[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
or
[__] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
_________________
PAVILION BANCORP, INC.
(Exact name of registrant as specified in its charter)
| Michigan (State or Other Jurisdiction of Incorporation or Organization) | 38-3088340 (I.R.S. Employer Identification No.) |
135 East Maumee Street, Adrian, Michigan 49221
(Address of Principal Executive Offices, including Zip Code)
Registrant’s telephone number, including area code: (517) 265-5144, Fax (517) 265-3926
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [ X ] No [__]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” (in Rule 12b-2 of the Exchange Act). (Check one:)
Large Accelerated Filer [__] Accelerated Filer [__] Non-Accelerated Filer [ X ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 126-2 of the Exchange Act)
Yes [__] No [ X ]
As of November 14, 2007 there were 729,223 outstanding shares of the registrant’s common stock, no par value.
Page 1
| ITEM NO. | DESCRIPTION | PAGE NO. | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| PART I - FINANCIAL INFORMATION | ||||||||||
| Item 1 | Financial Statements (Condensed and Unaudited) | |||||||||
| (a) | Report of Independent Registered Public Accounting Firm | 3 | ||||||||
| (b) | Condensed Consolidated Balance Sheets | 4 | ||||||||
| (c) | Condensed Consolidated Statements of Income | 5 | ||||||||
| (d) | Condensed Consolidated Statements of Changes in Shareholders' Equity | 6 | ||||||||
| (e) | Condensed Consolidated Statements of Cash Flows | 7 | ||||||||
| (f) | Notes to Condensed Consolidated Financial Statements | 8 | ||||||||
| Item 2 | Management's Discussion and Analysis of Financial Condition and Results of Operations | 11 | ||||||||
| Item 3 | Quantitative and Qualitative Disclosures About Market Risk | 20 | ||||||||
| Item 4 | Controls and Procedures | 21 | ||||||||
| PART II - OTHER INFORMATION | ||||||||||
| Item 1 | Legal Proceedings | 21 | ||||||||
| Item 1.A | Risk Factors | 21 | ||||||||
| Item 2 | Unregistered Sales of Equity Securities and Use of Proceeds | 22 | ||||||||
| Item 3 | Defaults Upon Senior Securities | 22 | ||||||||
| Item 4 | Submission of Matters to a Vote of Security Holders | 22 | ||||||||
| Item 5 | Other Information | 22 | ||||||||
| Item 6 | Exhibits | 22 | ||||||||
| Signatures | 23 | |||||||||
| Exhibit Index | 24 | |||||||||
Page 2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors
Pavilion Bancorp, Inc.
Adrian, Michigan
We have reviewed the condensed consolidated balance sheet of Pavilion Bancorp, Inc. (the “Corporation”) as of September 30, 2007, and the related condensed consolidated statements of income, shareholders’ equity, and cash flows for the three and nine month periods ended September 30, 2007 and 2006, included in the Corporation’s SEC Form 10-Q. These interim financial statements are the responsibility of the Corporation’s management.
We conducted our reviews in accordance with the standards established by the Public Company Accounting Oversight Board (placecountry-regionUnited States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated interim financial statements for them to be in conformity with generally accepted accounting principles in the placecountry-regionUnited States of America.
/s/ Plante & Moran, PLLC
Auburn Hills, Michigan
November 14, 2007
Page 3
CONDENSED CONSOLIDATED BALANCE SHEETS
(000’s omitted)
| September 30, 2007 (unaudited) | December 31, 2006 | |||||||
|---|---|---|---|---|---|---|---|---|
| ASSETS | ||||||||
| Cash and due from banks | $ | 8,969 | $ | 17,210 | ||||
| Securities available for sale | 11,818 | 17,828 | ||||||
| Federal Home Loan Bank, Freddie Mac, FNMA stock | 2,053 | 2,053 | ||||||
| Federal Reserve Bank stock | 630 | 630 | ||||||
| Loans held for sale | 939 | 377 | ||||||
| Loans receivable, net of allowance for loan and lease losses | 237,582 | 243,312 | ||||||
| Premises and equipment, net | 10,112 | 8,175 | ||||||
| Accrued interest receivable | 2,488 | 1,930 | ||||||
| Mortgage servicing rights | 2,253 | 2,558 | ||||||
| Other assets | 1,792 | 950 | ||||||
| Total assets | $ | 278,636 | $ | 295,023 | ||||
| LIABILITIES AND SHAREHOLDERS' EQUITY | ||||||||
| Deposits | ||||||||
| Noninterest bearing | $ | 41,783 | $ | 46,291 | ||||
| Interest bearing | 187,165 | 189,653 | ||||||
| Total deposits | 228,948 | 235,944 | ||||||
| Federal funds purchased | 3,069 | 6,601 | ||||||
| Repurchase agreements | 1,552 | 7,700 | ||||||
| Federal Home Loan Bank advances | 10,657 | 10,885 | ||||||
| Accrued interest payable | 623 | 851 | ||||||
| Other liabilities | 1,712 | 2,341 | ||||||
| Common stock in ESOP subject to repurchase obligation | 2,711 | 2,765 | ||||||
| Total liabilities | 249,272 | 267,087 | ||||||
| Shareholders' equity | ||||||||
| Common stock and paid-in capital, no par value: shares issued and | ||||||||
| and outstanding: 725,864 at September 30, 2007; 725,206 at | ||||||||
| December 31, 2006 | 10,668 | 10,629 | ||||||
| Retained earnings | 18,605 | 17,409 | ||||||
| Accumulated other comprehensive income (loss) | 91 | (102 | ) | |||||
| Total shareholders' equity | 29,364 | 27,936 | ||||||
| Total liabilities and shareholders' equity | $ | 278,636 | $ | 295,023 | ||||
See accompanying notes to the condensed consolidated financial statements
Page 4
CONDENSED CONSOLIDATED STATEMENTS OF
INCOME (unaudited)
(000’s omitted, except per share data)
| Three months ended September 30, | Nine months ended September 30, | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2007 | 2006 | |||||||||||
| Interest and dividend income | ||||||||||||||
| Loans receivable, including fees | $ | 4,707 | $ | 4,627 | $ | 13,941 | $ | 13,083 | ||||||
| Debt securities: | ||||||||||||||
| Taxable | 171 | 182 | 465 | 547 | ||||||||||
| Tax - exempt | 19 | 22 | 61 | 71 | ||||||||||
| Dividend income | 31 | 38 | 97 | 127 | ||||||||||
| Federal funds sold and other | 7 | 49 | 210 | 190 | ||||||||||
| Total interest and dividend income | 4,934 | 4,918 | 14,774 | 14,018 | ||||||||||
| Interest expense | ||||||||||||||
| Deposits | 1,655 | 1,439 | 5,083 | 3,885 | ||||||||||
| Subordinated debentures | - | 117 | - | 331 | ||||||||||
| Other borrowed funds | 218 | 363 | 571 | 920 | ||||||||||
| Total interest expense | 1,873 | 1,919 | 5,654 | 5,136 | ||||||||||
| Net interest income | 3,061 | 2,999 | 9,120 | 8,882 | ||||||||||
| Provision for loan losses | 165 | 120 | 458 | 225 | ||||||||||
| Net interest income after provision for loan losses | 2,896 | 2,879 | 8,662 | 8,657 | ||||||||||
| Noninterest income | ||||||||||||||
| Service charges and fees | 580 | 573 | 1,650 | 1,506 | ||||||||||
| Net gains on sale of loans | 196 | 213 | 577 | 776 | ||||||||||
| Loan servicing fees, net of amortization | 26 | 24 | 74 | 78 | ||||||||||
| Other | (68 | ) | (91 | ) | (25 | ) | (88 | ) | ||||||
| 734 | 719 | 2,276 | 2,272 | |||||||||||
| Noninterest expense | ||||||||||||||
| Compensation and employee benefits | 1,390 | 1,392 | 4,541 | 4,850 | ||||||||||
| Occupancy and equipment | 494 | 383 | 1,377 | 1,108 | ||||||||||
| Professional services | 182 | 126 | 339 | 399 | ||||||||||
| Marketing | 38 | 23 | 134 | 113 | ||||||||||
| Outside service fees | 290 | 268 | 833 | 818 | ||||||||||
| Postage and delivery services | 91 | 63 | 217 | 215 | ||||||||||
| Director and shareholders | 46 | 47 | 130 | 157 | ||||||||||
| Loan and collection | 90 | 81 | 243 | 228 | ||||||||||
| Other | 147 | 152 | 493 | 397 | ||||||||||
| 2,768 | 2,535 | 8,307 | 8,285 | |||||||||||
| Income before income taxes | 862 | 1,063 | 2,631 | 2,644 | ||||||||||
| Income taxes | 301 | 280 | 875 | 766 | ||||||||||
| Net income | $ | 561 | $ | 783 | $ | 1,756 | $ | 1,878 | ||||||
| Net earnings per share | ||||||||||||||
| Basic | $ | 0.77 | $ | 1.06 | $ | 2.42 | $ | 2.55 | ||||||
| Diluted | $ | 0.77 | $ | 1.06 | $ | 2.41 | $ | 2.54 | ||||||
| Dividends per share | $ | 0.26 | $ | 0.24 | $ | 0.77 | $ | 0.72 | ||||||
See accompanying notes to condensed consolidated financial statements
Page 5
PAVILION BANCORP, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(unaudited)
For the periods ended September 30, 2006 and 2007
| (000’s omitted) | Common Stock Paid-In Capital | Retained Earnings | Accumulated Other Comprehensive Income/(Loss) | Total Shareholders' Equity | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Balance January 1, 2006 | $ | 10,724 | $ | 15,963 | $ | (303 | ) | $ | 26,384 | |||||
| Comprehensive income: | ||||||||||||||
| Net income | - | 1,878 | - | 1,878 | ||||||||||
| Unrealized income on securities | ||||||||||||||
| available for sale | - | - | 203 | |||||||||||
| Tax effect | - | - | (69 | ) | ||||||||||
| Total other comprehensive income | - | - | 134 | 134 | ||||||||||
| Total comprehensive income | - | - | 2,012 | |||||||||||
| Change in common stock subject to | ||||||||||||||
| repurchase | (88 | ) | - | - | (88 | ) | ||||||||
| Stock repurchase and retirement | - | - | - | 17 | ||||||||||
| Stock option expense | 17 | - | - | 17 | ||||||||||
| Stock options exercised | 38 | - | - | 38 | ||||||||||
| Cash dividends - $0.72 per share | - | (528 | ) | - | (528 | ) | ||||||||
| Balance September 30, 2006 | $ | 10,691 | $ | 17,313 | $ | (169 | ) | $ | 27,835 | |||||
| Balance January 1, 2007 | $ | 10,629 | $ | 17,409 | $ | (102 | ) | $ | 27,936 | |||||
| Comprehensive income: | ||||||||||||||
| Net income | - | 1,756 | - | 1,756 | ||||||||||
| Unrealized gain on securities | ||||||||||||||
| available for sale | - | - | 292 | |||||||||||
| Tax effect | - | - | (99 | ) | ||||||||||
| Total other comprehensive income | - | - | 193 | 193 | ||||||||||
| Total comprehensive income | - | - | 1,949 | |||||||||||
| Change in common stock subject to | ||||||||||||||
| repurchase | (78 | ) | - | - | (78 | ) | ||||||||
| Stock option expense | 13 | - | - | 13 | ||||||||||
| Stock options exercised | 104 | - | - | 104 | ||||||||||
| Cash dividends - $0.77 per share | - | (560 | ) | - | (560 | ) | ||||||||
| Balance September 30, 2007 | $ | 10,668 | $ | 18,605 | $ | 91 | $ | 29,364 | ||||||
See accompanying notes to the condensed consolidated financial statements
Page 6
CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (unaudited)
(000’s omitted)
| Nine months ended September 30, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | |||||||
| Cash Flows from operating activities | ||||||||
| Net income | $ | 1,756 | $ | 1,878 | ||||
| Adjustments to reconcile net income to | ||||||||
| net cash from operating activities | ||||||||
| Depreciation | 697 | 516 | ||||||
| Stock option expense | 13 | 17 | ||||||
| Provision for loan losses | 458 | 225 | ||||||
| Amortization on securities available for sale | (3 | ) | 19 | |||||
| Gain on disposal of assets | (7 | ) | - | |||||
| Loss on sales of securities | - | 9 | ||||||
| Amortization of mortgage servicing rights | 620 | 637 | ||||||
| Origination of mortgage loans held for sale | (26,557 | ) | (33,821 | ) | ||||
| Proceeds from sales of mortgage loans held for sale | 26,257 | 34,500 | ||||||
| Net gains on sale of mortgage loans | (577 | ) | (776 | ) | ||||
| Net change in: | ||||||||
| Deferred loan origination fees | 7 | (6 | ) | |||||
| Accrued interest receivable | (558 | ) | (535 | ) | ||||
| Other assets | (1,665 | ) | (332 | ) | ||||
| Accrued interest payable | (228 | ) | 208 | |||||
| Other liabilities | (640 | ) | (449 | ) | ||||
| Net cash (used in) provided by operating activities | (427 | ) | 2,090 | |||||
| Cash flows from investing activities | ||||||||
| Securities available for sale: | ||||||||
| Maturities, calls and principal payments | 14,810 | 1,584 | ||||||
| Sales of securities available for sale | - | 990 | ||||||
| Purchases | (8,505 | ) | (996 | ) | ||||
| Redemption of Federal Home Loan Bank stock | - | 516 | ||||||
| Proceeds from the disposition of premises and equipment | 7 | - | ||||||
| Net premises and equipment expenditures | (2,634 | ) | (1,745 | ) | ||||
| Net decrease (increase) in loans | 6,063 | (7,585 | ) | |||||
| Recoveries on loans charged-off | 25 | 46 | ||||||
| Net cash provided by (used in) investing activities | 9,766 | (7,190 | ) | |||||
| Cash flows from financing activities | ||||||||
| Net change in deposits | (6,996 | ) | 22,571 | |||||
| Net change in short term borrowings | (9,680 | ) | (9,912 | ) | ||||
| Proceeds from Federal Home Loan Bank advances | 36,000 | 32,400 | ||||||
| Repayments of Federal Home Loan Bank advances | (36,228 | ) | (35,616 | ) | ||||
| Stock repurchased | (132 | ) | (260 | ) | ||||
| Stock options exercised | 82 | 38 | ||||||
| Dividends paid | (626 | ) | (529 | ) | ||||
| Net cash (used in) provided by from financing activities | (17,580 | ) | 8,692 | |||||
| Net (decrease) increase in cash and cash equivalents | (8,241 | ) | 3,592 | |||||
| Cash and cash equivalents at beginning of period | 17,210 | 11,308 | ||||||
| Cash and cash equivalents at end of period | $ | 8,969 | $ | 14,900 | ||||
| Transfer from: | ||||||||
| Loans to foreclosed real estate | $ | 964 | $ | 275 | ||||
| Cash paid for: | ||||||||
| Interest | $ | 5,882 | $ | 4,927 | ||||
| Income taxes | $ | 1,040 | $ | 853 | ||||
See accompanying notes to condensed consolidated financial statements
Page 7
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.
Basis of Financial Statement Presentation
The accompanying unaudited consolidated interim financial statements have been prepared in conformity with accounting principles generally accepted in the placecountry-regionUnited States of America and with the instructions to Form 10-Q. Accordingly, certain information and disclosures required by the accounting principles generally accepted in the placecountry-regionUnited States of America for complete financial statements are not included herein. The interim financial statements should be read in conjunction with the financial statements of Pavilion Bancorp, Inc. and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2006.
All adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary for a fair presentation of the results of operations and cash flows, have been made. The results of operations for the nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.
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 inter-company balances and transactions have been eliminated in consolidation.
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 an interest in a title insurance 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.
Recent Accounting Developments:
Establishing Standards on Measuring Fair Value
In September 2006, the FASB issued SFAS 157, “Fair Value Measurements.” SFAS 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.
Page 8
Fair Value Option
In February 2007, the FASB issued SFAS 159“The Fair Value Option for Financial Assets and FinancialLiabilities.” SFAS 159 permits entities to choose to measure financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The decision to elect the fair value option may be applied instrument by instrument, is irrevocable and is applied to the entire instrument and not to only specified risks, specific cash flows or portions of that instrument. An entity is restricted to choosing the dates to elect the fair value option for an eligible item. Adoption of SFAS 159 is effective for the Company on January 1, 2008. Early adoption is permitted, provided the entity also elects to apply the provisions of SFAS 157“Fair Value Measurements.” Management of the Company is currently evaluating the potential impact of SFAS 159 on the Company’s financial condition, results of operations and liquidity.
On October 2, 2007, Pavilion Bancorp, Inc. (OTCBB:PVLN) and First Defiance Financial Corp. (NASDAQ:FDEF) announced the execution of a definitive agreement for First Defiance to acquire Pavilion Bancorp, Inc. and its wholly owned subsidiary, the Bank of Lenawee. The merger is expected to be completed in the first quarter of 2008, subject to regulatory and shareholder approvals and other customary closing conditions.
Earnings per common share have been computed based on the following for the three and nine months ended September 30, 2007 and 2006 (000’s omitted, except antidilutive stock options):
| Three months ended September 30, | Nine months ended September 30, | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2007 | 2006 | |||||||||||
| Net income | $ | 561 | $ | 783 | $ | 1,756 | $ | 1,878 | ||||||
| Average number of common shares outstanding used | ||||||||||||||
| to calculate basic earnings per share | 726 | 734 | 727 | 736 | ||||||||||
| Effect of dilutive options | - | 2 | 1 | 2 | ||||||||||
| Average number of common shares outstanding used | ||||||||||||||
| to calculate diluted earnings per common share | 726 | 736 | 728 | 738 | ||||||||||
| Number of antidilutive stock options excluded from | ||||||||||||||
| the diluted earnings per share computation | 21,215 | 21,215 | 21,215 | 21,215 | ||||||||||
Loans receivable consist of the following (000’s omitted):
| September 30, 2007 | December 31, 2006 | |||||||
|---|---|---|---|---|---|---|---|---|
| Commercial | $ | 129,872 | $ | 133,545 | ||||
| Agricultural | 44,780 | 39,656 | ||||||
| Residential mortgage | 27,722 | 30,255 | ||||||
| Residential construction | 8,977 | 10,896 | ||||||
| Home equity lines of credit | 17,189 | 19,163 | ||||||
| Consumer | 12,127 | 12,614 | ||||||
| 240,667 | 246,129 | |||||||
| Less: allowance for loan and lease losses | (3,085 | ) | (2,817 | ) | ||||
| Loans receivable, net | $ | 237,582 | $ | 243,312 | ||||
Page 9
Activity in the allowance for loan and lease losses for the three and nine months ended September 30, are as follows (000’s omitted):
| Three months ended September 30, | Nine months ended September 30, | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2007 | 2006 | |||||||||||
| Balance at beginning of period | $ | 2,967 | $ | 2,694 | $ | 2,817 | $ | 2,683 | ||||||
| Charge-offs | (48 | ) | (56 | ) | (215 | ) | (195 | ) | ||||||
| Recoveries | 1 | 1 | 25 | 46 | ||||||||||
| Provision for loan losses | 165 | 120 | 458 | 225 | ||||||||||
| Balance at end of period | $ | 3,085 | $ | 2,759 | $ | 3,085 | $ | 2,759 | ||||||
The Bank is a party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.
The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance-sheet instruments.
The total contractual amounts of commercial and standby letters of credit and financial guarantees were $2.7 million and $2.4 million at September 30, 2007 and December 31, 2006, respectively.
Page 10
This discussion provides information about the consolidated financial condition and results of operations of the Company as of September 30, 2007 and for the three and nine month periods ended September 30, 2007 and 2006 and should be read in conjunction with the Company’s Condensed Consolidated Financial Statements and the notes thereto, appearing in Part 1, Item 1 of this document.
Forward-Looking Statements
This discussion and analysis of financial condition and results of operations and other sections of this Form 10-Q contain forward looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and about the Company itself. Words such as “anticipates”, “believes”, “estimates”, “expects”, “forecasts”, “foresee”, “intends”, “is likely”, “plans”, “projects”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecast in such forward-lookingstatements. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. Future Factors include:
| • | changes in interest rates and interest rate relationships; |
| • | demand for products and services; |
| • | the degree of competition by traditional and non-traditional competitors; |
| • | changes in banking regulations; |
| • | changes in tax laws; |
| • | changes in prices, levies and assessments; |
| • | the impact of technology, governmental and regulatory policy changes; |
| • | the outcome of pending and future litigation and contingencies; |
| • | trends in customer behavior as well as their ability to repay loans; |
| • | changes in the national and local economies; |
| • | the consummation of the pending sale of the Company to First Defiance Financial Corp.; and |
| • | the impact of the pending sale of the Company to First Defiance Financial Corp. on the Company’s business and performance. |
These are representative of the Future Factors that could cause a difference between an actual outcome and a forward-looking statement.
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 without limitation, changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include valuation of the allowance for loan and lease losses, fair value of securities and other financial instruments, the valuation of mortgage servicing rights and deferred tax and tax provision estimates. The Company’s critical accounting policies are described in the financial section of its 2006 Annual Report.
Financial Overview
Total assets decreased by $16.4 million or 5.6% from December 31, 2006 to September 30, 2007. Cash and cash equivalents decreased $8.2 million or 47.9%. Loans receivable, net of the allowance for loan and lease losses, decreased by $5.7 million or 2.4%. Investment securities available for sale decreased $6.0 million or 33.7%. Total deposits decreased $7.0 million or 3.0%. Borrowed funds decreased $9.9 million or 39.3%. Basic earnings per share (“EPS”) for the three and nine months ended September 30, 2007 were $0.77 per share and $2.42 per share, respectively. For the same periods in 2006 basic EPS were $1.06 and $2.55, respectively. Fully diluted EPS for the three and nine months ended September 30, 2007 were $0.77 per share and $2.41 per share, respectively. For the same periods in 2006 fully diluted EPS were $1.06 and $2.54 per share, respectively.
Page 11
On October 2, 2007, the Company entered into an Agreement and Plan of Merger with First Defiance Financial Corp. Under the terms of the agreement, First Defiance will acquire the Company and the Bank. First Defiance has agreed to pay 1.4209 shares of First Defiance common stock plus $37.50 in cash for each outstanding share of the Company’s common stock. The Company expects the transaction to close in the first quarter of 2008, subject to regulatory and shareholder approvals and other customary closing conditions. For more information regarding this merger, please refer to the Form 8-K filed by the Company on October 4, 2007, which includes a copy of the Agreement and Plan of Merger. For more information regarding First Defiance Financial Corp., please refer to its SEC filings (NASDAQ: FDEF).
Investments
Total investments securities available-for-sale decreased $6.0 million or 33.7%, to $11.8 million at September 30, 2007, compared to $17.8 million at December 31, 2006. The decrease in investment securities is primarily attributable to the maturity of two investment securities during the second and third quarter of 2007. Management has made the decision to not reinvest the funds at this point and instead utilize the proceeds to pay down borrowings and replace brokered CDs. Equity investment in the Federal Home Loan Bank of Indianapolis (“FHLBI”) remained at $2.1 million as of September 30, 2007, which is the same as December 31, 2006. Investment in Federal Reserve Bank (“FRB”) stock remains unchanged at $630,000 as of September 30, 2007 and December 31, 2006. The Company had no held-to-maturity securities as of September 30, 2007 or December 31, 2006.
Loans
The following table summarizes the Bank’s loan portfolio and loan mix at September 30, 2007 and December 31, 2006:
(000’s omitted)
| September 30, 2007 | December 31, 2006 | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Amount | Percent of Loans | Amount | Percent of Loans | |||||||||||||
| Commercial | $ | 129,872 | 54 | .0% | $ | 133,545 | 54 | .3% | ||||||||
| Agricultural | 44,780 | 18 | .6% | 39,656 | 16 | .1% | ||||||||||
| Residential mortgage | 27,722 | 11 | .5% | 30,255 | 12 | .3% | ||||||||||
| Residential construction | 8,977 | 3 | .7% | 10,896 | 4 | .4% | ||||||||||
| Home equity lines of credit | 17,189 | 7 | .2% | 19,163 | 7 | .8% | ||||||||||
| Consumer | 12,127 | 5 | .0% | 12,614 | 5 | .1% | ||||||||||
| Total loans receivable | 240,667 | 100 | .0% | 246,129 | 100 | .0% | ||||||||||
| Less: allowance for loan and lease losses | (3,085 | ) | (2,817 | ) | ||||||||||||
| Loans receivable, net | $ | 237,582 | $ | 243,312 | ||||||||||||
During the first nine months of 2007, loans, net of allowance for loan and lease losses, decreased by $5.7 million or 2.4%. The mix of the loan portfolio continues to remain relatively unchanged from the prior year. The commercial loan portfolio decreased by $3.7 million or 2.8% as of September 30, 2007 when compared to December 31, 2006. The decline can be attributed to the slowing economy within the Bank’s primary areas of operation. The agriculture portfolio grew by $5.1 million or 12.9%. The increase in the agricultural portfolio can be attributed to increased business development activity by the Bank's agriculture lenders and the strong economy within the local agriculture industry due to the increased demand for grain by area ethanol and bio-diesel fuel manufacturers. The residential mortgage loan portfolio declined by $2.5 million or 8.4%, which is consistent with the slowing of the real estate market in the Bank’s primary area of operation. The residential construction loan portfolio decreased approximately $1.9 million, or 17.6%. Home equity lines of credit decreased approximately $2.0 million, or 10.3%. Consumer loans decreased by $487,000 as of September 30, 2007 as repayments have outpaced new loan originations.
Page 12
Off-Balance Sheet Items
The following is a summary of outstanding commitments by the Bank to grant loans, unfunded commitments under lines of credit and letters of credit at September 30, 2007 and December 31, 2006:
| (000’s omitted) | September 30, 2007 | December 31, 2006 | ||||||
|---|---|---|---|---|---|---|---|---|
| Loan Category: | ||||||||
| Commitments to originate or refinance loans | $ | 5,710 | $ | 8,416 | ||||
| Unfunded commitments under lines of credit | 57,490 | 57,989 | ||||||
| Commercial and standby letters of credit | 2,746 | 2,430 | ||||||
| Total | $ | 65,946 | $ | 68,835 | ||||
Outstanding commitments to originate or refinance loans decreased by $2.7 million or 32.2% to $5.7 million at September 30, 2007 from $8.4 million at December 31, 2006. Unfunded commitments under lines of credit decreased $500,000 or 0.9% to $57.5 million as of September 30, 2007 from $58.0 million at December 31, 2006. Commercial and standby letters of credit have increased approximately $316,000 or 13.0% to $2.7 million as of September 30, 2007 up from $2.4 million as of December 31, 2006. Management does not expect that all commitments will result in funded loans.
Credit Quality
The Bank continues to monitor the asset quality of the loan portfolio utilizing the Chief Credit Officer who, combined with external loan review specialists, periodically submits reports to the Chief Executive Officer, Chief Financial Officer, Chief Lending Officer and to the Board of Directors regarding the credit quality of each loan portfolio. This review is independent of the loan approval process. Also, management continues to monitor delinquencies, nonperforming assets and potential problem loans to assess the continued quality of the Bank’s loan portfolios.
Nonperforming loans are comprised of (1) loans accounted for on a nonaccrual basis, (2) loans contractually past due 90 days or more as to interest or principal payments (but continuing to accrue interest) and (3) other nonperforming loans including real estate held for redemption, which is classified within (1) or (2) above dependent upon the respective collateralized position. The aggregate amount of nonperforming loans, in thousands of dollars, is shown in the table below. The Bank’s classifications of nonperforming loans are generally consistent with loans identified as impaired.
The chart below shows the composition of the Bank’s nonperforming assets by type as of September 30, 2007 and 2006, and December 31, 2006.
| (000’s omitted) | September 30, 2007 | December 31, 2006 | September 30, 2006 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Non-accruing loans past due | $ | 4,101 | $ | 2,728 | $ | 1,640 | |||||
| Loans past due 90 days or more still accruing | 605 | 668 | 606 | ||||||||
| Total nonperforming loans | 4,706 | 3,396 | 2,246 | ||||||||
| Other real estate | 917 | 169 | 315 | ||||||||
| Total nonperforming assets | $ | 5,623 | $ | 3,565 | $ | 2,561 | |||||
| Nonperforming loans as a percent of total loans | 1.96 | % | 1.38 | % | 0.92 | % | |||||
| Nonperforming assets as a percent of total assets | 2.01 | % | 1.21 | % | 0.86 | % | |||||
| Nonperforming loans as a percent of the allowance | |||||||||||
| for loan and lease losses | 152.54 | % | 120.55 | % | 81.41 | % | |||||
Page 13
At September 30, 2007, total nonperforming assets increased by $2.0 million or 56.4% from December 31, 2006. The Bank is closely monitoring and managing nonperforming loans to determine and implement corrective action to improve the quality of nonperforming assets. Non-accruing loans increased $1.4 million to $4.1 million as of September 30, 2007 up from $2.7 million as of December 31, 2006. Nonperforming assets as a percentage of total assets have increased to 2.01% at September 30, 2007 compared to 1.21% at December 31, 2006. The increase relates primarily to the increase in non-accruing loans discussed above. Nonperforming loans as a percentage of the allowance for loan and lease losses increased to 152.54% as of September 30, 2007 compared to 120.55% and 81.41% as of December 31, 2006 and September 30, 2006, respectively. A non performing loan (included in the amounts shown in the table above) with a balance of $527,000 as of September 30, 2007 is partially guaranteed by the Small Business Administration.
The activity in the allowance for loan and lease losses for the three months ended September 30, 2007 and 2006 and the nine months ended September 30, 2007 and 2006 is presented in the following table:
| Three months ended September 30, | Nine months ended September 30, | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2007 | 2006 | |||||||||||
| Beginning balance | $ | 2,967 | $ | 2,694 | $ | 2,817 | $ | 2,683 | ||||||
| Loan charge-offs | (48 | ) | (56 | ) | (215 | ) | (195 | ) | ||||||
| Loan recoveries | 1 | 1 | 25 | 46 | ||||||||||
| Net loan charge-offs | (46 | ) | (55 | ) | (189 | ) | (149 | ) | ||||||
| Provision for loan losses | 165 | 120 | 458 | 225 | ||||||||||
| Ending balance | $ | 3,085 | $ | 2,759 | $ | 3,085 | $ | 2,759 | ||||||
| Net charge-off rate | 0.03 | % | 0.09 | % | 0.10 | % | 0.08 | % | ||||||
The Bank increased its funding of the provision for loan losses during the first nine months of 2007 over the same period in 2006 based on management’s assessment of the adequacy of the allowance for loan and lease losses. The net loan portfolio has decreased to $237.6 million as of September 30, 2007 compared to $243.3 million outstanding as of September 30, 2006. Management is continuing to monitor credits with the increase in the level of nonperforming loans. Management discusses problem credits in periodic loan committee meetings. Problem credits are also monitored by the Board of Directors during monthly reviews of watch list. Management is actively calling on past due loans before the loans reach 30 days past due. Management is also proactively calling on troubled industry clients, including construction contractors and manufacturing clients.
The Bank 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 amount of provision for loan losses recognized by the Bank 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.
Page 14
Deposits and Borrowed Funds
Total deposits decreased $7.0 million or 3.0% during the first nine months to $228.9 million at September 30, 2007 from $235.9 million at December 31, 2006. The decline can be attributed to the slowing economy within the Bank's areas of operation. Noninterest-bearing deposits decreased $4.5 million, or 9.7% to $41.8 million at September 30, 2007 from $46.3 million at December 31, 2006. Interest-bearing deposits decreased $2.5 million, or 1.3% to $187.2 million at September 30, 2007 from $189.7 million at December 31, 2006. Specifically, certificates of deposit (“CD’s”) with balances of $100,000 and greater (Jumbo CD’s) decreased $5.4 million, or 7.4%, to $67.8 million at September 30, 2007 from $73.2 million at December 31, 2006. Certificates of Deposit with balances under $100,000 increased $3.5 million, or 8.2%, to $46.7 million at September 30, 2007 from $43.2 million at December 31, 2006. This increase is the result of business development efforts within the local communities. Other interest-bearing deposits, including savings and NOW accounts, decreased $610,000 or 0.8% to $72.6 million at September 30, 2007 from $73.2 million at December 31, 2006. The overall decline in the Bank’s core deposits is largely attributable to increased competition for deposits within the banking industry. The decline in core deposits continues to remain a concern for management as the use of non-traditional deposit products and borrowed funds has resulted in a rise in interest expense, increased costs of funds, and pressure on the Bank’s interest rate margin.
Borrowed funds decreased by $9.9 million, or 39.33%, to $15.3 million at September 30, 2007 from $25.2 million at December 31, 2006. The decrease in borrowed funds can be attributed to management’s decision to not renew a $5 million repurchase agreement with Citibank, which matured in June 2007 and the partial pay down of one of the Bank’s FHLBI borrowings.
Capital
During the first nine months of 2007, equity capital increased by $1.4 million, reflecting current year earnings as well as the exercise of stock options. The number of outstanding shares at December 31, 2006 of 725,206 increased to 725,864 at September 30, 2007. The Bank continues to maintain sufficient risk-based capital levels to remain categorized as “well-capitalized” under federal regulatory requirements. “Well capitalized” institutions are eligible for reduced FDIC premiums, and also enjoy other reduced regulatory restrictions. Management monitors the capital levels of the Company and the Bank to provide for current and future business opportunities.
Net Income
Net income for the three months ended September 30, 2007 decreased $222,000, or 28.4% to $561,000 compared to $783,000 for the same period in 2006. Basic earnings per share (“EPS”) attributable to continuing operations for the three months ended September 30, 2007 were $0.77 compared to $1.06 for the same period in 2006. Diluted EPS for the three months ended September 30, 2007 were $0.77 compared to $1.06 for the same period in 2006.
Net income for the nine months ended September 30, 2007 decreased by $122,000 or 6.5% to $1.76 million compared to $1.88 million for the same period in 2006. Basic earnings per share (“EPS”) attributable to continuing operations for the nine months ended September 30, 2007 were $2.42 compared to $2.55 for the same period in 2006. Diluted EPS for the nine months ended September 30, 2007 were $2.41 compared to $2.54 for the same period in 2006.
Page 15
Net Interest Margin
Following are the net interest margin calculations for the three and nine months ended September 30, 2007 and 2006:
| Three months ended | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| September 30, 2007 | September 30, 2006 | |||||||||||||||||||
| (000’s omitted) | Average Outstanding Balance | Interest Earned/ Paid | Yield/ Rate | Average Outstanding Balance | Interest Earned/ Paid | Yield/ Rate | ||||||||||||||
| Interest-earning assets: | ||||||||||||||||||||
| Loans receivable (1) | $ | 240,580 | $ | 4,707 | 7.76 | % | $ | 243,218 | $ | 4,627 | 7.55 | % | ||||||||
| Securities available for sale (3) | 16,089 | 190 | 4.69 | % | 24,088 | 204 | 3.36 | % | ||||||||||||
| Federal funds sold | 507 | 6 | 4.70 | % | 3,515 | 48 | 5.42 | % | ||||||||||||
| Equity securities (2) | 2,683 | 31 | 4.44 | % | 3,022 | 38 | 5.00 | % | ||||||||||||
| Interest-earning balances with | ||||||||||||||||||||
| other financial institutions | 6 | - | 8.29 | % | 104 | 1 | 3.81 | % | ||||||||||||
| Total interest-earning assets | 259,865 | 4,934 | 7.53 | % | 273,947 | 4,918 | 7.12 | % | ||||||||||||
| Noninterest-earning assets: | ||||||||||||||||||||
| Cash and due from financial | ||||||||||||||||||||
| institutions | 8,147 | 8,204 | ||||||||||||||||||
| Premises and equipment, net | 10,256 | 6,707 | ||||||||||||||||||
| Other assets | 5,947 | 6,051 | ||||||||||||||||||
| Total assets | $ | 284,215 | $ | 294,909 | ||||||||||||||||
| Interest-bearing liabilities: | ||||||||||||||||||||
| Interest-bearing demand deposits | $ | 46,070 | 196 | 1.69 | % | $ | 46,167 | 228 | 1.96 | % | ||||||||||
| Savings deposits | 25,566 | 26 | 0.40 | % | 27,090 | 27 | 0.40 | % | ||||||||||||
| Time deposits | 115,115 | 1,433 | 4.90 | % | 103,816 | 1,184 | 4.52 | % | ||||||||||||
| Subordinated debentures | - | - | - | 5,000 | 117 | 9.28 | % | |||||||||||||
| Other borrowings | 18,213 | 218 | 4.97 | % | 32,803 | 363 | 4.39 | % | ||||||||||||
| Total int.-bearing liabilities | 204,964 | 1,873 | 3.62 | % | 214,876 | 1,919 | 3.54 | % | ||||||||||||
| Demand deposits | 44,678 | 46,867 | ||||||||||||||||||
| Other liabilities | 5,311 | 6,029 | ||||||||||||||||||
| Total liabilities | 254,953 | 267,772 | ||||||||||||||||||
| Shareholders' equity | 29,262 | 27,137 | ||||||||||||||||||
| Total liabilities and shareholders' | ||||||||||||||||||||
| equity | $ | 284,215 | $ | 294,909 | ||||||||||||||||
| Net interest income | $ | 3,061 | $ | 2,999 | ||||||||||||||||
| Interest rate spread (4) | 3.91 | % | 3.58 | % | ||||||||||||||||
| Net interest margin (5) | 4.67 | % | 4.34 | % | ||||||||||||||||
| Ratio of interest-earning assets | ||||||||||||||||||||
| to interest-bearing liabilities | 1.27 | 1.27 | ||||||||||||||||||
Page 16
| Nine months ended | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| September 30, 2007 | September 30, 2006 | |||||||||||||||||||
| (000’s omitted) | Average Outstanding Balance | Interest Earned/ Paid | Yield/ Rate | Average Outstanding Balance | Interest Earned/ Paid | Yield/ Rate | ||||||||||||||
| Interest-earning assets: | ||||||||||||||||||||
| Loans receivable (1) | $ | 239,863 | $ | 13,941 | 7.77 | % | $ | 237,354 | $ | 13,083 | 7.37 | % | ||||||||
| Securities available for sale (3) | 17,228 | 526 | 4.08 | % | 24,492 | 618 | 3.37 | % | ||||||||||||
| Federal funds sold | 5,281 | 207 | 5.24 | % | 4,934 | 183 | 4.96 | % | ||||||||||||
| Equity securities (2) | 2,683 | 97 | 4.83 | % | 3,289 | 127 | 5.16 | % | ||||||||||||
| Interest-earning balances with | ||||||||||||||||||||
| other financial institutions | 58 | 3 | 6.92 | % | 186 | 7 | 5.03 | % | ||||||||||||
| Total interest-earning assets | 265,113 | 14,774 | 7.45 | % | 270,255 | 14,018 | 6.93 | % | ||||||||||||
| Noninterest-earning assets: | ||||||||||||||||||||
| Cash and due from financial | ||||||||||||||||||||
| institutions | 8,299 | 9,093 | ||||||||||||||||||
| Premises and equipment, net | 9,550 | 6,528 | ||||||||||||||||||
| Other assets | 5,557 | 5,879 | ||||||||||||||||||
| Total assets | $ | 288,519 | $ | 291,755 | ||||||||||||||||
| Interest-bearing liabilities: | ||||||||||||||||||||
| Interest-bearing demand deposits | $ | 46,531 | 620 | 1.78 | % | $ | 46,505 | 630 | 1.81 | % | ||||||||||
| Savings deposits | 25,945 | 77 | 0.40 | % | 28,479 | 78 | 0.37 | % | ||||||||||||
| Time deposits | 119,475 | 4,386 | 4.91 | % | 102,913 | 3,177 | 4.13 | % | ||||||||||||
| Subordinated debentures | - | - | - | 5,000 | 331 | 8.85 | % | |||||||||||||
| Other borrowings | 17,473 | 571 | 4.37 | % | 30,018 | 920 | 4.10 | % | ||||||||||||
| Total int.-bearing liabilities | 209,424 | 5,654 | 3.61 | % | 212,915 | 5,136 | 3.23 | % | ||||||||||||
| Demand deposits | 44,883 | 45,969 | ||||||||||||||||||
| Other liabilities | 5,669 | 5,805 | ||||||||||||||||||
| Total liabilities | 259,976 | 264,689 | ||||||||||||||||||
| Shareholders' equity | 28,543 | 27,066 | ||||||||||||||||||
| Total liabilities and shareholders' | ||||||||||||||||||||
| equity | $ | 288,519 | $ | 291,755 | ||||||||||||||||
| Net interest income | $ | 9,120 | $ | 8,882 | ||||||||||||||||
| Interest rate spread (4) | 3.84 | % | 3.70 | % | ||||||||||||||||
| Net interest margin (5) | 4.60 | % | 4.39 | % | ||||||||||||||||
| Ratio of interest-earning assets | ||||||||||||||||||||
| to interest-bearing liabilities | 1.27 | 1.27 | ||||||||||||||||||
| (1) | Non-accrual loans and overdrafts are included in the average balances of loans. |
| (2) | Includes Federal Home Loan Bank and Federal Reserve Bank stock. |
| (3) | Interest income on tax-exempt securities has not been adjusted to a taxable equivalent basis. |
| (4) | Interest rate spread is the difference between rates of interest-earning assets and rates of interest paid on interest-bearing liabilities |
| (5) | Net interest margin is the net interest income divided by average interest-earning assets. |
The yield on interest-earning assets increased for the quarter ended September 30, 2007 to 7.53% from 7.12% as compared to the same period in the prior year. The yield on loans receivable increased to 7.76% for the three months ended September 30, 2007 from 7.55% for the same period in 2006. The consumer loan portfolio had the greatest increase in yield as it is primarily a variable rate portfolio followed by the commercial lending portfolio which also has a significant portion of variable rate loans.
Page 17
The Company’s interest rate spread increased for the three months ended September 30, 2007 to 3.91% from 3.58% for the same period in 2006. The yield on interest-earning assets increased for the nine months ended September 30, 2007 to 7.45% from 6.93% for the same period in 2006. The increase primarily was in the yield on loans receivable which increased to 7.77% for the nine months ended September 30, 2007 from 7.37% for the same period in 2006.
The Company’s interest rate spread increased for the nine months ended September 30, 2007 to 3.84% from 3.70% for the same period in 2006. The Company’s net interest margin remains relatively strong compared to our peers.
Noninterest Income
Total non-interest income increased by $15,000 or 2.1% to $734,000 for the three months ended September 30, 2007 compared to $719,000 for the same period in 2006. Service charges on deposit accounts increased $7,000 of 1.2% to $580,000 compared to $573,000 for the same timeframe in 2006. Net gains of sale of loans decreased by $17,000 or 8.0% to $196,000 compared to $213,000 for the same time frame in 2006. The decline in income from the sale of loans can be attributed to declining mortgage originations. Loan servicing fees, net of amortization, increased $2,000 or 8.3%. Other income for the three-month period ended September 30, 2007 was ($68,000), which is primarily the result of the write-down of Bank-owned properties to bring the assets to their fair market value.
For the nine months ended September 30, 2007, total non-interest income remained flat at $2.27 million. Service charges and fees increased $144,000 or 9.6% to $1.7 million during the first nine months of 2007 compared to $1.5 million for 2006. The increase can primarily be attributed to increasing volume in the Bank’s merchant VISA product and increased income received from bank service charges. Net gains on the sale of loans decreased $199,000 or 25.6% to $577,000 compared to $776,000 for the same timeframe in 2006. Loan servicing fees, net of amortization decreased $4,000 for the first nine months of the year. Other income was ($25,000) for the first nine months of 2007, which is primarily the result of the write-down of Bank-owned properties to bring the assets to their fair market value.
Noninterest Expense
For the three months ended September 30, 2007, total non-interest expense increased by $233,000 or 9.2% to $2.8 million from $2.5 million for the same period in 2006. Compensation and employee benefits expense was flat at $1.39 million for the three month period ended September 30, 2007. Occupancy and equipment expenses increased by $111,000 or 29.0% to $494,000, up from $383,000 for the same period in 2006. This increase was primarily due to the opening of two new branches by the Bank during 2007. Professional services expense increased by $56,000 or 44.4% to $182,000 up from $126,000 for the same period in 2006. The Bank incurred professional services fees of $77,400 related to the definitive agreement to be acquired by First Defiance Financial Corp. for the three month period ended September 30, 2007. Other non-interest expense was $147,000 for the three months ended September 30, 2007, which represents a decrease of $5,000 or 2.0% from the same time frame in 2006. Other non-interest expense for the three months ended September 30, 2007 consists primarily of state taxes totaling approximately $27,000, demand deposit accounts charge-offs totaling $11,000 and donations totaling $35,000.
Noninterest expense for the nine months ended September 30, 2007 was $8.30 million, compared to $8.29 million for the same period in 2006, an increase of approximately $22,000 or 0.3%. Compensation and employee benefits expense decreased $309,000 or 6.4%, to $4.5 million for the nine months ended September 30, 2007 compared to $4.9 million for the same period in 2006. The year-to-date decrease can be attributed to management’s decision to eliminate some senior management positions. Occupancy and equipment costs increased by $269,000 or 24.3% to $1.4 million during the first nine months of 2007 from $1.1 million for the same period in 2006. The increase is primarily due to the opening of two new branches by the Bank in 2007. Fees for professional services decreased approximately $60,000 or 15.0% to $339,000 in the first nine months of 2007 compared to $399,000 for the same period in 2006. The decrease is primarily the result of a reduction in the use of third-party consultants during the first nine months of 2007. Other non-interest expense totaled $493,000 for the first nine months of 2007, which represents an increase of $55,000 or 13.9% over the first nine months of 2006. Other non-interest expense is primarily comprised of state taxes totaling $128,000, donations totaling $101,000, demand deposit charge offs totaling $31,000 and insurance expense totaling $49,000.
Page 18
Federal Income Tax
The provision for federal income tax was $301,000 for the three month period ended September 30, 2007, compared to $280,000 for the same period in 2006. The provision for federal income tax was $875,000 from continuing operations for the nine month period ended September 30, 2007, compared to $766,000 for the same period in 2006. The cause of the increase in income tax provision for the nine months ended September 30, 2007 is due to increased income for the nine-month period ended September 30, 2007 compared to the same time period in 2006. In addition, the Bank has reduced its investments in tax-exempt municipal bonds.
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 September 30, 2007, cash and short-term investments totaled $9.0 million and securities classified as available for sale totaled $11.8 million. However, available-for-sale securities with a market value of $6.6 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 less than the fair value at quarter end, primarily as the result of decreasing interest rates, which resulted in an unrealized gain of $138,000 within the investment portfolio.
Financing activities consist primarily of activity in deposit accounts, overnight borrowings from our correspondent banks and FHLBI advances. The Bank experienced a net decrease in total deposits of $7.0 million for the nine months ended September 30, 2007. Deposit flows are affected by the overall level of interest rates, products offered by the Bank and its local competitors as well as other factors.
The Bank’s borrowing position decreased during the first nine months of 2007 from $25.2 million at December 31, 2006 compared to the balance of $15.3 million as of September 30, 2007. As of September 30, 2007, the Bank had the ability to borrow a total of $15.3 million from the FHLBI based upon the amount of collateral pledged, of which $10.7 million was outstanding at that date. In addition to the FHLBI, the Bank had available borrowings on a line-of-credit of $10 million from a correspondent bank, of which $3.1 million was outstanding as of September 30, 2007. The Bank also had outstanding advances on repurchase agreements totaling $1.6 million at September 30, 2007, based on the collateral pledged. Additional advances could be obtained through repurchase agreements provided additional collateral is pledged. Repurchase agreements are terminable upon demand.
At September 30, 2007, the Bank had outstanding commitments to fund loans of $5.7 million, of which $2.7 million had fixed interest rates. The Bank believes that it will have sufficient funds available to meet its current loan commitments. Loan commitments, in recent periods, have been funded through liquidity and through FHLBI borrowings. Based on the foregoing, the Company considers its liquidity and capital resources sufficient to meets its outstanding short-term and long-term needs.
The Company is subject to various regulatory capital requirements administered by the Federal Deposit Insurance Corporation including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories.
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At September 30, 2007 and December 31, 2006, the Company and the Bank exceeded all regulatory minimum capital requirements. 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.
| Actual | Minimum Required For Capital Adequacy Purposes | Minimum Required to be Well-Capitalized Under Prompt Corrective Action Regulations | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||
| September 30, 2007 | ||||||||||||||||||||
| Total Capital (to risk weighted assets) | ||||||||||||||||||||
| Bank of Lenawee | $ | 34 | .7 | 14 | .54% | $ | 21 | .0 | >=8 | .0% | $ | 26 | .3 | >=10 | .0% | |||||
| Tier 1 Capital (to risk weighted assets) | ||||||||||||||||||||
| Bank of Lenawee | $ | 31 | .7 | 13 | .26% | $ | 10 | .5 | >=4 | .0% | $ | 15 | .8 | >=6 | .0% | |||||
| Tier 1 Capital (to average assets) | ||||||||||||||||||||
| Bank of Lenawee | $ | 31 | .7 | 11 | .16% | $ | 11 | .8 | >=4 | .0% | $ | 14 | .7 | >=5 | .0% | |||||
| 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% | |||||
The Company’s primary market risk exposure is interest rate risk and liquidity risk. All of the Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. The Company has a limited exposure to commodity prices related to agricultural loans. Any impacts that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant.
Interest rate risk (IRR) is the exposure of a banking organization’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of IRR could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains IRR at prudent levels is essential to the Company’s safety and soundness. The Board of Directors has instituted a policy setting limits on the amount of interest rate risk that may be assumed. Management provides information to the Board of Directors on a monthly basis detailing interest rate risk estimates and activities to control such risk.
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Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control IRR and the organization’s quantitative level of exposure. When assessing the IRR management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain IRR at prudent levels with consistency and continuity. Evaluating the quantitative level of IRR exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality.
The Company has not experienced a material change in its financial instruments that are sensitive to changes in interest rates since December 31, 2006, which information can be located in the Company’s annual report on Form 10-K.
| (a) | Evaluation of Disclosure Controls and Procedures. As of September 30, 2007, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures [(as defined in Exchange Act Rules 13a – 15(e) and 15d – 15(e))]. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were adequate and effective as of September 30, 2007, to ensure that material information relating to the Company would be made known to them by others within the Company, particularly during the period in which this Form 10-Q was being prepared. |
| (b) | Changes in Internal Controls. During the period covered by this report, there have been no changes in the Company’s internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting. |
ITEM 1 — LEGAL PROCEEDINGS
The Company is not involved in any material legal proceedings. Neither the Bank nor the Company are involved in any proceedings to which any director, principal officer, affiliate thereof, or person who owns of record or beneficially five percent (5%) or more of the outstanding stock of the Company or the Bank, or any associate of the foregoing, is a party or has a material interest adverse to the Company or the Bank.
ITEM 1A — RISK FACTORS
The Company disclosed various risk factors in its annual report on Form 10-K for the year ended December 31, 2006. Since that time, the Company has entered into an Agreement and Plan of Merger with First Defiance Financial Corp., dated October 2, 2007, pursuant to which First Defiance will acquire the Company and the Bank. The closing of this acquisition is expected to occur during the first quarter of 2008, subject to regulatory and shareholder approvals and other customary closing conditions. The Company has no reason to believe that this acquisition will not take place as currently contemplated. However, if for any reason the acquisition does not take place or is substantially delayed, the Company’s business operations and prospects could be materially and adversely affected.
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| ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
| (c) | During the three-month period ended September 30, 2007, the Company repurchased the following shares of its common stock: |
| Period | (a) Total Number of Shares Purchased | (b) Average Price Paid per Share | (c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | (d) Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs |
|---|---|---|---|---|
| 7/1/2007 - 7/31/2007 | 93(1) | $48.50 | N/A | N/A |
| 8/1/2007 - 8/31/2007 | - | - | N/A | N/A |
| 9/1/2007 - 9/30/2007 | - | - | N/A | |
(1) These shares of common stock were purchased by the Company in satisfaction of its obligation under its Employee Stock Ownership and 401(k) Savings Plan to repurchase shares of common stock distributed to a Plan participant upon request by such participant. Pursuant to the terms of the Plan, the price paid by the Company is the most recent appraised value of the Company’s common stock.
Listing of Exhibits (numbered as in Item 601 of Regulation S-K):
| 31.1 | Certificate of the Chief Executive Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2 | Certificate of the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1 | Certificate of the Chief Executive Officer and the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: November 14, 2007 Date: November 14, 2007 | Pavilion Bancorp, Inc. /s/ Richard J. DeVries —————————————— Richard J. DeVries President and Chief Executive Officer /s/ Mark D. Wolfe —————————————— Mark D. Wolfe Senior Vice President and Chief Financial Officer |
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EXHIBIT INDEX
| Exhibit | Description |
| 31.1 | Certificate of the Chief Executive Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2 | Certificate of the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1 | Certificate of the Chief Executive Officer and the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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