BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
General
Baylake Corp. is a Wisconsin corporation that is registered with the Board of Governors of the Federal Reserve (the “Federal Reserve”) as a bank holding company under the Bank Holding Company Act of 1956, as amended. Our wholly-owned banking subsidiary, Baylake Bank, is a Wisconsin state-chartered bank that provides a wide variety of loan, deposit and other banking products and services to its business, retail, and municipal customers, as well as a full range of trust, investment and cash management services. Baylake Bank is a member of the Federal Reserve and the Federal Home Loan Bank.
The following sets forth management’s discussion and analysis of our consolidated financial condition at March 31, 2010 and December 31, 2009 and our consolidated results of operations for the three months ended March 31, 2010 and 2009. This discussion and analysis should be read together with the consolidated financial statements and accompanying notes contained in Part I of this Form 10-Q, as well as our Annual Report on Form 10-K for the year ended December 31, 2009.
Forward-Looking Information
This discussion and analysis of consolidated financial condition and results of operations, and other sections of this report, may contain forward-looking statements that are based on the current expectations of management. Such expressions of expectations are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “projects,” and other such words are intended to identify such forward-looking statements. The statements contained herein and in such forward-looking statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond our control that may cause actual future results to differ materially from what may be expressed or forecasted in such forward-looking statements. Readers should not place undue expectations on any forward-looking statements. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could cause actual results to differ materially from the forward-looking statements: the factors described under “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2009, which are incorporated herein by reference, and other risks that may be identified or discussed in this Form 10-Q.
Critical Accounting Policies
In the course of our normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in our consolidated financial statements. The following is a summary of what management believes are our critical accounting policies.
Allowance for Loan Losses (“ALL”):
The ALL on our consolidated balance sheet represents management’s estimate of probable and inherent credit losses in the loan portfolio. Establishing the amount of the ALL requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and qualitative factors such as consideration of current economic trends and conditions, all of which may be susceptible to significant changes. The loan portfolio also represents the largest asset on the consolidated balance sheet. Loan losses are charged off against the ALL, while recoveries of amounts previously charged off are credited to the ALL. A PFLL is charged to earnings based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The ALL consists of specific reserves on impaired loans, general reserves on pools of homogeneous loans and a general portfolio allocation based on qualitative factors such as economic conditions and other factors specific to the markets in which we operate. The reserve component of the ALL on specific loans reflects expected losses based on analyses of impaired loans over a fixed dollar amount. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The reserve component on homogeneous pools of loans is based on our historical loss experience, which is updated quarterly. This component of the ALL also includes consideration of qualitative factors such as concentration changes in portfolio mix and volume and other qualitative factors. The unallocated component represents the portion of the ALL not specifically identified with specific loans or pools of loans.
There are many factors affecting the ALL; some are quantitative while others require qualitative judgment. The process for determining the ALL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change.
To the extent actual results differ from management estimates, an additional PFLL could be required that could adversely affect our earnings or financial position in future periods. In addition, management continues to refine the estimation process. Changes in the estimation process could also result in an additional provision for loan losses being recorded. Allocations of the ALL may be made for specific loans, but the entire ALL is available for any loan that, in management’s judgment, should be charged-off for which a loss is realized.
Foreclosed Properties:
Foreclosed properties acquired through or in lieu of loan foreclosure are initially recorded at lower of cost or fair value when acquired less estimated costs to sell, thereby establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Any costs incurred with respect to such assets after acquisition are expensed as incurred.
Provision for Impairment of Standby Letters of Credit:
The provision for impairment of standby letters of credit represents management’s estimate of probable incurred losses on off-balance sheet standby letters of credit which are used to support our customers’ business arrangements with an unrelated third party. In the event of impairment, a provision for impairment of standby letters of credit is charged to operations based on management’s periodic evaluation of the factors affecting the standby letters of credit. At March 31, 2010, the allowance for impairment of standby letters of credit was $0.05 million.
Income Tax Accounting:
The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of our operations and reported earnings. We believe that the tax assets and liabilities are adequate and properly recorded in the consolidated financial statements at March 31, 2010.
Goodwill:
Goodwill is not amortized but is subject to impairment tests on an annual basis or more frequently if deemed appropriate. For 2009, consideration of impairment was given due to the market value of our stock. However, based on current market conditions, we hired a firm specialized in rendering valuation opinions for banks and bank holding companies nationwide. In rendering their opinion as to our fair value, they considered our nature and history, the competitive and economic outlook for the trade area and for the banking industry in general, our book value and financial condition, our future earnings and dividend paying capacity, the size of the block valued, and the prevailing market prices of bank stocks. The following valuation methodologies were considered: 1) net asset value – defined as our net worth, 2) market value – defined as the price at which knowledgeable buyers and sellers would agree to buy and sell our common stock, and 3) investment value – defined as an estimate of the present value of the future benefits, usually earnings, cash flow, or dividends, that will accrue to our common stock. When consideration was given to the three valuation methodologies, as well as all other relevant valuation variables and factors, the fully-diluted cash fair value range of our common shares was deemed to be in excess of the book value and therefore, no impairment was recognized.
Results of Operations
The following table sets forth our consolidated results of operations and related summary information for the three month periods ended March 31, 2010 and 2009.
SUMMARY RESULTS OF OPERATIONS
(Dollar amounts in thousands, except per share data)
| | | | | | | |
| | Three months ended
March 31, | |
| | 2010 | | 2009 | |
Net income, as reported | | $ | 817 | | $ | 2,282 | |
EPS-basic, as reported | | $ | 0.10 | | $ | 0.29 | |
EPS-diluted, as reported | | $ | 0.10 | | $ | 0.29 | |
Cash dividends declared | | $ | — | | $ | — | |
| | | | | | | |
Return on average assets | | | 0.32 | % | | 0.87 | % |
Return on average equity | | | 4.40 | % | | 12.98 | % |
Efficiency ratio, as reported(1) | | | 77.31 | % | | 77.61 | % |
| |
(1) | Non-interest expense divided by the sum of taxable equivalent net interest income plus non-interest income, excluding net investment securities gains and excluding net gains on the sale of fixed assets. A lower ratio indicates greater efficiency. |
Net income of $0.8 million for the three months ended March 31, 2010 decreased from net income of $2.3 million for the comparable period in 2009. There were no securities gains reported during the first quarter of 2010 compared to gains of $2.8 million for the comparable period in 2009. Net interest income increased $0.3 million for the quarter ended March 31, 2010 versus the comparable quarter last year, resulting from a $1.5 million decline in interest expense partially offset by a $1.2 million reduction in interest income. Additionally, a PFLL of $1.1 million was charged to earnings for the first quarter of 2010, versus a PFLL of $1.2 million taken during the comparable quarter of 2009.
Net Interest Income:
Net interest income is the largest component of our operating income and represents the difference between interest earned on loans, investments and other interest-earning assets offset by the interest expense attributable to the deposits and borrowings that fund such assets. Interest fluctuations, together with changes in the volume and types of interest-earning assets and interest-bearing liabilities, combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of interest income earned. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable.
Average interest rates on loans were higher during the three-month period ending March 31, 2010 compared to the same period in 2009. The average interest rate on earning assets declined from 5.34% to 5.04% as the Bank’s emphasis was on maintaining adequate liquidity rather than investment returns. Also during the comparable periods, deposit yields declined from 2.24% to 1.53%. Emphasis was placed on deposit pricing strategies and maturing time deposits were repriced at lower yields. In mid December 2008, the Fed Funds target rate was set by the Federal Reserve at 0 basis points (“bps”) from 25 bps and has remained at this level throughout 2009 and the first three months of 2010.
Interest rate spread is the difference between the interest rate earned on average interest-earning assets and the rate paid on average interest-bearing liabilities. Interest rate spread increased 27 bps to 3.37% for the first quarter of 2010 compared to the same period in 2009, resulting primarily from a 30 bps decrease in the yield on interest-earning assets from 5.34% to 5.04% which was offset by a 57 bps decrease in the cost of interest-bearing liabilities from 2.24% to 1.67%. At December 31, 2009, our balance sheet was slightly liability sensitive (meaning liabilities will reprice more quickly than assets). Therefore, the decline in interest rates resulting from both economic and competitive forces allowed deposits to reprice downward at a faster pace than our loans.
Net interest income on a tax-equivalent basis was $8.0 million and $7.8 million for the three months ended March 31, 2010 and 2009, respectively. The decrease in interest received on loans during the first quarter ended March 31, 2010 versus the comparable quarter in 2009 was attributable to a reduction in average loans, which was offset by a comparable decrease in interest expense on funding costs, reflecting the continued decline in interest rates paid on deposit accounts.
Net interest margin represents net interest income expressed as an annualized percentage of average interest-earning assets. Net interest margin exceeds the interest rate spread because of the use of non-interest bearing sources of funds (demand deposits and equity capital) to fund a portion of earning assets. Net interest margin for the first quarter of 2010 was 3.46%, up 23 bps from 3.23% for the comparable period in 2009.
For the three months ended March 31, 2010, average interest-earning assets decreased $44.0 million (4.5%) from the same period in 2009. Decreases in average loans of $78.0 million (10.8%) and in average tax-exempt securities of $16.0 million (30.0%) were offset in part by a $5.0 million (3.0%) increase in taxable securities and a $45.0 million (228.4%) increase in Federal Funds Sold and interest-bearing deposits due from banks.
NET INTEREST INCOME ANALYSIS ON A TAX–EQUIVALENT BASIS
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | | |
| | Three months ended March 31, 2010 | | Three months ended March 31, 2009 | |
| | Average
Balance | | Interest
Income/
Expense | | Average Yield/
Rate | | Average
Balance | | Interest
Income/
Expense | | Average
Yield/
Rate | |
ASSETS | | | | | | | | | | | | | | | | | | | |
Average interest-earning assets: | | | | | | | | | | | | | | | | | | | |
Loans, net1,2 | | $ | 648,674 | | $ | 9,146 | | | 5.72 | % | $ | 726,967 | | $ | 10,000 | | | 5.58 | % |
Taxable securities | | | 179,239 | | | 1,864 | | | 4.16 | % | | 174,310 | | | 2,065 | | | 4.74 | % |
Tax exempt securities1 | | | 37,643 | | | 556 | | | 5.91 | % | | 53,456 | | | 799 | | | 5.98 | % |
Federal funds sold and interest bearing deposits due from banks | | | 64,594 | | | 32 | | | 0.20 | % | | 19,667 | | | 13 | | | 0.03 | % |
Total interest-earning assets | | | 930,150 | | | 11,598 | | | 5.04 | % | | 974,400 | | | 12,877 | | | 5.34 | % |
Non-interest earning assets | | | 105,979 | | | | | | | | | 92,350 | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Total assets | | $ | 1,036,129 | | | | | | | | $ | 1,066,750 | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | | | | | | | | | | | | | |
Average interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | |
Total interest-bearing deposits | | $ | 751,234 | | $ | 2,829 | | | 1.53 | % | $ | 787,135 | | | 4,353 | | | 2.24 | % |
Short-term borrowings | | | 12 | | | 0 | | | 1.67 | % | | 1,233 | | | 2 | | | 0.69 | % |
Customer repurchase agreements | | | 23,247 | | | 29 | | | 0.50 | % | | 27,896 | | | 69 | | | 1.01 | % |
Federal Home Loan Bank advances | | | 84,111 | | | 556 | | | 2.68 | % | | 85,117 | | | 538 | | | 2.56 | % |
Subordinated debentures | | | 16,100 | | | 64 | | | 1.60 | % | | 16,100 | | | 113 | | | 2.85 | % |
Convertible promissory notes | | | 5,555 | | | 147 | | | 10.48 | % | | — | | | — | | | — | |
Total interest-bearing liabilities | | | 880,259 | | | 3,625 | | | 1.67 | % | | 917,481 | | | 5,075 | | | 2.24 | % |
| | | | | | | | | | | | | | | | | | | |
Demand deposits | | | 71,831 | | | | | | | | | 65,619 | | | | | | | |
Accrued expenses and other liabilities | | | 8,669 | | | | | | | | | 12,311 | | | | | | | |
Stockholders’ equity | | | 75,370 | | | | | | | | | 71,339 | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Total liabilities and stockholders’ equity | | $ | 1,036,129 | | | | | | | | $ | 1,066,750 | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Net Interest Income | | | | | $ | 7,973 | | | | | | | | $ | 7,802 | | | | |
Interest rate spread3 | | | | | | | | | 3.37 | % | | | | | | | | 3.10 | % |
Net interest margin4 | | | | | | | | | 3.46 | % | | | | | | | | 3.23 | % |
| |
(1) | The interest income on tax exempt securities and loans is computed on a tax-equivalent basis using a tax rate of 34% for all periods presented |
| |
(2) | The average loan balances and rates include non-accrual loans. |
| |
(3) | Interest rate spread is the difference between the annualized average yield earned on average interest-earning assets for the period and the annualized average rate of interest accrued on average interest-bearing liabilities for the period. |
| |
(4) | Net interest margin is the annualized effect of net interest income for a period divided by average interest-earning assets for the period. |
RATE/VOLUME ANALYSIS(1)
(Dollar amounts in thousands)
Three Months ended March 31, 2010 compared to the Three Months ended March 31, 2009:
| | | | | | | | | | |
| | Increase (Decrease) due to(1) | |
| | Volume | | Rate | | Net | |
Interest income: | | | | | | | | | | |
Loans(2) | | $ | (1,110 | ) | $ | 256 | | $ | (854 | ) |
Taxable securities | | | 39 | | | (240 | ) | | (201 | ) |
Tax exempt securities(2) | | | (230 | ) | | (13 | ) | | (243 | ) |
Federal funds sold and interest bearing due from banks | | | 23 | | | (4 | ) | | 19 | |
Total interest-earning assets | | | (1,278 | ) | | (1 | ) | | (1,279 | ) |
| | | | | | | | | | |
Interest expense: | | | | | | | | | | |
Total interest-bearing deposits | | | (444 | ) | | (1,081 | ) | | (1,525 | ) |
Short term borrowings | | | (3 | ) | | 1 | | | (2 | ) |
Customer repurchase agreements | | | (10 | ) | | (30 | ) | | (40 | ) |
FHLB advances | | | (6 | ) | | 24 | | | 18 | |
Subordinated debentures | | | — | | | (49 | ) | | (49 | ) |
Convertible promissory notes | | | 147 | | | — | | | 147 | |
Total interest-bearing liabilities | | | (316 | ) | | (1,135 | ) | | (1,451 | ) |
| | | | | | | | | | |
Net interest income | | $ | (962 | ) | $ | 1,134 | | $ | 172 | |
| | |
| (1) | The change in interest due to both rate and volume has been allocated in proportion to the relationship to the dollar amounts of the change in each. |
| | |
| (2) | The yield on tax-exempt loans and securities is computed on a tax equivalent basis using a tax rate of 34% for all periods presented. |
The ratio of average interest-earning assets to average total assets was 91.1% and 91.2% for the three months ended March 31, 2010 and 2009, respectively.
Provision for Loan Losses:
The PFLL is the cost of providing an allowance for probable and inherent losses in our loan portfolio. The ALL consists of specific and general reserves. Our internal risk system is used to identify loans that meet the criteria for being “impaired” as defined by accounting guidance. Specific reserves relate to loans that are individually classified as impaired. Loans identified as impaired are evaluated for impairment using either the discounted expected cash flows or collateral value less estimated costs to sell and assigned a specific reserve based upon that analysis. The general reserve covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. These qualitative factors include: 1) changes in the nature, volume and terms of loans, 2) changes in lending personnel, 3) changes in the quality of the loan review function, 4) changes in nature and volume of past-due, non-accrual and/or classified loans, 5) changes in concentration of credit risk, 6) changes in economic and industry conditions, 7) changes in legal and regulatory requirements, 8) unemployment and inflation statistics, and 9) changes in underlying collateral values.
The PFLL for the quarter ended March 31, 2010 was $1.1 million compared to $1.2 million for the comparable quarter last year. Specific reserves on impaired loans decreased $5.7 million, which was offset by an increase of $1.4 million in our in our general reserves.
Net loan charge-offs for the first three months of 2010 were $0.5 million compared to $0.08 million for the same period in 2009. Net annualized charge-offs to average loans were 0.32% for the first three months of 2010 compared to 0.04% for the same period in 2009. For the three months ended March 31, 2010, non-performing loans decreased by $9.2 million (34.6%) to $17.4 million from $26.6 million at December 31, 2009 and decreased $31.1 million (64.1%) since March 31, 2009. Refer to the “Financial Condition - Risk Management and the Allowance for Loan Losses” and “Financial Condition - Non-Performing Loans, Potential Problem Loans and Other Real Estate” sections below for more information related to non-performing loans.
Our management believes that the ALL at March 31, 2010 and the related PFLL taken for the three months ended March 31, 2010 is appropriate in view of the present condition of the loan portfolio and the amount and quality of the collateral supporting non-performing loans. We continue to monitor non-performing loan relationships and will make additional provisions, as necessary, if the facts and circumstances change. In addition, a decline in the quality of our loan portfolio as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the ALL. If there are significant charge-offs against the ALL, or we otherwise determine that the ALL is inadequate, we will need to make additional PFLLs in the future. See “Financial Condition - Risk Management and the Allowance for Loan Losses” below for more information related to non-performing loans.
Non-Interest Income:
The following table reflects the various components of non-interest income for the three month periods ended March 31, 2010 and 2009, respectively.
NON-INTEREST INCOME
(Dollar amounts in thousands)
| | | | | | | | | | |
| | Three months ended
March 31, | | %
Change | |
| | 2010 | | 2009 | | |
Fees from fiduciary services | | $ | 216 | | $ | 126 | | | 71.4 | |
Fees from loan servicing | | | 157 | | | 175 | | | (10.3 | %) |
Service charges on deposit accounts | | | 806 | | | 920 | | | (12.4 | %) |
Other fee income | | | 188 | | | 187 | | | 0.5 | % |
Financial services income | | | 204 | | | 145 | | | 40.7 | % |
Gains from sales of loans | | | 168 | | | 227 | | | (26.0 | %) |
Net change in valuation of mortgage servicing rights | | | 6 | | | (73 | ) | | 108.2 | % |
Net gains from sale of securities | | | — | | | 2,762 | | | — | |
Increase (decrease) in cash surrender value of life insurance | | | 83 | | | (38 | ) | | 318.4 | % |
Income in equity of UFS subsidiary | | | 161 | | | 82 | | | 96.3 | % |
Other income | | | 22 | | | 23 | | | (4.3 | %) |
Total Non-Interest Income | | $ | 2,011 | | $ | 4,536 | | | (55.7 | %) |
Non-interest income decreased $2.5 million (55.7%) for the three months ended March 31, 2010 versus the comparable period in 2009. This was primarily due to $2.8 million of securities gains realized during the first quarter of 2009 versus no securities gains during the first quarter of 2010. This was partially offset by $.09 million increase in fiduciary services, $.06 million increase in financial services income, and a $.08 million increase in income of our UFS subsidiary.
Non-Interest Expense
The following Table reflects the various components of non-interest expense for the three months ended March 31, 2010 and 2009, respectively.
NON-INTEREST EXPENSE
(Dollar amounts in thousands)
| | | | | | | | | | |
| | Three months ended
March 31, | | %
Change | |
| | 2010 | | 2009 | | |
Salaries and employee benefits | | $ | 4,262 | | $ | 4,184 | | | 1.9 | % |
Occupancy | | | 611 | | | 669 | | | (8.7 | %) |
Equipment | | | 326 | | | 325 | | | 0.3 | % |
Data processing and courier | | | 225 | | | 242 | | | (7.0 | %) |
Operation of foreclosed properties | | | 425 | | | 92 | | | 362.0 | % |
Business development and advertising | | | 179 | | | 177 | | | 1.1 | % |
Charitable contributions | | | 27 | | | 31 | | | (12.9 | %) |
Stationary and supplies | | | 114 | | | 125 | | | (8.8 | %) |
Director fees | | | 82 | | | 143 | | | (42.7 | %) |
FDIC insurance premiums | | | 461 | | | 393 | | | 17.3 | % |
Legal and professional | | | 176 | | | 310 | | | (43.2 | %) |
Loan and collection | | | 151 | | | 221 | | | (31.7 | %) |
Provision for impairment of letter of credit | | | 87 | | | — | | | — | |
Other operating | | | 593 | | | 515 | | | 15.2 | % |
Total Non-interest Expense | | $ | 7,719 | | $ | 7,427 | | | 3.9 | % |
Non-interest expense increased $0.3 million (3.9%) to $7.7 million for the three months ended March 31, 2010 compared to $7.4 million for the same period in 2009. The non-interest expense to average assets ratio was 3.0% for the three months ended March 31, 2010 compared to 2.8% for the same period in 2009.
Net overhead expense is total non-interest expense less total non-interest income excluding securities gains. The net overhead expense to average assets ratio increased to 2.2% for the three months ended March 31, 2010 compared to 1.1% for the same period in 2009. The efficiency ratio represents total non-interest expense as a percentage of the sum of net-interest income on a fully taxable equivalent basis and total non-interest income (excluding net gains on the sale of securities and premises and equipment). A lower efficiency ratio indicates a more efficient operation. The efficiency ratio improved to 77.3% for the three months ended March 31, 2010 from 77.6% for the comparable period last year.
The decrease in director fees of $0.06 million (42.7%) to $0.08 million for the three month period ended March 31, 2010 compared to the same period in 2009 reflects the voluntary election of the board of directors to reduce their board fees beginning on April 1, 2009 and the elimination of fees payable to the Chairman of the Board as of July 1, 2009. Also effecting the decrease was the conversion of monthly regional board meetings to quarterly.
Legal and professional services expense decreased $0.13 million (43.2%) from the comparable period in 2009. Also, loan and collection expense decreased $0.07 million from $0.22 million at March 31, 2009 to $0.15 million at March 31, 2010. We anticipate that non-performing loans will continue to stabilize and moderate, allowing these expenses to follow a similar trend.
Expenses with the operation of foreclosed properties totaled $0.43 million for the period ending March 31, 2010 compared to $0.09 million for the same period in 2009. The $0.33 million increase reflected an increase in our foreclosed properties from $7.5 million at March 31, 2009 to $15.9 million at March 31, 2010. We intend to continue to evaluate all foreclosed property values and attempt to reduce the holding periods of these properties and, as a result, the related holding costs to the extent possible. Such expenses include but are not limited to insurance, maintenance, real estate taxes, management fees, utilities and legal fees.
Salaries and employee benefits represent our largest non-interest expense. We experienced a slight increase of $.08 million in salaries and employee benefits. Offsetting the increase is a reduction in 401K expense. The 5% employer match contribution was eliminated during the second quarter of 2009. Other operating expenses increased $0.24 million to $0.66 million for the period ending March 31, 2010 versus $0.42 million for the comparable period in 2009. The increase was due in part to our need to fill vacant positions during the first quarter of 2010. We anticipate other operating expenses to moderate during the second quarter of 2010.
Included in non-interest expenses are FDIC insurance premiums of $0.46 million for the three months ended March 31, 2010 compared to $0.39 million for the same period a year ago. FDIC insurance premiums consist of two components, deposit insurance premiums and payments for servicing obligations of the Financing Corporation (“FICO”) that were issued in connection with the resolution of savings and loan associations. With the enactment in early 2006 of the Federal Deposit Insurance Reform Act of 2005, major changes were introduced in the calculation of FDIC deposit insurance premiums. Such changes were effective January 1, 2007 and included establishment by the FDIC of a target reserve ratio range for the Deposit Insurance Fund (“DIF”) of between 1.15% and 1.50%, as opposed to the prior fixed reserve ratio of 1.25%. The FDIC approved 1.25% as the target ratio. At the same time, the FDIC adopted a new risk-based system for assessment of deposit insurance premiums under which all such institutions are required to pay minimum annual premiums. The system categorizes institutions in one of four risk categories, depending on capitalization and supervisory rating criteria. Baylake Bank’s assessment rate, like that of other financial institutions, is confidential and may not be directly disclosed, except to the extent required by law. Payments for the FICO portion will continue as long as FICO obligations remain outstanding. In February 2009, the FDIC adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009 at 12 bps to 45 bps. On November 12, 2009, the Board of Directors of the FDIC adopted a rule that required insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC Board also voted to adopt a uniform 3 bps increase in assessment rates effective January 1, 2011. We were required to prepay approximately $6.7 million in premiums in December 2009, which premiums are not be taken as a charge against our operations until the prepay period for which they apply.
Income Taxes
Our income tax expense for the three months ended March 31, 2010 was $0.15 million versus $1.1 million for the same period in 2009. The decrease in tax expense is attributable largely to a $2.1 million year-over-year decrease in net income primarily due to a reduction of $2.8 million in gains from sale of securities. We maintain significant net deferred tax assets for deductible temporary tax differences, such as allowance for loan losses, non-accrual loan interest, and foreclosed property valuations as well as net operating loss carry forwards. Our determination of the amount of our deferred tax asset to be realized is highly subjective and is based on several factors, including projected future income, income tax planning strategies, and federal and state income tax rules and regulations. At March 31, 2010, we determined no valuation allowance was required to be taken against our deferred tax asset other than a valuation allowance to reduce our state net operating loss carry forwards to an amount which we believe the benefit will more likely than not be realized. We continue to assess the amount of tax benefits we may realize.
Financial Condition
Loans:
The following table reflects the composition (mix) of the loan portfolio:
LOAN PORTFOLIO ANALYSIS
(Dollar amounts in thousands)
| | | | | | | | | | |
| | March 31,
2010 | | December 31,
2009 | | Percent
change | |
Amount of loans by type | | | | | | | | | | |
Real estate-mortgage | | | | | | | | | | |
Commercial | | $ | 347,524 | | $ | 353,110 | | | (1.6 | %) |
1-4 family residential | | | | | | | | | | |
First liens | | | 73,938 | | | 73,262 | | | 0.9 | % |
Junior liens | | | 13,013 | | | 13,041 | | | (0.2 | %) |
Home equity | | | 39,700 | | | 38,527 | | | 3.0 | % |
Commercial, financial and agricultural | | | 80,160 | | | 83,674 | | | (4.2 | %) |
Real estate-construction | | | 66,047 | | | 62,827 | | | 5.1 | % |
Installment | | | | | | | | | | |
Credit cards and related plans | | | 1,796 | | | 1,867 | | | (3.8 | %) |
Other | | | 9,488 | | | 9,937 | | | (4.5 | %) |
Obligations of states and political subdivisions | | | 12,002 | | | 16,009 | | | (25.0 | %) |
Less: deferred origination fees, net of costs | | | (380 | ) | | (360 | ) | | 5.6 | % |
Total | | $ | 643,288 | | $ | 651,894 | | | (1.3 | %) |
Total gross loans at March 31, 2010 decreased $8.6 million (1.3%) from $651.9 million at December 31, 2009 to $643.3 million at March 31, 2010. The decrease is primarily due to reductions in commercial real estate, commercial financial and agricultural loans, and obligations of states and political subdivisions. This is the result of the uncertainty in the economy as we have focused on credit quality in loans we originate.
Risk Management and the Allowance for Loan Losses:
The loan portfolio is our primary asset subject to credit risk. To address this credit risk, we maintain an ALL for probable and inherent credit losses through periodic charges to our earnings. These charges are shown in our consolidated statements of operations as PFLL. See “Provision for Loan Losses” earlier in this Report. We attempt to control, monitor and minimize credit risk through the use of prudent lending standards, a thorough review of potential borrowers prior to lending and ongoing and timely review of payment performance. Asset quality administration, including early identification of loans performing in a substandard manner, as well as timely and active resolution of problems, further enhances management of credit risk and minimization of loan losses. Any losses that occur and that are charged off against the ALL are periodically reviewed with specific efforts focused on achieving maximum recovery of both principal and interest.
On a quarterly basis, management reviews the adequacy of the ALL. The analysis of the ALL consists of three components: (i) specific reserves established for expected losses relating to specific individual loans for which the recorded investment in the loans exceeds its fair value; (ii) general reserves based on historical loan loss experience for significant loan categories; and (iii) general reserves based on qualitative factors such as concentrations, and changes in portfolio mix and volume.
On a regular basis, loan officers review all commercial credit relationships. The loan officers grade commercial credits and the loan review function validates the grades assigned. In the event that a loan review function downgrades the loan, it is included in the ALL analysis process at the lower grade. This grading system is in compliance with regulatory classifications. At least quarterly, all commercial loans over a fixed dollar amount that have been deemed impaired are evaluated. In compliance with accounting guidance for impaired loans, the fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the market price of the loan or, if the loan is collateral dependent, the fair value of the underlying collateral less the cost of sale. This evaluation may include obtaining supplemental market data and/or routine site visits to offer support to the evaluation process. A specific reserve is then allocated to the loans based on this assessment. Specific reserves are reviewed by the Chief Credit Officer (“CCO “) and management familiar with the credits.
The ALL at March 31, 2010 was $10.1 million, compared to $9.6 million at year-end 2009. This level was based on management’s analysis of the loan portfolio at March 31, 2010 as discussed above. As such, a PFLL of $1.1 million was charged to earnings for the three months ended March 31, 2010 compared to a $1.2 million PFLL recorded for the same period ended March 31, 2009. A majority of the net charge-offs of $0.5 million through March 31, 2010 had been included in the ALL at December 31, 2009. The PFLL recorded in 2010 reflects additional risks identified within the loan portfolio during the three months ended March 31, 2010.
During the second quarter of 2009, four related credit relationships with exposure to the construction and real estate development markets totaling $8.4 million experienced varying degrees of cash flow and collateral concerns. Prior to the second quarter of 2009, the relationships had been paying as agreed and did not appear to present any additional credit risk. In a conservative approach, the entire relationship was moved to a non-accrual status during the second quarter of 2009 to allow time for a complete evaluation of the credit. In addition, a $1.8 million specific reserve for this credit was recorded during the second quarter of 2009. During the evaluation in the third quarter of 2009, $3.7 million of the credit relationship was supported with independent cash flows and the customer proved the ability to make payments. Upon completion of negotiations, the $3.7 million was returned to accrual status and the remainder of the relationship remained on non-accrual status. A reduction in the impairment of the credit resulted from the debtor providing collateral to the debt.
We have two other major components of the ALL that do not pertain to specific loans: “General Reserves – Historical” and “General Reserves – Other.” We continue to use the same methodology of determining historical loss factors for the portfolio of loans to which there are no specific loss allocations. We determine General Reserves – Historical based on our historical recorded charge-offs of loans in particular categories, analyzed as a group. As it relates to the historical loss component, we reduced the historical loss lookback period from 16 quarters to an average of 8 and 12 quarters. This was primarily done to enable the model to provide a better reflection of the recent economic times. This resulted in increased allocations that we determined were appropriate. We determine General Reserves – Other by taking into account other factors, such as the concentration of loans in a particular industry or geographic area and adjustments for economic indicators. By nature, our general reserve changes with our fluid lending environment and the overall economic environment in which we lend. As such, we are continually attempting to enhance this portion of the allocation process to reflect anticipated losses in our portfolio driven by these changing factors. During the first quarter of 2009, the general component of the analysis was to specifically identify the inherent risks in the loan portfolio. Expanded economic statistics, specifically unemployment and inflation rates for national, state and local markets are monitored and factored into the allocation to address repayment risk. Further identification and management of portfolio concentration risks, both by loan category and by specific markets was enhanced and is reflected in the general allocation component. In fourth quarter of 2009, the model was further enhanced to include more specific qualitative factors, as mentioned previously, by loan type.
Non-Performing Loans, Potential Problem Loans and Foreclosed Properties
Management encourages early identification of non-accrual and problem loans in order to minimize the risk of loss. Non-performing loans are defined as non-accrual loans, loans 90 days or more past due but still accruing, and loans restructured in a troubled debt restructuring in the current year. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collection of principal or interest on loans, it is the practice of management to place such loans on non-accrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than recorded as interest income. Restructuring a loan typically involves the granting of some concession to the borrower involving a loan modification, such as payment schedule or interest rate changes. Restructured loans may involve loans that have had a charge-off taken against the loan to reduce the carrying amount of the loan to fair market value as determined pursuant to accounting guidance for troubled debt restructurings.
NON-PERFORMING ASSETS
(Dollar amounts in thousands)
| | | | | | | | | | |
| | March 31,
2010 | | December 31,
2009 | | March 31,
2009 | |
Nonperforming Assets: | | | | | | | | | | |
Nonaccrual loans | | $ | 16,969 | | $ | 23,247 | | $ | 46,879 | |
Nonaccrual loans, restructured | | | 386 | | | 3,343 | | | 1,601 | |
Accruing loans past due 90 days or more | | | — | | | — | | | — | |
| | | | | | | | | | |
Total nonperforming loans (“NPLs”) | | $ | 17,355 | | $ | 26,590 | | $ | 48,480 | |
Other real estate owned | | | 15,911 | | | 14,995 | | | 7,546 | |
| | | | | | | | | | |
Total nonperforming assets (“NPAs”) | | $ | 33,266 | | $ | 41,585 | | $ | 56,026 | |
Restructured loans, accruing(1) | | $ | 9,809 | | $ | 2,061 | | $ | 428 | |
| | | | | | | | | | |
Ratios: | | | | | | | | | | |
ALL to Net Charge-offs (“NCOs”) (annualized) | | | 4.85 | x | | 0.92 | x | | 44.60 | x |
NCOs to average loans (annualized) | | | 0.32 | % | | 1.50 | % | | 0.05 | % |
ALL to total loans | | | 1.58 | % | | 1.47 | % | | 2.03 | % |
NPLs to total loans | | | 2.70 | % | | 4.08 | % | | 6.73 | % |
NPAs to total assets | | | 3.26 | % | | 3.98 | % | | 5.34 | % |
ALL to NPLs | | | 58.40 | % | | 36.10 | % | | 30.22 | % |
(1) Restructured loans on accrual status were previously reported as nonperforming loans.
Non-performing loans decreased $9.2 million (34.7%) during the three months ended March 31, 2010 and decreased $31.1 million (64.2%) from March 31, 2009. Included in the $9.2 million decrease are loan charge-offs of $1.5 million, $1.4 million of balances transferred to foreclosed properties, $1.2 million of loans moved to an accrual status by payments being brought current, and loan payments of $9.2 million. This was partially offset by $4.1 million of loan balances being placed on a non-accrual status. Additionally, non-performing assets decreased $8.3 million (20.0%) since year end and $22.8 million (41.0%) since March 31, 2009. As of March 31, 2010 restructured loans on accrual status are $9.8 million compared to $2.0 million and $0.4 million at December 31, 2009 and March 31, 2009, respectively. The non-performing loan relationships are secured primarily by commercial or residential real estate and, secondarily, by personal guarantees from principals of the respective borrowers.
The following table presents an analysis of our past due loans excluding non-accrual loans:
PAST DUE LOANS (EXCLUDING NON-ACCRUALS)
30-89 DAYS PAST DUE
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | |
| | 03/31/10 | | 12/31/09 | | 09/30/09 | | 06/30/09 | | 03/31/09 | |
Total secured by real estate | | $ | 6,730 | | $ | 8,881 | | $ | 5,922 | | $ | 6,936 | | $ | 9,936 | |
Commercial and industrial loans | | | 806 | | | 255 | | | 862 | | | 2,512 | | | 3,255 | |
Loans to individuals | | | 65 | | | 370 | | | 204 | | | 104 | | | 131 | |
All other loans | | | 134 | | | 1 | | | 139 | | | 143 | | | 5 | |
Total | | $ | 7,735 | | $ | 9,507 | | $ | 7,127 | | $ | 9,695 | | $ | 13,327 | |
Percentage of total loans | | | 1.20 | % | | 1.46 | % | | 1.06 | % | | 1.37 | % | | 1.85 | % |
As indicated above, loan balances 30 to 89 days past due have decreased by $1.8 million since December 31, 2009 and $5.6 million since March 31, 2009. As the loans continue through the collection process, we anticipate these past due levels will continue to decline.
Information regarding other real estate owned is as follows:
FORECLOSED PROPERTIES
(Dollar amounts in thousands)
| | | | | | | | | | |
| | Three months
ended
March 31, 2010 | | Twelve months
ended
December 31, 2009 | | Three months
ended
March 31, 2009 | |
Beginning balance | | $ | 14,995 | | $ | 7,143 | | $ | 7,143 | |
Transfer of loans to foreclosed properties | | | 1,393 | | | 12,196 | | | 1,158 | |
Sales proceeds, net | | | (314 | ) | | (3,774 | ) | | (813 | ) |
Net gain from sale of foreclosed properties | | | 17 | | | 108 | | | 98 | |
Provision for foreclosed properties | | | (180 | ) | | (678 | ) | | (40 | ) |
| | | | | | | | | | |
Total foreclosed properties | | $ | 15,911 | | $ | 14,995 | | $ | 7,546 | |
Changes in the valuation allowance for losses on foreclosed properties were as follows:
| | | | | | | | | | |
| | Three months
ended
March 31, 2010 | | Twelve months
ended
December 31, 2009 | | Three months
ended
March 31, 2009 | |
Beginning balance | | $ | 2,773 | | $ | 3,391 | | $ | 3,391 | |
Provision charged to operations | | | 180 | | | 678 | | | 40 | |
Allowance recovered on properties disposed | | | (147 | ) | | (1,296 | ) | | (53 | ) |
| | | | | | | | | | |
Balance at end of period | | $ | 2,806 | | $ | 2,773 | | $ | 3,378 | |
Investment Portfolio
The investment portfolio is intended to provide us with adequate liquidity, flexibility in asset/liability management and an increase in our earning potential.
At March 31, 2010, the investment portfolio (which comprised investment securities available for sale) increased $26.8 million (13.1%) to $231.6 million compared to $204.8 million at December 31, 2009. At March 31, 2010, the investment portfolio represented 22.7% of total assets compared to 19.6% at December 31, 2009.
We continue to closely monitor corporate trust preferred securities we hold in our investment portfolio included in the private placement and corporate bond totals. Total unrealized losses on these securities are $1.5 million at March 31, 2010, representing 83.8% of the total gross unrealized losses. Based on in-depth analysis of the specific instruments and the creditworthiness of the related issuers, including their ability to continue payments under the terms of the security agreements, no declines were deemed to be other-than-temporary. Additionally, we do not have the intent to sell the trust preferred securities and it is more likely than not that we will not be required to sell these securities before their anticipated recovery. If at any point in time any losses are considered other than temporary, we would be required to recognize other-than-temporary impairment. This would require us to assess the cash flows expected to be collected from the security. The difference between the present value of the cash flows expected to be collected and the amortized cost basis would result in a credit loss for the amount of the impairment. This amount would reduce our earnings. The remaining portion of the impairment related to factors other than credit loss would be recognized through other comprehensive income. At March 31, 2010 and December 31, 2009, we did not hold securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity.
Deposits
Total deposits at March 31, 2010 decreased $18.2 million (2.2%) to $813.4 million from $831.6 million at December 31, 2009. Such decrease was a result of a decrease in our time deposits of $18.5 million from $373.0 million at December 31, 2009 to $354.5 million at March 31, 2010 and a $10.3 million decline in demand deposits, partially offset by $10.7 million growth in our savings deposits. Interest-bearing deposits decreased $13.4 million (1.8%) while non interest-bearing deposits decreased $4.8 million (5.9%). During that time period, brokered deposits increased $4.5 million (7.1%) from $58.9 million to $63.4 million.
Emphasis has been, and will continue to be, placed on generating additional core deposits in 2010 through competitive pricing of deposit products and through our pre-established branch delivery systems. We will also attempt to attract and retain core deposit accounts through new product offerings and quality customer service. We also may increase brokered certificates of deposit during the remainder of 2010 as an additional source of funds to support loan growth or other asset and liability needs in the event that core deposit growth goals are not achieved. Under that scenario, we will continue to look at other wholesale sources of funds if the brokered certificate of deposit market were to become illiquid or more costly. If liquidity concerns arise, we have alternative sources of funds such as lines of credit with correspondent banks and borrowing arrangements with the Federal Home Loan Bank (“FHLB”) and through the discount window at the Federal Reserve.
Other Funding Sources
Securities under agreements to repurchase at March 31, 2010 increased $3.6 million (17.1%) to $24.7 million from $21.1 million at December 31, 2009. We did not have any federal funds purchased at either March 31, 2010 or December 31, 2009.
FHLB advances were $75.0 million at March 31, 2010 compared to $85.0 million at December 31, 2009. During the quarter, we paid down $10.0 million in FHLB advances. We will borrow funds if borrowing is a less costly form of funding loans than acquiring deposits or if deposit growth is not sufficient. The availability of deposits also determines the amount of funds we need to borrow in order to fund loan demand.
Long Term Debt
In March 2006, we issued $16.1 million of variable rate, trust preferred securities and $0.5 million of trust common securities through Baylake Capital Trust II (the “Trust”) that will adjust quarterly at a rate equal to 1.35% over the three month LIBOR. At March 31, 2010, the interest rate on these securities was 1.63%. For banking regulatory purposes, these securities are considered Tier 1 capital.
The Trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon us making payment on the related subordinated debentures (“Debentures”) to the Trust. Under the terms of the Debentures, we would be precluded from paying dividends on our common stock if we were in default under the Debentures, if we exercised our right to defer payment of interest on the Debentures or if certain related defaults occurred. As of March 31, 2010 all payments are current.
During the third and fourth quarters of 2009 and the first quarter of 2010, we completed six separate closings of a private placement of 10% Convertible Notes due June 30, 2017 (the “Convertible Notes”). The Convertible Notes were offered and sold in reliance on the exemption from registration under Section 4(2) of the Securities Act of 1933 and Rule 506 promulgated thereunder. We issued $6.65 million principal amount of the Convertible Notes, at par, and received gross proceeds in the same amount.
Subsequent to the date of our consolidated financial statements for the period ended March 31, 2010, we completed a final closing of the Convertible Notes. On April 30, 2010 we issued $2.8 million principal amount of the Convertible Notes, at par, and received gross proceeds in the same amount. The total amount of the Convertible Notes issued as of the date of this report is $9.45 million. The offering expired on April 30, 2010.
The Convertible Notes accrue interest at a fixed rate of 10% per annum upon issuance and until maturity or earlier conversion or redemption. Interest is payable quarterly, in arrears, on January 1, April 1, July 1, and October 1, of each year. The Convertible Notes are convertible into shares of our common stock at a conversion ratio of one share of common stock for each $5.00 in aggregate principal amount held on the record date of the conversion subject to certain adjustments as described in the Convertible Notes. Prior to October 1, 2014, each holder of the Convertible Notes may convert up to 100% (at the discretion of the holder) of the original principal amount into shares of our common stock at the conversion ratio. On October 1, 2014, one-half of the original principal amounts are mandatorily convertible into common stock at the conversion ratio if conversion has not occurred. The principal amount of any Convertible Note that has not been converted will be payable at maturity on June 30, 2017. We are not obligated to register the common stock issued on the conversion of the Convertible Notes.
Contractual Obligations
We use a variety of financial instruments in the normal course of business to meet the financial needs of our customers. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, and forward commitments to sell residential mortgage loans. Please refer to our Annual Report on Form 10-K for the year ended December 31, 2009 for quantitative and qualitative disclosures about our fixed and determinable contractual obligations. Items disclosed in the 2009 Annual Report on Form 10-K have not materially changed since that Report was filed.
The following table summarizes our significant contractual obligations and commitments at March 31, 2010:
CONTRACTUAL OBLIGATIONS
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | |
| | Within 1
year | | 1-3 years | | 3-5 years | | After 5
years | | Total | |
Certificates of deposit and other time deposit obligations | | $ | 246,390 | | $ | 91,730 | | $ | 16,351 | | $ | — | | $ | 354,471 | |
Federal funds purchased and repurchase agreements | | | 24,663 | | | — | | | — | | | — | | | 24,663 | |
Federal Home Loan Bank advances | | | 45,000 | | | 30,000 | | | — | | | — | | | 75,000 | |
Subordinated debentures | | | — | | | — | | | — | | | 16,100 | | | 16,100 | |
Convertible promissory notes(1) | | | — | | | — | | | — | | | 6,650 | | | 6,650 | |
Operating leases | | | 13 | | | — | | | — | | | — | | | 13 | |
Total | | $ | 316,066 | | $ | 121,730 | | $ | 16,351 | | $ | 22,750 | | $ | 476,897 | |
| | |
| (1) | One-half of the Convertible Notes are mandatorily converted to shares of common stock by October 1, 2014. The principal amount of any Convertible Note that has not been converted or redeemed will be payable at maturity on June 30, 2017. |
Off balance Sheet Arrangements
The following is a summary of our off-balance sheet commitments, all of which were lending-related commitments:
LENDING RELATED COMMITMENTS
(Dollar amounts in thousands)
| | | | | | | |
| | March 31,
2010 | | December 31,
2009 | |
Commitments to fund home equity line loans | | $ | 48,503 | | $ | 46,565 | |
Commitments to fund 1-4 family loans | | | 3,880 | | | 2,704 | |
Commitments to fund residential real estate construction loans | | | 987 | | | 2,259 | |
Commitments unused on various other lines of credit loans | | | 125,139 | | | 116,667 | |
Total commitments to extend credit | | $ | 178,509 | | $ | 168,195 | |
| | | | | | | |
Financial standby letters of credit | | $ | 11,500 | | $ | 14,550 | |
Liquidity
Liquidity management refers to our ability to ensure that cash is available in a timely manner to meet loan demand and depositors’ needs, and to service other liabilities as they become due, without undue cost or risk, and without causing a disruption to normal operating activities. Baylake Corp. and Baylake Bank have different liquidity considerations.
Our primary sources of funds are dividends from Baylake Bank, investment income, and net proceeds from borrowings. We may also undertake offerings of junior subordinated obligations and issue our common stock if and when we deem it prudent to do so. We generally manage our liquidity position in order to provide funds necessary to meet interest obligations of our trust preferred securities and convertible notes, pay dividends to our shareholders, subject to regulatory restrictions, and repurchase shares. Such restrictions, which govern all state chartered banks, preclude the payment of dividends by a bank, without the prior written consent of the Wisconsin Department of Financial Institutions - - Division of Banking (“WDFI”) if dividends declared and paid by such bank in either of the two immediately preceding years exceeded that bank’s net income for those years. In consultation with our federal and state regulators, our Board of Directors elected to forego the dividend to our shareholders beginning in the first quarter of 2008. In addition, in order to pay dividends in the future, we will need to seek prior approval from WDFI as well as the Federal Reserve. There is no assurance, however, that we would receive such approval if sought.
Baylake Bank meets its cash flow needs by having funding sources available to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity is derived from deposit growth, payments on and maturities of loans, payments on and maturities of the investment portfolio, access to other funding sources, marketability of certain assets, the ability to use loan and investment portfolios as collateral for secured borrowings and a strong capital position.
Maturing investments have historically been a primary source of liquidity. For the three months ended March 31, 2010, principal payments totaling $39.7 million were received on investments. However, we purchased $64.0 million in investments in the same period. At March 31, 2010 the investment portfolio contained $153.0 million of mortgage-backed securities issued by U.S. government sponsored agencies, representing 66.1% of the total investment portfolio. These securities tend to be highly marketable.
Deposit decreases, reflected as a financing activity in the March 31, 2010 Unaudited Consolidated Statements of Cash Flows, resulted in $18.2 million of cash outflow during the first three months of 2010. Deposit growth is generally the most stable source of liquidity, although brokered deposits, which are inherently less stable than locally generated core deposits, are sometimes used. Our reliance on brokered deposits increased $4.5 million to $63.4 million during the three month period ended March 31, 2010, versus $58.9 million at December 31, 2009. If at any point we fall below the “well capitalized” regulatory capital threshold, it will become more difficult for us to obtain or renew brokered deposits in the future. Affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause a need to develop alternative sources of funds, which may not be as liquid and potentially a more costly alternative.
The scheduled payments and maturities of loans can provide a source of additional liquidity. There are $226.8 million, or 33.6% of total loans maturing within one year of March 31, 2010. Factors affecting liquidity relative to loans are loan origination volumes, loan prepayment rates and the maturity structure of existing loans. The liquidity position is influenced by changes in interest rates, economic conditions and competition. Conversely, loan demand creates a need for liquidity that may cause us to acquire other sources of funding, some of which could be more difficult to find and more costly to secure.
Within the classification of short-term borrowings at March 31, 2010 are federal funds purchased and securities sold under agreements to repurchase, which totaled $24.7 million compared to $21.1 million at the end of 2009. Federal funds are purchased from various upstream correspondent banks while securities sold under agreements to repurchase are obtained from a base of business customers. Short-term and long-term borrowings from the FHLB are another source of funds, totaling $75.0 million at March 31, 2010 and $85.0 million at December 31, 2009.
We expect that deposit growth will be our primary source of liquidity on a long-term basis, along with a stable earnings base, the resulting cash generated by operating activities and a strong capital position. We expect deposit growth to be a reliable funding source in the future as a result of marketing efforts to attract and retain core deposits. In addition, we may acquire additional brokered deposits as funding for short-term liquidity needs. Short-term liquidity needs will also be addressed by growth in short-term borrowings, maturing federal funds sold and portfolio investments and loan maturities and prepayments.
In assessing liquidity, historical information such as seasonality, local economic cycles and the economy in general are considered along with our current financial position and projections. We believe that in the current economic environment our liquidity position is adequate. To our knowledge, there are no known trends nor any known demands, commitments, events or uncertainties that will result or are reasonably likely to result in material increases or decreases in our liquidity.
Capital Resources
Stockholders’ equity at March 31, 2010 and December 31, 2009 was $77.0 million and $74.6 million, respectively. In total, stockholders’ equity increased $2.4 million (3.2%) during the current three month period. The increase in stockholders’ equity in the first three months of 2010 was primarily related to our net income of $0.8 million and an increase in other comprehensive income of $1.6 million (as a result of an increase in net unrealized gains on available-for-sale securities). The ratio of stockholders’ equity to assets was 7.5% and 7.2% at March 31, 2010 and December 31, 2009, respectively.
No cash dividends were declared during the first three months of 2010 or during all of 2009. Beginning in February 2008, our Board of Directors, in consultation with our federal and state bank regulators, elected to forego the payment of cash dividends on our common stock. We continue to monitor the payment of dividends in relationship to our financial position on a quarterly basis and our intention is to reinstate payment of dividends at the earliest appropriate opportunity, however there is no assurance if or when we will be able to do so or if we do, in what amounts. Our ability to pay dividends is subject to various factors including, among other things, sufficient earnings, available capital, board discretion and regulatory compliance. In order to pay dividends, advance approval from the WDFI as well as the Federal Reserve will need to be obtained.
We regularly review the adequacy of our capital to ensure that sufficient capital is available for our current and future needs and that it is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management.
The Federal Reserve has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8% of which at least half must comprise core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines which banks and bank holding companies must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a minimum ratio of 4% or 5%, depending on the rating. Failure to meet minimum capital requirements can initiate certain mandatory, as well as possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements.
At March 31, 2010, we were categorized as “well capitalized” under the regulatory framework for the prompt corrective action categorization. There are no conditions or events since that date that we believe have changed our category. To be “well capitalized” under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.
We have no material commitments for capital expenditures.
A strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share and to provide depositor and investor confidence. We believe our capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. We actively review our capital strategies to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements.
The following table presents the Company’s and Baylake Bank’s capital ratios as of March 31, 2010 and December 31, 2009:
CAPITAL RATIOS
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | |
| | Actual | | Required For
Capital Adequacy
Purposes | | Required To Be
Well Capitalized
under Prompt
Corrective Action
Provisions | |
| | Amount | | Ratio | | Amount | | Ratio | | Amount | | Ratio | |
As of March 31, 2010 | | | | | | | | | | | | | | | | | | | |
Total Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 93,345 | | | 12.63 | % | $ | 60,388 | | | 8.00 | % | | N/A | | | N/A | |
Bank | | | 92,404 | | | 12.23 | % | | 60,425 | | | 8.00 | % | $ | 75,531 | | | 10.00 | % |
Tier 1 Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 79,251 | | | 10.50 | % | $ | 30,194 | | | 4.00 | % | | N/A | | | N/A | |
Bank | | | 82,954 | | | 10.98 | % | | 30,212 | | | 4.00 | % | $ | 45,319 | | | 6.00 | % |
Tier 1 Capital (to Average Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 79,251 | | | 7.74 | % | $ | 40,942 | | | 4.00 | % | | N/A | | | N/A | |
Bank | | | 82,954 | | | 8.10 | % | | 40,977 | | | 4.00 | % | $ | 51,221 | | | 5.00 | % |
| | | | | | | | | | | | | | | | | | | |
| | Actual | | Required For
Capital Adequacy
Purposes | | Required To Be
Well Capitalized
under Prompt
Corrective Action
Provisions | |
| | Amount | | Ratio | | Amount | | Ratio | | Amount | | Ratio | |
As of December 31, 2009 | | | | | | | | | | | | | | | | | | | |
Total Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 92,667 | | | 12.18 | % | $ | 60,882 | | | 8.00 | % | | N/A | | | N/A | |
Bank | | | 90,321 | | | 11.86 | % | | 60,940 | | | 8.00 | % | $ | 76,175 | | | 10.00 | % |
Tier 1 Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 77,804 | | | 10.22 | % | $ | 30,441 | | | 4.00 | % | | N/A | | | N/A | |
Bank | | | 80,798 | | | 10.61 | % | | 30,470 | | | 4.00 | % | $ | 45,705 | | | 6.00 | % |
Tier 1 Capital (to Average Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 77,804 | | | 7.60 | % | $ | 40,961 | | | 4.00 | % | | N/A | | | N/A | |
Bank | | | 80,798 | | | 7.89 | % | | 40,978 | | | 4.00 | % | $ | 51,222 | | | 5.00 | % |
Item 3.Quantitative and Qualitative Disclosure about Market Risk
Our primary market risk exposure is interest rate risk. Interest rate risk is the risk that our earnings and capital will be adversely affected by changes in interest rates. Historically, we have not used derivatives to mitigate our interest rate risk.
Our earnings are derived from the operations of our direct and indirect subsidiaries with particular reliance on net interest income, calculated as the difference between interest earned on loans and investments and the interest expense paid on deposits and other interest-bearing liabilities, including advances from FHLB and other subordinated debentures. Like other financial institutions, our interest income and interest expense are affected by general economic conditions and by the policies of regulatory authorities, including the monetary policies of the Federal Reserve. Changes in the economic environment may influence, among other matters, the growth rate of loans and deposits, the quality of the loan portfolio and loan and deposit pricing. Fluctuations in interest rates are not predictable or controllable.
As of March 31, 2010, we were in compliance with our management policies with respect to interest rate risk. We have not experienced any material changes to our market risk position since December 31, 2009, as described in our 2009 Annual Report on Form 10-K.
Our overall interest rate sensitivity is demonstrated by net interest income shock analysis which measures the change in net interest income in the event of hypothetical changes in interest rates. This analysis assesses the risk of change in net interest income in the event of sudden and sustained 100 bp to 200 bp increases and decreases in market interest rates. The table below presents our projected changes in net interest income for the various rate shock levels at March 31, 2010.
INTEREST SENSITIVITY
(Dollar amounts in thousands)
| | | | | | | | | | | | | |
| | Change in Net Interest Income over One Year Horizon | |
| | At March 31, 2010 | | At December 31, 2009 | |
Change in levels of interest rates | | Dollar change | | Percentage
change | | Dollar change | | Percentage
change | |
+200 bp | | $ | 31,917 | | | 0.1 | % | $ | 29,388 | | | 1.4 | % |
+100 bp | | | 32,415 | | | 1.7 | % | | 29,453 | | | 1.6 | % |
Base | | | 31,887 | | | | | | 28,990 | | | | |
-100 bp | | | 31,940 | | | 0.2 | % | | 29,132 | | | 0.5 | % |
-200 bp | | | 31,217 | | | (2.1 | %) | | 28,110 | | | (3.0 | %) |
As shown above, at March 31, 2010, the effect of an immediate 200 bp increase in interest rates would have increased our net interest income by $0.03 million or 0.1%. The effect of an immediate 200 bp reduction in rates would have decreased our net interest income by $0.7 million or 2.1%. However, a 200 bp reduction in rates is not realistic given the low interest rate environment that currently exists. An interest rate floor of zero is used rather than assuming a negative interest rate.
During the first three months of 2010, Baylake Bank lengthened slightly the duration of its liabilities by replacing $5.2 million of maturing brokered certificates of deposit with $5.0 million of brokered certificates of deposit. This effort has contributed to moderation of the liability sensitivity that was present at December 31, 2009.
Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the relative levels of market interest rates and loan prepayments, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from the assumptions used in preparing the analyses. Further, the computations do not contemplate any actions we may undertake in response to changes in interest rates.
Item 4T.Controls and Procedures
Disclosures Controls and Procedures:Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of March 31, 2010. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Internal Control Over Financial Reporting
There have not been any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
PART II – OTHER INFORMATION
Item 1.Legal Proceedings
We and our subsidiaries may be involved from time to time in various routine legal proceedings incidental to our respective businesses. Neither we nor any of our subsidiaries is currently engaged in any legal proceedings that are expected to have a material adverse effect on our results of operations or financial position.
Item 1A.Risk Factors
See “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2009. There have been no material changes to the Risk Factors since that date.
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds
On February 26, 2010 and March 31, 2010, we completed closings for a private placement of 10% Convertible Notes due June 30, 2017 (“Notes”). The Notes were offered and sold primarily to “accredited investors” as defined in Securities Act of 1933 and up to 35 non-accredited investors in reliance on the exemption from registration under Section 4(2) of the Securities Act of 1933, as amended by Rule 506 promulgated thereunder. At the closings, we issued in aggregate $1.3 million of Notes. The proceeds of this financing will be contributed, in part, as additional capital to Baylake Bank and otherwise used for general corporate purposes.
The Notes accrue interest at a fixed rate of 10% per annum upon issuance and until maturity or earlier conversion or redemption. Interest is payable quarterly, in arrears, on January 1, April 1, July 1, and October 1, of each year, commencing October 1, 2009. The Notes are convertible into shares of our common stock at a conversion ratio of one share of common stock for each $5.00 in aggregate principal amount held on the record date of the conversion subject to certain adjustments as described in the Notes. Prior to October 1, 2014, each holder of the Notes may convert up to 100% (at the discretion of the holder) of the original principal amount into shares of our common stock at the conversion ratio. On October 1, 2014, one-half of the original principal amounts are mandatorily convertible at the conversion ratio if conversion has not occurred. The principal amount of any Note that has not been converted or redeemed will be payable at maturity on June 30, 2017. We are not obligated to register the common stock related to the conversion of the Notes.
Item 3.Defaults Upon Senior Securities
Not applicable.
Item 4.Submission of Matters to a Vote of Security Holders
Not applicable
Item 5.Other Information
Item 6.Exhibits
The following exhibits are furnished herewith:
| | | |
Exhibit
Number | | Description | |
| | |
31.1 | | Certification under Section 302 of Sarbanes-Oxley by Robert J. Cera, Chief Executive Officer, is attached hereto. |
| | |
31.2 | | Certification under Section 302 of Sarbanes-Oxley by Kevin L. LaLuzerne, Chief Financial Officer, is attached hereto. |
| | |
32.1 | | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto. |
| | |
32.2 | | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto. |
SIGNATURES
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.
| | | | | |
| | | | BAYLAKE CORP. | |
| | | | | |
Date: | May 10, 2010 | | | /s/ Robert J. Cera | |
| | | | Robert J. Cera | |
| | | | President and Chief Executive Officer | |
| | | | | |
Date: | May 10, 2010 | | | /s/ Kevin L. LaLuzerne | |
| | | | Kevin L. LaLuzerne | |
| | | | Treasurer and Chief Financial Officer | |
