||||
| Cash and cash equivalents at beginning of year | 11,308 | 11,700 | 9,072 | ||||||||
| Cash and cash equivalents at end of year | $ | 17,210 | $ | 11,308 | $ | 11,700 | |||||
| Supplemental schedule of noncash activities | |||||||||||
| Transfer from: Loans to foreclosed real estate | $ | 416 | $ | 295 | $ | 914 | |||||
| Cash paid for: | Interest | $ | 6,866 | $ | 4,015 | $ | 3,894 | ||||
| Income taxes | $ | 1,268 | $ | 2,615 | $ | 805 |
See accompanying notes to the consolidated financial statements.
8
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of Pavilion Bancorp, Inc. (the “Company”) and its wholly-owned subsidiary, Bank of Lenawee (the “Bank”), conform to accounting principles generally accepted in the United States of America and to general practice within the banking industry. The following describes the significant accounting and reporting policies which are employed in the preparation of the consolidated financial statements.
Principles of Consolidation: The consolidated financial statements include the accounts of the Company, the Bank and the Bank’s wholly-owned subsidiaries, Pavilion Mortgage Company and Pavilion Financial Services, Inc. All significant intercompany balances and transactions have been eliminated in consolidation.
Discontinued Operation: On July 16, 2004 Pavilion Bancorp, Inc. announced that it had signed a definitive agreement to sell the Bank of Washtenaw for $15,101,000 in cash. The sale was completed on October 29, 2004. In accordance with Financial Accounting Standard 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the financial position and results of operations of the Bank of Washtenaw are removed from the detail line items in the Company’s consolidated financial statements and presented separately as “discontinued operation.” Please refer to Note 16 to the Company’s Consolidated Financial Statements for additional information.
Nature of Operations and Industry Segments: The Company is a one-bank holding Company which conducts limited business activities. The Bank performs the majority of business activities.
The Bank provides a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in its service area. The Bank maintains a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking accounts, savings accounts, money market accounts, individual retirement accounts and certificates of deposit. Pavilion Mortgage Company originates personal mortgage loans, and the majority of the mortgage loans originated are sold on the secondary market. Pavilion Financial Services, Inc. owns interests in a title insurance and mortgage reinsurance agency. While the Company monitors the revenue stream of various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company’s banking operations are considered by management to be aggregated into one operating segment. The principal markets for the Bank’s financial services are the communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through its offices located in Lenawee and Hillsdale Counties in Michigan.
Use of Estimates: The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America. Management is required to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates and assumptions. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan and lease losses, foreclosed assets, impaired loans, deferred tax assets, mortgage servicing rights and fair value of securities and other financial instruments.
Cash and Cash Equivalents: For the purpose of the consolidated statement of cash flow cash and cash equivalents include cash on hand, demand deposits with other financial institutions, federal funds sold and commercial paper, all of which mature within 90 days.
9
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Securities: Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. There were no such investments at December 31, 2006 and 2005. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of securities held to maturity and securities available for sale below their cost that are deemed to be other than temporary (if any) are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been impacted, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Federal Home Loan Bank Stock and Federal Reserve Bank Stock: Federal Home Loan Bank stock (“FHLBI stock”) and Federal Reserve Bank stock (“FRB stock”) are considered restricted investment securities and are carried at cost. Purchases and sales of FHLBI stock are made directly with the FHLBI at par value. Purchases and sales of FRB stock are made directly with the Federal Reserve at par value.
Mortgage Banking Activities: The Company routinely sells to investors its originated long-term residential fixed rate mortgage loans. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.
Mortgage loans held for sale are generally sold with the mortgage servicing rights retained by the Company. The carrying value of mortgage loans sold is reduced by the cost allocated to the associated mortgage servicing rights. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the adjusted carrying value of the related mortgage loans sold.
Loans Held for Sale: Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income.
Loans: The Company grants mortgage, commercial and consumer loans to customers. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan and lease losses and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
Accrual of interest on loans is generally discontinued at the time a loan becomes 90 days delinquent in its payments, unless the credit is well-secured and in the process of collection. Loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.
Uncollected accrued interest attributable to the current fiscal year on loans that are placed on nonaccrual or charged-off is reversed against interest income. Uncollected accrued interest attributable to prior fiscal year(s) is reversed against the allowance for loan and lease losses. The interest on these loans is accounted for on the cash-basis, until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan and Lease Losses: The allowance for loan and lease losses (the “allowance”) is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines the uncollectibility of a loan balance. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan and lease losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of
10
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
historical experience, industry experience, regulatory guidance, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of specific, general, and unallocated components. The specific components relate to certain loans that are classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower that the carrying value of that loan. The general component covers classified and non-classified loans and is based on industry experience, regulatory guidance, and historical loss experience, adjusted for certain qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral, if the loan is collateral dependent.
Large groups of homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.
Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets.
Loan Servicing: Servicing assets are recognized as separate assets when rights are acquired through the sale of originated residential mortgage loans. Capitalized servicing rights are reported in other assets and are amortized against noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type and investor type. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or on a valuation model that calculates the present value of estimated future net servicing income using market based assumptions. Temporary impairment is recognized through a valuation allowance for an individual stratum to the extent that fair value is less than the capitalized amount for the stratum. If it is later determined that all or a portion of the temporary impairment no longer exists, the valuation allowance is reduced through a recovery of income. An other than temporary impairment results in a permanent reduction to the carrying value of the servicing asset.
Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal, or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.
11
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Foreclosed Assets: Assets acquired through, or in lieu of, foreclosure are held-for-sale and are initially recorded at fair value (less cost to sell) at the date of the foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets. Other real estate owned amounts to $169,000 and $549,000 at December 31, 2006 and 2005 and are included in other assets.
Repurchase Agreements: Repurchase agreement liabilities represent amounts advanced by two third party financial institutions as well as various Bank customers. Repurchase agreements are collateralized with securities owned by the Bank of Lenawee. Securities pledged as collateral for repurchase agreements are held in safekeeping at independent correspondent banks. Repurchase agreements are not covered by federal deposit insurance.
Benefit Plans: A defined benefit pension plan covers substantially all employees, with benefits based on years of service and compensation prior to retirement. The Company also maintains a profit-sharing and 401(k) plan. The profit-sharing and 401(k) plan expense and the amount contributed are determined by the Board of Directors. Employee benefits are discussed further in Note 11.
Stock-Based Compensation: In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment,” which requires that compensation costs related to share-based payment transactions be recognized in the financial statements. SFAS 123R eliminates the alternative to use the intrinsic method of accounting provided for in Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees or directors if certain conditions were met.
On January 1, 2006, the Company adopted SFAS 123R using the modified prospective method. SFAS 123R requires all share-based payments to employees or non-employee directors, including stock options, to be recognized as expense in the consolidated statement of earnings based on their fair values. Prior to SFAS 123R, only certain pro forma disclosures were required. The amount of compensation is measured at fair value of the options when granted, and this cost is expensed over the required service period, which is normally the vesting period of the options. SFAS 123R applies to awards granted or modified after January 1, 2006 or any unvested awards outstanding at December 31, 2005. Consequently, compensation cost is recorded for prior option grants that vest on or after January 1, 2006, the date of adoption.
12
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
The following table illustrates the effect on net income and earnings per share as of and for the years ended December 31, 2006, 2005 and 2004 if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based compensation (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net income as reported | $ | 2,401 | $ | 1,938 | $ | 7,132 | |||||
| Add: Stock-based compensation expense included in reported net income, net of related tax effects | 15 | 11 | 28 | ||||||||
| Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects | (15 | ) | (74 | ) | (65 | ) | |||||
| Pro forma net income | $ | 2,401 | $ | 1,875 | $ | 7,095 | |||||
| Basic earnings per share - As reported | $ | 3.27 | $ | 2.47 | $ | 8.42 | |||||
| Basic earnings per share - Pro forma | $ | 3.27 | $ | 2.38 | $ | 8.34 | |||||
| Diluted earnings per share - As reported | $ | 3.26 | $ | 2.45 | $ | 8.34 | |||||
| Diluted earnings per share - Pro forma | $ | 3.26 | $ | 2.37 | $ | 8.30 | |||||
Advertising Expenses: Advertising expenses are expensed as incurred.
Income Taxes: Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the various temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
Earnings per Common Share: Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.
13
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Earnings per common share have been computed based on the following (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net income | $ | 2,401 | $ | 1,938 | $ | 7,132 | |||||
| Average number of common shares outstanding | |||||||||||
| used to calculate basic earnings per share | 734,352 | 785,117 | 846,221 | ||||||||
| Effect of dilutive options | 1,680 | 4,762 | 8,682 | ||||||||
| Average number of common shares outstanding | |||||||||||
| used to calculate diluted earnings per | |||||||||||
| common share | 736,032 | 789,879 | 854,903 | ||||||||
| Number of antidilutive stock options | |||||||||||
| excluded from the diluted earnings per share | |||||||||||
| computation | 21,215 | 5,250 | - | ||||||||
Other Comprehensive Income: Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet. Such items, along with net income, are components of comprehensive income.
Financial Instruments with Off-Balance Sheet Risk: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby letters of credit issued to meet customers’ needs. The face amount for these items represents the exposure to loss before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Fair Values of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on and off-balance-sheet financial instruments does not include the value of anticipated future business or values of assets and liabilities not considered financial instruments.
Reclassifications: Certain amounts appearing in the prior year’s financial statements have been reclassified to conform to the current year’s financial statements.
14
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Recent Accounting Pronouncements:
Servicing of Financial Assets
In March 2006, the Financial Accounting Standards Board issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” an amendment of FASB Statement No. 140. SFAS No. 156 requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract. It requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value. SFAS No. 156 permits an entity to choose either an amortization or fair value measurement method for each class of separately recognized servicing assets and servicing liabilities. It also permits a one-time reclassification of available-for-sale securities to trading securities with recognized servicing rights. Lastly, it requires separate presentation of servicing assets and servicing liabilities. Adoption of the initial measurement provision of this statement is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. Management intends to implement the initial fair value recognition provisions of this pronouncement beginning January 1, 2007, but is still evaluating whether to continue with the amortization method for subsequent measurement or elect the fair value subsequent measurement method.
Accounting for Uncertainty in Income Taxes
In July 2006, the Financial Accounting Standards Board issued FIN No. 48, “Accounting for Uncertainty in Income Taxes.”This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. This interpretation requires that the Company recognize in the financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. This interpretation is effective for fiscal years beginning after December 15, 2006 and would be recognized with the cumulative effect of the change in accounting principle recorded as an adjustment to beginning retained earnings. Adoption of this interpretation is not expected to have a material effect on the results of operations or financial condition of the Company.
Establishing Standards on Measuring Fair Value
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP, and expands disclosures about fair value measurements. The Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. The statement emphasizes that fair value is a market-based measurement and not an entity-specific measurement. The statement establishes a fair value hierarchy used in fair value measurements and expands the required disclosures of assets and liabilities measured at fair value. Management will be required to adopt this statement beginning in 2008. The adoption of this standard is not expected to have a material impact on the Company’s financial condition, results of operations or liquidity.
Accounting for Defined Benefit Pension and Other Postretirement Plans
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other PostretirementPlans.” SFAS No. 158 amends SFAS No. 87, 88, 106, and 123(R). SFAS No. 158 requires employers to recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status. Secondly, it requires employers to measure the plan assets and obligations that determine its funded status as of the end of the fiscal year. Lastly, employers are required to recognize changes in the funded status of the defined benefit pension or postretirement plan in the year that the changes occur with the changes reported in comprehensive income. The standard is required to be adopted by entities having fiscal years ending after December 15, 2006. The Company is a participant in a multi-employer defined benefit plan, which is not within the scope of this pronouncement. This standard is not expected to have an impact on the Company’s financial condition, results of operations or liquidity.
15
NOTE 2 — SECURITIES
The amortized cost and estimated fair market value of available-for-sale securities are as follows at December 31, 2006 and 2005 (000’s omitted):
| Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Estimated Market Value | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2006 | ||||||||||||||
| U.S. Treasury & government agencies | $ | 14,496 | $ | 7 | $ | 169 | $ | 14,334 | ||||||
| Obligations of states & political subdivisions | 2,507 | 34 | 14 | 2,527 | ||||||||||
| Mortgage-backed securities | 979 | - | 12 | 967 | ||||||||||
| Total available for sale securities | $ | 17,982 | $ | 41 | $ | 195 | $ | 17,828 | ||||||
| 2005 | ||||||||||||||
| U.S. Treasury & government agencies | $ | 20,164 | $ | - | $ | 441 | $ | 19,723 | ||||||
| Obligations of states & political subdivisions | 4,350 | 31 | 32 | 4,349 | ||||||||||
| Mortgage-backed securities | 1,353 | 5 | 23 | 1,335 | ||||||||||
| Total available for sale securities | $ | 25,867 | $ | 36 | $ | 496 | $ | 25,407 | ||||||
Contractual maturities of securities at December 31, 2006 are as follows. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately (000’s omitted):
| Available-for-Sale | ||||||||
|---|---|---|---|---|---|---|---|---|
| Amortized Cost | Market Value | |||||||
| Due in one year or less | $ | 14,530 | $ | 14,353 | ||||
| Due from one to five years | 1,523 | 1,525 | ||||||
| Due from five to ten years | 550 | 564 | ||||||
| Due after ten years | 400 | 419 | ||||||
| Total debt securities | 17,003 | 16,861 | ||||||
| Mortgage-backed securities | 979 | 967 | ||||||
| Total | $ | 17,982 | $ | 17,828 | ||||
16
NOTE 2 — SECURITIES(continued)
Information pertaining to securities with gross unrealized losses at December 31, 2006 and 2005, aggregated by investment category and length of time that individual securities have been in a continuous loss position are as follows (000’s omitted):
| At December 31, 2006 | Less Than Twelve Months | Twelve Months or More | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | |||||||||||
| Available-for-sale securities: | ||||||||||||||
| U.S. treasury & government agencies | $ | - | $ | - | $ | 169 | $ | 13,330 | ||||||
| Obligations of states & political | ||||||||||||||
| subdivisions | - | - | 14 | 1,241 | ||||||||||
| Mortgage-backed securities | - | - | 12 | 706 | ||||||||||
| Total available-for-sale securities | $ | - | $ | - | $ | 195 | $ | 15,277 | ||||||
| At December 31, 2005 | Less Than Twelve Months | Twelve Months or More | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Gross Unrealized Losses | Fair Value | Gross Unrealized Losses | Fair Value | |||||||||||
| Available-for-sale securities: | ||||||||||||||
| U.S. treasury & government agencies | $ | - | $ | - | $ | 441 | $ | 19,723 | ||||||
| Obligations of states & political | ||||||||||||||
| subdivisions | 10 | 1,676 | 22 | 1,230 | ||||||||||
| Mortgage-backed securities | - | - | 23 | 915 | ||||||||||
| Total available-for-sale securities | $ | 10 | $ | 1,676 | $ | 486 | $ | 21,868 | ||||||
Unrealized losses on securities are considered temporary by management and have not been recognized into income because the issuers’ bonds are of high credit quality, the Company has the intent and ability to hold the securities for the foreseeable future, and the decline in fair value is primarily due to increased market interest rates. The fair value is expected to recover as the bonds approach the maturity date.
Securities with a fair value of approximately $13,431,000 and $16,102,000 at December 31, 2006 and 2005 were pledged to secure repurchase agreements and other borrowings. Of the $13,431,000 pledged in 2006, $13,133,000 was pledged to secure repurchase agreements with third party financial institutions and certain customers and $298,000 was pledged to the Federal Reserve Bank as security for treasury tax and loan (TT&Ls) accounts.
NOTE 3 – LOANS RECEIVABLE
Major categories of loans in the portfolio are as follows at December 31, 2006 and 2005 (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Commercial | $ | 133,545 | $ | 125,378 | ||||
| Agricultural | 39,656 | 38,778 | ||||||
| Residential mortgage | 30,255 | 28,113 | ||||||
| Residential construction | 10,896 | 11,902 | ||||||
| Home equity lines of credit | 19,163 | 20,693 | ||||||
| Consumer | 12,614 | 12,734 | ||||||
| Total loans receivable | $ | 246,129 | $ | 237,598 | ||||
17
NOTE 3 – LOANS RECEIVABLE(continued)
Certain directors and executive officers of the Company, including associates of such persons, were loan customers of the Company during 2006 and 2005. A summary of aggregate related-party loan activity for loans aggregating $50,000 or more to any related party at December 31, 2006 and 2005 is as follows (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Balance at January 1 | $ | 4,925 | $ | 5,140 | ||||
| New loans | 68 | 1,440 | ||||||
| Repayments | (881 | ) | (1,655 | ) | ||||
| Balance at December 31 | $ | 4,112 | $ | 4,925 | ||||
NOTE 4 — ALLOWANCE FOR LOAN AND LEASE LOSSES
Activity in the allowance for loan and lease losses for the twelve months ended December 31, 2006, 2005 and 2004 are as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Beginning balance | $ | 2,683 | $ | 2,495 | $ | 2,302 | |||||
| Charge-offs | (246 | ) | (221 | ) | (582 | ) | |||||
| Recoveries | 47 | 67 | 82 | ||||||||
| Provision for loan losses | 333 | 342 | 693 | ||||||||
| Ending balance | $ | 2,817 | $ | 2,683 | $ | 2,495 | |||||
Impaired loans at December 31, 2006, 2005 and 2004 are as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Impaired loans with no allowance for loan and lease losses allocated | $ | - | $ | - | $ | 13 | |||||
| Impaired loans with allowance for loan and lease losses allocated | $ | 2,082 | $ | 1,404 | $ | 900 | |||||
| Total impaired loans | $ | 2,082 | $ | 1,404 | $ | 913 | |||||
| Amount of the allowance allocated to impaired loans | $ | 240 | $ | 254 | $ | 151 | |||||
| Average investment in impaired loans | $ | 1,430 | $ | 1,269 | $ | 1,006 | |||||
| Interest income recognized during impairment | $ | 48 | $ | 27 | $ | 14 | |||||
No additional funds are committed to be advanced in connection with impaired loans.
Nonperforming loans at December 31, 2006 and 2005 were as follows (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Loans past due over 90 days still accruing interest | $ | 668 | $ | 672 | ||||
| Nonaccrual loans | $ | 2,728 | $ | 1,104 | ||||
Nonperforming loans includes both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.
18
NOTE 5 — LOAN SERVICING
The Bank routinely sells to investors its originated residential mortgage loans. The unpaid principal balance of loans serviced for others was approximately $375,841,000, $376,036,000, and $374,022,000 at December 31, 2006, 2005 and 2004 and are not included in the accompanying consolidated balance sheets. Related escrow balances were $1,215,000, $958,000, and $408,000 December 31, 2006, 2005, and 2004.
The key economic assumptions used in determining the fair value of the mortgage servicing rights are as follows:
| December 31, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2006 | 2005 | |||||||
| Annual constant prepayment speed | 12.69 | 7.48 | ||||||
| Weighted average life (in months) | 35 | 27 | ||||||
| Discount rate | 8.50 | % | 8.50 | % | ||||
At December 31, 2006 and 2005 the estimated fair value of the mortgage loan servicing portfolio was $3.5 million and $4.6 million, respectively. The fair value of the mortgage servicing rights is based on the above assumptions.
Activity for capitalized mortgage servicing rights was as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Beginning balance | $ | 2,898 | $ | 2,827 | $ | 2,739 | |||||
| Mortgage servicing rights capitalized | 518 | 734 | 532 | ||||||||
| Mortgage servicing rights amortized | (858 | ) | (663 | ) | (444 | ) | |||||
| Ending balance | $ | 2,558 | $ | 2,898 | $ | 2,827 | |||||
There was no valuation allowance at December 31, 2006, 2005 and 2004 for mortgage servicing rights.
NOTE 6 — PREMISES AND EQUIPMENT
Major classifications of bank premises and equipment at December 31, 2006 and 2005 are summarized as follows (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Land | $ | 2,110 | $ | 561 | ||||
| Buildings and improvement | 6,399 | 5,343 | ||||||
| Furniture and equipment | 5,853 | 5,135 | ||||||
| Construction in process | 474 | 1,041 | ||||||
| Total premises and equipment | 14,836 | 12,080 | ||||||
| Less: accumulated depreciation | (6,661 | ) | (5,945 | ) | ||||
| Net carrying amount | $ | 8,175 | $ | 6,135 | ||||
The Company is currently constructing a new branch with a total estimated cost of $1,808,000 (excluding cost of land totaling approximately $765,000), of which $235,000 has been incurred through December 31, 2006. The estimated cost to complete construction is approximately $1,573,000. Completion is expected in May 2007.
The Company has also acquired a parcel of land at a cost of approximately $503,000 in Adrian for the purpose of constructing another branch scheduled for completion in late 2008. Except for the cost of the land acquisition, no significant costs have been incurred or committed through December 31, 2006.
Depreciation expense for the years ended December 31, 2006, 2005 and 2004 amounted to $715,000, $688,000 and $579,000, respectively.
19
NOTE 6 — PREMISES AND EQUIPMENT (continued)
Future minimum rental commitments under non-cancelable operating leases are as follows at December 31, 2006: $78,000 per year for each year ending December 31, 2007, 2008, and 2009, and $53,000 for the year ending December 31, 2010. One lease is in the seventh year of a ten year lease. The lease provides for inflationary adjustments to the cost of the lease based upon changes in the Consumers Price Index beginning in 2006. No increase was made in the lease rate in the current year.
NOTE 7 — DEPOSITS
The following table summarizes interest-bearing deposits at December 31, 2006 and 2005 (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| NOW accounts | $ | 28,722 | $ | 26,273 | ||||
| Savings | 44,488 | 47,213 | ||||||
| Certificates of deposit: | ||||||||
| $100,000 and over | 72,870 | 55,056 | ||||||
| Under $100,000 | 43,573 | 36,853 | ||||||
| Total interest-bearing deposits | $ | 189,653 | $ | 165,395 | ||||
Stated maturities of time deposits at December 31, 2006 are as follows (000’s omitted):
| 2007 | $ | 104,220 | |||
| 2008 | 6,240 | ||||
| 2009 | 2,025 | ||||
| 2010 | 3,498 | ||||
| 2011 | 459 | ||||
| Thereafter | 1 | ||||
| $ | 116,443 | ||||
The following table indicates the schedule of maturities for certificates of deposit with a minimum denomination of $100,000:
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Three months or less | $ | 27,605 | $ | 25,091 | ||||
| Over three months through six months | 31,750 | 13,380 | ||||||
| Over six months through twelve months | 8,065 | 9,322 | ||||||
| One to two years | 2,114 | 5,139 | ||||||
| Thereafter | 3,336 | 2,124 | ||||||
| Total | $ | 72,870 | $ | 55,056 | ||||
NOTE 8 — BORROWED FUNDS
Borrowed funds at December 31, 2006 and 2005 are as follows (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Federal funds purchased | $ | 6,601 | $ | 9,000 | ||||
| Repurchase agreements - customers | 2,700 | 3,663 | ||||||
| Repurchase agreements - financial institutions | 5,000 | 10,000 | ||||||
| Federal Home Loan Bank advances | 10,885 | 16,901 | ||||||
| Total borrowed funds | $ | 25,186 | $ | 39,564 | ||||
20
NOTE 8 — BORROWED FUNDS (continued)
Federal funds purchased totaled $6,601,000 and $9,000,000 at December 31, 2006 and 2005, respectively. Federal funds purchased typically mature daily. The Bank utilizes a $10.0 million line of credit at a correspondent bank for this purpose. Rates on this line of credit ranged from 4.4375% to 5.50% during 2006. The weighted average interest rate at December 31, 2006 is 5.375%. The weighted average interest rate paid for the year ended December 31, 2006 was 5.69%.
Repurchase Agreements
The Company has repurchase agreements with Bank customers as well as third party financial institutions. Information concerning repurchase agreements at December 31, 2006 and 2005 are summarized as follows (000’s omitted):
| Customer Repurchase Agreements | ||||||||
| 2006 | 2005 | |||||||
| Amount outstanding at year-end | $ | 2,700 | $ | 3,663 | ||||
| Weighted average interest rate at year-end | 1.91 | % | 2.03 | % | ||||
| Average daily balance during the year | $ | 3,700 | $ | 5,304 | ||||
| Weighted average interest rate during the year | 1.74 | % | 1.55 | % | ||||
| Maximum month-end balance during the year | $ | 4,863 | $ | 14,177 | ||||
| Third Party Financial Institutions Repurchase Agreements | ||||||||
| 2006 | 2005 | |||||||
| Amount outstanding at year-end | $ | 5,000 | $ | 10,000 | ||||
| Weighted average interest rate at year-end | 3.88 | % | 3.90 | % | ||||
| Average daily balance during the year | $ | 9,517 | $ | 5,649 | ||||
| Weighted average interest rate during the year | 3.89 | % | 3.90 | % | ||||
| Maximum month-end balance during the year | $ | 10,000 | $ | 10,000 | ||||
Both customer and third party financial institution repurchase agreements are terminable upon demand.
Federal Home Loan Bank Advances
The Company has various term advances from the Federal Home Loan Bank of Indianapolis (“FHLBI”) with fixed and variable interest rates ranging from 2.93% to 5.28% at December 31, 2006 and from 2.93% to 4.90% at December 31, 2005. The weighted average interest rate at December 31, 2006 is 4.73%. Maturity dates range from February 2007 to May 2008. The weighted average remaining maturity at December 31, 2006 is 145 days, or May 25, 2007. Pursuant to collateral agreements with the FHLBI, the Company pledges various qualified one to four family mortgage loans as collateral for advances outstanding at the FHLBI. At December 31, 2006 and 2005 such pledged mortgage loans had outstanding balances of $21,616,000 and $31,752,000, respectively. Certain advances are subject to prepayment penalties and the provisions and conditions of the credit policies of the FHLBI.
Scheduled principal reductions on FHLBI advances at December 31, 2006 are as follows (000’s omitted):
| 2007 | $ | 9,000 | |||
| 2008 | 1,885 | ||||
| Total FHLBI advances | $ | 10,885 | |||
21
NOTE 9 – SUBORDINATED DEBENTURES
In December 2001, Lenawee Capital Trust I (“Capital Trust”), a trust formed by the Company, closed a pooled private offering of 5,000 Trust Preferred Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures with terms similar to the Trust Preferred Securities. The sole assets of Capital Trust are the junior subordinated debentures of the Company and payment thereunder. The junior subordinated debentures and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of Capital Trust under the Trust Preferred Securities. Distributions on the Trust Preferred Securities are payable semi-annually at a variable rate ofinterest and are included in interest expense in the consolidated financial statements. The variable rate of interest is equal to the sum of the six-month London Interbank Offered Rate and 3.75% with a maximum rate of 11.0% during the first five years. This subordinated debenture is considered Tier 1 capital (with certain limitations applicable) under current regulatory guidelines.
The Trust Preferred Securities, which mature December 8, 2031, were subject to mandatory redemption, in whole or in part, upon repayment of the subordinated debentures at maturity or their earlier redemption at the liquidation preference plus accrued but unpaid distributions. The subordinated debentures were redeemable prior to the maturity date at the option of the Company on or after December 8, 2006 at their principal amount plus accrued but unpaid interest. The subordinated debentures were also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The Company had the option to defer distributions on the subordinated debentures from time to time for a period not to exceed 5 consecutive years.
The Company redeemed the subordinated debentures on December 8, 2006 at their principal amount plus accrued but unpaid interest. As a result of this redemption, the Company recognized the deferred costs of the original issuance and redemption expense totaling approximately $145,000 before tax. As of December 31, 2005, the outstanding principal balance of the subordinated debentures was $5.0 million.
NOTE 10 – INCOME TAXES
Allocation of income taxes between current and deferred portions is as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Continuing Operations: | |||||||||||
| Current provision | $ | 1,375 | $ | 764 | $ | 518 | |||||
| Deferred (benefit) provision | (304 | ) | (161 | ) | 483 | ||||||
| Total from continuing operations | 1,071 | 603 | 1,001 | ||||||||
| Discontinued operation | - | - | 2,735 | ||||||||
| Total | $ | 1,071 | $ | 603 | $ | 3,736 | |||||
Income tax expense from continuing operations calculated at the statutory federal income tax rate of 34% differs from actual income tax expense for continuing operations as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Statutory rates | $ | 1,180 | $ | 864 | $ | 1,072 | |||||
| Increase (decrease) from: | |||||||||||
| Tax-exempt interest income | (52 | ) | (74 | ) | (88 | ) | |||||
| Non-deductible expenses | 9 | 6 | 13 | ||||||||
| Change in accounting estimate and other | (66 | ) | (193 | ) | 4 | ||||||
| $ | 1,071 | $ | 603 | $ | 1,001 | ||||||
22
NOTE 10 – INCOME TAXES (continued)
Year-end deferred tax assets and liabilities consist of (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Deferred tax assets | |||||||||||
| Allowance for loan and lease losses | $ | 756 | $ | 643 | $ | 609 | |||||
| Net deferred loan fees | - | 13 | 26 | ||||||||
| Accrued pension liability | 42 | 42 | - | ||||||||
| Net unrealized losses on securities available-for-sale | 52 | 156 | 23 | ||||||||
| Other | 268 | 206 | 230 | ||||||||
| Total deferred tax assets | 1,118 | 1,060 | 888 | ||||||||
| Deferred tax liabilities | |||||||||||
| Depreciation | (509 | ) | (537 | ) | (590 | ) | |||||
| Mortgage servicing rights | (870 | ) | (985 | ) | (961 | ) | |||||
| Prepaid expenses | (73 | ) | (58 | ) | (138 | ) | |||||
| Other | (78 | ) | (92 | ) | (105 | ) | |||||
| Total deferred tax liabilities | (1,530 | ) | (1,672 | ) | (1,794 | ) | |||||
| Net deferred tax liability | $ | (412 | ) | $ | (612 | ) | $ | (906 | ) | ||
NOTE 11 — EMPLOYEE BENEFITS
Defined Benefit Pension Plan
The Bank is a participant in the multi-employer Financial Institutions Retirement Funds (“FIRF” or the “Plan”), which covers substantially all of its officers and employees. Effective January 1, 2006, all new employees will no longer be eligible to participate in the defined benefit pension plan in use at the Bank for its existing officers and employees. The Plan, for eligible employees with one year of service, provides benefits based on basic compensation and years of service. The Bank’s contributions are determined by FIRF and generally represent the normal cost of the Plan. Specific Plan assets and accumulated benefit information for the Bank’s portion of the Plan are not available. Under the Employee Retirement Income Security Act of 1974 (“ERISA”), a contributor to a multiemployer pension plan may be liable in the event of complete or partial withdrawal for the benefit payments guaranteed under ERISA. Currently, the Bank does not intend to withdraw from the Plan, though management regularly reviews the structure of benefits offered for appropriateness and long-term cost effectiveness. The Bank has met the funding requirements in the Plan as of December 31, 2006. The expense of the Plan allocated to the Bank for the twelve months ended December 31, 2006 and 2005 was $341,344 and $347,817, respectively.
ESOP and 401(k) Plan
The Company adopted an employee stock ownership plan, or ESOP, originally known as the Bank of Lenawee Employee Stock Ownership Plan (the “Plan”), for the purpose of acquiring outstanding shares of the Company’s predecessor, for the benefit of eligible employees. The Plan was effective as of January 1, 1984 and has received notice of qualification by the Internal Revenue Service.
In connection with the adoption of the Plan, a Trust was established to hold the shares acquired. During the period 1984 through 1994, the Company (and its predecessors) made contributions to the Trust. Such contributions consisted of both shares of employer stock or cash which was used to acquire shares of employer stock from others. When cash contributions were used to acquire employer stock from others, such shares were acquired at or below fair market value as determined from time to time by reference to market transactions or by independent appraisal. On January 1, 1995 the Company ceased making contributions to the Plan.
23
NOTE 11 — EMPLOYEE BENEFITS (continued)
Effective January 1, 1996, the Company adopted an amendment to the Plan adding a so-called “cash or deferred” arrangement under Section 401(k) of the Internal Revenue Code and providing for elective contributions by employees (up to 20% of their eligible compensation) and matching contributions by the Company equal to 100% of each eligible employee’s elective contributions (but with the match capped at 2% of his or her eligible compensation). Matching contributions from the Company consist of the Company’s common shares. Since January 1, 1996, the Plan has been known as the Employee Stock Ownership and 401(k) Savings Plan. Expense relating to the 401(k) provision was $59,000, $100,000 and $108,000 in 2006, 2005 and 2004, respectively.
Accumulations of employer stock (now Company stock) allocated under the ESOP prior to 1995 continue to be allocated to employees and are to be held in the Trust until such employees become entitled to a distribution in accordance with the provisions of the Plan (normally at retirement or termination of employment for other reasons). At December 31, 2006 and 2005, the Trust held 57,001 and 61,636 of the Company’s stock, respectively, which includes both the ESOP and 401(k) portions of the plan. Upon distribution of shares to a participant, the participant has the right to require the Company to purchase shares at the most recent appraised value in accordance with the terms and conditions of the ESOP portion of the Plan. Under the 401(k) portion of the plan, the Company’s matching contribution applied to the purchase of Company stock on behalf of a participant is distributed in cash at the most recent appraised value upon termination or voluntary separation from the Company. A participant in the 401(k) plan does not have an option to receive company stock. Additionally, employee contributions to the 401(k) plan, which may not be invested in Company stock, are also distributed in cash when the participant is terminated or voluntarily leaves the Company. As such, these shares are classified as a liability in the financial statements and reported at their redemption value. Changes in redemption value are reported as adjustments to equity. The appraised value of the shares of Company stock held by the Trust was $2,765,000 and $2,989,000 at December 31, 2006 and 2005, respectively.
NOTE 12 – STOCK BASED COMPENSATION
In December 2004, the FASB issued SFAS 123R (revised 2004), “Share-Based Payment,” (“SFAS 123R”) which requires that compensation costs related to share-based payment transactions be recognized in financial statements. SFAS 123R eliminated the alternative to use the intrinsic method of accounting previously allowed under APB 25, “Accounting for Stock Issued to Employees,” which generally did not require any compensation expense to be recognized in the financial statements for the grant of stock options to employees if certain conditions were met. Only certain pro forma disclosures of share-based payments were required.
On January 1, 2006, the Company adopted SFAS 123R using the modified prospective method. SFAS 123R requires all share-based payment to employees, including grants of employee stock options, to be recognized as expense in the consolidated statement of earnings based on their fair values. The amount of compensation expense is determined based on the fair value of the options when granted and is expensed over the required service period, which is normally the vesting period of the options. SFAS 123R applies to awards granted or modified on or after January 1, 2006, and to any unvested awards that were outstanding at December, 31 2005. Consequently, the compensation expense is recorded for prior option grants that vest on or after January 1, 2006, the date of adoption.
At December 31, 2006, the Company has two stock compensation plans. Stock option plans are used to reward directors and certain executive officers and provide them with an additional equity interest. Options are issued for 10 year periods and vest over five years. Additionally, the options that are awarded to a director will become fully vested when an active director reaches the age of 62. Prior to adoption of SFAS 123R, the Company accounted for those plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,”and related Interpretations. Minimal stock-based employee compensation related to the Stock Option Plans was reflected in net earnings, as substantially all options granted under the Stock Option Plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
24
NOTE 12 - STOCK BASED COMPENSATION (continued)
The fair value concepts were not changed significantly in SFAS 123R; however, in adopting this standard, companies must choose among alternative valuation models and amortization assumptions. The Company has elected to continue to use both the Black-Scholes option pricing model and the straight-line method of amortization of compensation expense over the requisite service period of the grant. The Company would reconsider use of the Black-Scholes model if additional information in the future indicates another model would be more appropriate at that time, or if grants issued in future periods have characteristics that could not be reasonably estimated using this model.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes pricing model with the following weighted-average assumptions:
| 2005 | 2004 | |||||||
|---|---|---|---|---|---|---|---|---|
| Risk-free interest rate | 4.00% | 3.75% | ||||||
| Expected option life | 8 years | 8 years | ||||||
| Expected dividend yield | 2.14% | 1.73% | ||||||
| Expected stock price volatility | 25.07% | 19.86% | ||||||
The weighted average fair value of stock options granted was $15.85 and $11.43 for 2005 and 2004, respectively. There were no options granted in 2006.
The summary of option activity under the Plan as of December 31, 2006, and changes during the year then ended is presented below:
| Options | Shares | Weighted Average Exercise Price | Weighted Average Remaining Contractual Term | Aggregate Intrinsic Value | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Outstanding, January 1, 2006 | 30,791 | $ | 45.56 | |||||||||||
| Granted | - | - | ||||||||||||
| Exercised | (1,386 | ) | 17.65 | |||||||||||
| Forfeited or expired | - | - | ||||||||||||
| Outstanding, December 31, 2006 | 29,405 | $ | 46.76 | 5.2 | $ | 92,868 | ||||||||
| Options exercisable, end of period | 25,331 | $ | 45.30 | 4.8 | $ | 92,868 | ||||||||
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Company’s closing stock price on the last trading day of our fiscal year ended 2006 and the exercise price, times the number of shares) that would have been received by the option holders had all option holders exercised their options on December 31, 2006. Out of the money options (options that have an exercise price that exceeds market value) are excluded from the computation as they are assumed to have no intrinsic value. This amount changes based on the fair market value of the Company’s stock.
The total intrinsic value of options exercised during the years ended December 31, 2006, 2005, and 2004 was approximately $39,800, $326,700, and $169,500, respectively.
25
NOTE 12 - STOCK BASED COMPENSATION (continued)
The summary of the status of the Company’s nonvested shares as of December 31, 2006, and changes during the year then ended, is presented below:
| Nonvested Shares | Shares | Weighted Average Grant Date Fair Value | ||||||
|---|---|---|---|---|---|---|---|---|
| Nonvested at January 1, 2006 | 5,692 | $ | 13.86 | |||||
| Granted | - | �� | - | |||||
| Vested | (1,618 | ) | 14.23 | |||||
| Forfeited | - | - | ||||||
| Nonvested at December 31, 2006 | 4,074 | $ | 13.71 | |||||
As of December 31, 2006, there was $26,000, net of tax, of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plans. This cost is expected to be fully amortized in four years, with half of the total amortization cost being recognized within the next 18 months. The total fair value of shares vested during the years ended December 31, 2006, 2005, and 2004 was approximately $22,000, $113,000, and $102,000, respectively.
NOTE 13 — COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES
Credit-Related Financial Instruments: The Company is party to credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Company’s consolidated balance sheets.
The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for balance sheet instruments.
At December 31, 2006 and 2005, the following financial instruments were outstanding whose contract amounts represent off-balance sheet credit risk (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Commitments to extend credit | $ | 8,416 | $ | 7,370 | ||||
| Unfunded commitments under lines of credit | 57,989 | 61,242 | ||||||
| Commercial and standby letters of credit | 2,430 | 3,051 | ||||||
| $ | 68,835 | $ | 71,663 | |||||
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based upon management’s credit evaluation of the customer.
26
NOTE 13 - COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES (continued)
Unfunded commitments under commercial lines of credit and revolving lines of credit are commitments for possible future extensions of credit to existing customers. These lines of credit are typically collateralized and usually carry a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.
Commercial and standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party, and are used primarily to support public and private borrowing arrangements. Essentially, all letters of credit issued have expiration dates within one year. The Company generally holds collateral supporting those commitments if deemed necessary.
Required Reserves at the Federal Reserve Bank of Chicago: At December 31, 2006 and 2005 the required reserves at the Federal Reserve Bank of Chicago totaled $977,000 and $1,385,000, respectively. These reserves do not earn interest.
Legal Contingencies: Various legal claims arise from time to time in the normal course of business which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements.
NOTE 14 – PARENT-ONLY CONDENSED FINANCIAL STATEMENTS
The following represents the condensed financial statements of Pavilion Bancorp, Inc., (“Parent”) only. The Parent-only financial information should be read in conjunction with the Company’s consolidated financial statements.
The condensed balance sheets at December 31, 2006 and 2005 are as follows (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Assets | ||||||||
| Cash and cash equivalents | $ | 405 | $ | 3,208 | ||||
| Securities available for sale | 521 | 1,129 | ||||||
| Investment in subsidiaries | 29,767 | 30,279 | ||||||
| Other | 264 | 159 | ||||||
| Total assets | $ | 30,957 | $ | 34,775 | ||||
| Liabilities & Shareholders' Equity | ||||||||
| Subordinated debentures | $ | - | $ | 5,000 | ||||
| Other | 256 | 402 | ||||||
| Common stock subject to repurchase in ESOP | 2,765 | 2,989 | ||||||
| Shareholders' equity | 27,936 | 26,384 | ||||||
| Total liabilities & shareholders' equity | $ | 30,957 | $ | 34,775 | ||||
27
NOTE 14 - PARENT-ONLY CONDENSED FINANCIAL STATEMENTS(continued)
The Parent-only condensed statements of income for the years ended December 31, 2006, 2005 and 2004 are as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Dividends from subsidiaries | $ | 3,600 | $ | - | $ | 1,750 | |||||
| Interest income | 24 | 61 | 20 | ||||||||
| Interest expense | (419 | ) | (359 | ) | (285 | ) | |||||
| Other operating expense | (343 | ) | (290 | ) | (52 | ) | |||||
| Income (loss) before equity in undistributed | |||||||||||
| net income of subsidiary | 2,862 | (588 | ) | 1,433 | |||||||
| (Excess) equity in undistributed net income | |||||||||||
| from subsidiaries | (715 | ) | 2,344 | 750 | |||||||
| Income from continuing operations before | |||||||||||
| income taxes | 2,147 | 1,756 | 2,183 | ||||||||
| Income tax (benefit) provision | (254 | ) | (182 | ) | 30 | ||||||
| Income from continuing operations | 2,401 | 1,938 | 2,153 | ||||||||
| Income (loss) from discontinued operation, | |||||||||||
| net of income taxes, $0, $0, $162 | - | - | 562 | ||||||||
| Gain on sale of discontinued operation, net of tax | - | - | 4,417 | ||||||||
| Net income | $ | 2,401 | $ | 1,938 | $ | 7,132 | |||||
28
NOTE 14 - PARENT-ONLY CONDENSED FINANCIAL STATEMENTS (continued)
The condensed statements of cash flows for the years ended December 31, 2006, 2005 and 2004 are as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Cash flows from operating activities | |||||||||||
| Net income | $ | 2,401 | $ | 1,938 | $ | 7,132 | |||||
| Adjustments to reconcile net income to net cash | |||||||||||
| from operating activities | |||||||||||
| Excess (equity) in undistributed net income of | |||||||||||
| subsidiaries | 715 | (2,344 | ) | (750 | ) | ||||||
| Gain on sale of discontinued operation | - | - | (6,990 | ) | |||||||
| Amortization (accretion) of investment securities | 7 | 10 | (1 | ) | |||||||
| Stock option expense | 22 | 16 | 43 | ||||||||
| Stock award expense | 10 | - | - | ||||||||
| Other | (329 | ) | (2,362 | ) | 1,518 | ||||||
| Net cash provided by (used in) operating activities | 2,826 | (2,742 | ) | 952 | |||||||
| Cash flows from investing activities | |||||||||||
| Net proceeds from sale of discontinued operation | - | - | 15,101 | ||||||||
| Purchase of securities available for sale | - | (3,165 | ) | (1,755 | ) | ||||||
| Proceeds from maturities of securities available for sale | 600 | 3,985 | 162 | ||||||||
| Net cash provided by investing activities | 600 | 820 | 13,508 | ||||||||
| Cash flows from financing activities | |||||||||||
| Redemption of subordinated debentures | (5,000 | ) | - | - | |||||||
| Redemption and retirement of ESOP/401k shares | (311 | ) | - | - | |||||||
| Repurchase of common stock | (250 | ) | (8,518 | ) | (1 | ) | |||||
| Stock options exercised | 37 | 529 | 218 | ||||||||
| Dividends paid | (705 | ) | (986 | ) | (1,035 | ) | |||||
| Net cash used in financing activities | (6,229 | ) | (8,975 | ) | (818 | ) | |||||
| Net (decrease) increase in cash and cash equivalents | (2,803 | ) | (10,897 | ) | 13,642 | ||||||
| Beginning cash and cash equivalents | 3,208 | 14,105 | 463 | ||||||||
| Ending cash and cash equivalents | $ | 405 | $ | 3,208 | $ | 14,105 | |||||
29
NOTE 15 — FAIR VALUES OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, rather than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. The aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company. The following methods and assumptions were used to estimate fair values for financial instruments:
Cash and Cash Equivalents: The carrying amounts of cash and short-term instruments reasonably approximate fair values.
Securities available for sale: Fair values for securities are based on quoted market prices.
Equities: Equities largely include Federal Home Loan Bank of Indianapolis stock and Federal Reserve Bank of Chicago stock. The carrying amounts of FHLBI and FRB stock approximate fair value based on their redemption provisions.
Loans held for sale: Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market rates.
Loans receivable: Fair value of loans receivable are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for non-performing loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.
Accrued interest: The carrying value of accrued interest approximates fair value.
Demand and savings deposits: The carrying value of demand and savings accounts generally approximate the fair value, with the exception of certain larger relationships that may have a periodically negotiated rate of interest. The fair value of such relationships is estimated using a discounted cash flow calculation that applies interest rates currently being offered.
Time deposits: The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits with similar maturities.
Federal funds purchased: The carrying value of the Company’s federal funds purchased approximate the fair value.
Federal Home Loan Bank advances: The fair value of the Company’s Federal Home Loan Bank of Indianapolis advances are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar borrowing arrangements.
Repurchase agreements: The fair value of the Company’s repurchase agreements with third party financial institutions are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar borrowing arrangements. The fair value of the Company’s repurchase agreements with customers reasonably approximate the carrying value.
Subordinated debentures: The fair value of the Company’s subordinated debentures reasonably approximate the carrying value.
30
NOTE 15 - FAIR VALUES OF FINANCIAL INSTRUMENTS(continued)
The estimated fair values, and related carrying or notional amounts, of the Company’s financial instruments at December 31, 2006 and 2005 are as follows (000’s omitted):
| 2006 | 2005 | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Carrying Amount | Fair Value | Carrying Amount | Fair Value | |||||||||||
| Financial assets: | ||||||||||||||
| Cash and cash equivalents | $ | 17,210 | $ | 17,210 | $ | 11,308 | $ | 11,308 | ||||||
| Securities available-for-sale | 17,828 | 17,828 | 25,407 | 25,407 | ||||||||||
| Equities | 2,683 | 2,683 | 3,425 | 3,425 | ||||||||||
| Loans held for sale | 377 | 380 | 927 | 936 | ||||||||||
| Loans, net | 243,312 | 241,566 | 234,915 | 232,870 | ||||||||||
| Accrued interest receivable | 1,930 | 1,930 | 1,651 | 1,651 | ||||||||||
| Financial liabilities: | ||||||||||||||
| Demand and savings deposits | 119,501 | 119,501 | 118,839 | 119,014 | ||||||||||
| Time deposits | 116,443 | 115,832 | 91,909 | 91,669 | ||||||||||
| Federal funds purchased | 6,601 | 6,601 | 9,000 | 9,000 | ||||||||||
| Federal Home Loan Bank advances | 10,885 | 10,871 | 16,901 | 16,795 | ||||||||||
| Repurchase agreements | 7,700 | 7,670 | 13,663 | 13,526 | ||||||||||
| Accrued interest payable | 851 | 851 | 667 | 667 | ||||||||||
| Subordinated debentures | - | - | 5,000 | 5,000 | ||||||||||
NOTE 16 – DISCONTINUED OPERATION
On July 16, 2004 Pavilion Bancorp, Inc. announced that it had signed a definitive agreement to sell the Bank of Washtenaw for $15,101,000. The sale was completed on October 29, 2004. In accordance with Financial Accounting Standard 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the results of operations of Bank of Washtenaw are removed from the detail line items in the company’s financial statements and presented separately as “discontinued operation.”
The condensed income statement (unaudited) for the twelve months ended December 31, 2006, 2005 and 2004 for Bank of Washtenaw is as follows (000’s omitted):
| 2006 | 2005 | 2004 | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Interest income | $ | - | $ | - | $ | 3,428 | |||||
| Interest expense | - | - | 1,052 | ||||||||
| Net interest income | - | - | 2,376 | ||||||||
| Provision for loan losses | - | - | 19 | ||||||||
| Noninterest income | - | - | 537 | ||||||||
| Noninterest expenses | - | - | 2,170 | ||||||||
| Income (loss) before taxes | - | - | 724 | ||||||||
| Income tax expense (benefit) | - | - | 162 | ||||||||
| Net income (loss) | $ | - | $ | - | $ | 562 | |||||
31
NOTE 17 — REGULATORY MATTERS
Beginning in the first quarter of 2006, the Company became exempt from the Capital Guidelines, as the Board of Governors of the Federal Reserve System increased the asset size threshold from $150 million to $500 million in consolidated assets for determining whether a Bank Holding Company may qualify for an exemption from the Capital Guidelines. Under the revised regulatory financial reporting requirements, the Company will only be required to file parent-only financial data on a semi-annual basis. This change only impacts the Company and the Bank will continue to file necessary regulatory reports.
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 and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’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 their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators regarding components, risk weightings, and other factors. Prompt corrective action provisions are not applicable for bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts, and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined).
At December 31, 2006 the Bank was considered well-capitalized under the regulatory framework for prompt corrective action. The Bank’s actual capital amounts and ratios at December 31, 2006 and 2005 and the Company’s capital amounts and ratios at December 31, 2005 are presented in the following table (in millions):
| Actual | Minimum Required For Capital Adequacy Action Regulations | Minimum Required to be Well-Capitalized Under Prompt Corrective Purposes | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||
| 2006 | ||||||||||||||||||||
| Total capital (to risk weighted assets) | ||||||||||||||||||||
| Bank of Lenawee | $ | 32.7 | 12.5% | $ | 20.9 | >=8.0% | $ | 26.1 | >=10.0% | |||||||||||
| Tier 1 Capital (to risk weighted assets) | ||||||||||||||||||||
| Bank of Lenawee | $ | 29.9 | 11.4% | $ | 10.5 | >=4.0% | $ | 15.7 | >=6.0% | |||||||||||
| Tier 1 Capital (to average assets) | ||||||||||||||||||||
| Bank of Lenawee | $ | 29.9 | 10.4% | $ | 11.5 | >=4.0% | $ | 14.4 | >=5.0% | |||||||||||
| 2005 | ||||||||||||||||||||
| Total Capital (to risk weighted assets) | ||||||||||||||||||||
| Consolidated | $ | 37.3 | 15.2% | $ | 19.6 | >=8.0% | n/a | n/a | ||||||||||||
| Bank of Lenawee | $ | 33.3 | 13.7% | $ | 19.4 | >=8.0% | $ | 24.3 | >=10.0% | |||||||||||
| Tier 1 Capital (to risk weighted assets) | ||||||||||||||||||||
| Consolidated | $ | 34.7 | 14.1% | $ | 9.8 | >=4.0% | n/a | n/a | ||||||||||||
| Bank of Lenawee | $ | 30.6 | 12.6% | $ | 9.7 | >=4.0% | $ | 14.5 | >=6.0% | |||||||||||
| Tier 1 Capital (to average assets) | ||||||||||||||||||||
| Consolidated | $ | 34.7 | 12.4% | $ | 11.2 | >=4.0% | n/a | n/a | ||||||||||||
| Bank of Lenawee | $ | 30.6 | 10.7% | $ | 11.5 | >=4.0% | $ | 14.3 | >=5.0% | |||||||||||
As of December 31, 2005, the Company’s regulatory capital includes $5.0 million of subordinated debentures, issued by Lenawee Capital Trust I in December 2001, and are subject to certain limitations. Federal Reserve guidelines limit the amount of subordinated debentures which may be included in Tier 1 capital of the Company to 25% of total Tier 1 capital. At December 31, 2005 the entire amount of subordinated debentures was included as Tier 1 capital of the Company. The Company redeemed the subordinated debentures on December 8, 2006. Please refer to Note 9 to the Company’s Consolidated Financial Statements for additional information.
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NOTE 18 – RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES
Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The total amount of dividends which may be paid at any date is generally limited to the retained earnings of the Bank, and loans or advances are limited to 10% of the Bank’s capital stock and surplus on a secured basis. At December 31, 2006, the Bank’s retained earnings available for the payment of dividends was $1,262,000. Accordingly, $28,505,000 of the Company’s equity in the net assets of the Bank was restricted at December 31, 2006. Funds available for loans or advances by the Bank to the Company amounted to $2.1 million.
In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.
NOTE 19 – QUARTERLY RESULTS OF OPERATIONS (unaudited)
The following table summarizes the Company’s quarterly results for the years ended December 31, 2006 and 2005 (000’s omitted):
| For the Three-Month Period ended | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| March 31 | June 30 | September 30 | December 31 | |||||||||||
| 2006 | ||||||||||||||
| Interest income | $ | 4,480 | $ | 4,620 | $ | 4,918 | $ | 4,857 | ||||||
| Interest expense | 1,556 | 1,661 | 1,919 | 1,914 | ||||||||||
| Net interest income | 2,924 | 2,959 | 2,999 | 2,943 | ||||||||||
| Provision for loan losses | - | 105 | 120 | 108 | ||||||||||
| Net interest income after | ||||||||||||||
| provision for loan losses | 2,924 | 2,854 | 2,879 | 2,835 | ||||||||||
| Noninterest income | 707 | 846 | 719 | 796 | ||||||||||
| Noninterest expense | 3,062 | 2,688 | 2,535 | 2,803 | ||||||||||
| Net income before income taxes | 569 | 1,012 | 1,063 | 828 | ||||||||||
| Federal income tax expense | 169 | 317 | 280 | 305 | ||||||||||
| Net income | $ | 400 | $ | 695 | $ | 783 | $ | 523 | ||||||
| Net earnings per share | ||||||||||||||
| Basic | $ | 0.54 | $ | 0.95 | $ | 1.06 | $ | 0.72 | ||||||
| Diluted | $ | 0.54 | $ | 0.94 | $ | 1.06 | $ | 0.72 | ||||||
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NOTE 19 - QUARTERLY RESULTS OF OPERATIONS (unaudited) (continued)
| For the Three-Month Period ended | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| March 31 | June 30 | September 30 | December 31 | |||||||||||
| 2005 | ||||||||||||||
| Interest income | $ | 3,636 | $ | 3,924 | $ | 4,196 | $ | 4,374 | ||||||
| Interest expense | 820 | 986 | 1,256 | 1,387 | ||||||||||
| Net interest income | 2,816 | 2,938 | 2,940 | 2,987 | ||||||||||
| Provision for loan losses | 30 | 150 | 105 | 57 | ||||||||||
| Net interest income after | ||||||||||||||
| provision for loan losses | 2,786 | 2,788 | 2,835 | 2,930 | ||||||||||
| Noninterest income | 939 | 899 | 801 | 638 | ||||||||||
| Noninterest expense | 3,328 | 3,019 | 2,939 | 2,789 | ||||||||||
| Net income before income taxes | 397 | 668 | 697 | 779 | ||||||||||
| Federal income tax expense | 138 | 204 | 220 | 41 | ||||||||||
| Net income | $ | 259 | $ | 464 | $ | 477 | $ | 738 | ||||||
| Net earnings per share | ||||||||||||||
| Basic | $ | 0.30 | $ | 0.57 | $ | 0.63 | $ | 0.97 | ||||||
| Diluted | $ | 0.30 | $ | 0.56 | $ | 0.63 | $ | 0.96 | ||||||
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35
Forward-Looking Statements
This report includes “forward-looking statements” as that term is used in the securities laws. All statements regarding the Company’s expected financial position, business and strategies are forward-looking statements. In addition, the words “anticipates,” “believes,” “estimates,” “seeks,” “expects,” “plans,” “intends,” and similar expressions, as they relate to the Company and its management, are intended to identify forward-looking statements. The presentation and discussion of the provision and allowance for loan and lease losses, determining the fair value of securities and other financial instruments, the valuation of mortgage servicing rights and statements concerning future profitability or future growth or increases, are examples of inherently forward looking statements in that they involve judgments and statements of belief as to the outcome of future events. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on the Company’s operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning the Company and its business, including additional factors that could materially affect the Company’s financial results, is included in its filings with the Securities and Exchange Commission.
INTRODUCTION
The following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (the “MD&A”) provides information about the consolidated financial condition and results of operations of Pavilion Bancorp, Inc. (the “Company”) as of December 31, 2006 and for the three year period ended December 31, 2006 and is intended to assist in understanding the results of operations of the Company. Information contained in this section should be read in conjunction with the consolidated financial statements and accompanying notes contained in this report.
BUSINESS OF PAVILION BANCORP, INC.
Pavilion Bancorp, Inc. (the “Company”), a bank holding company, was incorporated in Michigan in 1993. The shareholders elected to change its name to Pavilion Bancorp Inc. from Lenawee Bancorp Inc. on April 18, 2002. The Bank of Lenawee (the “Bank”), a Michigan banking corporation chartered in 1869, is a wholly-owned subsidiary of the Company. Pavilion Mortgage Company, a wholly-owned subsidiary of the Bank, engages in the residential mortgage origination business. Pavilion Financial Services, Inc., a wholly-owned subsidiary of the Bank, owns an interest in a title and mortgage reinsurance agency.
The Company’s primary business is concentrated in a single industry segment — commercial banking. The Bank provides a full range of banking services to individuals, commercial businesses and industries located in its service area. The Bank maintains diversified loan portfolios, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking accounts, savings accounts, money market accounts, individual retirement accounts and certificates of deposit.
The principal markets for financial services provided are in the southern-Michigan communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through 7 locations in or near its communities. The Bank does not have any material foreign assets or income.
The principal source of revenue is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 80.7% of total revenue in 2006 compared to 77.0% in 2005. Interest and fees on loans increased in the current year as the loan portfolio grew considerably and the level of mortgage loan sale activity continued to decline from levels experienced in 2005. Mortgage loan sale activity accounted for 4.4% of total revenue in 2006 compared to 7.2% in 2005 due to this decline. Proceeds from the sale of mortgage loans decreased $16.8 million, or 27.8%, to $43.4 million in 2006, down from $60.2 million in 2005, due to increases in mortgage rates and slowing of the real estate market.
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CRITICAL ACCOUNTING POLICIES
Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, the performance of the economy or the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan and lease losses, determining the fair value of securities and other financial instruments, the valuation of mortgage servicing rights and deferred tax and tax provision estimates. Additional information regarding the Company’s critical accounting policies is discussed in detail in Note 1 to the consolidated financial statements.
Discontinued Operation
As previously disclosed in earlier regulatory filings, in accordance with Statement of Financial Accounting Standards No. 144, on July 16, 2004 Pavilion Bancorp, Inc. announced that it had signed a definitive agreement to sell the Bank of Washtenaw for $15,101,000. The sale of the Bank of Washtenaw was initiated to concentrate the Company’s resources in the Lenawee County market and other potential markets that are more homogenous to the Bank’s traditional market area. In accordance with Statement of Financial Accounting Standards 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the financial position and results of operations of the Bank of Washtenaw are removed from the detail line items in the Company’s consolidated financial statements and presented separately as “discontinued operation.” Accordingly, the various supporting schedules contained in the MD&A are also presented with Bank of Washtenaw-related information removed. The sale was completed on October 29, 2004. Please refer to Note 16 to the Company’s Consolidated Financial Statements for additional information.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses is management’s estimate of losses inherent in the Bank’s loan portfolio. Management relies on a number of factors and sources of information in preparing this estimate. These include, but are not limited to, internal credit analyses and loan risk ratings, local economic conditions and trends, regulatory requirements, collateral values, loan types and loan documentation. Accordingly, the allowance for loan and lease losses includes a reserve calculation based on an evaluation of loans determined to be impaired, risk ratings, historical losses, loan types and other subjective factors management may believe to be relevant and/or material. Please refer to the section entitled “Loans, Credit Quality and Allowance for Loan and Lease Losses” located elsewhere in this report for additional information.
Loan Classifications
The Company has established a risk rating system for loans that evaluates a variety of credit quality-related characteristics of each loan being rated. Initial risk ratings for loans are established by the originating (or assigned) lending official. The lending official is responsible for the continuing accuracy of the risk rating and is authorized to downgrade a loan to a lower risk rating if warranted by any information received. Loan risk ratings are also evaluated for accuracy through several processes that are independent of the loan origination process. The Bank retains independent consultants to review the accuracy of loan risk ratings on an annual basis. These results are reported to senior management of the Bank, as well as the Audit Committee and the Board of Directors. Additionally, the Bank’s Chief Credit Officer monitors individual loan risk ratings and overall credit quality through several monitoring systems and reports. The Chief Credit Officer reports directly to the CEO of the Bank. Criticized loans have been risk-rated 5 and are individually included on a monthly Loan Watch Report submitted to senior management and the Board of Directors of the Bank. Classified loans have been risk-rated 6, 7 or 8 and are individually included on a monthly Problem Loan Report submitted to senior management and the Board of Directors of the Bank. The Bank’s Loan Policy specifically defines the characteristics of each risk rating as follows:
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| 1 Rating: “Essentially risk free credit. Credit to premier customers having the Bank’s highest credit rating based on an extremely strong financial condition, which compares favorably with industry standards (upper quartile of RMA ratios). Secured by readily marketable liquid collateral (traded stocks, bonds, certificates of deposit, savings account, etc.) with comfortable margins. Highly profitable firms that have a track record of always servicing their debts. Possible characteristic of such accounts: |
| - | Substantial net worth |
| - | Low debt to worth ratio |
| - | Significantly above average working capital |
| - | Current accounts payable |
| - | Deposits are 15% of outstanding loans |
| - | 25% of assets are liquid” |
| 2 Rating: “Low risk. Multiple ‘strong’ sources of repayment. Debt of borrower is modest relative to the borrower’s financial strength and ability to pay. Borrower must be profitable, have a demonstrated track record, very strong cash flow and margins above projected needs. Loan supported by unaudited financial statements containing strong balance sheets and five consecutive years of profits combined with a satisfactory relationship with the Bank. Customer demonstrates the ability to manage the working capital position and term financing requirements. Possessing a sound repayment source (and a secondary source) which definitely will allow repayment in a reasonable period of time. Individual loans backed by liquid personal assets, established history and unquestionable character. Other characteristics: |
| - | Significant net worth |
| - | Better than average debt to worth ratio (e.g. 2.0 to 1 or less) |
| - | Above average working capital ratio |
| - | Current accounts payable |
| - | Secured loans must have collateral Loan/value ratio of 70% or lower |
| - | 10% of assets are liquid” |
| 3 Rating: “Moderate risk. ‘Good’ primary and secondary sources of repayment. Debt of the borrower is reasonable relative to borrower’s financial strength and ability to pay. Borrower must be profitable, have a demonstrated track record, exhibits sufficient cash flow and margins above projected needs. Borrowers have satisfactory asset quality and liquidity, adequate debt capacity and coverage, and good management in critical positions. Earning statements may reflect a one year loss, but borrowers have sufficient strength and financial flexibility to offset this event. Occasionally has a need for working capital and or term financing. Other characteristics: |
| - | Acceptable net worth |
| - | Acceptable industry average for debt to worth ratio |
| - | Adequate working capital |
| - | Not significantly slow in paying accounts payable |
| - | Cash flow ratio = 1.3 or above” |
| 4 Rating: “Acceptable risk. Sufficient primary source of repayment and acceptable secondary source of repayment has either: |
| - | Minimum net worth |
| - | Fairly high debt to worth ratio |
| - | Adequate cash flow ratio (1.2 or above) with higher than desired leverage; or marginal cash flow (1.2 or below) with strong capitalization and liquidity. |
| - | Declining earnings, limited additional debt capacity, or market fundamentals that indicate above average risks.” |
| 5 Rating: “Borderline risk, potential weaknesses. Borrowers who exhibit potential credit weaknesses or downward trends deserving Bank management’s attention. If not checked or corrected, these trends will weaken the Bank’s asset position. Acceptable primary source of repayment, but less than preferable secondary source of repayment. Credit will have minimal excess cash flow, and financially will be moderately or highly leveraged. A “satisfactory” credit exhibits manageable credit risk with two measurable sources of repayment.Loans may lack technical or legal support, including deficiencies in loan documentation. |
| - | Little or no net worth |
| - | High debt to worth ratio |
| - | Cash Flow ratio = 1.1 or above |
| - | Start up or deteriorating industries or with a poor and declining market share in an average industry |
| - | An element of asset quality, financial flexibility, or management is below average” |
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6 Rating: “Substandard. A loan with well-defined credit weakness or weaknesses that jeopardize liquidation of the debt. A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. These may be loans that have been restructured so that payment terms and collateral represent major concessions to the borrower when compared to normal loan terms. Also, this category should include those loans with contemplated or pending foreclosure or legal action due to the apparent deterioration in the credit. Loans are characterized by the distinct possibility that a bank will sustain loss if the deficiencies are not corrected. Loss potential, while existing in aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.”
7 Rating: “Doubtful. A loan with weaknesses inherent to a substandard loan. The loan also has the added provision that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain known factors which may work to the advantage and strengthening of the asset, (i.e., capital injection, perfecting liens on additional collateral, refinancing plans, etc.) its classification as an estimated loss is deferred until its more exact status may be determined.”
8 Rating: “Loss. Loans classified as Loss are considered uncollectible and of such nominal value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is unpractical or desirable to defer writing-off this basically worthless asset, even though partial recovery may be affected in the future. Losses should be taken in the period in which they surface as uncollectible. Known losses should be in process of charge off.”
Mortgage Servicing Rights (“MSRs”)
The Bank records the original MSRs based on market data. A periodic independent third party valuation is completed to determine potential impairment of MSRs as a result of changes in interest rates and expected future loan repayment speeds. Significant changes in interest rates or repayment speeds could have a significant impact on the carrying value of the MSRs asset. The Bank obtains quarterly independent valuations. For additional information, please refer to Note 5 to the Company’s Consolidated Financial Statements located elsewhere in this report.
Income Taxes
Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based upon the tax effects of the various temporary differences between book and tax bases of the various balance sheet asset and liabilities and gives current recognition to changes in tax rates and laws. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. For additional information, please refer to Note 10 to the Company’s Consolidated Financial Statements and the section entitled “Federal Income Tax Expense,” both located elsewhere in this report.
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FINANCIAL CONDITION
Total assets increased by 2.5%, or $7.1 million, to $295.0 million at December 31, 2006 from $287.9 million at December 31, 2005. The increase in total assets is attributable to strong loan growth in the current year.
Total liabilities increased by $5.6 million, or 2.1%, to $267.1 million at December 31, 2006 from $261.5 million at December 31, 2005. The Bank increased the level of deposits in the current year to fund the growth in the loan portfolio. Growth in deposits and maturities of securities permitted repayment on certain other borrowings.
Total shareholders’ equity increased $1.5 million, or 5.8%, to $27.9 million at December 31, 2006 compared to $26.4 million at December 31, 2005. Current year net income was the primary reason for the increase, which was offset by current year dividends. Management monitors the capital levels of the Bank to provide for current and future business opportunities and to meet regulatory guidelines for “well capitalized” institutions.
Investments and Fed Funds Sold
Total investments securities available-for-sale decreased 29.8%, or $7.6 million, to $17.8 million at December 31, 2006, compared to $25.4 million at December 31, 2005. The decrease in investment securities is attributable to maturities and repayments on investments being used to fund loan growth and repayment of other borrowings in the current year. Equity investment in the Federal Home Loan Bank of Indianapolis (“FHLBI”) decreased $742,000, or 26.5% to $2.1 million at December 31, 2006 from $2.8 million at December 31, 2005. The Bank reduced the stock investment in FHLBI with the reduction in outstanding advances and collateral. Investment in Federal Reserve Bank (“FRB”) stock remained unchanged at $630,000 at December 31, 2006 compared to December 31, 2005. The Bank did not have any Fed Funds Sold at December 31, 2006 and 2005. The Company had no held-to-maturity securities as of December 31, 2006 and 2005.
The following table presents the maturity schedule of securities (based on estimated fair value) held and weighted average yield of those securities, as of December 31, 2006 (000’s omitted):
| Within One Year | After One but Within Five Years | After Five but within Ten | After Ten Years | Mortgage-Backed Securities | Total | |||||||||||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | |||||||||||||||||||||||||||
| U.S. Treasury & | ||||||||||||||||||||||||||||||||||||||
| Government agencies | $ | 13,330 | 3.05% | $ | 1,004 | 5.68% | $ | - | $ | - | $ | - | $ | 14,334 | 3.58% | |||||||||||||||||||||||
| Obligations of state & political subdivisions | 1,023 | 3.86% | 521 | 3.34% | 564 | 4.57% | 419 | 6.75% | - | 2,527 | 4.42% | |||||||||||||||||||||||||||
| Mortgage-backed securities | - | - | - | - | 967 | 5.01% | 967 | 5.01% | ||||||||||||||||||||||||||||||
| Total | $ | 14,353 | $ | 1,525 | $ | 564 | $ | 419 | $ | 967 | $ | 17,828 | ||||||||||||||||||||||||||
Maturity information does not incorporate any call provisions that the various securities may contain. Mortgage-backed securities do not have specific maturity dates, and thus have been incorporated into the above table as a separate maturity column. An analysis of the amortized cost and estimated fair market value of the investment portfolio is contained in Note 2 to the Company’s Consolidated Financial Statements.
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The following table summarizes the Company’s loan mix at December 31, 2006, 2005, 2004, 2003 and 2002 (000’s omitted):
| 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Commercial, financial and agricultural | $ | 173,201 | $ | 164,156 | $ | 143,583 | $ | 154,243 | $ | 139,971 | |||||||
| Residential-construction | 10,896 | 11,902 | 8,768 | 8,851 | 8,677 | ||||||||||||
| Residential-mortgage | 30,255 | 28,113 | 21,685 | 16,630 | 9,175 | ||||||||||||
| Consumer | 31,777 | 33,427 | 33,123 | 29,743 | 27,014 | ||||||||||||
| Total | $ | 246,129 | $ | 237,598 | $ | 207,159 | $ | 209,467 | $ | 184,837 | |||||||
The Company’s loan portfolio increased $8.5 million, or 3.6%, to $246.1 million at December 31, 2006 from $237.6 million at December 31, 2005. Growth in the commercial loan portfolio was the primary cause for the increase. Commercial, financial and agricultural loans increased by $9.0 million, or 5.5%, to $173.2 million at December 31, 2006 from $164.2 million at December 31, 2005. Residential mortgages increased by $2.2 million, or 7.6%, to $30.3 million at December 31, 2006 from $28.1 million at December 31, 2005. The growth in commercial and residential loans was due to management’s focus on business development and expansion of market presence in Hillsdale and Jackson. Other loan categories decreased somewhat in the current year. Specifically, real estate construction loans decreased by $1.0 million, or 8.5%, to $10.9 million at December 31, 2006 from $11.9 million at December 31, 2005. The decline in residential construction is consistent with the slowing in both the real estate and new housing markets in the local area. Consumer loans decreased $1.6 million, or 4.9%, to $31.8 million at December 31, 2006 from $33.4 million at December 31, 2005. The portfolio mix as of December 31, 2006 has remained relatively consistent with the prior year, as much of the commercial loan growth was matched by increases in residential mortgage loans as well.
Management expects continued loan growth in 2007, primarily in the commercial and agricultural loan portfolio. The growth in the commercial lending area will be driven by continued business development efforts. Consumer loans are expected to remain relatively stable or decline slightly with the present interest rate environment.
The following table presents the remaining maturity of total loans outstanding for the categories shown at December 31, 2006, based on scheduled principal repayments (000’s omitted), as well as categorized as fixed or variable rate loans (000’s omitted):
| Due Within 1 Year | Due After 1 but Within 5 Years | Due After 5 Years | Total | Fixed | Variable | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Commercial, financial and agricultural | $ | 40,515 | $ | 42,407 | $ | 90,279 | $ | 173,201 | $ | 69,780 | $ | 103,421 | ||||||||
| Residential - construction | 10,782 | - | 114 | 10,896 | 4,675 | 6,221 | ||||||||||||||
| Residential - mortgage | 4,112 | 8,922 | 17,221 | 30,255 | 16,938 | 13,317 | ||||||||||||||
| Consumer | 1,921 | 5,234 | 24,622 | 31,777 | 10,694 | 21,083 | ||||||||||||||
| Total | $ | 57,330 | $ | 56,563 | $ | 132,236 | $ | 246,129 | $ | 102,087 | $ | 144,042 | ||||||||
Closed-end commercial and agricultural loans, though they may mature within five years, typically have principal amortization periods that exceed five years. Principal balances on commercial and agricultural lines of credit are typically due in full at maturity (usually one year).
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Off-Balance Sheet Items
The following is a summary of outstanding commitments by the Company to grant loans, unfunded commitments under lines of credit and letters of credit at December 31, 2006 and 2005 (000’s omitted):
| 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|
| Commitments to extend credit | $ | 8,416 | $ | 7,370 | ||||
| Unfunded commitments under lines of credit | 57,989 | 61,242 | ||||||
| Commercial and standby letters of credit | 2,430 | 3,051 | ||||||
| Total | $ | 68,835 | $ | 71,663 | ||||
Outstanding commitments to grant loans, lines of credit and letters of credit decreased $2.9 million, or 3.9% to $68.8 million at December 31, 2006 from $71.7 million at December 31, 2005. The decrease in such off-balance sheet items is due primarily to a reduction in variable rate revolving lines of credit, as borrowers moved to fixed rate products with the rate increases in 2006. Included in these totals are commitments to lend on 1-4 family residences. Such loans are generally sold to the secondary market. Management does not expect that all commitments will result in funded loans.
Criticized and Classified Loans
The following tables present criticized and classified loans of the Bank at December 31, 2006 and 2005 (000’s omitted):
| Loan Risk Ratings | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 5 | 6 | 7 | 8 | Total | |||||||||||||
| Loan Type | |||||||||||||||||
| December 31, 2006 | |||||||||||||||||
| Commercial | $ | 11,875 | $ | 5,648 | $ | 2 | $ | - | $ | 17,525 | |||||||
| Agricultural | 1,128 | 1,971 | - | - | 3,099 | ||||||||||||
| Residential real estate mortgage | - | 1,055 | 114 | - | 1,169 | ||||||||||||
| Consumer | 27 | 54 | - | - | 81 | ||||||||||||
| Total | $ | 13,030 | $ | 8,728 | $ | 116 | $ | - | $ | 21,874 | |||||||
| December 31, 2005 | |||||||||||||||||
| Commercial | $ | 3,839 | $ | 7,547 | $ | - | $ | - | $ | 11,386 | |||||||
| Agricultural | 1,297 | 1,936 | - | - | 3,233 | ||||||||||||
| Residential real estate mortgage | 637 | - | - | - | 637 | ||||||||||||
| Consumer | 99 | - | - | - | 99 | ||||||||||||
| Total | $ | 5,872 | $ | 9,483 | $ | - | $ | - | $ | 15,355 | |||||||
Loans risk-rated as 5 are considered criticized loans, while loans risk-rated as 6 or higher are considered classified loans. Please refer to the section entitled “Critical Accounting Policies” located within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the definition of each loan risk rating. The Bank’s credit administration function is designed to provide increased information on all types of loans to identify adverse credit risk characteristics in as timely a manner as possible. Total criticized and classified loans increased $6.5 million, or 42.5% to $21.9 million at December 31, 2006 from $15.4 million at December 31, 2005. The largest increase was noted in loans risk-rated 5, which increased $7.1 million, or 121.9%, to $13.0 million at December 31, 2006 from $5.9 million at December 31, 2005. Loans risk-rated 6 decreased $0.8 million, or 8.0%, to $8.7 million at December 31, 2006 from $9.5 million at December 31, 2005. There was $116,000 in loans risk-rated 7 as of December 31, 2006. There were no loans risk-rated 7 at December 31, 2005. There were no loans risk-rated 8 at either December 31, 2006 or 2005. The increase in loan risk-rated 5 is related in large part to enhancements in the Bank’s loan review process including monthly examinations of criticized loans and more coverage of the loan portfolio. Management is focusing on early detection and monitoring of potential credit weakness. Management continues to closely monitor each criticized or classified loan and institute appropriate measures to eliminate the basis of criticism.
42
A continual process of monitoring, review and analysis is maintained to identify credit-related weaknesses of loans within the loan portfolio and assure that loans are risk-rated in an accurate and timely manner. Several levels of management oversight and Board of Directors oversight have been established as part of this process. Both internal and external resources are utilized in this process. Internally, the credit administration function reports directly to the CEO of the Company and is not subordinate to the loan origination function. Management maintains a “Loan Watch List” Committee for the purpose of providing continuing oversight of each criticized or classified loan’s financial condition and performance, payment performance, collateral analysis, trend analysis and other relevant information. Loan workout plans are developed and reviewed in detail. Staff resources have been allocated to conduct internal review of loan customers’ financial information. Oversight from the Board of Directors is provided through the Directors Loan Committee, which meets on a monthly basis. Additionally, the full Board of Directors is provided detailed information on criticized and classified loans.
Non-performing Assets
Non-performing assets are comprised of other real estate owned (“OREO”), loans accounted for on a non-accrual basis, and loans contractually past due 90 days or more as to interest or principal payments but still accruing interest. Accrual of interest on loans is generally discontinued at the time a loan becomes 90 days delinquent in its payments, unless the credit is well-secured and in the process of collection.
The following table sets forth information with respect to the Company’s non-performing assets at December 31, 2006, 2005, 2004, 2003 and 2002 (000’s omitted):
| 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Non-accruing loans past due | $ | 2,728 | $ | 1,104 | $ | 671 | $ | 1,459 | $ | 603 | |||||||
| Loans past due 90 days or more still accruing | 668 | 672 | 556 | 693 | 1,853 | ||||||||||||
| Total non-performing loans | 3,396 | 1,776 | 1,227 | 2,152 | 2,456 | ||||||||||||
| Other Real Estate | 169 | 549 | 715 | 181 | 1,783 | ||||||||||||
| Total non-performing assets | $ | 3,565 | $ | 2,325 | $ | 1,942 | $ | 2,333 | $ | 4,239 | |||||||
| Non-performing loans as a percent | |||||||||||||||||
| of total loans | 1.38% | 0.75% | 0.59% | 1.03% | 1.33% | ||||||||||||
| Non-accruing loans | |||||||||||||||||
| as a percent of total loans | 1.11% | 0.46% | 0.32% | 0.70% | 0.33% | ||||||||||||
| Non-performing assets as a percent | |||||||||||||||||
| of total assets | 1.21% | 0.81% | 0.75% | 0.72% | 1.48% | ||||||||||||
| Non-performing loans as a percent | |||||||||||||||||
| of the loan loss reserve | 120.55 | % | 66.19% | 49.18% | 93.48% | 116.95 | % | ||||||||||
Total non-performing assets increased $1.3 million, or 53.3%, to $3.6 million at December 31, 2006 from $2.3 million at December 31, 2005. The increase in non-performing assets primarily related to non-accrual loans. The level of non-performing loans as a percent of total loans increased to 1.38% as of December 31, 2006 compared to 0.75% as of December 31, 2005. Approximately $738,000 of commercial and residential loans went to nonaccrual in the month of December 2006. This increase is reflective of the poor economic conditions within the state of Michigan. Management is working closely with the borrowers to correct the respective deficiencies in these loans. Management is closely monitoring the credit quality of the loan portfolio. As noted above, loans risk-rated as 6 decreased $0.8 million, or 8.0%, during 2006. This decrease was offset by a significant increase in the 5-rated credits, which increased $7.1 million, or 121.9%. The risk that such loans will become nonperforming loans is higher than non-classified loans, despite efforts to eliminate the basis of criticism through the credit administration process.
Non-performing loans as a percentage of the loan loss reserve has increased to 120.55% as of December 31, 2006 compared to 66.19% as of December 31, 2005. The non-performing loans are primarily comprised of both commercial and residential real estate properties, which management believes are adequately collateralized or have specific reserves allocated to cover estimated losses.
43
Other real property that we acquire as a result of the foreclosure process is classified as OREO until it is sold. Our credit administration department decides whether to rehabilitate the property or sell it “as is,” and whether to list the property with a broker or sell it at auction. OREO is carried at the lesser of the cost or net realizable value. Subsequent to foreclosure, valuations are periodically performed by management in order to determine whether additional write-downs are required. Generally, we are able to dispose of a substantial portion of this type of real estate and other repossessed assets during each year, but we invariably acquire additional real estate and other assets through repossession in the ordinary course of business. At December 31, 2006, we had $169,000 of other real estate compared to $549,000 at December 31, 2005.
The following tables detail the allocation among individual loan portfolios within the allowance for loan and lease losses at December 31, 2006, 2005, 2004, 2003 and 2002 (000’s omitted):
| 2006 | 2005 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Allowance | % of Total Allowance | % of Loans to Total Loans | Allowance | % of Total Allowance | % of Loans to Total Loans | |||||||||||||||
| Commercial, financial and agricultural | $ | 1,904 | 67.59% | 70.37% | $ | 2,088 | 77.82% | 69.09% | ||||||||||||
| Residential-mortgage | 285 | 10.12% | 12.29% | 84 | 3.13% | 11.83% | ||||||||||||||
| Residential-construction | 131 | 4.65% | 4.43% | 70 | 2.61% | 5.01% | ||||||||||||||
| Consumer | 313 | 11.11% | 12.91% | 262 | 9.77% | 14.07% | ||||||||||||||
| Other qualitative factors & trends | 184 | 6.53% | na | 179 | 6.67% | na | ||||||||||||||
| $ | 2,817 | 100.00% | 100.00% | $ | 2,683 | 100.00% | 100.00% | |||||||||||||
| 2004 | 2003 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Allowance | % of Total Allowance | % of Loans to Total Loans | Allowance | % of Total Allowance | % of Loans to Total Loans | |||||||||||||||
| Commercial, financial and agricultural | $ | 1,965 | 78.76% | 69.31% | $ | 1,991 | 86.49% | 73.64% | ||||||||||||
| Residential-mortgage | 97 | 3.89% | 10.47% | 9 | 0.39% | 4.22% | ||||||||||||||
| Residential-construction | 37 | 1.48% | 4.23% | 25 | 1.09% | 7.94% | ||||||||||||||
| Consumer | 311 | 12.46% | 15.99% | 126 | 5.47% | 14.20% | ||||||||||||||
| Other qualitative factors & trends | 85 | 3.41% | na | 151 | 6.56% | na | ||||||||||||||
| $ | 2,495 | 100.00% | 100.00% | $ | 2,302 | 100.00% | 100.00% | |||||||||||||
| 2002 | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Allowance | % of Total Allowance | % of Loans to Total Loans | ||||||||||||||||||
| Commercial, financial and agricultural | $ | 1,613 | 76.81% | 75.85% | ||||||||||||||||
| Residential-mortgage | 18 | 0.86% | 4.67% | |||||||||||||||||
| Residential-construction | 25 | 1.19% | 5.31% | |||||||||||||||||
| Consumer | 182 | 8.67% | 14.17% | |||||||||||||||||
| Other qualitative factors & trends | 262 | 12.47% | na | |||||||||||||||||
| $ | 2,100 | 100.00% | 100.00% | |||||||||||||||||
The allowance for loan and lease losses (the “allowance”) as a percentage of total loans was 1.14% at December 31, 2006, compared to 1.13% at December 31, 2005. For the twelve months ended December 31, 2006 provision for loan losses decreased $9,000, or 2.6%, to $333,000 from $342,000 for the same period in 2005. The allowance as a percentage of loans increased slightly in the current year with some worsening in credit quality. The provision for loan losses decreased in the current year, as the loan portfolio did not grow as significantly in 2006 as compared to 2005. The loan portfolio grew by 3.6% in 2006 compared to 14.7% in 2005. Management continues to closely monitor the credit risk within the individual loan pools. Please refer to the subsection entitled “Criticized and Classified Loans” within the section entitled “Loans, Credit Quality and Allowance for Loan and Lease Losses” above for more detail.Commercial and agricultural loans represent the largest segment of the Company’s loan portfolio. The portion of the allowance attributable to commercial and agricultural loans declined, as a percentage of the entire allowance, to 71.9% (or $2.02 million) at December 31, 2006 from 77.8% (or $2.09 million) at December 31, 2005. This is related to management’s more detail analysis of the required specific reserves on the commercial credits. While other loan categories registered relatively small changes as a percentage of the allowance, the impact on the overall allowance analysis is minimal because of the substantially smaller dollar amounts involved.
44
The Company maintains an allowance for loan and lease losses believed to be sufficient to absorb estimated probable credit losses inherent in the loan portfolio, recognizing the imprecision inherent in the process of estimating credit losses.
The allowance represents management’s estimate of probable net loan charge-offs in the portfolio at each balance sheet date. The allowance contains provisions for probable losses that have been identified relating to specific borrowing relationships as well as probable losses believed to be inherent in the loan portfolio without specific identification of loan relationships.
The allowance for loan and lease losses represents the Company’s estimate of probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date. The allowance for loan and lease losses is maintained at an adequate level through additions to the provision for loan losses. An appropriate level of the risk allocated allowance is determined based on the application of risk percentages to graded loans by categories. Specific reserves are established for individual loans when deemed necessary by management. In addition, management considers other factors when determining the unallocated allowance, including loan quality, changes in the size and character of the loan portfolio, consultation with regulatory authorities, amount of non-performing loans, delinquency trends, economic conditions and industry trends.
Inherent risks and uncertainties related to the operation of a financial institution require the Company to rely on estimates, appraisals and evaluations of loans to prepare its financial statements. Changes in economic conditions and the financial prospects of borrowers may result in abrupt changes to the estimates, appraisals or evaluations used. In addition, if actual circumstances and losses differ substantially from management’s assumptions and estimates, the allowance for loan and lease losses may not be sufficient to absorb all future losses, and net income could be significantly impacted.
Deposits
Total deposits increased $25.2 million, or 12.0%, to $235.9 million at December 31, 2006 from $210.7 million at December 31, 2005. Specifically, noninterest-bearing deposits increased $0.9 million, or 2.1%, to $46.3 million at December 31, 2006 from $45.4 million at December 31, 2005. The increase in noninterest bearing deposits is attributable to continuing business development efforts. Interest-bearing deposits increased $24.2 million, or 14.7%, to $189.6 million at December 31, 2006 from $165.4 million at December 31, 2005. Specifically, certificates of deposit (“CD’s”) with balances of $100,000 and greater increased $17.8 million, or 32.4%, to $72.9 million at December 31, 2006 from $55.1 million at December 31, 2005. The increase is attributable to a greater amount of local municipal CD’s obtained through a competitive bidding process. Municipal CD’s generally have shorter maturity lengths and thus can reprice more often than longer term CD’s. Certificates of deposit with balances under $100,000 increased $6.7 million, or 18.2%, to $43.6 million at December 31, 2006 from $36.9 million December 31, 2005. The increase is attributable to business development efforts of the retail branches.
Borrowed Funds
Borrowed funds consist of advances from the Federal Home Loan Bank of Indianapolis (“FHLBI”), agreements to repurchase securities sold under Repurchase Agreements (“repos”) with specific customers and third-party financial institutions, and draws on a Federal funds purchased line of credit at a correspondent bank. FHLBI advances decreased by $6.0 million, or 35.6%, to $10.9 million at December 31, 2006 from $16.9 million at December 31, 2005. The decrease in the current year is due to deposit growth outpacing loan growth which provided liquidity to repay the higher rate FHLBI advances. Repurchase agreements decreased $6.0 million, or 43.6%, to $7.7 million at December 31, 2006 from $13.7 million at December 31, 2005. The majority of the decrease is due to the repayment of a $5.0 million repurchase agreement to a third party financial institution. The balance of the decrease is related to fluctuations in normal daily activity within the customer repurchase balances. Borrowings under the Bank’s Federal funds purchased line of credit decreased $2.4 million, or 26.7%, to $6.6 million at December 31, 2006 from $9.0 million at December 31, 2005. The decrease is attributable to normal daily fluctuations in the liquidity needs of the Company.
45
Amounts borrowed from the FHLBI may be collateralized with either investment securities or certain types of loans. At December 31, 2006 no investment securities were pledged as collateral against FHLBI borrowings. As disclosed in Note 8 to the Company’s Consolidated Financial Statements, $21.6 million and $31.8 million of 1-4 family residential mortgage loans were pledged as collateral at December 31, 2006 and 2005, respectively. For additional information regarding borrowed funds please refer to Note 8 to the Consolidated Financial Statements included elsewhere in this report.
Capital
Beginning in the first quarter of 2006, the Company became exempt from the Capital Guidelines, as the Board of Governors of the Federal Reserve System increased the asset size threshold from $150 million to $500 million in consolidated assets for determining whether a Bank Holding Company may qualify for an exemption from the Capital Guidelines. Under the revised regulatory financial reporting requirements, the Company will only be required to file parent-only financial data on a semi-annual basis. This change only impacts the Company and the Bank will continue to file necessary regulatory reports.
The Bank continues to maintain sufficient risk-based capital levels to remain categorized as “well-capitalized” under federal regulatory requirements. At the Bank level total risk-based capital (RBC) to risk-weighted assets (RWA) decreased from 13.7% at December 31, 2005 to 12.5% at December 31, 2006. Similarly, the ratio of Tier 1 RBC to RWA decreased to 11.4% at December 31, 2006 from 12.6% at December 31, 2005. The ratio of Tier 1 RBC to average assets decreased to 10.4% at December 31, 2006 from 10.7% at December 31, 2005. Risk-based capital levels decreased as a result of a dividend of $3.6 million from the Bank to the Holding Company in December 2006 to provide liquidity to redeem the subordinated debt, as discussed in Note 9 of the consolidated financial statements. The dividend exceeded the net income at the Bank in the current year, thereby reducing capital.
The number of outstanding shares at December 31, 2005 of 735,379 decreased to 725,206 at December 31, 2006, as a result of the redemption and retirement of ESOP/401k shares as well as repurchase and retirement of shares in December 2006. Management monitors the capital levels of the Company and the Bank to provide for current and future business opportunities.
RESULTS OF OPERATIONS
Net Income
2006.Continuing Operations – Income from continuing operations for the year ended December 31, 2006 increased $0.5 million, or 23.9%, to $2.4 million in 2006 compared to $1.9 million in 2005. Basic earnings per share (“EPS”) attributable to continuing operations for the twelve months ended December 31, 2006 were $3.27 compared to $2.47 for the same period in 2005. Diluted EPS for the twelve months ended December 31, 2006 was $3.26 compared to $2.45 for the same period in 2005. Increase in net income due primarily to cost reductions over the prior year as well as some improvement in net interest income.
2005.Continuing Operations – Income from continuing operations for the year ended December 31, 2005 declined $215,000, or 10.0%, to $1.9 million in 2005 compared to $2.2 million in 2004. Basic earnings per share (“EPS”) attributable to continuing operations for the twelve months ended December 31, 2005 were $2.47 compared to $2.54 for the same period in 2004. Diluted EPS for the twelve months ended December 31, 2005 was $2.45 compared to $2.52 for the same period in 2004.
Combined – On a combined basis net income for the year ended December 31, 2005 decreased $5.2 million, or 72.8%, to $1.9 million from $7.1 million for the same period in 2004. Basic EPS for the year ended December 31, 2005 were $2.47 compared to $8.42 for the same period in 2004. Diluted EPS for the year ended December 31, 2005 were $2.45 compared to $8.34 for the same period in 2004. The reason for the decrease is due to the gain on sale of the Bank of Washtenaw in the fourth quarter of 2004, which is discussed in more detail below.
2004.Continuing Operations — Income from continuing operations for the twelve months ended December 31, 2004 declined $1.2 million, or 35.9%, to $2.2 million compared to $3.4 million for the same period in 2003. Basic EPS attributable to continuing operations for the twelve months ended December 31, 2004 were $2.54 compared to $3.92 for the same period in 2003. Diluted EPS for the twelve months ended December 31, 2004 was $2.52 compared to $3.89 for the same period in 2003.
46
The decline in income from continuing operations results primarily from lower levels of mortgage origination-related income in 2004. Though interest rates remained low compared to historical levels, residential mortgage refinance activity declined as most homeowners had previously refinanced their residential mortgages and wouldn’t have benefited from additional refinance activity.
Discontinued Operation – On October 29, 2004 the Company completed the sale of its former subsidiary, the Bank of Washtenaw (“discontinued operation” or “discontinued component”). All activity attributable to Bank of Washtenaw is presented as a separate item within the Company’s financial statements. Income attributable to discontinued operation for the twelve months ended December 31, 2004 was $5.0 million compared to a loss of $(124,000) for the same period in 2003. Income from the discontinued operation in 2004 consisted of income from the operation of the discontinued component and gain on sale of the discontinued component. In 2004 the Company recognized a net gain of $4.4 million on the sale of Bank of Washtenaw. Income attributable to the operation of the discontinued component in 2004 totaled $562,000 compared to a loss of $(124,000) for the twelve months ended December 31, 2003. Basic EPS attributable to the discontinued operation for the twelve months ended December 31, 2004 were $5.88 compared to $(.14) for the same period in 2003. Diluted EPS for the twelve months ended December 31, 2004 were $5.82 compared to $(.14) for the same period in 2003.
Combined – On a combined basis net income for the twelve months ended December 31, 2004 increased $3.9 million, or 120.5%, to $7.1 million compared to $3.2 million for the same period in 2003. Basic EPS for the twelve months ended December 31, 2004 were $8.42 compared to $3.78 for the same period in 2003. Diluted EPS for the twelve months ended December 31, 2004 were $8.34 compared to $3.75 for the same period in 2003.
Net Interest Income
2006.Net interest income for the twelve months ended December 31, 2006 increased $0.1 million, or 1.2%, to $11.8 million compared to $11.7 million for the same period in 2005. The increase in net interest income was primarily attributable to increases in the volume and yield in the loan portfolio, offset in large part to higher rates paid on interest-bearing liabilities. Total interest income increased by $2.8 million, or 17.0%, to $18.9 million for the twelve months ended December 31, 2006 compared to $16.1 million during the same period in 2005. An increase in the loan portfolio coupled with continued increases in the prime lending rate was the cause of the increase in interest income. Interest expense increased by $2.7 million, or 58.5%, to $7.1 million for the twelve months ended December 31, 2006 compared to $4.4 million during the same period in 2005. Increases in the level of time deposits as well as an increase in rates paid on interest bearing deposits caused the increase in interest expense. Please refer to the discussion of the Rate/Volume Table that follows for additional information.
2005.Net interest income for the twelve months ended December 31, 2005 decreased $409,000, or 3.4%, to $11.7 million compared to $12.1 million for the same period in 2004. The decrease in net interest income was primarily attributable to increases in interest expense attributable to higher levels of deposits and borrowing coupled with increases in rates paid on interest-bearing liabilities. Total interest income increased by $1.2 million, or 8.4%, to $16.1 million for the twelve months ended December 31, 2005 compared to $14.9 million during the same period in 2004. An increase in the loan portfolio coupled with a 2% increase in the prime lending rate was the cause of the increase in interest income. Interest expense increased by $1.6 million, or 59.2%, to $4.4 million for the twelve months ended December 31, 2005 compared to $2.8 million during the same period in 2004. Increases in the level of borrowings and time deposits as well as an increase in rates paid on interest bearing deposits caused the increase in interest expense. Please refer to the discussion of the Rate/Volume Table that follows for additional information.
2004. Net interest income for the twelve months ended December 31, 2004 increased $303,000, or 2.6%, to $12.1 million compared to $11.8 million for the same period in 2003. The increase in net interest income was primarily attributable to decreasing interest expense during 2004. Total interest income declined by $154,000, or 1.0%, to $14.9 million for the twelve months ended December 31, 2004 compared to $15.0 million during the same period in 2003. A lower amount of loans outstanding, coupled with a continued low rate environment were the primary causes of the decline. Interest expense decreased by $457,000, or 14.1%, to $2.8 million for the twelve months ended December 31, 2004 compared to $3.3 million during the same period in 2003. Reductions in rates paid on interest-bearing accounts accounted for most of the decline.
47
The following table presents the Company’s consolidated average balances of interest-earning assets, interest-bearing liabilities, and the amount of interest income or interest expense attributable to each category, the average yield or rate for each category, and the net interest margin for the years ended December 31, 2006, 2005 and 2004 (000’s omitted). Average loans are presented net of unearned income and the allowance for loan and lease losses. Interest on loans includes loan fees. Nonaccrual loans are included in the average balance of loans.
| ------------2006------------ | ------------2005------------ | ------------2004------------ | |||||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Average Balance | Interest | Average Yield/ Rate | Average Balance | Interest | Average Yield/ Rate | Average Balance | Interest | Average Yield/ Rate | |||||||||||||||||||||
| Interest-earning assets: | |||||||||||||||||||||||||||||
| Loans receivable | $ | 238,495 | $ | 17,711 | 7.43 | % | $ | 219,995 | $ | 14,951 | 6.80 | % | $ | 209,600 | $ | 13,914 | 6.64 | % | |||||||||||
| Securities available for sale(1) | 23,548 | 796 | 3.38 | % | 27,257 | 915 | 3.36 | % | 24,063 | 784 | 3.26 | % | |||||||||||||||||
| Federal funds sold | 3,937 | 196 | 4.98 | % | 3,800 | 114 | 3.00 | % | 4,257 | 46 | 1.08 | % | |||||||||||||||||
| Equity securities | 3,178 | 162 | 5.10 | % | 3,229 | 146 | 4.52 | % | 3,036 | 140 | 4.61 | % | |||||||||||||||||
| Interest-bearing balances with | |||||||||||||||||||||||||||||
| other financial institutions | 191 | 10 | 5.24 | % | 148 | 4 | 2.70 | % | 57 | 1 | 1.75 | % | |||||||||||||||||
| Total interest-earning assets | 269,349 | 18,875 | 7.01 | % | 254,429 | 16,130 | 6.34 | % | 241,013 | 14,885 | 6.18 | % | |||||||||||||||||
| Noninterest-earning assets: | |||||||||||||||||||||||||||||
| Cash and due from financial institutions | 8,834 | 9,215 | 12,441 | ||||||||||||||||||||||||||
| Premises and equipment, net | 6,787 | 5,719 | 5,640 | ||||||||||||||||||||||||||
| Other assets | 5,881 | 4,648 | 4,270 | ||||||||||||||||||||||||||
| Total assets | $ | 290,851 | $ | 274,011 | $ | 263,364 | |||||||||||||||||||||||
| Interest-bearing liabilities: | |||||||||||||||||||||||||||||
| Interest-bearing demand deposits | $ | 46,146 | 856 | 1.85 | % | $ | 49,425 | 586 | 1.19 | % | $ | 60,683 | 328 | 0.54 | % | ||||||||||||||
| Savings deposits | 27,996 | 105 | 0.38 | % | 31,376 | 109 | 0.35 | % | 33,087 | 112 | 0.34 | % | |||||||||||||||||
| Time deposits | 104,938 | 4,506 | 4.29 | % | 87,988 | 2,639 | 3.00 | % | 75,767 | 1,704 | 2.25 | % | |||||||||||||||||
| Subordinated debentures | 4,671 | 419 | 8.97 | % | 5,000 | 359 | 7.18 | % | 5,000 | 285 | 5.70 | % | |||||||||||||||||
| Repurchase agreements and other borrowings | 28,519 | 1,164 | 4.08 | % | 21,193 | 756 | 3.57 | % | 12,223 | 366 | 2.99 | % | |||||||||||||||||
| Total interest-bearing liabilities | 212,270 | 7,050 | 3.32 | % | 194,982 | 4,449 | 2.28 | % | 186,760 | 2,795 | 1.50 | % | |||||||||||||||||
| Non-interest bearing demand deposits | 45,594 | 43,258 | 42,343 | ||||||||||||||||||||||||||
| Other liabilities | 5,845 | 3,164 | 2,969 | ||||||||||||||||||||||||||
| Total liabilities | 263,709 | 241,404 | 232,072 | ||||||||||||||||||||||||||
| Shareholders' equity | 27,142 | 32,607 | 31,292 | ||||||||||||||||||||||||||
| Total liabilities and shareholders' equity | $ | 290,851 | $ | 274,011 | $ | 263,364 | |||||||||||||||||||||||
| Net interest income | $ | 11,825 | $ | 11,681 | $ | 12,090 | |||||||||||||||||||||||
| Net spread | 3.69 | % | 4.06 | % | 4.68 | % | |||||||||||||||||||||||
| Net interest margin(2) | 4.39 | % | 4.59 | % | 5.02 | % | |||||||||||||||||||||||
| Ratio of interest-earning assets | |||||||||||||||||||||||||||||
| to interest-bearing liabilities | 126.89 | % | 130.49 | % | 129.05 | % | |||||||||||||||||||||||
| (1) | Interest income on tax-exempt securities has not been adjusted to a taxable equivalent basis. |
| (2) | Net interest earnings divided by average interest-earning assets. |
2006.The Bank’s net interest margin decreased 20 basis points, to 4.39% for the year ended December 31, 2006 compared to 4.59% for the same period in 2005. This decrease in net interest margin is primarily attributable to increases in rates paid on interest-bearing liabilities. The average rate paid on interest-bearing liabilities increased 104 basis points to 3.32% for the year ended December 31, 2006 compared to 2.28% for the same period in 2005. Much of this increase in rates paid relates to costs of deposits. The average rate paid on interest-bearing demand accounts as well as time deposits increased in the current year in response to competitive pressures in the local market. The cost of the subordinated debentures also increased substantially in 2006 to an average rate of 8.97% up from 7.18% in 2005. Management redeemed the subordinated debt in December 2006 and will likely opt for lower cost liquidity sources. The average yield earned on interest-earning assets increased 67 basis points to 7.01% for the year ended December 31, 2006 up from 6.34% for the same period in 2005. The Company’s net interest margin remains quite strong, and management continues to take steps to neutralize some portion of this risk.
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2005. The Bank’s net interest margin decreased 43 basis points, to 4.59% for the year ended December 31, 2005 compared to 5.02% for the same period in 2004. Much of the decrease in net interest margin is attributable to an increase in the rates paid on interest-bearing liabilities. The Bank’s cost of funds increased as the loan growth was funded primarily by higher rate time deposits and other borrowings. The average rate paid on interest-bearing liabilities increased 78 basis points, to 2.28% for the year ended December 31, 2005 compared to 1.50% for the same period in 2004. The average yield earned on interest-earning assets increased 16 basis points, to 6.34% for the year ended December 31, 2005 compared to 6.18% for the same period in 2004. The yield on loans receivable increased to 6.80% for the year ended December 31, 2005 compared to 6.64% for the same period in 2004. The increases in the overall lending rates caused much of this increase. Improvements to the yield attributable to increases in lending rates were offset by a reduction in the Business Manager portfolio in 2005. The Business Manager was a high yield product which posed higher credit risk to the Bank. Management made the determination in late 2004 to discontinue the product. The Business Manager portfolio averaged $2.1 million in principal in 2004. Without the income from the Business Manager portfolio, the yield on loans would have been 6.51% in 2004. Please refer to the Rate-Volume Table presented below for additional information.
2004.The Bank’s net interest margin decreased 36 basis points, to 5.02% for the twelve months ended December 31, 2004 compared to 5.38% for the same period in 2003. The decrease in net interest margin was primarily attributable to an historically low rate environment in which the average rate earned on interest-earning assets declined more sharply than the decline of the average rate paid on interest-bearing liabilities. The average rate earned on interest-earning assets declined 68 basis points to 6.18% for the twelve months ended December 31, 2004 from 6.86% during the same period in 2003. The average rate paid on interest-bearing liabilities declined 41 basis points to 1.50% for the twelve months ended December 31, 2004 from 1.91% during the same period in 2003.
The following table presents 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: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change (the sum of the prior columns). The changes attributable to the combined impact of volume and rate have been allocated on a proportional basis between changes in rate and volume (000’s omitted):
| 2006-2005 | 2005-2004 | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Net | Increase/(decrease) due to | Net | Increase/(decrease) due to | |||||||||||||||||
| Change | Volume | Rate | Change | Volume | Rate | |||||||||||||||
| Interest-earning assets: | ||||||||||||||||||||
| Loans receivable | $ | 2,760 | $ | 1,317 | $ | 1,443 | $ | 1,037 | $ | 690 | $ | 347 | ||||||||
| Securities available-for-sale | (119 | ) | (125 | ) | 6 | 131 | 104 | 27 | ||||||||||||
| Federal funds sold | 82 | 7 | 75 | 68 | (5 | ) | 73 | |||||||||||||
| Equity securities | 16 | (3 | ) | 19 | 6 | 9 | (3 | ) | ||||||||||||
| Interest-bearing balances with | ||||||||||||||||||||
| other financial institutions | 6 | 2 | 4 | 3 | 2 | 1 | ||||||||||||||
| Total interest-earning assets | 2,745 | 1,198 | 1,547 | 1,245 | 800 | 445 | ||||||||||||||
| Interest-bearing liabilities: | ||||||||||||||||||||
| Interest-bearing demand | ||||||||||||||||||||
| deposits | 270 | (61 | ) | 331 | 258 | (61 | ) | 319 | ||||||||||||
| Savings deposits | (4 | ) | (13 | ) | 9 | (3 | ) | (6 | ) | 3 | ||||||||||
| Time deposits | 1,867 | 728 | 1,139 | 935 | 275 | 660 | ||||||||||||||
| Subordinated debentures | 60 | (29 | ) | 89 | 74 | - | 74 | |||||||||||||
| Repurchase agreements and | ||||||||||||||||||||
| other borrowings | 408 | 299 | 109 | 390 | 375 | 15 | ||||||||||||||
| Total interest-bearing liabilities | 2,601 | 924 | 1,677 | 1,654 | 583 | 1,071 | ||||||||||||||
| Net change in net interest | ||||||||||||||||||||
| income | $ | 144 | $ | 274 | ($ | 130 | ) | ($ | 409 | ) | $ | 217 | ($ | 626 | ) | |||||
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As the above table indicates, in 2006 net interest income increased $144,000 with the increase in interest income earned on the loans receivable portfolio, which increased $2.8 million for the twelve months ended December 31, 2006. This increase was due to both growth in volume and increases in yield earned. This increase in interest income was largely offset by similar increases in interest expense. For the twelve months ended December 31, 2006 total interest expense increased $2.6 million compared to the same period in 2005. The rate increases were most significant in the interest-bearing demand deposits and time deposits. The rate increases in interest-bearing demand deposits and time deposits accounted for $0.3 million and $1.1 million of the increase in interest expense, respectively. While net interest margin has been reduced due to the above mentioned factors, it still remains strong in comparison to peer community banks. In an effort to preserve margin, the Company plans to reduce the cost of funds through multiple initiatives which include gathering additional core deposits and locking into fixed rate borrowings.
Provision for Loan Losses
The activity in the allowance for loan and lease losses for the twelve months ended December 31, 2006, 2005, 2004, 2003 and 2002 is presented in the following table (000’s omitted):
| Years ended December 31, (in thousands) | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||
| Balance at beginning of year | $ | 2,683 | $ | 2,495 | $ | 2,302 | $ | 2,100 | $ | 1,891 | |||||||
| Loans charged off: | |||||||||||||||||
| Residential real estate - mortgage | 67 | 22 | 18 | - | 23 | ||||||||||||
| Residential real estate - construction | - | - | - | - | - | ||||||||||||
| Commercial and agricultural | 55 | 46 | 427 | 329 | 357 | ||||||||||||
| Consumer | 124 | 153 | 137 | 177 | 226 | ||||||||||||
| 246 | 221 | 582 | 506 | 606 | |||||||||||||
| Recoveries of loans previously charged-off: | |||||||||||||||||
| Residential real estate - mortgage | - | - | - | - | 1 | ||||||||||||
| Commercial and agricultural | 27 | 24 | 51 | 44 | 101 | ||||||||||||
| Consumer | 20 | 43 | 31 | 69 | 46 | ||||||||||||
| 47 | 67 | 82 | 113 | 148 | |||||||||||||
| Net loans charged-off | 199 | 154 | 500 | 393 | 458 | ||||||||||||
| Provision for loan losses | 333 | 342 | 693 | 595 | 667 | ||||||||||||
| Balance at end of year | $ | 2,817 | $ | 2,683 | $ | 2,495 | $ | 2,302 | $ | 2,100 | |||||||
| Net charge-off ratio | 0.08 | % | 0.07 | % | 0.24 | % | 0.20 | % | 0.25 | % | |||||||
| Allowance to total loans | 1.14 | % | 1.13 | % | 1.20 | % | 1.10 | % | 1.14 | % | |||||||
2006.For the year ended December 21, 2006, gross loan charge-offs increased $25,000, or 11.3%, to $246,000 compared to $221,000 for the same period in 2005. The most significant change was in the residential real estate category with increased to $67,000 for the twelve months ended December 31, 2006 compared to $22,000 for the same period in 2005. This increase is reflective of the worsening economic conditions with the local market, as well as the slow real estate market in Michigan. Commercial and agricultural charge-offs increased $9,000, or 19.6%, to $55,000 up from $46,000 for the same period in 2005. Consumer charge-offs decreased in the current year by $29,000, or 19.0%, to $124,000 down from $153,000 for the year ended December 31 2005. The net charge-off rate increased to 0.08% for the twelve months ended December 31, 2006 compared to 0.07% for the same period in 2005. Despite the current year increase, the charge-off rate is still well below the levels experienced in 2004, 2003, and 2002, which were 0.24%, 0.20% and 0.25%, respectively. This decrease is largely due to the discontinuance of the Business Manager program in late 2004, which was a product with the higher yield but also posed a higher credit risk.
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Gross recoveries for the year ended December 31, 2006 decreased to $47,000 down from $67,000 for the same period in 2005. The decrease in recoveries is considered a normal business fluctuations and varies based on the circumstances of the related charge-offs.
For the year ended December 31, 2006, provision for loan losses decreased $9,000, or 2.6%, to $333,000 compared to $342,000 for the same period in 2005. The provision for loan losses decreased in the current year, as the loan portfolio did not grow as significantly in 2006 as compared to 2005. The loan portfolio grew by only 3.6% in 2006 compared to 14.7% in 2005.
2005.For the twelve months ended December 31, 2005, gross loan charge-offs decreased $361,000, or 62.0%, to $221,000 compared to $582,000 during the same period in 2004. The gross loan charge-offs for the year ended December 31, 2004 included approximately $165,000 in loan charge-offs related to an accrued interest receivable adjustment, which is discussed in more detail below. After consideration of this adjustment, gross loan charge-offs for the year decreased $196,000, or 47.0%. The most significant change was the decrease in gross charge-offs related to commercial and agricultural loans, which decreased $381,000, or $247,000 after consideration of the charge-offs related to the accrued interest adjustment. This decrease is largely due to the discontinuance of the Business Manager program as indicated above. Levels of criticized loans decreased in 2005 as well. Charge-offs on consumer loans increased somewhat over the prior year levels but the change is considered a normal business fluctuation.
Gross recoveries for the year ended December 31, 2005 decreased to $67,000 down from $82,000 for the same period in 2004. The decrease in recoveries is related to the overall decreased level of charge-offs.
For the twelve months ended December 31, 2005 provision for loan losses decreased $351,000, or 50.6%, to $342,000 from $693,000 for the same period in 2004. The decrease is related to the overall decrease in the level of net charge-offs, as well as a significant improvement in the level of criticized and classified loans during 2005. Please refer to the subsection entitled “Criticized and Classified Loans” within the section entitled “Loans, Credit Quality and Allowance for Loan and Lease Losses” above for more detail.
2004. For the twelve months ended December 31, 2004, gross loan charge-offs increased $76,000, or 15.0%, to $582,000 compared to $506,000 during the same period in 2003. During the fourth quarter of 2004 the Company recognized $165,000 in loan charge-offs related to accrued interest receivable associated with loans previously charged-off or placed on non-accrual status. Any uncollected accrued interest receivable must be written off against the allowance (for uncollected accrued interest attributable to previous calendar years) or income (for uncollected accrued interest attributable to the current calendar year). During the fourth quarter management discovered numerous loans that had been previously charged-off or placed on nonaccrual where uncollected accrued interest had not been written off, as described above. After detailed analysis it was determined that the uncollected accrued interest associated with these loans was attributable to previous calendar years. Accordingly, the aggregate amount was charged against the allowance for loan and lease losses. Written procedures were developed and implemented during the fourth quarter to avoid recurrence. Of the $165,000 in uncollected accrued interest that was charged against the allowance, approximately $134,000 was associated with commercial and agricultural loans.
In the aggregate, commercial loan charge-offs increased $98,000, or 29.8% for the twelve months ended December 31, 2004 compared with the same period in 2003. Discounting the amounts associated with the accrued interest receivable accounting issue, commercial loan charge-offs would have been approximately $293,000, representing a $36,000 decline, or 10.9%. Consumer loan charge-offs decreased by $40,000, or 22.6%, for the twelve months ended December 31, 2004 compared with the same period in 2003. For the year ended 2004 residential mortgage loan charge-offs totaled $18,000, while none were noted in 2003. Recoveries of loans previously charged-off fell $31,000, or 27.4%, for the twelve months ended December 31, 2004 to $82,000 compared to $113,000 for the same period in 2003. The decline in recoveries from previously charged-off loans resulted from typical fluctuations noted with this activity.
For the twelve months ended December 31, 2004 provision for loan losses increased $98,000, or 16.5%, to $693,000 from $595,000 for the same period in 2003. Several factors affected the decision to increase the loan loss provision including a continued elevated amount of criticized and classified loans, significant migration of loans from a 5 risk-rating to a 6 risk-rating, local economic conditions and the overall mix of the loan portfolio.
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The amount of provision for loan losses recognized by the Company is based on management’s evaluation as to the amounts required to maintain an allowance adequate to provide for potential losses inherent in the loan portfolio. The level of the allowance is dependent upon the total amount of classified loans, past due and non-performing loans, historical charge-off experience, general economic conditions and management’s assessment of potential losses based upon internal credit evaluation of the loan portfolio and particular loans. In determining the provision for loan losses, management first determines the estimated allowance required for any specifically identified classified loans. Management then estimates potential charge-offs based on historical experience. Management also evaluates the general loan portfolio for credit risk based upon, but not limited to, the criteria noted above, and allocates an amount believed to be sufficient to cover estimated loan charge-offs inherent in the general loan portfolio. Management may then add, at its discretion, an allocation amount to adjust for current economic conditions, any additional perceived credit risk in the portfolio and any other information that management considers relevant.
Non-interest Income
2006.Total non-interest income decreased $209,000, or 6.4%, to $3.1 million for the year ended December 31, 2006 compared to $3.3 million for the same period in 2005. Service charges on deposit accounts increased $36,000, or 2.7%, to $1.4 million for the year ended December 31, 2006 compared to $1.3 million for the same period in 2005. This increase was due to some increases in rates charged. Net gains on the sale of loans decreased $0.4 million, or 29.8%, to $1.0 million for the year ended December 31, 2006 compared to $1.4 million for the same period in 2005. This is due to a continued decrease in mortgage volume, which is related to higher levels of interest rates as well as softening within the local residential real estate market. Mortgage loan sales were down approximately 27.8% to $43.4 million for 2006 down from $60.2 million for 2005. Loan servicing fees, net of amortization, decreased $190,000, or 66.2%, to $97,000 for the twelve months ended December 31, 2006 compared to $287,000 for the same period in 2005. This decrease is due to increased levels of amortization of the mortgage servicing asset. Other non-interest income increased $359,000, or 127.3%, to $641,000 for the year ended December 31, 2006 up from $282,000 for the same period in 2005. This increase is due largely to fee income earned on Merchant Visa services as well as increases in fees charged for mobile courier service.
2005. Total non-interest income decreased $289,000, or 8.1%, to $3.3 million for the year ended December 31, 2005 compared to $3.6 million for the same period in 2004. Service charges on deposit accounts decreased $113,000, or 7.9%, to $1.3 million for the year ended December 31, 2005 compared to $1.4 million for the same period in 2004. This decrease is reflective of the overall decrease in transactional demand deposit accounts, which generate the majority of fee income. Net gains on sale of loans also decreased 8.3% or $126,000 to $1.4 million in 2005 compared to $1.5 million for the same period in 2004 due to a reduction in mortgage volume. Mortgage loan sales were down approximately 30.7% in 2005 compared to the same period in 2004. The reduction in secondary marketing gains on sale of mortgage loans was offset by increased value in the mortgage servicing rights capitalized resulting in the net reduction of only 8.3%. Loan servicing fees, net of amortization, decreased $213,000, or 42.6%, to $287,000 for the year ended December 31, 2005 compared to $500,000 for the same period in 2004. This decrease is due to increased levels of amortization of the mortgage servicing asset. Other non-interest income increased $163,000, or 137.0%, to $282,000 for the year ended December 31, 2005 compared to $119,000 for the same period in 2004. In 2004, an impairment loss of approximately $140,000 was recognized in the fourth quarter when management made the determination to close one of the two branches in Hudson, which reduced the overall level of other non-interest income.
2004.Total non-interest income decreased $2.2 million, or 38.9%, to $3.6 million for the twelve months ended December 31, 2004 compared to $5.8 million for the same period in 2003. A substantial decline in gains on residential mortgage loan sales accounted for the reduction. For the twelve months ended December 31, 2004 gains on loan sales declined $4.1 million, or 73.2%, to $1.5 million compared to $5.7 million for the same period in 2003. Demand for secondary market residential mortgage loans decreased as significantly fewer homeowners refinanced existing residential mortgages. Loan servicing fees, net of amortization (“loan servicing fees”) registered a substantial increase in 2004. For the twelve months ended December 31, 2004, loan servicing fees increased $2.1 million, or 131.9%, to $500,000 from $(1.6 million) during the same period in 2003. Amortization expense of mortgage servicing rights on secondary market residential mortgage loans declined significantly as residential mortgage refinancing activity decreased.
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Non-interest Expenses
2006.For the year ended December 31, 2006, total non-interest expense decreased $1.0 million, or 8.2% to $11.1 million down from $12.1 million for the same period in 2005. Compensation and benefits decreased approximately $1.0 million, or 13.6%, to $6.2 million for the year ended December 31, 2006 compared to $7.2 million for the same period in 2005. This decrease was due in large part to the cost savings associated with Reduction-in-Force plans (“RIF”), which were developed with the goal of increasing operating efficiency. The Bank eliminated various staff positions in the first quarters of 2006 and 2005, and severance packages were provided to employees affected by the RIF. The aggregate cost of the RIF plans were approximately $210,000 and $264,000 for the RIFs that occurred in the first quarter of 2006 and 2005, respectively. Occupancy and equipment expense increased $53,000, or 3.7%, to $1.502 million for the twelve months ended December 31, 2006 up from $1.449 million for the same period in 2005. This increase is primarily related to the costs associated with the new branch that was opened in the first quarter of 2006. Professional services expense decreased $137,000, or 20.4%, to $536,000 for the year ended December 31, 2006 down from $673,000 for 2005. This decrease is due to higher professional services costs associated with the tender offer, contingency planning and other consulting engagements incurred in 2005. Outside services expense increased $133,000, or 12.8%, to $1.17 million for 2006 up from $1.04 million for 2005. This increase is related to higher costs associated with Merchant Visa services. Marketing and advertising expense decreased to $166,000 for the year ended December 31, 2006 down $106,000, or 39.9%, from $272,000 for the same period in 2005. This reduction is due to certain cost controls implemented by management. Loan and collection expense decreased $45,000, or 13.1%, to $298,000 for the twelve months ended December 31 2006 compared $343,000 for the same period in 2005. Other non-interest expense increased to $717,000 for the twelve months ended December 31, 2006, up $102,000, or 16.6%, from $615,000 for the same period in 2005. This increase is due to the deferred costs of the trust preferred issuance which were recognized at the time of redemption. The total costs incurred at redemption were approximately $145,000. Excluding the effect of this one-time charge, non-interest expenses were down for 2006.
2005. For the year ended December 31, 2005, total non-interest expense increased $266,000, or 2.3%, to $12.1 million up from $11.8 million for the same period in 2004. Compensation and employee benefits decreased $15,000, or 0.2%, to $7.2 million for the year ended December 31, 2005. The aggregate cost of the severance packages associated with the 2005 RIF totaled approximately $264,000. This total cost included $137,000 in wages, $70,000 in pension costs, and $57,000 in medical insurance costs. The benefits of the RIF were visible in the latter half of 2005. Occupancy and equipment expense increased $32,000, or 2.3%, to $1.45 million for the year ended December 31, 2005 compared to $1.42 million for the same period in 2004. Postage and delivery expense decreased slightly to $300,000 for the year ended December 31, 2005 compared to $305,000 compared to the same period in 2004. These fluctuations are considered typical in the normal course of business. Expenses related to professional services increased $372,000, or 123.6%, to $673,000 for the year ended December 31, 2005 compared to $301,000 for the same period in 2004. This increase was due to increased payments to the Company’s auditing firms for services related to contingency planning, for Sarbanes-Oxley compliance and for additional work related to the Company’s annual report. In addition, legal and accounting costs were incurred in connection with the tender offer for the Company’s common stock that was completed in the second quarter of 2005. Marketing and advertising expense decreased $70,000, or 20.5%, to $272,000 for the year ended December 31, 2005 down from $342,000 for the same period in 2004. The decrease was due to an overall cost reduction strategy. Loan and collection expense increased $21,000, or 6.5%, to $343,000 for the year ended December 31, 2005 up from $322,000 for 2004. The increase is primarily due to costs associated with the maintenance and disposition of the other real estate assets (OREO). For the year ended December 31, 2005, director and shareholder expense increased $16,000, or 9.1%, to $191,000 compared to $175,000 for the same period in 2004. This increase is due to an increase in directors’ fees as well as an increase in the number of directors from 2004 to 2005. Other non-interest expense decreased $97,000, or 13.6%, to $615,000 for the year ended December 31, 2005 compared to $712,000 for the same period in 2004. The decrease is due to an overall cost reduction strategy implemented by management.
2004. For the twelve months ended December 31, 2004, total non-interest expenses declined $301,000, or 2.5%, to $11.8 million from $12.1 million during the same period in 2003. Various non-interest expenses increased during 2004, while other categories of non-interest expenses decreased. For the twelve months ended December 31, 2004, compensation and employee benefit expenses declined $380,000, or 5.0%, to $7.2 million from $7.6 million during the same period in 2003. A decline in residential mortgage loan-related incentive compensation accounted for the decrease. Occupancy and equipment expense increased $24,000, or 1.7%, to $1.42 million for the twelve months ended December 31, 2004 compared to $1.39 million for the same period in 2003. Various technology
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expenditures to upgrade operational capabilities were incurred during 2004, including digital check imaging. Postage and delivery expense decreased $7,000, or 2.2%, to $305,000 for the twelve months ended December 31, 2004 compared to $312,000 during the same period in 2003. Professional services decreased by $51,000, or 14.5%, to $301,000 for the twelve months ended December 31, 2004 from $352,000 for the same period in 2003. Outside services decreased $44,000 or 4.1% to $1.0 million for the twelve months ended December 31, 2004 from $1.1 million during the same period in 2003. The decrease in 2004 is due to reduced employee recruitment costs and to the reduction in reliance on temporary mortgage processing help provided by outside agencies. Marketing and advertising expense increased $170,000, or 98.8%, to $342,000 for the twelve months ended December 31, 2004 compared to $172,000 for the same period in 2003. The increase in 2004 is due primarily to the Company initiating a campaign to develop a new brand identity throughout its market area. Loan and collection expense decreased by $135,000 or 29.5% to $322,000 for the twelve months ended December 31, 2004 compared to $457,000 for the same period in 2003. The decrease in 2004 was due to the curtailment of the Business Manager program during the fourth quarter of 2004. Other noninterest expenses increased $77,000, or 12.1%, to $712,000 for the twelve months ended December 31, 2004 compared to $635,000 during the same period in 2003. Such change in other noninterest expenses is considered typical in the normal course of business.
Federal Income Tax Expense
2006.The provision for federal income tax increased $468,000, or 77.6%, to $1.1 million (30.8% of pretax income from continuing operations) for the twelve months ended December 31, 2006 compared to $0.6 million (23.7% of pretax income from continuing operations) for the same period in 2005. This increase is primarily related to the increased level of earnings in the current year. The increase is also related to a change in accounting estimate recognized in the fourth quarter of 2005, which is discussed in greater detail below.
2005.The provision for federal income tax associated with continuing operations declined $0.4 million, or 39.8%, to $0.6 million (23.7% of pretax income from continuing operations) for the twelve months ended December 31, 2005 compared to $1.0 million (31.7% of pretax income from continuing operations) for the same period in 2004. The reduction in federal income tax provision, as well as the lower percentage of tax provision to pretax income, is partially attributable to lower pretax income from continuing operations. In addition the Company recognized an expense reduction of $200,000 related to an excess accrual for federal income tax specifically related to final accounting for the sale of the Bank of Washtenaw in 2004. This excess accrual was determined by management after completion of the 2004 federal income tax return and detailed analysis of the 2004 and 2005 federal income tax liabilities, which was performed in the fourth quarter of 2005. Federal income tax expense was adjusted in the fourth quarter related to this change in accounting estimate.
Liquidity and Capital Resources
Liquidity is the ability to meet current and future financial obligations, including the ability to have funds available to respond to the needs of depositors and borrowers as well as maintaining the flexibility to take advantage of investment opportunities. The Company’s primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities and borrowings from the FHLBI. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
Liquidity management is both a daily and long-term responsibility of management. The Company adjusts its investments in liquid assets based upon management’s assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities, and (4) the objectives of its asset/liability management program. Excess liquid assets are invested generally in interest-earning overnight deposits and short- and immediate-term U.S. Government and agency obligations.
The Company’s most liquid assets are cash and short-term investments. The levels of these assets are dependent on the Company’s operating, financing, lending and investing activities during any given period. At December 31, 2006, cash and short-term investments totaled $17.2 million and securities classified as available for sale totaled $17.8 million. However, available-for-sale securities with a market value of $13.4 million were pledged as collateral for Treasury Tax & Loan accounts and repurchase agreements and therefore were not available for liquidity needs. The amortized cost of the available-for-sale securities was more than the fair value at year end, primarily as the result of increasing interest rates, which resulted in an unrealized loss of $155,000 within the investment portfolio. This unrealized loss, however, is normal given interest rate changes and does not represent a permanent impairment of value to the investment portfolio. Management does not consider such an unrealized loss a material risk to the Company’s capital. Management does not believe the sale of any of the Company’s securities would materially affect the overall financial condition of the Company. Management believes it has sufficient liquidity and sources of funds to meet its obligations.
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Financing activities consist primarily of activity in deposit accounts, overnight borrowings from our correspondent banks and FHLBI advances. The Bank experienced a net increase in total deposits of $25.1 million for the year ended December 31, 2006. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by the Bank and its local competitors and other factors. To help fund the increased loan demand, the Bank has increased its level of public funds CDs.
The Bank’s borrowing position decreased in 2006 to $25.2 million as of December 31, 2006 down from $39.6 million at December 31, 2005. As of December 31, 2006, the Bank had the ability to borrow a total of $15.1 million from the FHLBI based upon the amount of collateral pledged, of which $10.9 million was outstanding at that date. The Bank has contractual payments due on FHLBI advances totaling $9.0 million in 2007. In addition to the FHLBI, the Bank had available borrowings on a line-of-credit of $10.0 million from a correspondent bank, of which $6.6 million was outstanding at December 31, 2006. The Bank also had outstanding advances on repurchase agreements totaling $7.7 million at December 31, 2006, based on the collateral pledged. Additional advances could be obtained through repurchase agreements, provided additional collateral is pledged. Repurchase agreements are terminable upon demand.
Beginning in the first quarter of 2006, the Company became exempt from the Capital Guidelines, as the Board of Governors of the Federal Reserve System increased the asset size threshold from $150 million to $500 million in consolidated assets for determining whether a Bank Holding Company may qualify for an exemption from the Capital Guidelines. Under the revised regulatory financial reporting requirements, the Company will only be required to file parent-only financial data on a semi-annual basis. This change only impacts the Company and the Bank will continue to file necessary regulatory reports.
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 and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’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 their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators regarding components, risk weightings, and other factors. Prompt corrective action provisions are not applicable for bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts, and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined).
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At December 31, 2006 the Bank was considered well-capitalized under the regulatory framework for prompt corrective action. The Bank’s actual capital amounts and ratios at December 31, 2006 and 2005 and the Company’s capital amounts and ratios at December 31, 2005 are presented in the following table (in millions):
| Actual | Minimum Required For Capital Adequacy Purposes | Minimum Required to be Well-Capitalized Under Prompt Corrective Action Regulations | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Amount | Ratio | Amount | Ratio | Amount | Ratio | ||||||||||||||||
| December 31, 2006 | |||||||||||||||||||||
| Total capital (to risk weighted assets) | |||||||||||||||||||||
| Bank of Lenawee | $ | 32.7 | 12.5% | $ | 20.9 | >=8.0% | $ | 26.1 | >=10.0% | ||||||||||||
| Tier 1 Capital (to risk weighted assets) | |||||||||||||||||||||
| Bank of Lenawee | $ | 29.9 | 11.4% | $ | 10.5 | >=4.0% | $ | 15.7 | >=6.0% | ||||||||||||
| Tier 1 Capital (to average assets) | |||||||||||||||||||||
| Bank of Lenawee | $ | 29.9 | 10.4% | $ | 11.5 | >=4.0% | $ | 14.4 | >=5.0% | ||||||||||||
| December 31, 2005 | |||||||||||||||||||||
| Total Capital (to risk weighted assets) | |||||||||||||||||||||
| Consolidated | $ | 37.3 | 15.2% | $ | 19.6 | >=8.0% | n/a | n/a | |||||||||||||
| Bank of Lenawee | $ | 33.3 | 13.7% | $ | 19.4 | >=8.0% | $ | 24.3 | >=10.0% | ||||||||||||
| Tier 1 Capital (to risk weighted assets) | |||||||||||||||||||||
| Consolidated | $ | 34.7 | 14.1% | $ | 9.8 | >=4.0% | n/a | n/a | |||||||||||||
| Bank of Lenawee | $ | 30.6 | 12.6% | $ | 9.7 | >=4.0% | $ | 14.5 | >=6.0% | ||||||||||||
| Tier 1 Capital (to average assets) | |||||||||||||||||||||
| Consolidated | $ | 34.7 | 12.4% | $ | 11.2 | >=4.0% | n/a | n/a | |||||||||||||
| Bank of Lenawee | $ | 30.6 | 10.7% | $ | 11.5 | >=4.0% | $ | 14.3 | >=5.0% | ||||||||||||
Contractual Obligations
The following table presents contractual obligations as of December 31, 2006 (000’s omitted):
| Payments due by period | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | Less Than 1 Year | 1-3 Years | 3-5 Years | More than 5 Years | |||||||||||||
| Time deposits | $ | 116,443 | $ | 104,220 | $ | 8,265 | $ | 3,957 | $ | 1 | |||||||
| Long-term debt obligations (FHLBI advances) | 10,885 | 9,000 | 1,885 | - | - | ||||||||||||
| Capital lease obligations | - | - | - | - | - | ||||||||||||
| Operating lease obligations* | 288 | 78 | 157 | 53 | - | ||||||||||||
| Purchase agreements | - | - | - | - | - | ||||||||||||
| Total | $ | 127,616 | $ | 113,298 | $ | 10,307 | $ | 4,010 | $ | 1 | |||||||
* Annual inflation adjustments to one of the operating lease obligations, based on changes in the Consumers Price Index, may take effect in sixth year of ten year lease, at the discretion of the lessor. Potential inflation adjustments are not estimated in this presentation.
Long-term obligations consist of time deposits (certificates of deposit) and advances from the FHLBI. The above schedule represents principal payments only and does not include interest (where applicable).
The Company has contractual payments due on time deposits and FHLBI advances totaling $104.2 million and $9.0 million, respectively, in 2007. The Company anticipates that a significant portion of maturing time deposits will be renewed and retained. Depending on the economic and competitive conditions at the time of maturity, the rates paid on renewed time deposits may differ from rates currently paid. FHLBI advances may be renewed, and additional advances obtained, at prevailing market rates. At December 31, 2006 the Company had the ability to borrow an additional $4.2 million from the FHLBI based on the amount of collateral pledged. The availability to borrow from the FHLBI varies depending on the amount of collateral available for pledging.
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The following table presents loan commitments by time period as of December 31, 2006 (000’s omitted):
| Amount of commitment expiration per period | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | Less Than 1 Year | 1-3 Years | 3-5 Years | More than 5 Years | |||||||||||||
| Commitments to grant loans | $ | 8,416 | $ | 8,416 | $ | - | $ | - | $ | - | |||||||
| Unfunded commitments under lines of credit | 57,989 | 42,680 | - | - | 15,309 | ||||||||||||
| Commercial and standby letters of credit | 2,430 | 2,430 | - | - | - | ||||||||||||
| Total | $ | 68,835 | $ | 53,526 | $ | - | $ | - | $ | 15,309 | |||||||
Commitments to grant loans are governed by the Company’s credit underwriting standards, as established in the Company’s Loan Policy. As the above schedule illustrates, in general, it is the Company’s practice to grant loan commitments for a finite period of time, usually lasting one year or less. The most significant departure from this practice involves home equity lines of credit (“HELOC’s”). The Company’s HELOC’s have a contractual draw period of 120 months. The Company has the ability to suspend the draw privileges on a HELOC where a default situation or other impairment issue is identified.
Quantitative and Qualitative Disclosures about Market Risk
The Company’s primary market risk exposure is interest rate risk (“IRR”) and, to a lesser extent, liquidity risk. The Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Also, the Bank has a limited exposure to commodity prices related to agricultural loans. Any impact that changes in foreign exchange rate and commodity prices would have on interest rates is assumed to be insignificant.
Interest rate risk is the exposure of the Company’s financial condition to adverse movements in interest rates. IRR is generated from differences in the maturities or timing of interest rate adjustments of the Company’s assets, liabilities and off-balance-sheet instruments; from changes in the slope of the yield curve; from imperfect correlations in the adjustment of interest rates earned and paid on different financial instruments with otherwise similar repricing characteristics; and from interest rate related options embedded in the Company’s products such as prepayment and early withdrawal options.
The Company employs several measures to monitor and manage interest rate risk, including interest sensitivity and income simulation analyses. An interest income simulation model is the primary tool used to assess IRR. The simulation model is used to estimate the effect that certain changes in interest rate changes would have on twelve months of pretax net interest income assuming an immediate and sustained up or down proportional change in interest rates of 200 basis points. Key assumptions in the model include prepayment speeds of various types of loans, loan volumes and pricing, and management’s determination of core deposit sensitivity. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions.
The following tables provide information about the Company’s financial instruments that are sensitive to changes in interest rates as of December 31, 2006 and 2005. The Company had no derivative financial instruments, or trading portfolio, as of those dates. The expected maturity date values for loans receivable, mortgage-backed securities and investment securities were calculated without adjusting the instrument’s contractual maturity date for expectations of prepayments. Expected maturity date values for non-maturity interest-bearing core deposits were not based upon estimates of the period over which the deposits would be outstanding, but rather the opportunity for repricing.
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The following table presents principal/notional contractual maturities at December 31, 2006 (000’s omitted):
| 2007 | 2008 | 2009 | 2010 | 2011 | Thereafter | Total | Fair Value | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| RATE-SENSITIVE ASSETS | ||||||||||||||||||||||||||
| Gross loans | $ | 57,330 | $ | 8,070 | $ | 13,120 | $ | 14,987 | $ | 20,386 | $ | 132,236 | $ | 246,129 | $ | 244,383 | ||||||||||
| Average interest rate | 8.1% | 7.2% | 7.2% | 7.0% | 7.5% | 7.2% | ||||||||||||||||||||
| Debt & equity securities | $ | 17,277 | $ | - | $ | 95 | $ | 986 | $ | 1,004 | $ | 1,149 | $ | 20,511 | $ | 20,511 | ||||||||||
| Average interest rate | 3.4% | 0.0% | 5.3% | 3.8% | 5.7% | 5.9% | ||||||||||||||||||||
| Other interest-earning assets | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||
| Average interest rate | 0.0% | 0.0% | 0.0% | 0.0% | 0.0% | 0.0% | ||||||||||||||||||||
| RATE-SENSITIVE LIABILITIES | ||||||||||||||||||||||||||
| Savings & interest bearing | ||||||||||||||||||||||||||
| demand deposits | $ | 73,210 | $ | - | $ | - | $ | - | $ | - | $ | - | $ | 73,210 | $ | 73,210 | ||||||||||
| Average interest rate | 1.3% | 0.0% | 0.0% | 0.0% | 0.0% | 0.0% | ||||||||||||||||||||
| Time deposits | $ | 104,220 | $ | 6,240 | $ | 2,025 | $ | 3,498 | $ | 459 | $ | 1 | $ | 116,443 | $ | 115,832 | ||||||||||
| Average interest rate | 4.8% | 3.7% | 3.5% | 4.8% | 4.1% | 4.0% | ||||||||||||||||||||
| Other borrowings | $ | 23,529 | $ | 1,657 | $ | - | $ | - | $ | - | $ | - | $ | 25,186 | $ | 25,142 | ||||||||||
| Average interest rate | 4.5% | 2.9% | 0.0% | 0.0% | 0.0% | 0.0% | ||||||||||||||||||||
The following table presents principal/notional contractual maturities at December 31, 2005 (000’s omitted):
| 2006 | 2007 | 2008 | 2009 | 2010 | Thereafter | Total | Fair Value | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| RATE-SENSITIVE ASSETS | ||||||||||||||||||||||||||
| Gross loans | $ | 54,724 | $ | 10,302 | $ | 9,072 | $ | 11,275 | $ | 16,010 | $ | 136,215 | $ | 237,598 | $ | 235,553 | ||||||||||
| Average interest rate | 7.2% | 7.1% | 6.9% | 6.5% | 6.7% | 6.7% | ||||||||||||||||||||
| Debt & equity securities | $ | 11,323 | $ | 14,527 | $ | - | $ | 176 | $ | 1,091 | $ | 1,715 | $ | 28,832 | $ | 28,832 | ||||||||||
| Average interest rate | 3.6% | 3.1% | 0.0% | 5.4% | 3.8% | 5.2% | ||||||||||||||||||||
| Other interest-earning assets | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | $ | - | ||||||||||
| Average interest rate | 0.0% | 0.0% | 0.0% | 0.0% | 0.0% | 0.0% | ||||||||||||||||||||
| RATE-SENSITIVE LIABILITIES | ||||||||||||||||||||||||||
| Savings & interest bearing | ||||||||||||||||||||||||||
| demand deposits | $ | 73,486 | $ | - | $ | - | $ | - | $ | - | $ | - | $ | 73,486 | $ | 73,661 | ||||||||||
| Average interest rate | 1.2% | 0.0% | 0.0% | 0.0% | 0.0% | 0.0% | ||||||||||||||||||||
| Time deposits | $ | 67,191 | $ | 17,503 | $ | 3,817 | $ | 1,176 | $ | 2,222 | $ | - | $ | 91,909 | $ | 91,669 | ||||||||||
| Average interest rate | 3.4% | 3.3% | 3.3% | 3.4% | 4.8% | 0.0% | ||||||||||||||||||||
| Other borrowings | $ | 31,679 | $ | 6,228 | $ | 1,657 | $ | - | $ | - | $ | 5,000 | $ | 44,564 | $ | 44,321 | ||||||||||
| Average interest rate | 4.2% | 3.8% | 2.9% | 0.0% | 0.0% | 8.4% | ||||||||||||||||||||
| Disclosure Controls and Procedures The Company’s management is responsible for establishing and maintaining adequate internal controls over the financial reporting process to ensure that it is able to collect the information it is required to disclose in the reports it files with the SEC, and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Additionally, the Company’s principal executive officer (the Company’s chief executive officer) and principal financial officer (the Company’s chief financial officer) are required to evaluate internal controls of the financial reporting process. The framework for evaluating the internal controls of the financial reporting process consists of, but is not limited to, the following criteria: |
| o | Evaluation of financial reporting internal controls is an on-going process that incorporates the evaluation and review for accuracy and completeness of the various internal and external reporting activities conducted throughout each fiscal year. Such reviews are completed in the normal course of business on a periodic basis consistent with the frequency of the reporting activity and include: |
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| • | Review and discussion of various internal reporting activities designed to identify and disclose items of a material nature to management and the Board of Directors. |
| • | Periodic retention of external specialists to review and analyze various activities. |
| • | Preparation and review of monthly financial information that is provided to the Board of Directors and management. |
| • | Review and maintenance of supporting documentation utilized to prepare interim financial information, regulatory reports and quarterly and annual financial statements. |
| • | Review of interim financial reports and supporting documentation in connection with preparation of financial reports and financial statements to evaluate accuracy and consistency. |
| • | Evaluation of various estimates and related methodologies, including those typical for banks and bank holding companies. Primarily, these consist of the allowance for loan and lease losses, mortgage servicing rights and tax provisions. Other estimates, including supporting documentation and methodologies, are reviewed, such as accrual of various operating expenses where there is a timing difference between the incurrence of and payment of such expenses. |
The Company’s Chief Executive Officer and the Chief Financial Officer, based on such evaluations noted above of the Company’s financial reporting controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15(d)-15(e)) as of the end of the period covered by this Form 10-K Annual Report, have concluded that the Company’s financial reporting controls and procedures were adequate and effective. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparations and presentation.
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Common Stock Data
The Company’s common stock is traded on the over-the-counter market under the stock symbol PVLN.OB. There is limited trading volume of the Company’s common shares of stock.
The following table sets forth the range of high and low sales prices of the Company’s common stock during 2006, 2005, and 2004, based on information made available to the Company, as well as per share cash dividends declared during those periods. The prices shown below reflect inter-dealer prices and may not include retail markups, markdowns, or commissions. The Company is not necessarily aware of all trades of its common stock, therefore other transactions at prices outside the ranges listed below may have occurred:
| Sales Prices(1) | Cash | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| 2006 | High | Low | Dividends Declared(1) | ||||||||
| First Quarter | $ | 49.00 | $ | 43.50 | $ | 0.24 | |||||
| Second Quarter | $ | 46.50 | $ | 44.75 | $ | 0.24 | |||||
| Third Quarter | $ | 48.00 | $ | 45.50 | $ | 0.24 | |||||
| Fourth Quarter | $ | 47.00 | $ | 43.25 | $ | 0.35 | |||||
| 2005 | |||||||||||
| First Quarter | $ | 59.80 | $ | 55.00 | $ | 0.24 | |||||
| Second Quarter | $ | 67.00 | $ | 53.00 | $ | 0.24 | |||||
| Third Quarter | $ | 55.00 | $ | 50.00 | $ | 0.24 | |||||
| Fourth Quarter | $ | 50.25 | $ | 46.15 | $ | 0.24 | |||||
| 2004 | |||||||||||
| First Quarter | $ | 52.50 | $ | 48.25 | $ | 0.24 | |||||
| Second Quarter | $ | 55.00 | $ | 51.30 | $ | 0.24 | |||||
| Third Quarter | $ | 65.00 | $ | 52.75 | $ | 0.24 | |||||
| Fourth Quarter | $ | 61.00 | $ | 57.50 | $ | 0.50 | |||||
(1) All per share data has been adjusted to reflect stock splits and stock dividends including a stock dividend of 5% declared on December 19, 2003 and issued on January 30, 2004 to shareholders as of January 16, 2004.
Total authorized shares of the Company’s common stock are 3,000,000, of which 727,852 shares were issued and outstanding as of March 9, 2007. There were approximately 600 shareholders of record, including trusts and shares jointly owned, as of that date.
The holders of the Company’s common stock are entitled to dividends when, as and if declared by the Board of Directors of the Company out of funds legally available for that purpose. Dividends have typically been declared on a quarterly basis. In determining dividends, the Board of Directors considers the earnings, capital requirements and financial condition of the Company and the Bank, along with other relevant factors. The Company’s principal source of funds for cash dividends is the dividends paid to the Company by the Bank. Dividends are declared at the sole discretion of the Board of Directors. Historical practice for dividends is not a guarantee of future dividends. Additionally, the ability of the Company and the Bank to pay dividends is subject to regulatory restrictions and requirements.
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During the fourth quarter of 2006, the Company made the following repurchases of its common stock:
| Period | (a) Total No. of Shares Purchased | (b) Average Price Paid per Share | (c) Total No. of Shares Purchased as Part of Publicly Announced Plans or Programs | (d) Maximum No. (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| October 2006 | 0 | N/A | N/A | N/A | ||||||||||
| November 2006 | 0 | N/A | N/A | N/A | ||||||||||
| December 2006 | 5,329 | $47.00 | 5,329 | 0 | ||||||||||
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Set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on the Corporation’s common stock with that of the cumulative total return on the HEMSCOTTGroup Index and the NASDAQ Stock Market Index for the five-year period ended December 31, 2006. The HEMSCOTTGroup Index is an index composed of 114 banks and bank holding companies located in the Midwest and published by HEMSCOTT, Inc. The following information is based on an investment of $100, on December 31, 2001, in the Corporation’s common stock, the HEMSCOTTGroup Index, and the NASDAQ Stock Market Index, with dividends reinvested. There has been only limited trading in the Corporation’s common stock and the Corporation’s common stock does not trade on any stock exchange or on the NASDAQ market. Accordingly, the returns reflected in the following graph and table are based on sale prices of the Corporation’s stock of which management is aware. There may have been sales at higher or lower prices of which management is not aware.
| 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Pavilion Bancorp | 100.00 | 88.08 | 95.08 | 116.80 | 99.88 | 90.12 | ||||||||||||||
| Regional-Midwest Banks | 100.00 | 95.70 | 123.04 | 131.19 | 125.96 | 146.02 | ||||||||||||||
| NASDAQ Market Index | 100.00 | 69.75 | 104.88 | 113.70 | 116.19 | 128.12 | ||||||||||||||
Source: HEMSCOTT, Inc., Richmond, Virginia
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