BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2011
| | | | |
As of the date of this filing, Baylake Corp and the Bank have complied with all terms of the Written Agreement. Specific steps taken include, but are not limited to: |
| 1. | Continuing to reduce the Bank’s concentration in Commercial Real Estate loans and placing a greater emphasis on Commercial and Industrial loans. |
| 2. | Delegating primary responsibility to the Bank’s Directors’ Loan Committee for the following: |
| | | a. | Monitoring loan relationships and other assets, including Other Real Estate Owned, in excess of $0.5 million with an emphasis on improving the Bank’s position. |
| | | b. | Overseeing the Bank’s current policy for determining, documenting and recording an adequate allowance for loan losses and monitoring the Bank’s compliance with such policy. |
| | | c. | Charging-off all assets classified as “loss” in a federal or state report of examination. |
| 3. | Delegating primary responsibility to the full Board of Directors for the following: |
| | | a. | Pre-approving any extension, renewal, or restructure of any asset criticized by the Federal Reserve Bank or WDFI. |
| | | b. | Obtaining prior regulatory approval on any form of payment resulting in a reduction in Baylake Corp’s or the Bank’s capital, including interest payments on our debentures and trust preferred securities. |
| | | c. | Obtaining Federal Reserve Bank approval prior to purchasing or redeeming any shares of our stock. |
| | | d. | Submitting required capital plans to the Federal Reserve Bank and WDFI. |
| | | e. | Complying with notice provisions with respect to new directors and senior executive officers. |
| | | f. | Complying with legal and regulatory limitations on indemnification payments and severance payments. |
| | | g. | Obtaining prior regulatory approval for the declaration and payment of dividends. |
| | | | |
| | Our senior management, primarily through our Chief Executive Officer, has established a regular dialogue with our lead examiner. These open communication lines provide timely feedback to the Company and the Bank on proposed action plans and keep our regulators updated on progress we have made. |
Table of Contents
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 of Chicago.
The following sets forth management’s discussion and analysis of our consolidated financial condition at June 30, 2011 and December 31, 2010 and our consolidated results of operations for the three and six months ended June 30, 2011 and 2010. 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, 2010.
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 this Quarterly Report on Form 10-Q and of our Annual Report on Form 10-K for the year ended December 31, 2010, which are incorporated herein by reference, and other risks that may be identified or discussed in this Form 10-Q.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) into law. This legislation makes extensive changes to the laws regulating financial services firms and requires significant rule-making. In addition, the legislation mandates multiple studies, which could result in additional legislative or regulatory action. While the full effects of the legislation on us and Baylake Bank cannot yet be determined, this legislation is generally perceived as negatively impacting the banking industry. This legislation may result in higher compliance and other costs, reduced revenues and higher capital and liquidity requirements, among other things, which could adversely affect our business and the business of Baylake Bank.
Critical Accounting Policies
In the course of our normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in our consolidated financial statements. The following is a summary of what management believes are our critical accounting policies.
Allowance for Loan Losses: The ALL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALL requires the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on 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 operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
30
Table of Contents
The ALL consists of specific reserves on certain impaired loans and general reserves for non-impaired loans. Specific reserves reflect estimated losses on impaired loans from analyses developed through specific credit allocations for individual loans. The specific credit allocations are based on regular analyses of all impaired non-homogenous loans. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based on our historical loss experience which is updated quarterly. The general reserve portion of the ALL also includes consideration of certain qualitative factors such as (i) changes in the nature, volume and terms of loans, (ii) changes in lending personnel, (iii) changes in the quality of the loan review function, (iv) changes in nature and volume of past-due, nonaccrual and/or classified loans, (v) changes in concentration of credit risk, (vi) changes in economic and industry conditions, (vii) changes in legal and regulatory requirements, (viii) unemployment and inflation statistics, and (ix) changes in underlying collateral values.
There are many factors affecting the ALL, some are quantitative while others require qualitative judgment. The process for determining the ALL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional PFLL could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged-off or for which an actual loss is realized.
As an integral part of their examination process, various regulatory agencies review the ALL as well. Such agencies may require that changes in the ALL be recognized when such regulatory credit evaluations differ from those of management based on information available to the regulators at the time of their examinations.
Foreclosed Properties: Foreclosed properties acquired through or in lieu of loan foreclosure are initially recorded at the lower of carrying cost or fair value, less estimated costs to sell, establishing a new cost basis. Fair value is determined using a variety of market information including but not limited to appraisals, professional market assessments and real estate tax assessment information. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Costs incurred after acquisition are expensed.
Provision for Impairment of Standby Letters of Credit: The provision for losses on standby letters of credit represents management’s estimate of probable incurred losses with respect to off-balance sheet standby letters of credit which are used to support our customers’ business arrangements with an unrelated third party. In the event of further impairment, a provision for impairment of standby letters of credit is charged to operations based on management’s periodic evaluation of the factors affecting the standby letters of credit.
Income Tax Accounting: The assessment of income tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of our operations and reported earnings. We believe that the deferred income tax assets on our June 30, 2011 balance sheet are recoverable, and the deferred income tax liabilities are adequate and fairly stated in the consolidated financial statements.
Goodwill: Goodwill represents the excess of the cost of businesses acquired over fair value or net identifiable assets at the date of acquisition. Goodwill is not amortized but is subject to impairment tests on an annual basis or more frequently if deemed appropriate. Goodwill is subject to a periodic assessment by applying a fair value test based upon a two-step method. The first step of the process compares the fair value of the reporting unit with its carrying value, including any goodwill. During 2010, we, with the assistance of a third party valuation firm determined an estimated cash fair value of our common stock. Consideration was given to our nature and history, the competitive and economic outlook for our trade area and for the banking industry in general, our book value and financial condition, our future earnings and dividend paying capacity, the size of the block valued, and the prevailing market prices of bank stocks. The following valuation methodologies were considered: (i) net asset value – defined as our net worth, (ii) market value – defined as the price at which knowledgeable buyers and sellers would agree to buy and sell our common stock, and (iii) investment value – defined as an estimate of the present value of the future benefits, usually earnings, cash flow, or dividends, that will accrue to our common stock. When consideration was given to the three valuation methodologies, as well as all other relevant valuation variables and factors, the fully-diluted cash fair value range of our common shares was considered to be in excess of the book value. Since the valuation range obtained from that firm exceeded our carrying value including goodwill, we did not fail step one of the impairment test established under generally accepted accounting principles and, therefore, no goodwill impairment was recognized. If the carrying amount would have exceeded fair value, we would have performed the second step to measure the amount of impairment loss. Based on the valuation obtained as of September 30, 2010, our valuation exceeded our carrying value by a range of 22% to 33%. As of June 30, 2011, there are no conditions that would require us to reevaluate goodwill impairment.
31
Table of Contents
Results of Operations
The following table sets forth our results of operations and related summary information for the three and six month periods ended June 30, 2011 and 2010.
SUMMARY RESULTS OF OPERATIONS
(Dollar amounts in thousands, except per share data)
| | | | | | | | | | | | | |
| | Three months ended
June 30, | | Six months ended
June 30, | |
|
| | 2011 | | 2010 | | 2011 | | 2010 | |
|
Net income, as reported | | $ | 775 | | $ | 1,349 | | $ | 1,426 | | $ | 2,166 | |
Earnings per share-basic, as reported | | $ | 0.10 | | $ | 0.17 | | $ | 0.18 | | $ | 0.27 | |
Earnings per share-diluted, as reported | | $ | 0.10 | | $ | 0.17 | | $ | 0.18 | | $ | 0.27 | |
Cash dividends declared | | $ | — | | $ | — | | $ | — | | $ | — | |
| | | | | | | | | | | | | |
Return on average assets | | | 0.31 | % | | 0.59 | % | | 0.28 | % | | 0.42 | % |
Return on average equity | | | 3.89 | % | | 7.01 | % | | 3.65 | % | | 5.72 | % |
Efficiency ratio(1) | | | 73.13 | % | | 71.06 | % | | 77.00 | % | | 74.31 | % |
| |
(1) | Noninterest expense divided by the sum of taxable equivalent net interest income plus noninterest 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 June 30, 2011 decreased from net income of $1.3 million for the comparable period in 2010. Net interest income decreased $0.2 million for the quarter ended June 30, 2011 versus the comparable quarter last year resulting from a $1.0 million reduction in interest income partially offset by a $0.8 million reduction in interest expense. A PFLL of $2.0 million was charged to operations for the second quarter of 2011, which is $0.7 million higher than the $1.3 million PFLL taken during the comparable quarter of 2010. Noninterest expense increased $0.4 million, which was partially offset by a $0.1 million increase in noninterest income in the second quarter of 2011 compared to the similar period in 2010.
Net Interest Income:
Net interest income is the largest component of our operating income and represents the difference between interest earned on loans, investments and other interest-earning assets offset by the interest expense attributable to the deposits and borrowings that fund such assets. Interest rate fluctuations, together with changes in the volume and types of interest-earning assets and interest-bearing liabilities, combine to affect total net interest income. This analysis discusses net interest income on a tax-equivalent basis in order to provide comparability among the various types of earned interest income. Tax-exempt interest income is adjusted to a level that reflects such income as if it were fully taxable.
Net interest income on a tax-equivalent basis was $8.3 million for the three months ended June 30, 2011 compared to $8.4 million for the same period in 2010. The decrease for the second quarter of 2011 resulted primarily from a decrease in interest income on loans attributable to both a decline in interest rates and a reduction in average loan balances, partially offset by a decrease in funding costs on interest-bearing liabilities. Positively impacting net interest income was an $11.8 million increase in average noninterest-bearing demand deposits, from $75.5 million during the second quarter of 2010 to $87.3 million for the comparable period in 2011. Interest rate spread is the difference between the interest rate earned on average interest-earning assets and the rate paid on average interest-bearing liabilities.
Interest rate spread decreased 7 bps to 3.51% for the second quarter of 2011 compared to the same period in 2010, resulting primarily from a 43 bps decrease in the yield on earning assets from 5.12% to 4.69%, partially offset by a 36 bps decrease in the cost of interest-bearing liabilities from 1.54% to 1.18%. We continue to be positively impacted by the interest rate floors on a large number of loans on our balance sheet, which has resulted in the recognition of a greater amount of interest income than would have been recognized had the floors not existed.
32
Table of Contents
Net interest margin represents net interest income expressed as an annualized percentage of average interest-earning assets. Net interest margin exceeds the interest rate spread because of the use of noninterest-bearing sources of funds (demand deposits and equity capital) to fund a portion of earning assets. Net interest margin for the second quarter of 2011 was 3.62%, down 6 bps from 3.68% for the comparable period in 2010.
For the three months ended June 30, 2011, average interest-earning assets increased $0.7 million from the same period in 2010. Increases in average taxable securities of $30.4 million (15.6%) and in tax exempt securities of $3.0 million (8.0%) were partially offset by a $22.8 million (3.5%) decrease in loans and a $10.0 million decrease (23.8%) in federal funds sold and interest-bearing due from bank balances.
NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | |
| | Three months ended
June 30, 2011 | | Three months ended
June 30, 2010 | |
| | Average
Balance | | Interest
Income/
Expense | | Average
Yield/
Rate | | Average
Balance | | Interest
Income/
Expense | | Average
Yield/
Rate | |
ASSETS | | | | | | | | | | | | | | | | | | | |
Average Earning Assets: | | | | | | | | | | | | | | | | | | | |
Loans, net 1,2 | | $ | 622,179 | | $ | 8,308 | | | 5.36 | % | $ | 644,987 | | $ | 9,011 | | | 5.60 | % |
Taxable securities | | | 225,293 | | | 1,878 | | | 3.33 | % | | 194,856 | | | 2,160 | | | 4.43 | % |
Tax exempt securities1 | | | 41,125 | | | 568 | | | 5.52 | % | | 38,084 | | | 560 | | | 5.89 | % |
Federal funds sold and interest-bearing due from banks | | | 32,064 | | | 18 | | | 0.24 | % | | 42,062 | | | 21 | | | 0.20 | % |
Total earning assets | | | 920,661 | | | 10,772 | | | 4.69 | % | | 919,989 | | | 11,752 | | | 5.12 | % |
Noninterest earning assets | | | 95,105 | | | | | | | | | 103,815 | | | | | | | |
Total Assets | | $ | 1,015,766 | | | | | | | | $ | 1,023,804 | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | | | | | | | | | | | | | |
Average Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | |
Total interest-bearing deposits | | $ | 734,314 | | $ | 1,872 | | | 1.02 | % | $ | 734,533 | | $ | 2,490 | | | 1.36 | % |
Short-term borrowings | | | — | | | — | | | — | % | | 38 | | | — | | | 0.68 | % |
Customer repurchase agreements | | | 24,654 | | | 20 | | | 0.32 | % | | 27,566 | | | 33 | | | 0.48 | % |
Federal Home Loan Bank advances | | | 55,000 | | | 258 | | | 1.88 | % | | 75,000 | | | 499 | | | 2.67 | % |
Convertible promissory notes | | | 9,450 | | | 245 | | | 10.26 | % | | 8,542 | | | 222 | | | 10.44 | % |
Subordinated debentures | | | 16,100 | | | 67 | | | 1.66 | % | | 16,100 | | | 68 | | | 1.69 | % |
Total interest-bearing liabilities | | | 839,518 | | | 2,462 | | | 1.18 | % | | 861,779 | | | 3,312 | | | 1.54 | % |
Demand deposits | | | 87,342 | | | | | | | | | 75,504 | | | | | | | |
Accrued expenses and other liabilities | | | 8,952 | | | | | | | | | 9,282 | | | | | | | |
Stockholders’ equity | | | 79,954 | | | | | | | | | 77,239 | | | | | | | |
Total liabilities and stockholders’ equity | | $ | 1,015,766 | | | | | | | | $ | 1,023,804 | | | | | | | |
Net Interest Income | | | | | $ | 8,310 | | | | | | | | $ | 8,440 | | | | |
Interest rate spread (3) | | | | | | | | | 3.51 | % | | | | | | | | 3.58 | % |
Net interest margin (4) | | | | | | | | | 3.62 | % | | | | | | | | 3.68 | % |
33
Table of Contents
| |
(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 nonaccrual 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. |
Net income of $1.4 million for the six months ended June 30, 2011 decreased from net income of $2.2 million for the comparable period in 2010. Net interest income increased $0.2 million for the six months ended June 30, 2011 versus the comparable period last year resulting from a $1.9 million reduction in interest expense partially offset by a $1.7 million reduction in interest income. A PFLL of $3.3 million was charged to operations for the first six months of 2011, which is $1.0 million higher than the $2.3 million PFLL taken during the comparable period of 2010. Noninterest expense increased $1.4 million, which was partially offset by a $0.5 million increase in noninterest income in the six months of 2011 compared to the similar period in 2010. Refer to the “Net Interest Income,” “Provision for Loan Losses,” “Noninterest Expense” and “Noninterest Income” sections below for additional details.
Interest rate spread increased 4 bps to 3.49% for the first six months of 2011 compared to the same period in 2010, resulting primarily from a 43 bps decrease in the cost of interest-bearing liabilities from 1.63% to 1.20%, partially offset by a 39 bps decrease in the yield on interest-bearing assets from 5.08% to 4.69%.
Net interest income on a tax-equivalent basis was $16.6 million for the six months ended June 30, 2011 compared to $16.4 million for the same period in 2010. The increase in 2011 resulted primarily from a decrease in funding costs on liabilities attributable to both a decline in interest rates and a reduction in average interest-bearing liabilities, partially offset by a decrease in interest income on loans, due to both a decline in yields and a reduction in average loans. Contributing to the improved net interest income was a $13.9 million increase in average noninterest-bearing demand deposits, from $73.7 million during the second quarter of 2010 to $87.6 million for the comparable period in 2011.
For the six months ended June 30, 2011, average interest-earning assets increased $5.8 million (0.6%) from the same period in 2010. Increases in average taxable securities of $41.1 million (22.0%) and in tax exempt securities of $2.7 million (7.1%) were partially offset by a $19.5 million (3.0%) decrease in loans and an $18.4 million (34.5%) decrease in federal funds sold and interest-bearing due from bank balances.
34
Table of Contents
NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | |
| | Six months ended
June 30, 2011 | | Six months ended
June 30, 2010 | |
| | Average
Balance | | Interest
Income/
Expense | | Average
Yield/
Rate | | Average
Balance | | Interest
Income/
Expense | | Average
Yield/
Rate | |
ASSETS | | | | | | | | | | | | | | | | | | | |
Average Earning Assets: | | | | | | | | | | | | | | | | | | | |
Loans, net 1,2 | | $ | 627,269 | | $ | 16,862 | | | 5.42 | % | $ | 646,820 | | $ | 18,156 | | | 5.66 | % |
Taxable securities | | | 228,185 | | | 3,629 | | | 3.18 | % | | 187,091 | | | 4,024 | | | 4.30 | % |
Tax exempt securities1 | | | 40,553 | | | 1,143 | | | 5.64 | % | | 37,865 | | | 1,116 | | | 5.90 | % |
Federal funds sold and interest-bearing due from banks | | | 34,861 | | | 39 | | | 0.23 | % | | 53,266 | | | 53 | | | 0.20 | % |
Total earning assets | | | 930,868 | | | 21,673 | | | 4.69 | % | | 925,042 | | | 23,349 | | | 5.08 | % |
Noninterest earning assets | | | 98,336 | | | | | | | | | 104,890 | | | | | | | |
Total Assets | | $ | 1,029,204 | | | | | | | | $ | 1,029,932 | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
LIABILITIES AND STOCKHOLDERS’ EQUITY | | | | | | | | | | | | | | | | | | | |
Average Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | |
Total interest-bearing deposits | | $ | 740,321 | | $ | 3,828 | | | 1.04 | % | $ | 742,838 | | $ | 5,319 | | | 1.44 | % |
Short-term borrowings | | | — | | | — | | | — | % | | 25 | | | 1 | | | 0.92 | % |
Customer repurchase agreements | | | 26,536 | | | 42 | | | 0.32 | % | | 25,418 | | | 61 | | | 0.49 | % |
Federal Home Loan Bank advances | | | 61,768 | | | 572 | | | 1.87 | % | | 79,530 | | | 1,055 | | | 2.68 | % |
|
Convertible promissory notes | | $ | 9,450 | | $ | 490 | | | 10.37 | % | $ | 7,057 | | $ | 370 | | | 10.41 | % |
Subordinated debentures | | | 16,100 | | | 134 | | | 1.65 | % | | 16,100 | | | 132 | | | 1.63 | % |
Total interest-bearing liabilities | | | 854,175 | | | 5,066 | | | 1.20 | % | | 870,968 | | | 6,938 | | | 1.63 | % |
Demand deposits | | | 87,584 | | | | | | | | | 73,678 | | | | | | | |
Accrued expenses and other liabilities | | | 8,710 | | | | | | | | | 8,977 | | | | | | | |
Stockholders’ equity | | | 78,735 | | | | | | | | | 76,309 | | | | | | | |
Total liabilities and stockholders’ equity | | $ | 1,029,204 | | | | | | | | $ | 1,029,932 | | | | | | | |
Net Interest Income | | | | | $ | 16,607 | | | | | | | | $ | 16,411 | | | | |
Interest rate spread(3) | | | | | | | | | 3.49 | % | | | | | | | | 3.45 | % |
Net interest margin(4) | | | | | | | | | 3.59 | % | | | | | | | | 3.57 | % |
| |
(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 nonaccrual 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. |
35
Table of Contents
RATE/VOLUME ANALYSIS(1)
(Dollar amounts in thousands)
Three months ended June 30, 2011 compared to the three months ended June 30, 2010:
| | | | | | | | | | |
| | Increase (Decrease) due to(1) | |
| | Volume | | Rate | | Net | |
| | | | | | | | | | |
Interest income: | | | | | | | | | | |
Loans | | $ | (1,311 | ) | $ | 608 | | $ | (703 | ) |
Taxable securities | | | 1,114 | | | (1,396 | ) | | (282 | ) |
Tax exempt securities | | | 174 | | | (166 | ) | | 8 | |
Federal funds sold and interest-bearing due from banks | | | (22 | ) | | 19 | | | (3 | ) |
Total interest-earning assets | | $ | (45 | ) | $ | (935 | ) | $ | (980 | ) |
| | | | | | | | | | |
Interest expense: | | | | | | | | | | |
Total interest-bearing deposits | | $ | (139 | ) | $ | (479 | ) | $ | (618 | ) |
Short term borrowings | | | — | | | — | | | — | |
Repurchase agreements | | | (13 | ) | | — | | | (13 | ) |
FHLB advances | | | (459 | ) | | 218 | | | (241 | ) |
Subordinated debentures | | | — | | | (1 | ) | | (1 | ) |
Long term debt | | | 93 | | | (70 | ) | | 23 | |
Total interest-bearing liabilities | | $ | (518 | ) | $ | (332 | ) | $ | (850 | ) |
| | | | | | | | | | |
Net interest income | | $ | 473 | | $ | (603 | ) | $ | (130 | ) |
| |
(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. |
Our management’s ability to employ overall assets for the production of interest income can be measured by the ratio of average interest-earning assets to average total assets. This ratio was 90.6% and 89.9% for the second quarter of 2011 and 2010, respectively.
36
Table of Contents
RATE/VOLUME ANALYSIS(1)
(Dollar amounts in thousands)
Six months ended June 30, 2011 compared to the six months ended June 30, 2010:
| | | | | | | | | | |
| | Increase (Decrease) due to(1) | |
| | Volume | | Rate | | Net | |
| | | | | | | | | | |
Interest income: | | | | | | | | | | |
Loans | | $ | (570 | ) | $ | (724 | ) | $ | (1,294 | ) |
Taxable securities | | | 650 | | | (1,045 | ) | | (395 | ) |
Tax exempt securities | | | 76 | | | (49 | ) | | 27 | |
Federal funds sold and interest-bearing due from banks | | | (20 | ) | | 6 | | | (14 | ) |
Total interest-earning assets | | $ | 136 | | $ | (1,812 | ) | $ | (1,676 | ) |
| | | | | | | | | | |
Interest expense: | | | | | | | | | | |
Total interest-bearing deposits | | $ | (174 | ) | $ | (1,317 | ) | $ | (1,491 | ) |
Short term borrowings | | | — | | | (1 | ) | | (1 | ) |
Repurchase agreements | | | 3 | | | (22 | ) | | (19 | ) |
FHLB advances | | | (205 | ) | | (278 | ) | | (483 | ) |
Subordinated debentures | | | — | | | 2 | | | 2 | |
Long term debt | | | 120 | | | — | | | 120 | |
Total interest-bearing liabilities | | $ | (256 | ) | $ | (1,616 | ) | $ | (1,872 | ) |
| | | | | | | | | | |
Net interest income | | $ | 392 | | $ | (196 | ) | $ | 196 | |
| |
(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. |
Our management’s ability to employ overall assets for the production of interest income can be measured by the ratio of average interest-earning assets to average total assets. This ratio was 90.5% and 89.8% for the first six months of 2011 and 2010, respectively.
Provision for Loan Losses:
The ALL consists of specific and general reserves. The PFLL is the cost of providing an allowance for probable and inherent losses in our loan portfolio. Our internal risk system is used to identify loans that meet the criteria for being “impaired” as defined by accounting guidance. Specific reserves are computed on 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. When the fair value of the collateral is less than amortized cost, a specific reserve is required. In addition to the specific reserves, a general reserve is computed on non-impaired loans and is based on historical loss experience adjusted for qualitative factors. These qualitative factors include: (i) changes in the nature, volume and terms of loans, (ii) changes in lending personnel, (iii) changes in the quality of the loan review function, (iv) changes in nature and volume of past-due, nonaccrual and/or classified loans, (v) changes in concentration of credit risk, (vi) changes in economic and industry conditions, (vii) changes in legal and regulatory requirements, (viii) unemployment and inflation statistics, and (ix) changes in underlying collateral values. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged-off or for which an actual loss is realized.
The PFLL for the quarter ended June 30, 2011 was $2.0 million compared to $1.3 million for the second quarter of 2010. New impairments of $1.2 million on loans not previously identified, with associated loan balances of $5.8 million, were recorded during the second quarter of 2011. Included in those amounts are impairments of $0.9 million on loan balances of $5.1 million for a credit relationship previously identified as a TDR. During the second quarter of 2011, that credit was transferred to a nonaccrual status.
37
Table of Contents
Net loan charge-offs for the second quarter of 2011 were $1.4 million. Net annualized charge-offs to average loans were 0.89% for the second quarter of 2011 compared to 0.04% for the same period in 2010. For the three months ended June 30, 2011, nonperforming loans increased by $4.8 million (27.9%) to $22.0 million from $17.2 million at December 31, 2010.
Net loan charge-offs for each of the first six months of 2011 and 2010 were $2.1 million and $0.4 million, respectively. Net annualized charge-offs to average loans were 0.67% for the first six months of 2011 compared to 0.14% for the same period in 2010. For the six months ended June 30, 2011, nonperforming loans increased by $5.5 million (33.3%) to $22.0 million from $16.5 million at December 31, 2010. Refer to the “Financial Condition - Risk Management and the Allowance for Loan Losses” and “Financial Condition - Nonperforming Loans, Potential Problem Loans and Foreclosed Properties” sections below for more information related to nonperforming loans. Our management believes that the ALL at June 30, 2011 and the related PFLL charged to earnings for the quarter and six months ended June 30, 2011 are appropriate in light of the present condition of the loan portfolio and the amount and quality of the collateral supporting nonperforming loans. We continue to monitor nonperforming loan relationships and will make additional PFLLs, as necessary, if the facts and circumstances change. In addition, a decline in the quality of our loan portfolio as a result of general economic conditions, factors affecting particular borrowers or our market area, or otherwise, could affect the adequacy of the ALL. If there are significant charge-offs against the ALL, or we otherwise determine that the ALL is inadequate or our estimates are different than our regulators’ estimates, we will need to make additional PFLLs in the future.
Noninterest Income:
The following table reflects the various components of noninterest income for the three and six month periods ended June 30, 2011 and 2010, respectively.
NONINTEREST INCOME
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | |
| | Three months ended | | Six months ended | |
| | June 30,
2011 | | June 30,
2010 | | %
Change | | June 30,
2011 | | June 30,
2010 | | %
Change | |
| | | | | | | | | | | | | | | | | | | |
Fees from fiduciary services | | $ | 220 | | $ | 284 | | | (22.8 | )% | $ | 503 | | $ | 500 | | | 0.6 | % |
Fees from loan servicing | | | 223 | | | 116 | | | 91.8 | % | | 413 | | | 273 | | | 51.1 | % |
Service charges on deposit accounts | | | 849 | | | 873 | | | (2.7 | )% | | 1,644 | | | 1,681 | | | (2.2 | )% |
Other fee income | | | 169 | | | 182 | | | (6.8 | )% | | 333 | | | 370 | | | (10.1 | )% |
Financial services income | | | 197 | | | 223 | | | (11.5 | )% | | 489 | | | 427 | | | 14.6 | % |
Net gains from sales of loans | | | 211 | | | 233 | | | (9.5 | )% | | 597 | | | 401 | | | 49.1 | % |
Net gain/(loss) in valuation of mortgage servicing rights | | | (84 | ) | | 32 | | | (365.1 | )% | | (114 | ) | | 38 | | | (402.1 | )% |
Net gains from sale of securities | | | — | | | 434 | | | NM | % | | 125 | | | 434 | | | (71.2 | )% |
Gains from sale of fixed assets | | | (11 | ) | | — | | | NM | % | | (3 | ) | | — | | | NM | % |
Increase (decrease) in cash surrender value of life insurance | | | 122 | | | (17 | ) | | 817.7 | % | | 252 | | | 66 | | | 283.4 | % |
|
Equity in income of UFS subsidiary | | | 202 | | | 78 | | | 160.0 | % | | 433 | | | 239 | | | 81.2 | % |
Other income | | | 323 | | | 36 | | | 798.5 | % | | 363 | | | 57 | | | 538.6 | % |
Total Noninterest Income | | $ | 2,421 | | $ | 2,474 | | | (2.1 | )% | $ | 5,035 | | $ | 4,486 | | | 12.2 | % |
Noninterest income decreased $0.1 million for the three months ended June 30, 2011 versus the comparable period in 2010. This was primarily due to a decrease of $0.1 million in fees from fiduciary services, a decrease of $0.4 million on gains from the sale of securities, and a $0.1 million reduction in the valuation of mortgage servicing rights. The decrease was partially offset by a $0.3 million gain on life insurance proceeds from a death benefit on a policy in which the Bank was the beneficiary, a $0.1 million increase in income from our subsidiary, UFS, and a $0.1 million increase in fees from loan servicing.
Noninterest income increased $0.5 million (12.2%) for the six months ended June 30, 2011 versus the comparable period in 2010. This was primarily due to a $0.2 million increase in net gains from sales of loans due to increased secondary market mortgage originations, a $0.3 million increase in death benefit claims on a life insurance policy, a $0.2 million increase in equity in income of our subsidiary, UFS, a $0.2 million increase in the cash surrender value of life insurance, and a $0.1 million increase in fees from loan servicing. This was partially offset by a decrease of $0.1 million on the valuation of mortgage servicing rights and a $0.3 million reduction in gains on sales of securities.
38
Table of Contents
Noninterest Expense:
The following table reflects the various components of noninterest expense for the three and six months ended June 30, 2011 and 2010, respectively.
NONINTEREST EXPENSE
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | | | | |
| | Three months ended | | Six months ended | |
| | June 30,
2011 | | June 30,
2010 | | %
Change | | June 30,
2011 | | June 30,
2010 | | %
Change | |
| | | | | | | | | | | | | |
Salaries and employee benefits | | $ | 4,058 | | $ | 3,687 | | | 10.1 | % | $ | 8,614 | | $ | 7,949 | | | 8.4 | % |
Occupancy | | | 575 | | | 587 | | | (1.9 | )% | | 1,180 | | | 1,198 | | | (1.5 | )% |
Equipment | | | 308 | | | 348 | | | (11.5 | )% | | 588 | | | 674 | | | (12.8 | )% |
Data processing and courier | | | 203 | | | 216 | | | (6.1 | )% | | 411 | | | 441 | | | (6.9 | )% |
Operation of foreclosed properties | | | 729 | | | 518 | | | 40.7 | % | | 1,767 | | | 943 | | | 87.4 | % |
Business development & advertising | | | 180 | | | 152 | | | 17.8 | % | | 307 | | | 331 | | | (7.2 | )% |
Charitable contributions | | | 19 | | | 19 | | | — | % | | 36 | | | 46 | | | (20.6 | )% |
Stationery and supplies | | | 150 | | | 137 | | | 9.5 | % | | 262 | | | 252 | | | 4.1 | % |
Director fees | | | 106 | | | 103 | | | 3.2 | % | | 199 | | | 185 | | | 7.5 | % |
FDIC insurance expense | | | 559 | | | 780 | | | (28.3 | )% | | 1,290 | | | 1,241 | | | 4.0 | % |
Legal and professional | | | 189 | | | 169 | | | 12.2 | % | | 383 | | | 345 | | | 11.0 | % |
Loan and collection | | | 163 | | | 186 | | | (12.4 | )% | | 331 | | | 337 | | | (1.8 | )% |
Other outside services | | | 158 | | | 150 | | | 5.8 | % | | 323 | | | 333 | | | (3.1 | )% |
Provision for impairment of letter of credit | | | 7 | | | — | | | NM | % | | 14 | | | 87 | | | (83.9 | )% |
Other operating | | | 451 | | | 436 | | | 3.4 | % | | 864 | | | 845 | | | 2.2 | % |
Total Noninterest Expense | | $ | 7,855 | | $ | 7,488 | | | 4.9 | % | $ | 16,569 | | $ | 15,207 | | | 9.0 | % |
Total noninterest expense increased $0.4 million for the three months ended June 30, 2011 compared to the same period in 2010. The noninterest expense to average assets ratio was 3.1% for the three months ended June 30, 2011 compared to 2.9% for the same period in 2010.
Net overhead expense is total noninterest expense less total noninterest income excluding securities gains. The net overhead expense to average assets ratio was at 2.2% for the three months ended June 30, 2011 compared to 2.1% for the same period in 2010. The efficiency ratio represents total noninterest expense as a percentage of the sum of net interest income on a fully taxable equivalent basis and total noninterest income (excluding net gains on the sale of securities and premises and equipment). A lower efficiency ratio indicates a more efficient operation. The efficiency ratio increased to 73.1% for the three months ended June 30, 2011 from 71.5% for the comparable period last year. This is primarily due to the increase of $0.4 million in noninterest expense, of which $0.2 million was related to operation of foreclosed properties and an increase of $0.4 million or 10.1% in salaries and benefits. Partially offsetting those increases was a $0.2 million decrease in FDIC insurance expense, discussed in more detail below.
39
Table of Contents
Included in noninterest expense are FDIC insurance premiums of $0.6 million for the three months ended June 30, 2011 compared to $0.8 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%. 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 between 12 bps and 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. In October 2010, the FDIC Board voted to eliminate a uniform 3 bps increase in assessment rates that was to be effective January 1, 2011. We were required to prepay approximately $6.7 million in premiums in December 2009, which premiums are being taken as a charge against our operations in the period for which they apply.
On February 7, 2011, the FDIC finalized the rule to change its assessment base from total domestic deposits to average total assets minus average tangible equity, as required in the Dodd-Frank Act. The new assessment base began in the second quarter of 2011, with the premium payable in September 2011. The result of the change will be a reduction in future assessments.
Expenses related to the operation of foreclosed properties held for sale by the Bank increased $0.9 million to $1.8 million for the six-month period ended June 30, 2011 compared to $0.9 million for the same period in 2010. The increase consists of a $0.6 million increase in write-downs due to the revaluation of properties held and a $0.3 million increase in operating expenses, offset by a $0.1 million increase in gain on sale of foreclosed properties. We continue to evaluate all foreclosed property values and attempt to reduce the holding periods of these properties and, as a result, the related holding costs, to the extent possible. Such expenses include but are not limited to insurance, maintenance, real estate taxes, management fees, utilities and legal fees. A majority of the properties have been revalued within the last six months.
Salaries and employee benefits increased $0.7 million (8.4%) to $8.6 million for the six months ended June 30, 2011 compared to $7.9 million for the six months ended June 30, 2010. The number of full-time equivalent employees (FTEs) increased from 298 at June 30, 2010 to 301 at June 30, 2011. Contributing to an increase in salary expense of $0.4 million was the increase in FTEs as well as cost of living adjustments to employee salaries and wages. Commission expense for commissioned salespersons, including financial advisors and mortgage originators, increased $0.1 million due to increased activity and expenses related to deferred compensation plans increased $0.2 million due to increases in the returns on the investments within the plans.
Income Taxes:
We recorded an income tax benefit of $0.1 million for the three months ended June 30, 2011 versus tax expense of $0.6 million for the same period in 2010. The decrease in tax expense is primarily attributable to a $1.2 million year-over-year decrease in pre-tax income.
We recorded an income tax benefit of $0.1 million for the six months ended June 30, 2011 versus tax expense of $0.7 million for the same period in 2010. The decrease in tax expense is primarily attributable to a $1.6 million decrease in pre-tax income.
We maintain significant net deferred income tax assets for deductible temporary tax differences, such as allowance for loan losses, nonaccrual loan interest, and foreclosed property valuations as well as net operating loss carryforwards. Our determination of the amount of our deferred income tax assets to be realized is highly subjective and is based on several factors, including projected future income, income tax planning strategies, and federal and state income tax rules and regulations. At June 30, 2011, we determined that no valuation allowance was required to be taken against our deferred income tax assets other than a valuation allowance to reduce our state net operating loss carryforwards 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.
40
Table of Contents
Financial Condition
Loans:
The following table reflects the composition (mix) of the loan portfolio:
LOAN PORTFOLIO ANALYSIS
(Dollar amounts in thousands)
| | | | | | | | | | |
| | June 30,
2011 | | December 31,
2010 | | Percent
Change | |
|
Amount of Loans by Type: | | | | | | | | | | |
Real estate-mortgage: | | | | | | | | | | |
Commercial | | $ | 332,003 | | $ | 344,263 | | | (3.6 | )% |
1-4 Family residential | | | | | | | | | | |
First liens | | | 82,376 | | | 76,874 | | | 7.2 | % |
Junior liens | | | 9,207 | | | 11,143 | | | (17.4 | )% |
Home equity | | | 42,133 | | | 41,432 | | | 1.7 | % |
Commercial, financial and agricultural | | | 77,565 | | | 73,928 | | | 4.9 | % |
Real estate-construction | | | 52,159 | | | 55,467 | | | (6.0 | )% |
Installment | | | | | | | | | | |
Credit cards and related plans | | | 1,688 | | | 1,662 | | | 1.6 | % |
Other | | | 7,690 | | | 8,563 | | | (10.2 | )% |
Obligations of states and political subdivisions | | | 16,380 | | | 16,892 | | | (3.0 | )% |
Less: Deferred origination fees, net of costs | | | (378 | ) | | (333 | ) | | 13.5 | % |
Less: Allowance for loan losses | | | (12,660 | ) | | (11,502 | ) | | 10.1 | % |
Total | | $ | 608,163 | | $ | 618,389 | | | (1.7 | )% |
Net loans at June 30, 2011 decreased $10.2 million (1.7%) from $618.4 million at December 31, 2010 to $608.2 million at June 30, 2011. The decrease is primarily due to reductions in commercial real estate of $12.3 million, a decrease of $3.3 million in construction loans, and a decrease of $1.9 million in junior liens on 1-4 family residential. This was partially offset by an increase of $3.6 million (4.9%) in commercial, financial, and agricultural loan, and an increase of $5.5 million in first lien 1-4 family residential. We continue to reduce our exposure in the commercial real estate sector.
Risk Management and the Allowance for Loan Losses:
The loan portfolio is our primary asset subject to credit risk. To address this credit risk, we maintain an ALL for probable and inherent credit losses through periodic charges to our earnings. These charges are shown in our consolidated statements of operations as PFLL. See “Provision for Loan Losses” earlier in this Report. We attempt to control, monitor and minimize credit risk through the use of prudent lending standards, a thorough review of potential borrowers prior to lending and ongoing and timely review of payment performance. Asset quality administration, including early identification of loans performing in a substandard manner, as well as timely and active resolution of problems, further enhances management of credit risk and minimization of loan losses. Any losses that occur and that are charged off against the ALL are periodically reviewed with specific efforts focused on achieving maximum recovery of both principal and interest.
The ALL at June 30, 2011 was $12.7 million, compared to $11.5 million at December 31, 2010. On a quarterly basis, management reviews the adequacy of the ALL. The analysis of the ALL consists of three components: (i) specific reserves established for expected losses relating to impaired loans for which the recorded investment in the loans exceeds its fair value; (ii) general reserves based on historical loan loss experience for significant loan classes; and (iii) general reserves based on qualitative factors such as concentrations and changes in portfolio mix and volume. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized.
41
Table of Contents
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 a loan, it is included in the ALL analysis process at the lower grade. This grading system is in compliance with regulatory classifications. At least quarterly, all commercial loans that have been deemed impaired are evaluated. In compliance with accounting guidance for impaired loans, the fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the market price of the loan or, if the loan is collateral dependent, the fair value of the underlying collateral less the estimated costs to sell. This evaluation may include obtaining supplemental market data and/or routine site visits to offer support to the evaluation process. A specific reserve is then allocated to the loans based on this assessment. Specific reserves are reviewed by the Chief Credit Officer (“CCO”) and management familiar with the credits.
During the second quarter of 2011, a loan review engagement was performed by an external third party. The objective of the review was to assist management with proactively identifying and quantifying the credit risk in the loan portfolio. The engagement included an assessment of our control and methodology for identifying, monitoring, and addressing credit quality issues, as well as our methodology for determining the adequacy of our ALL. The sample consisted of approximately 30% of our non-classified risk rated loan portfolio. Based on the review, two rating changes were recommended: (i) a $3.9 million relationship from a 0006A to a 0006B, and (ii) a $3.7 million relationship from a 0004 to a 0003. Additional results of the review concluded that our credit approval and credit administration processes are satisfactory, including but not limited to the following: (1) detailed and accurate credit presentations are on file, (2) loans were closed as approved, (3) collateral was perfected in a timely manner, (4) compliance with loan covenants existed, and (5) appropriate loan file documentation is maintained in the credit files.
We have two other major components of the ALL that do not pertain to specific loans: “General Reserves – Historical” and “General Reserves – Other.” We determine General Reserves – Historical based on our historical recorded charge-offs of loans in particular classes, analyzed as a group. As it relates to the historical loss component, in December 2009 we reduced the historical loss look-back period from sixteen quarters to between eight and twelve 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. Economic statistics, specifically unemployment and inflation rates for national, state and local markets are monitored and factored into the allocation to address repayment risk. Further identification and management of portfolio concentration risks, both by loan class and by specific markets is reflected in the general allocation component. In the fourth quarter of 2009 the model was enhanced to include more specific qualitative factors, as mentioned previously, by loan type.
Nonperforming Loans, Potential Problem Loans and Foreclosed Properties:
Management encourages early identification of nonaccrual and problem loans in order to minimize the risk of loss. Nonperforming loans are defined as nonaccrual loans, loans 90 days or more past due but still accruing, and loans restructured in a troubled debt restructuring that haven’t shown a sufficient period of performance with the restructured terms. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collection of principal or interest on loans, it is the practice of management to place such loans on nonaccrual status immediately rather than waiting until the loans become 90 days past due. The accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest or earlier as deemed appropriate. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on nonaccrual loans are used to reduce principal rather than recorded as interest income. Restructuring a loan typically involves the granting of some concession to the borrower involving a loan modification, such as payment schedule or interest rate changes. Restructured loans may involve loans that have had a charge-off taken against the loan to reduce the carrying amount of the loan to fair market value as determined pursuant to accounting guidance for troubled debt restructurings.
42
Table of Contents
NONPERFORMING ASSETS
(Dollar amounts in thousands)
| | | | | | | | | | | | | |
| | June 30,
2011 | | March 31,
2011 | | December 31,
2010 | | June 30,
2010 | |
Nonperforming Assets: | | | | | | | | | | | | | |
Nonaccrual loans | | $ | 16,759 | | $ | 17,027 | | $ | 15,877 | | $ | 23,550 | |
Nonaccrual loans, restructured | | | 5,288 | | | 165 | | | 623 | | | 160 | |
Accruing loans past due 90 days or more | | | — | | | — | | | — | | | — | |
Total nonperforming loans (“NPLs”) | | $ | 22,047 | | $ | 17,192 | | $ | 16,500 | | $ | 23,710 | |
Foreclosed assets, net | | | 11,946 | | | 13,725 | | | 15,952 | | | 15,962 | |
Total nonperforming assets (“NPAs”) | | $ | 33,993 | | $ | 30,917 | | $ | 32,452 | | $ | 39,672 | |
| | | | | | | | | | | | | |
Restructured loans, accruing(1) | | $ | 18,559 | | $ | 22,777 | | $ | 13,090 | | $ | 9,845 | |
| | | | | | | | | | | | | |
Ratios: | | | | | | | | | | | | | |
ALL to Net Charge-offs (“NCOs”) (annualized) | | | 3.00 | x | | 4.24 | x | | 2.11 | x | | 12.79 | x |
NCOs to average loans (annualized) | | | 0.67 | % | | 0.45 | % | | 0.85 | % | | 0.14 | % |
ALL to total loans | | | 2.04 | % | | 1.95 | % | | 1.83 | % | | 1.79 | % |
NPLs to total loans | | | 3.55 | % | | 2.77 | % | | 2.62 | % | | 3.71 | % |
NPAs to total assets | | | 3.34 | % | | 3.03 | % | | 3.08 | % | | 3.81 | % |
ALL to NPLs | | | 57.42 | % | | 70.37 | % | | 69.71 | % | | 48.31 | % |
| |
(1) | Restructured loans on nonaccrual status are returned to accruing when a sufficient period of performance in accordance with the restructured terms, generally six months, has passed. |
Restructured nonaccrual loans at December 31, 2010 were $0.6 million. During the second quarter of 2011, a $5.1 million restructured loan was transferred from the accruing category to the nonaccruing category. In addition, an impairment of $0.9 million on nonaccruing restructured loans was recognized. Principal payments of $0.3 million were received on those loans and $0.1 million was charged-off. As of June 30, 2011, principal balances of $5.3 million remain.
Restructured loans accruing at December 31, 2010 were $13.1 million. New restructured loans of $11.1 million were recorded during the first six months of 2011. Of that amount $1.4 million were recorded in the second quarter of 2011 consisting of two credits; one in the amount of $0.9 million and the other for $0.5 million. Principal payments of $0.2 million were received on those loans and $0.3 million was charged off. In addition, a restructured loan of $5.1 million was transferred to nonaccrual during the second quarter of 2011. As of June 30, 2011, $18.6 million of principal balances continue to be reported as restructured loans accruing.
Nonperforming loans increased $5.5 million (33.3%) from December 31, 2010 to June 30, 2011 primarily due to the transfer of the $5.1 million restructured loan from the accruing category to the nonaccruing category. The nonperforming loan relationships are secured primarily by commercial or residential real estate and, secondarily, by personal guarantees from principals of the respective borrowers.
43
Table of Contents
The following table presents an analysis of our past due loans excluding nonaccrual loans:
PAST DUE LOANS (EXCLUDING NONACCRUALS)
30-89 DAYS PAST DUE
(Dollar amounts in thousands)
| | | | | | | | | | | | | | | | |
| | June 30,
2011 | | March 31,
2011 | | December 31,
2010 | | September 30,
2010 | | June 30,
2010 | |
| | | | | | | | | | | | | | | | |
Secured by Real Estate | | $ | 3,355 | | $ | 7,615 | | $ | 5,428 | | $ | 6,877 | | $ | 5,474 | |
Commercial and industrial loans | | | 249 | | | 1,877 | | | 280 | | | 140 | | | 476 | |
Loans to individuals | | | 44 | | | 54 | | | 95 | | | 80 | | | 41 | |
All other loans | | | — | | | 60 | | | 9 | | | 1 | | | 149 | |
Total | | $ | 3,648 | | $ | 9,606 | | $ | 5,812 | | $ | 7,098 | | $ | 6,140 | |
| | | | | | | | | | | | | | | | |
Percentage of total loans | | | 0.59 | % | | 1.55 | % | | 0.92 | % | | 1.12 | % | | 0.96 | % |
As indicated above, loan balances 30 to 89 days past due have decreased by $2.2 million since December 31, 2010. During the quarter ended June 30, 2011, loan balances 30 to 89 days past due have decreased by $6.0 million. Payments were made on loan balances totaling $2.4 million to be brought current, $2.0 million of loan balances moved to nonaccrual status, and $2.4 million of loan balances were brought current through a modification of loan terms. Partially offsetting the decrease was a net increase of $0.4 million of other loans that reached the 30 day past due status.
Information regarding foreclosed properties is as follows:
FORECLOSED PROPERTIES
(Dollar amounts in thousands)
| | | | | | | | | | |
| | Six months
ended
June 30,
2011 | | Twelve months
ended
December 31,
2010 | | Six months
ended
June 30,
2010 | |
| | | | | | | | | | |
Beginning Balance | | $ | 15,952 | | $ | 14,995 | | $ | 14,995 | |
Transfer of loans to foreclosed properties | | | 1,361 | | | 5,587 | | | 2,449 | |
Sales proceeds, net | | | (4,383 | ) | | (2,520 | ) | | (1,002 | ) |
Net gain from sale of foreclosed properties | | | 103 | | | 39 | | | 32 | |
Provision for foreclosed properties | | | (1,087 | ) | | (2,149 | ) | | (512 | ) |
| | | | | | | | | | |
Total Foreclosed Properties | | $ | 11,946 | | $ | 15,952 | | $ | 15,962 | |
Changes in the valuation allowance for losses on foreclosed properties were as follows:
| | | | | | | | | | |
| | Six months
ended
June 30,
2011 | | Twelve months
ended
December 31,
2010 | | Six months
ended
June 30,
2010 | |
| | | | | | | |
Beginning Balance | | $ | 3,982 | | $ | 2,773 | | $ | 2,773 | |
Provision charged to operations | | | 1,087 | | | 2,149 | | | 512 | |
Allowance recovered on properties disposed | | | (1,062 | ) | | (940 | ) | | (333 | ) |
| | | | | | | | | | |
Ending Balance | | $ | 4,007 | | $ | 3,982 | | $ | 2,952 | |
44
Table of Contents
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 June 30, 2011, the investment portfolio (comprising investment securities available for sale) decreased $12.6 million (4.7%) to $254.1 million compared to $266.7 million at December 31, 2010. At June 30, 2011, the investment portfolio represented 25.0% of total assets compared to 25.4% at December 31, 2010.
We closely monitor securities we hold in our investment portfolio that remain in an unrealized loss position for greater than twelve months. Total gross unrealized losses on these securities are $0.4 million at June 30, 2011, representing 44.4% of total gross unrealized securities losses. Based on an in-depth analysis, which may include ratings from external rating agencies and/or brokers, 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 securities and it is not more likely than not that we will be required to sell these securities before their anticipated recovery. If at any point in time any losses are considered other-than-temporary, we would be required to recognize other-than-temporary impairment. This would require us to assess the cash flows expected to be collected from the security. The difference between the present value of the cash flows expected to be collected and the amortized cost basis would result in a credit loss for the amount of the impairment. This amount would reduce our earnings. The remaining portion of the impairment related to factors other than credit loss would be recognized through other comprehensive income/ (loss). At June 30, 2011 and December 31, 2010, 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. As of June 30, 2011, the highest concentration of loans issued in any state was issued in California and those loans represented approximately 19.6% of the total amount invested in mortgage-backed securities.
Deposits:
Total deposits at June 30, 2011 decreased $27.6 million (3.2%) to $825.0 million from $852.6 million at December 31, 2010. This decrease was a result of a decrease of $26.8 million (11.1%) in our demand deposits from $242.1 million at December 31, 2010 to $215.3 million at June 30, 2011, and a decrease in our time deposits (excluding brokered time deposits) of $13.4 million (4.7%) from $287.3 million at December 31, 2010 to $273.9 million at June 30, 2011, partially offset by a $5.5 million (12.0%) increase in our brokered deposits from $46.0 million at December 31, 2010 to $51.5 million at June 30, 2011 and a $7.1 million (2.6%) increase in our savings deposits from $277.2 million at December 31, 2010 to $284.3 million at June 30, 2011. Total interest-bearing deposits decreased $35.7 million (4.7%) while non-interest-bearing deposits increased $8.1 million (9.6%) from December 31, 2010 to June 30, 2011.
Emphasis has been, and will continue to be, placed on generating additional core deposits in 2011 through competitive pricing of deposit products and through our existing branch delivery systems. We will also attempt to attract and retain core deposit accounts through new product offerings and quality customer service. We also may increase brokered certificates of deposit during 2011 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 and through the discount window at the Federal Reserve.
Other Funding Sources:
Securities under agreements to repurchase increased $1.3 million (6.9%) from $19.2 million at December 31, 2010 to $20.5 million at June 30, 2011. We did not have any federal funds purchased at either June 30, 2011 or December 31, 2010.
FHLB advances were $55.0 million at June 30, 2011, compared to $70.0 million at December 31, 2010. During the first quarter of 2011, $15.0 million of borrowings matured and were paid in full. 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.
Table of Contents
Long Term Debt:
In March 2006, we issued $16.1 million of variable rate, trust preferred securities (“TruPS”) and $0.5 million of trust common securities through Baylake Capital Trust II (the “Trust”) that adjust quarterly at a rate equal to 1.35% over the three month LIBOR. At June 30, 2011, the interest rate on these securities was 1.60%. These securities were issued to replace trust preferred securities issued in 2001 through Baylake Capital Trust I. For bank regulatory purposes, these securities are considered Tier 1 capital.
The Trust’s ability to pay amounts due on the TruPS is solely dependent upon us making payment on the related subordinated debentures (“Debentures”) to the Trust. Under the terms of the Debentures, we would be precluded from paying dividends on our common stock if we were in default under the Debentures, if we exercised our right to defer payment of interest on the Debentures or if certain related defaults occurred. After discussion with our regulators during the first quarter of 2011, we exercised our right to defer payment of interest on the Debentures beginning with the March 30, 2011 interest payment, even though we had sufficient cash to make the interest payment. Our payment due June 29, 2011 was also deferred. The expense related to the interest payment was recorded with a corresponding liability for the interest payment amount. We will reevaluate with our regulators the continued deferral of interest payments on the TruPS quarterly as future payments come due.
During 2009 and 2010, we completed several separate closings of a private placement of Convertible Notes. The Convertible Notes were offered and sold in reliance on the exemption from registration under Section 4(2) of the Securities Act of 1933 and Rule 506 promulgated there under. The total amount of the Convertible Notes outstanding as of the date of this report is $9.45 million. The 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 voluntary conversion has not occurred. The principal amount of any Convertible Note that has not been converted will be payable at maturity on June 30, 2017.
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, 2010 for quantitative and qualitative disclosures about our fixed and determinable contractual obligations. Items disclosed in the 2010 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 June 30, 2011:
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 | | $ | 195,215 | | $ | 108,474 | | $ | 19,303 | | $ | — | | $ | 322,992 | |
Repurchase agreements | | | 20,560 | | | — | | | — | | | — | | | 20,560 | |
Federal Home Loan Bank advances | | | — | | | 30,000 | | | 25,000 | | | — | | | 55,000 | |
Subordinated debentures | | | — | | | — | | | — | | | 16,100 | | | 16,100 | |
Convertible promissory notes(1) | | | — | | | — | | | 9,450 | | | — | | | 9,450 | |
Total | | $ | 215,775 | | $ | 138,474 | | $ | 53,753 | | $ | 16,100 | | $ | 424,102 | |
| |
(1) | One-half of the Convertible Notes are mandatorily converted to shares of our 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. |
Table of Contents
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)
| | | | | | | |
| | June 30,
2011 | | December 31,
2010 | |
| | | | | | | |
Commitments to fund home equity line loans | | $ | 54,540 | | $ | 51,195 | |
Commitments to fund 1-4 family loans | | | 4,402 | | | 1,394 | |
Commitments to fund residential real estate construction loans | | | 1,888 | | | 777 | |
Commitments unused on various other lines of credit loans | | | 157,860 | | | 133,457 | |
Total commitments to extend credit | | $ | 218,690 | | $ | 186,823 | |
Financial standby letters of credit | | $ | 10,062 | | $ | 12,448 | |
Liquidity:
Liquidity management refers to our ability to ensure that cash is available on a timely basis to meet loan demand and depositors’ needs and to service other liabilities as they become due without undue cost or risk and without causing a disruption to normal operating activities. 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 debt and issue our common stock if and when we deem it prudent to do so, subject to regulatory approval. We generally manage our liquidity position in order to provide funds necessary to meet interest obligations of our trust preferred securities and convertible notes, pay dividends to our shareholders, subject to regulatory restrictions, and repurchase shares. Such restrictions, which govern all state chartered banks, preclude the payment of dividends without the prior written consent of the 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 Board. There is no assurance 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 six months ended June 30, 2011, principal payments totaling $21.9 million were received on maturing investments. In addition, we received proceeds of $21.5 million from the sale of investments and we purchased $27.2 million in investments in the same period. At June 30, 2011 the investment portfolio contained $153.4 million of mortgage-backed securities issued by U.S. government sponsored agencies, representing 60.4% of the total investment portfolio. These securities tend to be highly marketable.
Deposit decreases, reflected as a financing activity in the June 30, 2011 Unaudited Consolidated Statements of Cash Flows, resulted in $27.6 million of cash outflow during the first six months of 2011. Deposit growth is normally the most stable source of liquidity, although brokered deposits, which are inherently less stable than locally-generated core deposits, are sometimes used. Our reliance on brokered deposits increased $5.5 million from $46.0 million at December 31, 2010 to $51.5 million at June 30, 2011. If at any point in the future we fall below the “well capitalized” regulatory capital threshold, it will become more difficult for us to obtain brokered deposits. Also affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause a need to develop alternative sources of funds, which may not be as liquid and potentially a more costly alternative.
Table of Contents
The scheduled payments and maturities of loans can provide a source of additional liquidity. There are $224.9 million, or 36.2% of total loans, maturing within one year of June 30, 2011. 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 June 30, 2011, securities sold under agreements to repurchase totaled $20.6 million compared to $19.2 million at the end of 2010. Securities sold under agreements to repurchase are obtained from a base of business customers. Short-term and long-term borrowings from the FHLB are another source of funds, totaling $55.0 million at June 30, 2011 and $70.0 million at December 31, 2010. During the first quarter of 2011, we reduced our FHLB borrowings by $15.0 million.
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 June 30, 2011 and December 31, 2010 was $81.4 million and $77.1 million, respectively, reflecting an increase of $4.3 million (5.6%) during the first six months of 2011. The increase in stockholders’ equity was primarily related to our net income of $1.4 million and an increase in comprehensive income of $2.9 million (as a result of an increase in unrealized gains on available for sale securities). The ratio of stockholders’ equity to assets was 8.0% and 7.3% at June 30, 2011 and December 31, 2010, respectively.
No cash dividends were declared during the first six months of 2011 or during all of 2010. 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 Board will need to be obtained. There is no assurance that we would receive such approval if sought.
We regularly review the adequacy of our capital to ensure that sufficient capital is available for our current and future needs and 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.
Table of Contents
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 June 30, 2011, we were in excess of the minimum capital ratios established for “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%.
Effective December 29, 2010, we and the Bank entered into a written agreement with the Federal Reserve Bank and WDFI. Under the terms of the Written Agreement, both we and the Bank have agreed to: (i) submit for approval plans to maintain sufficient capital; (ii) comply with applicable notice provisions with respect to the appointment of new directors and senior executive officers and legal and regulatory limitations on indemnification payments and severance payments; (iii) refrain from declaring or paying dividends absent prior regulatory approval. It is the intent of our directors and senior management and the directors and senior management of the Bank to diligently seek to comply with all requirements specified in the Written Agreement.
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.
Table of Contents
The following tables present our and the Bank’s capital ratios as of June 30, 2011 and December 31, 2010:
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 June 30, 2011 | | | | | | | | | | | | | | | | | | | |
Total Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 97,171 | | | 13.43 | % | $ | 57,889 | | | 8.00 | % | $ | N/A | | | N/A | |
Bank | | | 95,567 | | | 13.20 | % | | 57,921 | | | 8.00 | % | | 72,401 | | | 10.00 | % |
Tier 1 Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 78,632 | | | 10.87 | % | $ | 28,944 | | | 4.00 | % | $ | N/A | | | N/A | |
Bank | | | 86,472 | | | 11.94 | % | | 28,960 | | | 4.00 | % | | 43,441 | | | 6.00 | % |
Tier 1 Capital (to Average Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 78,632 | | | 7.86 | % | $ | 40,031 | | | 4.00 | % | $ | N/A | | | N/A | |
Bank | | | 86,472 | | | 8.63 | % | | 40,091 | | | 4.00 | % | | 50,113 | | | 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, 2010 | | | | | | | | | | | | | | | | | | | |
Total Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company` | | $ | 96,245 | | | 12.76 | % | $ | 60,364 | | | 8.00 | % | $ | N/A | | | N/A | |
Bank | | | 94,194 | | | 12.48 | % | | 60,394 | | | 8.00 | % | | 75,493 | | | 10.00 | % |
Tier 1 Capital (to Risk-Weighted Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 77,338 | | | 10.25 | % | $ | 30,182 | | | 4.00 | % | $ | N/A | | | N/A | |
Bank | | | 84,732 | | | 11.22 | % | | 30,197 | | | 4.00 | % | | 45,296 | | | 6.00 | % |
Tier 1 Capital (to Average Assets) | | | | | | | | | | | | | | | | | | | |
Company | | $ | 77,338 | | | 7.41 | % | $ | 41,720 | | | 4.00 | % | $ | N/A | | | N/A | |
Bank | | | 84,732 | | | 8.12 | % | | 41,237 | | | 4.00 | % | | 52,171 | | | 5.00 | % |
Table of Contents
Item 3.Quantitative and Qualitative Disclosures 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 June 30, 2011, 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, 2010, as described in our 2010 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 June 30, 2011.
INTEREST SENSITIVITY
(Dollar amounts in thousands)
| | | | | | | | | | | | | |
| | Change in Net Interest Income Over One Year Horizon | |
|
| | At June 30, 2011 | | At December 31, 2010 | |
Change in levels of interest rates | | Dollar
change | | Percentage
change | | Dollar
change | | Percentage
change | |
+200 bp | | $ | (362 | ) | | (1.2 | )% | $ | 191 | | | 0.6 | % |
+100 bp | | | (644 | ) | | (2.1 | )% | | (118 | ) | | (0.4 | )% |
Base | | | — | | | — | | | — | | | — | |
-100 bp | | | (1,322 | ) | | (4.2 | )% | | (1,468 | ) | | (4.4 | )% |
-200 bp | | | (2,376 | ) | | (7.6 | )% | | (2,622 | ) | | (7.9 | )% |
As shown above, at June 30, 2011, the effect of an immediate 200 bp increase in interest rates would have decreased our net interest income by $0.4 million or 1.2%. The effect of an immediate 200 bp reduction in rates would have decreased our net interest income by $2.4 million or 7.6%. However, a 200 bp reduction in rates is not realistic given the low interest rate environment that currently exists. An interest rate floor of zero is used rather than assuming a negative interest rate.
During the first six months of 2011, Baylake Bank lengthened slightly the duration of its liabilities by issuing longer term brokered deposits. This effort has contributed to moderation of the liability sensitivity that was present at December 31, 2010.
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.
Table of Contents
Item 4.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 June 30, 2011. 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 are 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
The mortgage-backed securities in which we invest are subject to several types of risk.
Mortgage-backed securities are securities that evidence interests in, or are secured by, a single mortgage loan or a pool of mortgage loans. Accordingly, these securities are subject to all of the risks of the underlying mortgage loans. In a rising interest rate environment, the value of mortgage-backed securities may be adversely affected when payments on underlying mortgages do not occur as anticipated, resulting in the extension of the security’s effective maturity and the related increase in interest rate sensitivity of a longer-term instrument. The value of mortgage-backed securities may also change due to shifts in the market’s perception of issuers and regulatory or tax changes adversely affecting the mortgage securities’ market as a whole. Most mortgage-backed securities are issued by agencies of the United States government, however some mortgage-backed securities are issued by investment banks, and while the loans that are pooled to create the security carry government agency guarantees, the securities themselves are not insured or guaranteed by the United States government. Approximately 73% or $116.5 million of the mortgage-backed securities outstanding at June 30, 2011 were agency mortgage-backed securities which are guaranteed by the United States government. Non-agency mortgage-backed securities comprised approximately 27% or $43.1 million of the outstanding mortgage-backed securities at June 30, 2011. Finally, mortgage-backed securities are also subject to geographic risk, when the mortgages underlying the securities are concentrated in one or more geographic areas. This risk is managed by monitoring the geographic dispersion of the underlying loans in each security. As of June 30, 2011, the highest concentration of loans issued in any state was issued in California and those loans represented approximately 19.6% of the total amount invested in mortgage-backed securities.
Although we generally invest only in mortgage-backed securities collateralized by residential loans, the value of such securities can be negatively impacted by any dislocation in the mortgage-backed securities market in general. The mortgage-backed securities market has recently suffered from a severe dislocation created by mortgage pools that included sub-prime mortgages secured by residential real estate.
See “Risk Factors” in Item 1A of our annual report on Form 10-K for the year ended December 31, 2010. Other than as described above, there have been no material changes to the risk factors since then.
Table of Contents
Item 2.Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3.Defaults Upon Senior Securities
Not applicable.
Item 5.Other Information
Not applicable.
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. |
Table of Contents
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: | August 9, 2011 | | /s/ Robert J. Cera |
| | | Robert J. Cera |
| | | President and Chief Executive Officer |
| | | |
Date: | August 9, 2011 | | /s/ Kevin L. LaLuzerne |
| | | Kevin L. LaLuzerne |
| | | Treasurer and Chief Financial Officer |
