Baylake (BYLK) 10-Q 2014 Q2 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

x     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period endedJune 30, 2014

OR

o      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________to ________________

Commission file number 001-16339

BAYLAKE CORP.
(Exact name of registrant as specified in its charter)

Wisconsin	39-1268055
(State or other jurisdiction of	(I.R.S. Employer Identification No.)
incorporation or organization)
217 North Fourth Avenue, Sturgeon Bay, WI	54235
(Address of principal executive offices)	(Zip Code)

(920) 743-5551
(Registrant’s telephone number, including area code)

None
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesx Noo

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yesx Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filero	Accelerated filero	Non-accelerated filero	Smaller reporting companyx
	(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yeso Nox

The number of outstanding shares of common stock, $5.00 par value per share, as of August 1, 2014 was 8,620,321 shares.

BAYLAKE CORP.
INDEX

		PAGE NO.
PART I - FINANCIAL INFORMATION
ITEM 1 -	FINANCIAL STATEMENTS	3
ITEM 2 -	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	32
ITEM 3 -	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	51
ITEM 4 -	CONTROLS AND PROCEDURES	52
PART II - OTHER INFORMATION
ITEM 1 -	LEGAL PROCEEDINGS	53
ITEM 1A -	RISK FACTORS	53
ITEM 2 -	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	53
ITEM 3 -	DEFAULTS UPON SENIOR SECURITIES	53
ITEM 4 -	MINE SAFETY DISCLOSURES	53
ITEM 5 -	OTHER INFORMATION	53
ITEM 6 -	EXHIBITS	54

2

PART I - FINANCIAL INFORMATION

Item 1.Financial Statements

BAYLAKE CORP.

CONSOLIDATED BALANCE SHEETS

June 30, 2014 (unaudited) and December 31, 2013

(Dollar amounts in thousands)

	June 30, 2014			December 31, 2013
ASSETS
Cash and due from financial institutions	$	76,672		$	76,179
Federal funds sold		857			63
Securities held to maturity, at amortized cost		20,678			10,275
Securities available for sale, at fair value		206,284			220,608
Loans held for sale		725			1,360
Loans, net of allowance of $7,443 at June 30, 2014 and $7,658 at December 31, 2013		622,379			610,302
Cash surrender value of life insurance		23,603			23,401
Premises and equipment, net		20,569			19,714
Premises and equipment held for sale		844			844
Federal Home Loan Bank stock		4,238			3,598
Other real estate owned, net		5,053			6,298
Goodwill		7,222			6,641
Deferred income taxes, net		5,003			6,636
Accrued interest receivable		2,795			2,506
Other assets		8,452			8,351
Total Assets	$	1,005,374		$	996,776
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Noninterest-bearing	$	138,936		$	127,940
Interest-bearing		597,259			616,272
Total Deposits		736,195			744,212
Federal Home Loan Bank advances		98,985			66,700
Repurchase agreements		40,770			58,448
Subordinated debentures		16,100			16,100
Convertible promissory notes		8,175			9,400
Accrued expenses and other liabilities		8,031			8,035
Total Liabilities		908,256			902,895
Commitments and Contingencies - Note 15
Common stock, $5 par value, authorized 50,000,000 shares;
Issued-8,472,834 shares at June 30, 2014 and 8,194,010 shares at December 31, 2013;
Outstanding-7,860,321 shares at June 30, 2014 and 7,809,997 shares at December 31, 2013		42,364			40,970
Additional paid-in capital		12,468			12,371
Retained earnings		47,843			44,719
Treasury stock 612,513 shares at June 30, 2014 and 384,013 shares at December 31, 2013		(8,114	)		(5,256	)
Accumulated other comprehensive income		2,557			1,077
Total Stockholders’ Equity		97,118			93,881
Total Liabilities and Stockholders’ Equity	$	1,005,374		$	996,776

See accompanying Notes to Consolidated Financial Statements

3

BAYLAKE CORP.

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

Three and Six Months ended June 30, 2014 and 2013

(Dollar amounts in thousands, except per share data)

	Three months ended June 30,						Six Months Ended June 30,
	2014			2013			2014			2013
INTEREST AND DIVIDEND INCOME
Loans, including fees	$	7,157		$	6,998		$	14,036		$	14,019
Taxable securities		1,249			1,179			2,499			2,402
Tax exempt securities		370			372			743			746
Federal funds sold		19			15			29			50
Total Interest and Dividend Income		8,795			8,564			17,307			17,217
INTEREST EXPENSE
Deposits		406			692			826			1,455
Repurchase agreements		24			15			50			35
Federal Home Loan Bank advances and other debt		241			201			414			400
Subordinated debentures		65			66			129			133
Convertible promissory notes		213			244			452			488
Total Interest Expense		949			1,218			1,871			2,511
Net interest income before provision for loan losses		7,846			7,346			15,436			14,706
Provision for loan losses		—			600			—			1,200
Net interest income after provision for loan losses		7,846			6,746			15,436			13,506
NONINTEREST INCOME
Fees from fiduciary activities		252			286			504			537
Fees from loan servicing		138			143			300			293
Fees from financial services to customers		252			244			518			557
Fees for other services to customers		867			852			1,664			1,642
Net gain on sale of loans		126			440			253			1,034
Net change in valuation of mortgage servicing rights		(57	)		(118	)		(134	)		(120	)
Net realized gain on sale of securities		92			221			161			209
Net gains on sale of premises and equipment		5			5			5			5
Increase in cash surrender value of life insurance		124			91			202			169
Income in equity of UFS subsidiary		288			198			582			433
Other income (losses)		79			(3	)		127			99
Total Noninterest Income		2,166			2,359			4,182			4,858
NONINTEREST EXPENSE
Salaries and employee benefits		4,389			3,908			8,456			8,093
Occupancy expense		514			483			1,074			1,007
Equipment expense		341			294			654			589
Data processing and courier expense		195			213			403			420
FDIC insurance expense		151			178			300			369
Operation of other real estate		141			364			307			563
Loan and collection expense		18			52			37			147
Other outside services		291			185			626			384
Other operating expenses		954			1,002			1,905			1,915
Total Noninterest Expense		6,994			6,679			13,762			13,487
Income before provision for income taxes		3,018			2,426			5,856			4,877
Provision for income taxes		859			695			1,632			1,391
Net Income	$	2,159		$	1,731		$	4,224		$	3,486
Basic earnings per share	$	0.27		$	0.22		$	0.54		$	0.44
Diluted earnings per share	$	0.24		$	0.19		$	0.47		$	0.38
Cash dividends paid per share	$	0.07		$	0.05		$	0.14		$	0.09

See accompanying Notes to Consolidated Financial Statements

4

BAYLAKE CORP.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

Three and Six Months ended June 30, 2014 and 2013

(Dollar amounts in thousands)

	Three Months Ended June 30,						Six Months Ended June 30,
	2014			2013			2014			2013
Net Income	$	2,159		$	1,731		$	4,224		$	3,486
Other comprehensive income (losses), net of tax
Unrealized gains (losses) on securities
Net unrealized holding gains (losses) arising during the period	$	1,610		$	(3,282	)	$	2,596		$	(4,030	)
Less: reclassification adjustment for gains included in net income		(92	)		(221	)		(161	)		(209	)
Tax effect		(595	)		1,374			(955	)		1,687
Other comprehensive income (loss)		923			(2,129	)		1,480			(2,552	)
Comprehensive income (loss)	$	3,082		$	(398	)	$	5,704		$	934

See accompanying Notes to Consolidated Financial Statements

5

BAYLAKE CORP.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

Six Months ended June 30, 2014

(Dollar amounts in thousands)

	Common Stock					Additional Paid-In			Retained			Treasury			Accumulated Other Comprehensive			Stockholders’
	Shares			Amount		Capital			Earnings			Stock			Income			Equity
Balance, January 1, 2014		7,809,997		$	40,970	$	12,371		$	44,719		$	(5,256	)	$	1,077		$	93,881
Net income		—			—		—			4,224			—			—			4,224
Net changes in unrealized gains on securities available for sale		—			—		—			—			—			2,596			2,596
Reclassification adjustment for net gains realized in income		—			—		—			—			—			(161	)		(161	)
Tax effect		—			—		—			—			—			(955	)		(955	)
Total comprehensive income																			5,704
Purchase of treasury stock		(228,500	)		—		—			—			(2,858	)		—			(2,858	)
Stock-based compensation expense recognized, net		—			—		168			—			—			—			168
Vesting of RSUs		32,267			161		(161	)		—			—			—			—
Tax benefit from vesting of RSUs		—			—		92			—			—			—			92
Exercise of stock options		1,557			8		(1	)		—			—			—			7
Tax benefit from exercise of stock options/RSUs		—			—		3			—			—			—			3
Forfeiture of stock options/RSUs not exercised		—			—	��	(6	)		—			—			—			(6	)
Tax benefit from forfeiture of unexercised stock options/RSUs		—			—		2			—			—			—			2
Conversion of debentures		245,000			1,225														1,225
Cash dividends - ($0.14 per share)		—			—		—			(1,100	)		—			—			(1,100	)
Balance, June 30, 2014		7,860,321		$	42,364	$	12,468		$	47,843		$	(8,114	)	$	2,557		$	97,118

See accompanying Notes to Consolidated Financial Statements

6

BAYLAKE CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

Six months ended June 30, 2014 and 2013

(Dollar amounts in thousands)

	2014			2013
CASH FLOWS FROM OPERATING ACTIVITIES
Reconciliation of net income to net cash provided by operating activities:
Net Income	$	4,224		$	3,486
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		655			644
Amortization of debt issuance costs		17			17
Amortization of core deposit intangible		10			—
Provision for loan losses		—			1,200
Net amortization of premium/discount on securities		841			1,437
Increase in cash surrender value of life insurance		(202	)		(169	)
Net realized gain on sale of securities		(161	)		(209	)
Net gain on sale of loans		(253	)		(1,034	)
Proceeds from sale of loans held for sale		12,720			48,281
Origination of loans held for sale		(11,863	)		(47,765	)
Change in valuation of mortgage servicing rights, net of payments and payoffs		134			120
Provision for valuation allowance on other real estate owned		201			445
Net gains on sale of premises and equipment		(5	)		(5	)
Net gain on disposals of other real estate owned		(43	)		(128	)
Provision for deferred income tax expense		679			911
Stock-based compensation expense		168			141
Forfeiture of options not exercised and RSUs not vested		(6	)		—
Tax expense (benefit) from exercise/forfeiture of options		5			(4	)
Income in equity of UFS subsidiary		(582	)		(433	)
Changes in assets and liabilities:
Return of prepaid FDIC assessment		—			358
Accrued income taxes		383			1,070
Accrued interest receivable and other assets		(309	)		156
Income tax refund		(173	)		(316	)
Accrued expenses and other liabilities		(59	)		(667	)
Net cash provided by operating activities		6,381			7,536
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of securities available for sale		3,773			3,937
Principal payments on securities available for sale		16,332			30,151
Purchase of securities held to maturity		(10,456	)		—
Purchase of securities available for sale		(3,973	)		(32,275	)
Purchase of FHLB stock		(640	)		—
Proceeds from sale of other real estate owned		1,162			3,302
Proceeds from sale of premises and equipment		82			7
Loan originations and payments, net		(12,149	)		(4,978	)
Additions to premises and equipment		(637	)		(606	)
Net change in federal funds sold		(794	)		(134	)
Dividend from UFS subsidiary		276			199
Net cash provided in purchase of branch		12,086			—
Net cash provided by (used in) investing activities		5,062			(397	)

See accompanying Notes to Unaudited Consolidated Financial Statements.

7

BAYLAKE CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

Six months ended June 30, 2014 and 2013

(Dollar amounts in thousands)

	2014			2013
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in deposits	$	(21,698	)	$	(49,556	)
Net change in repurchase agreements		(17,678	)		(29,111	)
Repayments on Federal Home Loan Bank advances		(18,015	)		—
Proceeds from Federal Home Loan Bank advances		50,300			—
Tax benefit from vesting of restricted stock units		92			47
Proceeds from exercise of stock options		7			18
Purchase of treasury stock		(2,858	)		(99	)
Cash dividends paid		(1,100	)		(716	)
Net cash used in financing activities		(10,950	)		(79,417	)
Net change in cash		493			(72,278	)
Beginning cash		76,179			109,621
Ending cash	$	76,672		$	37,343
Supplemental cash flow information:
Interest paid	$	1,865		$	2,568
Income taxes paid (refunded), net		652			(316	)
Supplemental noncash disclosure:
Transfers from loans to other real estate owned	$	75		$	696
Transfers from premises and equipment to other real estate owned		—			36
Mortgage servicing rights resulting from sale of loans		31			166
Conversion of debentures to equity		1,225			—

See accompanying Notes to Unaudited Consolidated Financial Statements.

8

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

1.	The consolidated financial statements of Baylake Corp. (the “Company”) include the accounts of the Company, its wholly owned subsidiaries Baylake Bank (the “Bank”) and Admiral Asset Management, LLC (“Admiral”), and the Bank’s wholly owned subsidiary, Baylake Investments, Inc. In the fourth quarter of 2013, the Company capitalized Admiral, a registered investment advisory subsidiary to provide investment advisory services in addition to those offered by the Bank. All significant intercompany items have been eliminated. The accompanying interim consolidated financial statements should be read in conjunction with the 2013 Annual Report on Form 10-K of the Company. The accompanying consolidated financial statements are unaudited. These interim consolidated financial statements are prepared in accordance with the requirements of Form 10-Q, and accordingly do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for complete financial statements. In the opinion of management, the unaudited consolidated financial information included in this report reflects all adjustments, consisting of normal recurring accruals of operations for the three and six month periods ending June 30, 2014 and 2013 necessary to make the consolidated financial information not misleading. The consolidated results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of results to be expected for the entire year. Management of the Company has evaluated all subsequent events to August 1, 2014, the date the interim consolidated financial statements were issued, and determined that all subsequent events have been recognized and disclosed in the accompanying financial statements through the date of this report.
2.	Use of Estimates
	To prepare consolidated financial statements in conformity with U.S. GAAP, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the consolidated financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, value of other real estate owned, other than temporary impairment of securities, mortgage servicing rights, income tax expense, and fair values of financial instruments are particularly subject to change.
3.	Earnings Per Share
	Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share, which reflects the potential dilution that could occur if outstanding stock options were exercised, stock awards were fully vested, and promissory notes were converted, resulting in the issuance of common stock that then shared in the Company’s earnings, is computed by dividing net income as adjusted for the income impact of assumed conversions by the weighted average number of common shares outstanding and common stock equivalents. The following table shows the computation of the basic and diluted earnings per share:

9

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

EARNINGS PER SHARE
(Dollar amounts in thousands, except per share data)

	Three months ended June 30,				Six months ended June 30,
	2014		2013		2014		2013
(Numerator):
Net income available to common stockholders	$	2,159	$	1,731	$	4,224	$	3,486
Plus: Income impact of assumed conversions
Interest on 10% convertible debentures, net of income tax		130		148		259		296
Income available to common stockholders plus assumed conversions	$	2,289	$	1,879	$	4,483	$	3,782
(Denominator):
Weighted average number of common shares outstanding-basic		7,907,761		7,967,782		7,842,192		7,954,308
Plus: Incremental shares of assumed conversions:
Dilutive effect of stock options(1)		44,151		25,502		43,860		23,186
Dilutive effect of restricted stock units(2)		28,270		29,053		37,997		35,506
Dilutive effect of convertible promissory notes(3)		1,635,000		1,880,000		1,635,000		1,880,000
Dilutive potential common shares		1,707,421		1,934,555		1,716,857		1,938,692
Adjusted weighted-average shares		9,615,182		9,902,337		9,559,049		9,893,000
Basic Earnings Per Share	$	0.27	$	0.22	$	0.54	$	0.44
Diluted Earnings Per Share	$	0.24	$	0.19	$	0.47	$	0.38

(1)	For the three and six months ended June 30, 2014 and 2013, there were 64,130 and 53,176 outstanding stock options that were not included in the computation of diluted earnings per share because they were considered anti-dilutive.
(2)	For the three and six months ended June 30, 2014 and 2013, respectively, there were 15,040 and 68,572 outstanding restricted stock units, respectively, that were not included in the computation of diluted earnings per share because they were considered anti-dilutive.
(3)	At June 30, 2014 and 2013, respectively, the Company had $8.18 million and $9.40 million of outstanding Convertible Promissory Notes (the “Convertible Notes”). The Convertible Notes are convertible into shares of common stock of the Company 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 (the “Conversion Ratio”). Prior to the quarterly interest date preceding the fifth anniversary of issuance of the Convertible Notes 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 common stock at the Conversion Ratio. On October 1, 2014, one-half of the original principal amounts of the Convertible Notes are mandatorily convertible at the Conversion Ratio if voluntary conversion has not yet occurred. The principal amount of any Convertible Note that has not been converted will be payable at maturity on June 30, 2017. At June 30, 2014 and 2013, respectively, the entire 1,635,000 and 1,880,000 of common shares are included in the computation of diluted earnings per share since the average market price per share for the three and six months ended June 30, 2014 and 2013 exceeded the conversion price of $5.00 per share.

10

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

4.	Recent Accounting Pronouncements
	In June 2014, the FASB issued ASU No. 2014-11,Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financing, and Disclosures.The amendments in this guidance requires repurchase-to-maturity transactions to be accounted for as secured borrowings. The guidance for certain transactions accounted for as a sale, repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions accounted for as secured borrowings is effective prospectively, for annual and interim periods, beginning after December 15, 2014. The adoption of the guidance is not expected to have a significant impact on consolidated financial conditions, results of operations or liquidity of the Company.
	In May 2014, the FASB issued ASU No. 2014-09,Revenue from Contracts with Customers (Topic 606).Under the amended guidance, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This guidance is effective prospectively, for annual and interim periods, beginning after December 15, 2016. Management is currently evaluating this guidance and does not expect this guidance to have a significant impact on consolidated financial condition, results of operation or liquidity of the Company.
	In January 2014, the FASB issued ASU No. 2014-04,Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40) Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).The amendments in ASU 2014-04 clarify when an in-substance repossession or foreclosure occurs — that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The new ASU requires a creditor to reclassify a collateralized consumer mortgage loan to real estate property upon obtaining legal title to the real estate collateral, or the borrower voluntarily conveying all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. This ASU is effective for the Company beginning January 1, 2015. The provisions of this guidance are not expected to have a significant impact on the consolidated financial condition, results of operation or liquidity of the Company.

11

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

5.	Fair Value
	Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure fair value:
	Level 1:	Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
	Level 2:	Significant other observable inputs, other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
	Level 3:	Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input within the valuation hierarchy that is significant to the fair value measurement.

The methods and assumptions used to estimate fair value are described below.

Securities available for sale - the fair value of securities available for sale is determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). For other securities not able to be priced on matrix pricing, outside third parties are relied upon (Level 3 inputs). One of the Company’s securities available for sale at June 30, 2014 and December 31, 2013 was measured using Level 3 inputs.

Non-impaired loans and deposits - the fair value of fixed rate non-impaired loans and deposits and non-impaired variable rate loans and deposits with infrequent repricing or repricing limits, is based on discounted cash flows using current market rates applied to the estimated life and credit risk (Level 3 inputs). Fair value of loans held for sale is based on market quotes (Level 3 inputs).

Impaired Loans - the fair value of impaired loans is based on a review of comparable collateral in similar marketplaces (Level 3 inputs) or an analysis of expected cash flows of the loan in relationship to the contractual terms of the loan (Level 3 inputs). Impaired loans are carried at the lower of amortized cost or fair value less estimated costs to sell. Impaired loans are not carried at fair value if there is sufficient collateral or if expected repayments exceed the recorded investments of such loans.

Mortgage servicing rights - the fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. These assumptions include servicing costs, expected loan lives, discount rates, and the determination of whether the loan is likely to be refinanced. The Company compares the valuation model inputs and results to published industry data for reasonableness (Level 2 inputs).

Other real estate owned - the fair value of other real estate owned is determined using a variety of market information including, but not limited to, appraisals, professional market assessments and real estate tax assessment information. Properties obtained by the Bank in foreclosure are adjusted to fair value less estimated costs to sell upon their transfer to other real estate owned, establishing a new cost basis. Subsequently, other real estate owned is carried at the lower of cost or fair value less estimated costs to sell (Level 3 inputs).

Convertible promissory notes - fair value of convertible promissory notes is based on current rates for similar financing arrangements (Level 3 inputs).

12

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

ASSETS MEASURED AT FAIR VALUE ON A RECURRING BASIS
(Dollar amounts in thousands)

Assets measured at fair value on a recurring basis are summarized below:

	June 30, 2014		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available for sale:
U.S. government-sponsored agency securities	$	3,490	$	—	$	3,490	$	—
Mortgage-backed securities		136,256		—		135,877		379
Asset-backed securities		1,333		—		1,333		—
Obligations of states and political subdivisions		59,740		—		59,740		—
Private placement and corporate bonds		3,561		—		3,561		—
Other securities		1,904		—		1,904		—
Total securities available for sale		206,284		—		205,905		379
Mortgage servicing rights		864		—		864		—
Total	$	207,148	$	—	$	206,769	$	379

	December 31, 2013		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available for sale:
U.S. government-sponsored agency securities	$	2,964	$	—	$	2,964	$	—
Mortgage-backed securities		152,176		—		151,694		482
Asset-backed securities		1,460		—		1,460		—
Obligations of states and political subdivisions		58,669		—		58,669		—
Private placement and corporate bonds		3,435		—		3,435		—
Other securities		1,904		—		1,904		—
Total securities available for sale		220,608		—		220,126		482
Mortgage servicing rights		967		—		967		—
Total	$	221,575	$	—	$	221,093	$	482

13

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

The following table presents additional information about assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

	For the three months ended June 30, 2014			For the six months ended June 30, 2014
Balance, beginning of period	$	406		$	482
Transfer into Level 3		—			—
Other comprehensive loss		—			33
Transfer out of Level 3		—			—
Principal payments		(27	)		(136	)
Balance, end of period	$	379		$	379

ASSETS MEASURED AT FAIR VALUE ON A NON-RECURRING BASIS
(Dollar amounts in thousands)

Assets measured at fair value on a non-recurring basis are summarized below:

	June 30, 2014		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans with allocated allowances	$	1,736	$	—	$	—	$	1,736
Other real estate owned, net		5,053		—		—		5,053
Total	$	6,789	$	—	$	—	$	6,789

	December 31, 2013		Quoted Prices in Active Markets For Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans with allocated allowances	$	1,252	$	—	$	—	$	1,252
Other real estate owned, net		6,298		—		—		6,298
Total	$	7,550	$	—	$	—	$	7,550

Required Financial Disclosures about Fair Value of Financial Instruments

The accounting guidance for financial instruments requires disclosures of estimated fair value of certain financial instruments and the methods and significant assumptions used to estimate their fair values. Certain financial instruments and all nonfinancial instruments are excluded from the scope of this guidance. Accordingly, the fair value disclosures required by this guidance are only indicative of the value of individual financial instruments as of the dates indicated and should not be considered an indication of the Company’s fair value.

14

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

The following table presents the carrying amount and estimated fair value of certain financial instruments:

	(Dollar amounts in thousands)
	June 30, 2014				December 31, 2013
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
FINANCIAL ASSETS
Cash	$	76,672	$	76,672	$	76,179	$	76,179
Federal funds sold		857		857		63		63
Securities held to maturity		20,678		20,998		10,275		10,275
Securities available for sale		206,284		206,284		220,608		220,608
Loans held for sale		725		738		1,360		1,384
Loans, net		622,379		627,429		610,302		605,655
Federal Home Loan Bank stock		4,238		4,238		3,598		3,598
Mortgage servicing rights		864		864		967		967
Other real estate owned, net		5,053		5,053		6,298		6,298
Accrued interest receivable		2,795		2,795		2,506		2,506
FINANCIAL LIABILITIES
Deposits	$	736,195	$	736,042	$	744,212	$	739,315
Federal funds purchased and repurchase agreements		40,770		40,770		58,448		58,448
Federal Home Loan Bank advances		98,985		98,681		66,700		66,304
Subordinated debentures		16,100		16,100		16,100		16,100
Convertible promissory notes		8,175		8,139		9,400		9,316
Accrued interest payable		554		554		548		548

The methods and assumptions that were used to estimate the fair value of financial assets and financial liabilities that are measured at fair value on a recurring and non-recurring basis have been previously disclosed. The following methods and assumptions were used to estimate the fair value of other financial instruments for which it is practicable to estimate that value:

(a) Cash

The carrying amount of cash approximates fair value.

(b) Federal Funds Sold

The carrying amount of federal funds sold approximates fair value.

(c) Securities Held to Maturity and Available for Sale

The fair value of securities held to maturity and securities available for sale is based on quoted prices in active markets, or if quoted prices are not available for a specific security, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows.

(d) Loans Held for Sale

Loans held for sale, which generally consists of the current production of first-lien residential mortgage loans, are carried at the lower of cost or estimated fair value. Fair value is estimated based on actual market quotes from investors in the secondary market.

15

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

(e) Federal Home Loan Bank Stock

It is not practical to determine the fair value of Federal Home Loan Bank (“FHLB”) stock due to restrictions placed on its transferability. No secondary market exists for FHLB stock. The stock is bought and sold at par by the FHLB. Management believes that the recorded value is fair value.

(f) Accrued Interest Receivable

The carrying amount of accrued interest receivable approximates fair value.

(g) Deposits

The carrying amount of demand deposits (interest-bearing and noninterest-bearing), savings deposits, and money market deposits approximates fair value. The carrying amount of variable rate time deposits, including certificates of deposit, approximates fair value. For fixed rate time deposits, fair value is based on discounted cash flows using current market interest rates.

(h) Federal Funds Purchased and Repurchase Agreements

The carrying amount of federal funds repurchased and repurchase agreements approximates fair value.

(i) Federal Home Loan Bank Advances

The carrying amount of variable rate FHLB advances approximates fair value. For fixed rate advances, fair value is based on discounted cash flows using current market interest rates.

(j) Subordinated Debentures

The carrying amount of variable rate subordinated debentures approximates fair value.

(k) Accrued Interest Payable

The carrying amount of accrued interest payable approximates fair value.

16

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

6. Investments

INVESTMENT SECURITY ANALYSIS
(Dollar amounts in thousands)

The fair value of securities available for sale (“AFS”), the fair value of securities held to maturity (“HTM”) and the related unrealized gains and losses as of June 30, 2014 and December 31, 2013 are as follows:

	June 30, 2014
	Fair Value		Gross Unrealized Gains		Gross Unrealized Losses
Securities Available for Sale:
U.S. government-sponsored agency securities	$	3,490	$	2	$	(19	)
Obligations of states and political subdivisions		59,740		2,521		(74	)
Asset-backed securities		1,333		78		(95	)
Mortgage-backed securities		136,256		2,863		(1,110	)
Private placement and corporate bonds		3,561		41		—
Other securities		1,904		—		—
Total Securities Available for Sale	$	206,284	$	5,505	$	(1,298	)
Securities Held to Maturity:
Mortgage-backed securities	$	20,998	$	320	$	—
Total Securities Held to Maturity	$	20,998	$	320	$	—
Total Investment Securities	$	227,282	$	5,825	$	(1,298	)

	December 31, 2013
	Fair Value		Gross Unrealized Gains		Gross Unrealized Losses
Securities Available for Sale:
U.S. government-sponsored agency securities	$	2,964	$	—	$	(50	)
Obligations of states and political subdivisions		58,669		2,232		(193	)
Asset-backed securities		1,460		94		(110	)
Mortgage-backed securities		152,176		2,197		(2,313	)
Private placement and corporate bonds		3,435		—		(85	)
Other securities		1,904		—		—
Total Securities Available for Sale	$	220,608	$	4,523	$	(2,751	)
Securities Held to Maturity:
Mortgage-backed securities	$	10,275	$	—	$	—
Total Securities Held to Maturity	$	10,275	$	—	$	—
Total Investment Securities	$	230,883	$	4,523	$	(2,751	)

17

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

At June 30, 2014 and December 31, 2013, the mortgage-backed securities portfolio at market value was $157.3 million (69.3%) and $162.5 million (70.4%), respectively, of the investment portfolios. Approximately 8.3%, or $13.0 million, of the mortgage-backed securities outstanding at June 30, 2014 were issued by the Government National Mortgage Association (“GNMA”) and guaranteed by the United States Department of Veterans Affairs (“VA”) or the Federal Housing Administration (“FHA”); agencies of the United States government. An additional 79.3%, or $124.7 million, of the mortgage-backed securities outstanding at June 30, 2014 were issued by either the Federal National Mortgage Association (“FNMA”), the FHLB or the Federal Home Loan Mortgage Corporation (“FHLMC”); United States government-sponsored agencies. Non-agency mortgage-backed securities present a level of credit risk that does not exist currently with United States government agency-backed securities and comprised approximately 12.4%, or $19.6 million of the outstanding mortgage-backed securities at June 30, 2014. Management evaluates these non-agency mortgage-backed securities at least quarterly and more frequently when economic or market concerns warrant such evaluation.

Securities with unrealized losses at June 30, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows (dollar amounts in thousands):

	June 30, 2014
	Less than 12 Months					12 Months or More					Total
Description of Securities	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Securities Available for Sale:
U.S. government-sponsored agency securities	$	—	$	—		$	2,922	$	(19	)	$	2,922	$	(19	)
Obligations of states and political subdivisions		2,762		(51	)		1,563		(23	)		4,325		(74	)
Mortgage-backed securities		15,345		(252	)		25,771		(858	)		41,116		(1,110	)
Asset-backed securities		—		—			454		(95	)		454		(95	)
Private placement and corporate bonds		—		—			—		—			—		—
Total temporarily impaired	$	18,107	$	(303	)	$	30,710	$	(995	)	$	48,817	$	(1,298	)

	December 31, 2013
	Less than 12 Months					12 Months or More					Total
Description of Securities	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
Securities Available for Sale:
U.S. government-sponsored agency securities	$	2,964	$	(50	)	$	—	$	—		$	2,964	$	(50	)
Obligations of states and political subdivisions		5,290		(193	)		—		—			5,290		(193	)
Mortgage-backed securities		65,198		(1,640	)		15,164		(673	)		80,362		(2,313	)
Asset-backed securities		—		—			503		(110	)		503		(110	)
Private placement and corporate bonds		3,435		(85	)		—		—			3,435		(85	)
Total temporarily impaired	$	76,887	$	(1,968	)	$	15,667	$	(783	)	$	92,554	$	(2,751	)

At June 30, 2014, the AFS mortgage-backed securities category with continuous unrealized losses for twelve months or more comprised eleven securities. Each of the AFS asset-backed securities and U.S. government-sponsored agency securities category with continuous unrealized losses for twelve months or more comprised one security. The obligations of states and political subdivisions securities category with continuous unrealized losses for twelve months or more comprised nine securities.

At December 31, 2013, each of the AFS mortgage-backed securities category and the AFS asset-backed securities category with continuous unrealized losses for twelve months or more comprised two securities.

At both June 30, 2014 and December 31, 2013, the HTM portfolio had no unrealized losses.

18

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. As part of such monitoring, the credit quality of individual securities and their issuers is assessed. Adjustments to market value that are considered temporary are recorded as a separate component of other comprehensive income, net of tax. If an impairment of a security is identified as other-than-temporary based on information available, such as the decline in the creditworthiness of the issuer, external market ratings or the anticipated or realized elimination of associated dividends, such impairments are further analyzed to determine if a credit loss exists. If there is a credit loss, it will be recorded in the consolidated statement of operations. Unrealized losses other than credit losses will continue to be recognized in other comprehensive income, net of tax. Unrealized losses reflected in the preceding tables have not been included in the results of operations because the unrealized losses were not deemed other-than-temporary. Management does not have the intent to sell the securities and has determined that it is not more likely than not that the Company will be required to sell the debt securities before their anticipated recovery and therefore, there is no other-than-temporary impairment.

19

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

7.	Loans
	Loans held for investment, including purchased loan participations from other financial institutions and in the syndicated loan market, are summarized as follows (dollar amounts in thousands):

	June 30, 2014			December 31, 2013
Construction	$	38,047		$	36,948
Real estate-residential		146,601			142,398
Real estate-commercial		291,031			287,815
Commercial		129,936			125,290
Consumer		6,165			6,495
Tax exempt		18,420			19,435
Gross loans		630,200			618,381
Less: Deferred origination fees, net of costs		(378	)		(421	)
Less: Allowance for loan losses		(7,443	)		(7,658	)
Loans, net	$	622,379		$	610,302

Loans having a carrying value of $136.9 million and $132.6 million are pledged as collateral for borrowings from the FHLB at June 30, 2014 and December 31, 2013, respectively.

A breakdown of the allowance for loan losses and recorded investment in loans as of and for the six months ended June 30, 2014 is as follows (dollar amounts in thousands):

	Construction			Real Estate- Residential			Real Estate- Commercial			Commercial			Consumer			Tax Exempt		Not Specifically Allocated			Total
Allowance for Loan Losses:
Beginning balance	$	372		$	1,373		$	4,431		$	663		$	64		$	—	$	755		$	7,658
Charge-offs		(2	)		(77	)		(309	)		(83	)		(41	)		—		—			(512	)
Recoveries		47			97			125			21			7			—		—			297
Provision		(112	)		(225	)		(115	)		683			18			—		(249	)		—
Ending balance	$	305		$	1,168		$	4,132		$	1,284		$	48		$	—	$	506		$	7,443
Loans:
Ending balance	$	38,047		$	146,601		$	290,653		$	129,936		$	6,165		$	18,420	$	—		$	629,822
ALL		(305	)		(1,168	)		(4,132	)		(1,284	)		(48	)		—		(506	)		(7,443	)
Recorded investment	$	37,742		$	145,433		$	286,521		$	128,652		$	6,117		$	18,420	$	(506	)	$	622,379
Ending balance:
Individually evaluated	$	660		$	609		$	13,356		$	887		$	10		$	—	$	—		$	15,522
Collectively evaluated		37,387			145,992			277,297			129,049			6,155			18,420		—			614,300
Total	$	38,047		$	146,601		$	290,653		$	129,936		$	6,165		$	18,420	$	—		$	629,822

20

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

A breakdown of the allowance for loan losses and recorded investment in loans as of and for the year ended December 31, 2013 is as follows (dollar amounts in thousands):

	Construction			Real Estate- Residential			Real Estate- Commercial			Commercial			Consumer			Tax Exempt		Not Specifically Allocated			Total
Allowance for Loan Losses:
Beginning balance	$	652		$	1,658		$	5,787		$	678		$	102		$	—	$	288		$	9,165
Charge-offs		(93	)		(552	)		(2,132	)		(758	)		(55	)		—		—			(3,590	)
Recoveries		15			100			269			272			27			—		—			683
Provision		(202	)		167			507			471			(10	)		—		467			1,400
Ending balance	$	372		$	1,373		$	4,431		$	663		$	64		$	—	$	755		$	7,658
Loans:
Ending balance	$	36,948		$	142,398		$	287,394		$	125,290		$	6,495		$	19,435	$	—		$	617,960
ALL		(372	)		(1,373	)		(4,431	)		(663	)		(64	)		—		(755	)		(7,658	)
Recorded investment	$	36,576		$	141,025		$	282,963		$	124,627		$	6,431		$	19,435	$	(755	)	$	610,302
Ending balance:
Individually evaluated	$	660		$	540		$	14,181		$	266		$	21		$	—	$	—		$	15,668
Collectively evaluated		36,288			141,858			273,213			125,024			6,474			19,435		—			602,292
Total	$	36,948		$	142,398		$	287,394		$	125,290		$	6,495		$	19,435	$	—		$	617,960

A summary of past due loans at June 30, 2014 and December 31, 2013 is as follows (dollar amounts in thousands):

	June 30, 2014
	30-89 Days Past Due (accruing)		90 Days or More Past Due on Non-accrual		Total
Construction	$	103	$	660	$	763
Real estate – residential		924		608		1,532
Real estate – commercial		999		4,907		5,906
Commercial		222		865		1,087
Consumer		29		10		39
Tax exempt		—		—		—
Total	$	2,277	$	7,050	$	9,327

21

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

	December 31, 2013
	30-89 Days Past Due (accruing)		90 Days or More Past Due on Non-accrual		Total
Construction	$	—	$	660	$	660
Real estate – residential		363		540		903
Real estate – commercial		676		5,171		5,847
Commercial		15		266		281
Consumer		26		21		47
Tax exempt		—		—		—
Total	$	1,080	$	6,658	$	7,738

Credit Quality: Management utilizes a risk grading matrix on each of the Company’s commercial loans. Loans are graded on a scale of 0001 to 0007. A description of the loan grades is as follows:

0001 - Excellent risk. Borrowers of highest quality and character. Almost no risk possibility. Balance sheets are very strong with superior liquidity, excellent debt capacity and low leverage. Cash flow trends are positive and stable. Excellent ratios.

0002 - Very good risk. Good ratios in all areas. High quality borrower. Normally quite liquid. Differs slightly from a 0001 customer.

0003 - Strong in most categories. Possible higher levels of debt or shorter track record. Minimal attention required. Good management.

0004 - Better than average risk. Adequate ratios, fair liquidity, desirable customer. Proactive management. Performance trends are positive. Any deviations are limited and temporary.

0005 - Satisfactory risk. Some ratios slightly weak. Overall ability to repay is adequate. Capable and generally proactive management in all critical positions. Margins and cash flow may lack stability but trends are stable to positive. Company is normally profitable year to year but may experience an occasional loss.

0006 A - Weakness detected in either management, capacity to repay or balance sheet. Erratic profitability and financial performance. Loan demands more attention. Includes loans deemed to have weaknesses but that are less than 90 days past due.

0006 B - Have weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Bank’s collateral position at some future date. Loans with this rating do not expose the Bank to sufficient risk to warrant adverse classification. Includes loans deemed to have weaknesses but are less than 90 days past due.

0007 – Have well defined weaknesses and trends that jeopardize the repayment of the loan. Range from workout to legal. Includes loans that are on nonaccrual and/or are 90 days or more past due.

In addition to the risk grading on commercial loans, management utilizes a risk grading process on its real estate mortgage, consumer, and municipal loans when the loan becomes past due 90 days or more and/or is moved to nonaccrual status.

22

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

Below is a breakdown of loans by risk grading as of June 30, 2014 (dollar amounts in thousands):

	0001-0005			0006A			0006B			0007(1)			Total
Commercial	$	118,717		$	9,353		$	702		$	1,164		$	129,936
Real estate – commercial		243,978			24,649			3,641			18,763			291,031
Construction		34,577			1,553			1,081			856			38,047
		397,272			35,535			5,424			20,783			459,014
Real estate - residential		143,492			1,431			419			1,259			146,601
Consumer		6,155			—			—			10			6,165
Tax exempt		17,396			1,024			—			—			18,420
Total	$	564,315		$	37,990		$	5,843		$	22,052			630,200
Deferred origination fees, net of costs														(378	)
Total loans													$	629,822
Percent of Total Loans		89.6	%		6.0	%		0.9	%		3.5	%		100.0	%

⁽¹⁾Included in the 0007 risk grading are $6.5 million of loans that are collectively evaluated and not considered impaired because, in the event of default, no loss is expected.

Below is a breakdown of loss by risk grading as of December 31, 2013 (dollar amounts in thousands):

	0001-0005			0006A			0006B			0007(2)			Total
Commercial	$	118,284		$	2,510		$	3,080		$	1,416		$	125,290
Real estate – commercial		237,773			20,732			10,549			18,761			287,815
Construction		33,125			1,857			1,105			861			36,948
		389,182			25,099			14,734			21,038			450,053
Real estate - residential		139,364			1,305			464			1,265			142,398
Consumer		6,473			—			—			22			6,495
Tax exempt		19,435			—			—			—			19,435
Total	$	554,454		$	26,404		$	15,198		$	22,325			618,381
Deferred origination fees, net of costs														(421	)
Total loans													$	617,960
Percent of Total Loans		89.7	%		4.3	%		2.4	%		3.6	%		100.0	%

⁽²⁾Included in the 0007 risk grading are $6.7 million of loans that are collectively evaluated and not considered impaired because, in the event of default, no loss is expected.

Loan balances with a risk grading of 0005 or better were $564.3 million as of June 30, 2014, representing 89.6% of the total loan portfolio, versus $554.5 million as of December 31, 2013, representing 89.7% of the total loan portfolio.

Loan balances with a risk grading of 0006A increased by $11.6 million since December 31, 2013. The increase resulted from $10.0 million of loans (primarily three relationships) being downgraded from 0001-0005 ratings to the 0006A category and $5.3 million of loans (primarily two relationships) being upgraded from risk category 0006B to 0006A. These increases were offset in part by $2.5 million (primarily one loan relationship) being upgraded to risk category 0005 and $1.0 million of loans in category 0006A that paid off during the first six months of 2014.

Loan balances with a risk grading of 0006B have decreased by $9.3 million since December 31, 2013. The decrease resulted primarily from $0.1 million of additions due to net ratings downgrades which were more than offset by the $5.3 million of loan upgrades moved to category 0006A, $1.2 million of loans (primarily one loan relationship) moved to risk rating 0007 and a $2.3 million loan relationship which paid off during the first six months of 2014. The net movement in these troubled assets from risk category 0006B to 0006A continues to be an indication of improvement in the quality of the loan portfolio as management actively works to prudently resolve problem credits.

23

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

Loan balances with risk grading of 0007 decreased $0.3 million from December 31, 2013 due to payoffs of $1.2 million and charge-offs of $0.4 million, offset in part by $1.2 million of loans (primarily one loan relationship) downgraded from 0006B to 0007 during the first six months of 2014.

8.	Allowance For Loan Losses (“ALL”)
	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 Company’s consolidated balance sheet. Loan losses are charged off against the ALL, while recoveries of amounts previously charged off are credited to the ALL. A provision for loan losses (“PFLL”) is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
	The ALL consists of specific reserves on certain impaired loans and general reserves for non-impaired loans. Specific reserves reflect estimated losses 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 the Bank’s historical loss experience which is updated quarterly. The general reserve portion of the ALL also includes consideration of certain qualitative factors such as 1) changes in the nature, volume and terms of loans, 2) changes in lending personnel, 3) changes in the quality of the loan review function, 4) changes in nature and volume of past-due, nonaccrual and/or classified loans, 5) changes in concentration of credit risk, 6) changes in economic and industry conditions, 7) changes in legal and regulatory requirements, 8) unemployment and inflation statistics, and 9) changes in underlying collateral values.
	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 that 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 the Company’s 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 regulators may require that changes in the ALL be recognized when such regulators’ credit evaluations differ from those of management based on information available to the regulators at the time of their examinations.

24

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

Information regarding impaired loans is as follows (dollar amounts in thousands):

IMPAIRED LOANS AND ALLOCATED ALLOWANCE

June 30, 2014	Construction		Real Estate- Residential		Real Estate- Commercial		Commercial		Consumer		Tax Exempt		Not Specifically Allocated		Totals
With an allowance recorded:
Recorded investment	$	649	$	282	$	805	$	—	$	—	$	—	$	—	$	1,736
Unpaid principal balance		660		386		1,230		652		—		—		—		2,928
Related allowance		11		104		425		652		—		—		—		1,192
With no related allowance recorded:
Recorded investment	$	—	$	223	$	12,126	$	235	$	10	$	—	$	—	$	12,594
Unpaid principal balance		—		223		12,126		235		10		—		—		12,594
Related allowance		—		—		—		—		—		—		—		—
Total:
Recorded investment	$	649	$	505	$	12,931	$	235	$	10	$	—	$	—	$	14,330
Unpaid principal balance		660		609		13,356		887		10		—		—		15,522
Related allowance		11		104		425		652		—		—		—		1,192
Average recorded investment during quarter	$	703	$	534	$	14,631	$	310	$	16	$	—	$	—	$	16,194
Interest income recognized while impaired during the period	$	—	$	4	$	170	$	—	$	—	$	—	$	—	$	174

December 31, 2013	Construction		Real Estate- Residential		Real Estate- Commercial		Commercial		Consumer		Tax Exempt		Not Specifically Allocated		Totals
With an allowance recorded:
Recorded investment	$	—	$	201	$	1,032	$	19	$	—	$	—	$	—	$	1,252
Unpaid principal balance		—		277		1,569		49		—		—		—		1,895
Related allowance		—		76		537		30		—		—		—		643
With no related allowance recorded:
Recorded investment	$	660	$	263	$	12,611	$	218	$	21	$	—	$	—	$	13,773
Unpaid principal balance		660		263		12,611		218		21		—		—		13,773
Related allowance		—		—		—		—		—		—		—		—
Total:
Recorded investment	$	660	$	464	$	13,643	$	237	$	21	$	—	$	—	$	15,025
Unpaid principal balance		660		540		14,180		267		21		—		—		15,668
Related allowance		—		76		537		30		—		—		—		643
Average recorded investment during quarter	$	767	$	434	$	13,503	$	227	$	31	$	—	$	—	$	14,962
Interest income recognized while impaired during the period	$	3	$	8	$	316	$	—	$	—	$	—	$	—	$	329

Management regularly monitors impaired loan relationships. In the event facts and circumstances change, an additional PFLL may be necessary.

25

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

Nonperforming loans are as follows (dollar amounts in thousands):

NONPERFORMING LOANS

	June 30, 2014		March 31, 2014		December 31, 2013		September 30, 2013		June 30, 2013
Nonaccrual loans	$	6,794	$	6,686	$	6,403	$	6,215	$	8,231
Loans restructured in a troubled debt restructuring, nonaccrual		256		255		255		299		114
Total nonperforming loans (“NPLs”)	$	7,050	$	6,941	$	6,658	$	6,514	$	8,345
Restructured loans, accruing	$	8,472	$	8,370	$	9,009	$	9,020	$	3,959

During the quarter ended June 30, 2014, $0.1 million of nonaccrual loans were brought current, $0.1 million were charged off, $0.1 million were transferred to other real estate, and $0.4 million of pay downs were received on nonaccrual loans. Offsetting those decreases were $0.8 million of additions to nonaccrual loans. Restructured loans accruing interest increased during the second quarter of 2014 due to one loan of $0.1 million being restructured during the quarter involving a reduction of interest rate terms.

9.	Other Real Estate Owned, Net
	Other real estate owned is summarized as follows (dollar amounts in thousands):

	For the six months ended June 30,
	2014			2013
Beginning balance	$	8,566		$	14,334
Transfer of net realizable value to other real estate owned		75			696
Sale proceeds		(1,162	)		(3,302	)
Net gain from disposal of other real estate owned		43			128
Valuation allowance related to properties disposed		(646	)		(1,382	)
Total other real estate owned		6,876			10,474
Valuation allowance for losses		(1,823	)		(2,921	)
Total other real estate owned, net	$	5,053		$	7,553
Changes in the valuation allowance for losses on total other real estate owned were as follows (dollar amounts in thousands):
	For the six months ended June 30,
	2014			2013
Beginning balance	$	2,268		$	3,858
Provision charged to operations		201			445
Amounts related to properties disposed		(646	)		(1,382	)
Balance at end of period	$	1,823		$	2,921

26

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

10.	Income Taxes
	In accordance with the accounting guidance for income taxes, deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred income tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
	A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination. The amount recognized is the largest amount of tax benefit that has a greater than 50% chance of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
	Management regularly reviews the carrying amount of the Company’s deferred income tax assets to determine if the establishment of a valuation allowance is necessary. If, based on the available evidence, it is more likely than not that all or a portion of the deferred income tax assets will not be realized in future periods, a deferred income tax valuation allowance would be established. Consideration is given to various positive and negative factors that could affect the realization of the deferred income tax assets. In evaluating available evidence, management considers, among other things, historical financial performance, expectation of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carryforward periods, experience with operating loss and tax credit carryforwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earning trends and the timing of reversals of temporary differences. The evaluation is based on current tax laws as well as management’s expectations of future performance. At June 30, 2014 and December 31, 2013, the Company determined that no valuation allowance was required to be taken against the deferred income tax asset.
	The Company is subject to the income tax laws of the U.S., its states and municipalities. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. Accounting guidance related to uncertainty in income taxes prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under the guidance, tax positions shall initially be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions shall initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50% chance of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The guidance also revises disclosure requirements to include an annual tabular roll forward of unrecognized tax benefits. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws within the framework existing under U.S. GAAP. The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
	The Company is no longer subject to examination by U.S. Federal taxing authorities for years before 2010 and for Wisconsin state income taxes for years before 2009. During the third quarter of 2013, the IRS began an audit of the Company’s 2011 federal income tax return. The audit concluded in the fourth quarter of 2013 and the Company received a refund of $0.2 million in the first quarter of 2014 resulting from identification during the audit of timing differences of deductions taken for income tax purposes.

27

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

11.	Equity Investment
	The Bank owns a 49.8% interest (500 shares) in United Financial Services, Inc. (“UFS”), a data processing company. In addition to the ownership interest, the Bank and UFS have a common member on each of their respective Boards of Directors. The investment in this entity is carried on the Bank’s balance sheet under the equity method of accounting and the pro rata share of its net income is included in noninterest income in the consolidated statement of operations and increases the Bank’s investment. As dividends are received from UFS, the investment is reduced. The carrying value of the investment in UFS was $4.2 million at June 30, 2014 and $3.8 million at December 31, 2013. The book value of UFS was approximately $8,309 per share and $7,697 per share at June 30, 2014 and December 31, 2013, respectively.
	On June 28, 2013, UFS acquired a similar data processing entity located in St. Louis, Missouri, expanding its service base from Wisconsin to four additional states.
12.	Mortgage Servicing Rights
	The Company has obligations to service residential first mortgage loans and commercial loans that have been sold in the secondary market with servicing retained. Mortgage servicing rights (“MSRs”) are recorded at fair value when loans are sold in the secondary market with servicing retained. On a quarterly basis, MSRs are valued based on a valuation model that calculates the fair value using assumptions that market participants would use in estimating the present value of future net servicing income.
	Changes in the carrying value of MSRs are as follows (dollar amounts in thousands):
MORTGAGE SERVICING RIGHTS
		For the three months ended June 30,						For the six months ended June 30,
		2014			2013			2014			2013
	Balance at beginning of period	$	906		$	948		$	967		$	839
	Additions from loans sold with servicing retained		15			55			31			166
	Loan payments and payoffs		(25	)		(38	)		(45	)		(91	)
	Changes in valuation		(32	)		(80	)		(89	)		(29	)
	Fair value of MSRs at the end of period	$	864		$	885		$	864		$	885
	Unpaid principal balance of loans serviced for others was $123.4 million and $128.1 million at June 30, 2014 and June 30, 2013, respectively.

28

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

13.	Promissory Notes
	During 2009 and 2010, the Company issued 10% Convertible Notes due June 30, 2017 totaling $9.5 million. The Convertible Notes were offered and sold in reliance on the exemption from registration under Section 4(2) of the Securities Act of 1933 and Rule 506 promulgated thereunder.
	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 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. Beginning on July 1, 2014, the Company may redeem the notes in whole or in part. A notice of redemption supersedes and takes priority over any notice of conversion. Prior to the five year anniversary of issuance, 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 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, along with accrued, but unpaid interest, of any Convertible Note that has not been converted will be payable at maturity on June 30, 2017. The outstanding principal balance at June 30, 2014 is $8.2 million. During the second quarter of 2014, $1.0 million of Convertible Notes were converted into 205,000 shares of the Company’s common stock at the option of the holder. Subsequent to June 30, 2014 an additional $3.8 million of Convertible Notes were converted into 760,000 shares of the Company’s common stock at the option of the holders.

29

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

14.	Troubled Debt Restructuring
	A troubled debt restructuring (“TDR”) is a loan modification resulting from a borrower experiencing financial difficulty and the Bank granting a concession to that borrower that would not otherwise be considered except for the borrower’s financial difficulties. A TDR may be either accrual or nonaccrual status based upon the performance of the borrower and management’s assessment of collectability. A TDR remains as such until a sufficient period of performance under the restructured terms has occurred, generally six months, at which time it is no longer deemed to be restructured.
	Changes in troubled debt restructurings for the six months ended June 30, 2014 are as follows (dollars in thousands):

	Construction		Real Estate- Residential		Real Estate- Commercial			Commercial			Consumer		Tax Exempt		Total
Accruing
December 31, 2013	$	—	$	—	$	9,009		$	—		$	—	$	—	$	9,009
Principal payments		—		—		(16	)		(4	)		—		—		(20	)
Charge-offs		—		—		—			—			—		—		—
Advances		—		—		3			—			—		—		3
New restructured		—		—		111			27			—		—		138
Transferred out of TDRs		—		—		(658	)		—			—		—		(658	)
Transfers to nonaccrual		—		—		—			—			—		—		—
June 30, 2014	$	—	$	—	$	8,449		$	23		$	—	$	—	$	8,472
Nonaccrual
December 31, 2013	$	—	$	—	$	255		$	—		$	—	$	—	$	255
Principal payments		—		—		—			—			—		—		—
Charge-offs		—		—		—			—			—		—		—
Advances		—		—		1			—			—		—		1
New restructured		—		—		—			—			—		—		—
Transfers to other real estate owned		—		—		—			—			—		—		—
Transfers from accruing		—		—		—			—			—		—		—
June 30, 2014	$	—	$	—	$	256		$	—		$	—	$	—	$	256
Totals
December 31, 2013	$	—	$	—	$	9,264		$	—		$	—	$	—	$	9,264
Principal payments		—		—		(16	)		(4	)		—		—		(20	)
Charge-offs		—		—		—			—			—		—		—
Advances		—		—		4			—			—		—		4
New restructured		—		—		111			27			—		—		138
Transfers out of TDRs		—		—		(658	)		—			—		—		(658	)
Transfers to other real estate owned		—		—		—			—			—		—		–
June 30, 2014	$	—	$	—	$	8,705		$	23		$	—	$	—	$	8,728

30

BAYLAKE CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2014

During the six months ended June 30, 2014, two loan balances totaling $0.1 million were transferred to restructured status. The larger of the two loans with a balance of $0.1 million was restructured as a reduction of interest rate terms. The smaller loan balance was restructured as an A/B split structure. Also during the six months ended June 30, 2014, a $0.7 million accruing restructured loan was removed from restructured status due to compliance with its restructured terms for a sufficient period of time, generally six months.

A summary of troubled debt restructurings as of June 30, 2014 and December 31, 2013 is as follows (dollar amounts in thousands):

	June 30, 2014				December 31, 2013
	Number of Modifications		Recorded Investment		Number of Modifications		Recorded Investment
Construction		—	$	—		—	$	—
Real estate – residential		—		—		—		—
Real estate – commercial		7		8,705		8		9,264
Commercial		1		23		—		—
Consumer		—		—		—		—
Tax exempt		—		—		—		—
Total		8	$	8,728		8	$	9,264

A summary of troubled debt restructurings as of June 30, 2014 by restructure type is as follows (dollar amounts in thousands):

	Accruing		Nonaccruing		Total
A/B Note Structure	$	22	$	—	$	22
Payment schedule changes		6,371		256		6,627
Interest rate reduction		2,079		—		2,079
Total	$	8,472	$	256	$	8,728

15. Commitments and Contingencies

The following is a summary of the Company’s off-balance sheet commitments, all of which were lending-related commitments:

LENDING RELATED COMMITMENTS
(Dollar amounts in thousands)

	June 30, 2014		December 31, 2013
Commitments to fund unused home equity line loans	$	61,054	$	59,022
Commitments to fund 1-4 family loans		5,335		1,350
Commitments to fund residential real estate construction loans		3,517		2,549
Commitments unused on commercial lines of credit loans		156,201		156,177
Commitments unused on consumer lines of credit loans		9,293		9,110
Total commitments to extend credit	$	235,400	$	228,208
Financial standby letters of credit	$	11,796	$	9,898

31

Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

Baylake Corp. (“we,” “us” or “our”) 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. We have two wholly-owned subsidiaries: Admiral Asset Management, LLC (“Admiral”) and Baylake Bank (the “Bank”). Admiral was formed in the fourth quarter of 2013 as a registered investment advisory subsidiary to provide investment advisory services in addition to those offered by the Bank. Our banking subsidiary, the Bank, is a Wisconsin state-chartered bank that provides a wide variety of loan, deposit and other banking products and services to its business, retail, and municipal customers, as well as a full range of trust, investment and cash management services. The Bank is a member of the Federal Reserve and the Federal Home Loan Bank of Chicago.

The following sets forth management’s discussion and analysis of our consolidated financial condition at June 30, 2014 and December 31, 2013 and our consolidated results of operations for the three and six months ended June 30, 2014 and 2013. 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, 2013.

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 Part II of this Quarterly Report on Form 10-Q and Part I of our Annual Report on Form 10-K for the year ended December 31, 2013, which are incorporated herein by reference, and other risks that may be identified or discussed in this Form 10-Q.

Branch Purchase

On February 7, 2014 we consummated the purchase of a branch facility located in Outagamie County, Wisconsin and $13.7 million in related deposits. This transaction resulted in $0.1 million of core deposits intangible and $0.6 million of goodwill.

Critical Accounting Policies

In the course of our normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in our consolidated financial statements. The following is a summary of what management believes are our critical accounting policies.

Allowance for Loan Losses (“ALL”): The ALL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALL requires the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on our consolidated balance sheet. Loan losses are charged off against the ALL while recoveries of amounts previously charged off are credited to the ALL. A Provision for Loan Losses (“PFLL”) is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.

The ALL consists of specific reserves on certain impaired loans and general reserves for non-impaired loans. Specific reserves reflect estimated losses on impaired loans from analyses developed through specific credit allocations for individual loans. The specific credit allocations are based on regular analyses of all impaired non-homogenous loans. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based on our historical loss experience which is updated quarterly. The general reserve portion of the ALL also includes consideration of certain qualitative factors such as (i) changes in the nature, volume and terms of loans, (ii) changes in lending personnel, (iii) changes in the quality of the loan review function, (iv) changes in nature and volume of past-due, nonaccrual and/or classified loans, (v) changes in concentration of credit risk, (vi) changes in economic and industry conditions, (vii) changes in legal and regulatory requirements, (viii) unemployment and inflation statistics, and (ix) changes in underlying collateral values.

32

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.

Other Real Estate Owned: Other real estate owned 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 the fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Costs incurred after acquisition are expensed.

Income Tax Accounting: The assessment of income tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of our operations and reported earnings.

Goodwill: Goodwill represents the excess of the cost of businesses acquired over fair value of net identifiable assets at the date of acquisition. Goodwill is not amortized but is subject to impairment tests on an annual basis or more frequently if deemed appropriate. Goodwill is subject to a periodic assessment by applying a fair value test based upon a two-step method. The first step of the process compares the fair value of the reporting unit with its carrying value, including any goodwill. During 2013, 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 accounting principles generally accepted in the United States of America 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, 2013, our most recent annual valuation exceeded our carrying value by a range of 41% to 52%.

In conjunction with our first quarter of 2014 purchase of the branch facility in Outagamie County, Wisconsin, $0.6 million of additional goodwill was recorded. As of June 30, 2014 the total balance of goodwill held on our balance sheet was $7.2 million. As of June 30, 2014, there are no conditions that would require goodwill impairment to be reevaluated.

33

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, 2014 and 2013.

SUMMARY RESULTS OF OPERATIONS
(Dollar amounts in thousands, except per share data)

	Three months ended June 30,						Six months ended June 30,
	2014			2013			2014			2013
Net income, as reported	$	2,159		$	1,731		$	4,224		$	3,486
Earnings per share-basic, as reported	$	0.27		$	0.22		$	0.54		$	0.44
Earnings per share-diluted, as reported	$	0.24		$	0.19		$	0.47		$	0.38
Cash dividends declared per share	$	0.07		$	0.05		$	0.14		$	0.09
Return on average assets		0.88	%		0.73	%		0.88	%		0.73	%
Return on average equity		9.00	%		7.31	%		8.94	%		7.45	%
Efficiency ratio(1)		68.72	%		68.46	%		68.87	%		67.78	%

⁽¹⁾    Noninterest expense divided by the sum of taxable equivalent net interest income plus noninterest income, excluding net investment securities gains, net gains on the sale of fixed assets, and net gain on sale of branches. A lower ratio indicates greater efficiency.

Net income of $2.2 million for the three months ended June 30, 2014 increased from net income of $1.7 million for the comparable period in 2013. Net interest income was $7.8 million for the quarter ended June 30, 2014 and $7.3 million for the comparable quarter last year, resulting from a $0.2 million increase in interest income and a $0.3 million reduction in interest expense. No PFLL was charged to operations for the second quarter of 2014, compared to the $0.6 million PFLL taken during the comparable quarter of 2013. Noninterest income decreased by $0.2 million in the second quarter of 2014 versus the comparable quarter of 2013, primarily related to a $0.3 million reduction in gains on the sale of loans offset in part by a $0.1 million increase in income related to our equity ownership in UFS. Noninterest expense was relatively unchanged at $7.0 million for the second quarter of 2014 compared to $6.7 million for the comparable quarter of 2013.

Net income of $4.2 million for the six months ended June 30, 2014 increased from net income of $3.5 million for the comparable period in 2013. Net interest income was $15.4 million for the six months ended June 30, 2014 and $14.7 million for the comparable period last year, resulting from a $0.1 million increase in interest income and a $0.6 million reduction in interest expense. No PFLL was charged to operations for the six month of 2014, compared to the $1.2 million PFLL taken during the comparable period of 2013. Noninterest income decreased by $0.7 million in the six months of 2014 versus the comparable period of 2013, primarily related to a $0.8 million reduction in gains on the sale of loans offset in part by a $0.1 million increase in income related to our equity ownership in UFS. Noninterest expense for the six months ended June 30, 2014 and 2013 was $13.8 million and $13.5 million, respectively. The increase resulted primarily from an increase in salaries and benefits of $0.4 million (4.5%) and an increase in other outside services of $0.2 million (63.0%) offset in part by a reduction in expenses relating to the collection of loans of $0.1 million (74.8%) and operation of other real estate of $0.3 million (45.5%).

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 $8.1 million for the three months ended June 30, 2014, compared to $7.6 million for the same period in 2013. The increase for the second quarter of 2014 resulted primarily from a $0.3 million decrease in interest expense on interest-bearing liabilities and by a $0.2 million increase in interest income on interest-earning assets. Interest income increased to $9.1 million for the three months ended June 30, 2014 compared to $8.8 million for the same period in 2013. Contributing to the change was an increase in average earning assets to $896.3 million for the second quarter of 2014 compared to $860.1 million of average earning assets at June 30, 2013. However, the yield on average earning assets for the quarter ended June 30, 2014 decreased 7 bps to 4.05% compared to 4.12% for the same period in 2013 due to the average yield on loans declining 19 bps to 4.58% for the second quarter of 2014 from 4.77% for the same period in 2013. This was offset in part by increases in yields on both taxable and tax-exempt securities during the second quarter of 2014 compared to the second quarter of 2013.

34

Average interest-bearing liabilities for the three months ended June 30, 2014 increased to $750.2 million from $727.8 million for the same period in 2013 in addition to an increase of noninterest-bearing demand deposits to $125.1 million for the three months ended June 30, 2014 from $115.9 million for the comparable three month period in 2013.

The cost of average interest-bearing liabilities for the three months ended June 30, 2014 declined 16 bps to 0.51% from 0.67% for the same quarter of 2013. The reductions in the cost of interest-bearing liabilities resulted primarily from the maturity of higher cost term funding, both core and wholesale as well as the use of lower cost FHLB advances in the continued low rate environment.

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 improved to 3.54% for the second quarter of 2014 from 3.45% for the second quarter of 2013, resulting from the 16 bp decrease in the cost of interest-bearing liabilities from 0.67% to 0.51% offset in part by the 7 bp decrease in the yield on earning assets from 4.12% to 4.05%.

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 2014 was 3.63% compared to 3.55% from the same period in 2013.

For the three months ended June 30, 2014, average interest-earning assets increased $36.2 million (4.2%) from the same period in 2013. Increases in federal funds sold and interest-bearing due from financial institutions balances of $11.5 million (61.2%), and an increase of $37.6 million (6.3%) in average loans were partially offset by a $12.0 million (6.0%) decrease in average taxable securities and a slight reduction in tax exempt securities of $0.1 million.

Net interest income on a tax-equivalent basis was $15.9 million for the six months ended June 30, 2014, compared to $15.2 million for the same period in 2013. The increase for the six months of 2014 resulted primarily from a $0.6 million decrease in interest expense on interest-bearing liabilities and by a $0.1 million increase in interest income on interest-earning assets. Interest income increased to $17.8 million for the six months ended June 30, 2014 compared to $17.7 million for the same period in 2013. Contributing to the increase was a $6.7 million increase in average earning assets to $883.5 million for the six months ended June 30, 2014 compared to $876.8 million of average earning assets at June 30, 2013. However, the yield on average earning assets for the six months ended June 30, 2014 decreased 2 bps to 4.06% compared to 4.08% for the same period in 2013.

Average interest-bearing liabilities for the six months ended June 30, 2014 declined to $741.4 million from $744.5 million for the same period in 2013 offset in part with an increase of noninterest-bearing demand deposits to $122.6 million for the six months ended June 30, 2014 from $115.9 million for the comparable six month period in 2013.

The cost of average interest-bearing liabilities for the six months ended June 30, 2014 declined 17 bps to 0.51% from 0.68% for the same period in 2013. The reductions in the cost of interest-bearing liabilities during the first six months of 2014 compared to the same period in 2013 resulted primarily from the maturity of higher cost term funding, both core and wholesale as well as the use of lower cost FHLB advances in the continued low rate environment.

Interest rate spread improved to 3.56% for the first six months of 2014 compared to 3.40% for the same period in 2013, resulting primarily from the 18 bp decrease in the cost of interest-bearing liabilities from 0.68% to 0.50%, offset in part by the 2 bp decrease in the yield on earning assets from 4.08% to 4.06%.

Net interest margin for the six months ended June 30, 2014 was 3.64% compared to 3.50% from the same period in 2013.

For the six months ended June 30, 2014, average interest-earning assets increased $6.8 million from the same period in 2013. A $34.3 million (5.8%) increase in average loans was offset in part by decreases in average taxable securities of $17.2 million (8.4%), federal funds sold and interest-bearing due from financial institutions balances of $9.8 million (30.1%), and a slight reduction in tax exempt securities account for the change.

35

NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS (Dollar amounts in thousands)

	Three months ended June 30, 2014							Three months ended June 30, 2013
	Average Balance		Interest Income/ Expense		Average Yield/ Rate			Average Balance		Interest Income/ Expense		Average Yield/ Rate
ASSETS
Average Interest-Earning Assets:
Loans (1,2)	$	632,472	$	7,229		4.58	%	$	594,883	$	7,074		4.77	%
Taxable securities		188,650		1,249		2.65	%		200,698		1,179		2.35	%
Tax exempt securities(1)		44,934		561		5.00	%		45,805		563		4.92	%
Federal funds sold and interest-bearing due from financial institutions		30,250		19		0.25	%		18,705		15		0.32	%
Total interest-earning assets		896,306		9,058		4.05	%		860,091		8,831		4.12	%
Noninterest earning assets		82,558							85,377
Total assets	$	978,864						$	945,468
LIABILITIES AND STOCKHOLDERS’ EQUITY
Average Interest-Bearing Liabilities:
Total interest-bearing deposits	$	593,265		406		0.27	%	$	633,865		691		0.44	%
Customer repurchase agreements		38,903		24		0.24	%		28,416		15		0.21	%
Federal Home Loan Bank advances		93,716		241		1.03	%		40,000		201		2.02	%
Convertible promissory notes		8,175		213		10.44	%		9,400		244		10.38	%
Subordinated debentures		16,100		64		1.58	%		16,100		66		1.63	%
Total interest-bearing liabilities		750,159		948		0.51	%		727,781		1,217		0.67	%
Demand deposits		125,057							115,273
Accrued expenses and other liabilities		7,425							7,464
Stockholders’ equity		96,223							94,950
Total liabilities and stockholders’ equity	$	978,864						$	945,468
Net interest income			$	8,110						$	7,614
Interest rate spread(3)						3.54	%						3.45	%
Net interest margin (4)						3.63	%						3.55	%

(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.

36

NET INTEREST INCOME ANALYSIS ON A TAX-EQUIVALENT BASIS (Dollar amounts in thousands)

	Six months ended June 30, 2014							Six months ended June 30, 2013
	Average Balance		Interest Income/ Expense		Average Yield/ Rate			Average Balance		Interest Income/ Expense		Average Yield/ Rate
ASSETS
Average Interest-Earning Assets:
Loans (1,2)	$	628,527	$	14,182		4.55	%	$	594,261	$	14,170		4.81	%
Taxable securities		187,280		2,499		2.67	%		204,500		2,402		2.35	%
Tax exempt securities(1)		45,034		1,126		5.00	%		45,534		1,129		4.96	%
Federal funds sold and interest-bearing due from financial institutions		22,693		29		0.26	%		32,474		49		0.30	%
Total interest-earning assets		883,534		17,836		4.06	%		876,769		17,750		4.08	%
Noninterest earning assets		83,288							85,967
Total assets	$	966,822						$	962,736
LIABILITIES AND STOCKHOLDERS’ EQUITY
Average Interest-Bearing Liabilities:
Total interest-bearing deposits	$	598,602		827		0.28	%	$	647,150		1,455		0.45	%
Federal funds purchased		159		1		0.67	%		—		—		0.00	%
Customer repurchase agreements		41,643		50		0.24	%		31,882		35		0.22	%
Federal Home Loan Bank advances		76,224		414		1.10	%		40,000		400		2.02	%
Convertible promissory notes		8,685		452		10.41	%		9,400		488		10.38	%
Subordinated debentures		16,100		129		1.59	%		16,100		133		1.65	%
Total interest-bearing liabilities		741,413		1,873		0.50	%		744,532		2,511		0.68	%
Demand deposits		122,646							115,868
Accrued expenses and other liabilities		7,439							8,025
Stockholders’ equity		95,324							94,311
Total liabilities and stockholders’ equity	$	966,822						$	962,736
Net interest income			$	15,963						$	15,239
Interest rate spread(3)						3.56	%						3.40	%
Net interest margin (4)						3.64	%						3.50	%

(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.

37

RATE/VOLUME ANALYSIS⁽¹⁾
(Dollar amounts in thousands)

The following table presents an analysis of changes in net interest income resulting from changes in average volumes in interest-earning assets and interest-bearing liabilities, and average rates earned and paid for the three months ended June 30, 2014 compared to the three months ended June 30, 2013:

	Increase (Decrease) due to (1)
	Volume			Rate			Net
Interest income:
Loans	$	404		$	(249	)	$	155
Taxable securities		(78	)		148			70
Tax exempt securities		(11	)		9			(2	)
Federal funds sold and interest-bearing due from financial institutions		8			(4	)		4
Total interest-earning assets	$	323		$	(96	)	$	227
Interest expense:
Total interest-bearing deposits	$	(122	)	$	(163	)	$	(285	)
Repurchase agreements/short-term borrowings		6			3			9
FHLB advances		174			(134	)		40
Convertible promissory notes		(32	)		1			(31	)
Subordinated debentures		—			(2	)		(2	)
Total interest-bearing liabilities	$	26		$	(295	)	$	(269	)
Net interest income	$	297		$	199		$	496

⁽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.

Management’s ability to employ overall assets for the production of interest income can be measured by the ratio of average interest-earning assets to average total assets. This ratio was 91.6% for the three months ended June 30, 2014 improved from 91.0% for the three months ended June 30, 2013.

RATE/VOLUME ANALYSIS⁽¹⁾
(Dollar amounts in thousands)

The following table presents an analysis of changes in net interest income resulting from changes in average volumes in interest-earning assets and interest-bearing liabilities, and average rates earned and paid for the six months ended June 30, 2014 compared to the six months ended June 30, 2013:

	Increase (Decrease) due to(1)
	Volume			Rate			Net
Interest income:
Loans	$	735		$	(723	)	$	12
Taxable securities		(217	)		314			97
Tax exempt securities		(12	)		9			(3	)
Federal funds sold and interest-bearing due from financial institutions		(13	)		(7	)		(20	)
Total interest-earning assets	$	493		$	(407	)	$	86
Interest expense:
Total interest-bearing deposits	$	(272	)	$	(356	)	$	(628	)
Repurchase agreements/short-term borrowings		13			3			16
FHLB advances		252			(238	)		14
Convertible promissory notes		(37	)		1			(36	)
Subordinated debentures		—			(4	)		(4	)
Total interest-bearing liabilities	$	(44	)	$	(594	)	$	(638	)
Net interest income	$	537		$	187		$	724

⁽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.

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The ratio of average interest-earning assets to average total assets for the six months ended June 30, 2014 was 91.4%, increased from 91.1% for the same period in 2013.

Provision for Loan Losses:

The PFLL is the periodic cost of providing an allowance for probable and inherent losses in our loan portfolio. The ALL consists of specific and general components. Our internal risk system is used to identify loans that meet the criteria for being “impaired” as defined in the accounting guidance. The specific component relates to loans that are individually classified as impaired and where expected cash flows are less than carrying value. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. These qualitative factors include: 1) changes in the nature, volume and terms of loans, 2) changes in lending personnel, 3) changes in the quality of the loan review function, 4) changes in nature and volume of past-due, nonaccrual and/or classified loans, 5) changes in concentration of credit risk, 6) changes in economic and industry conditions, 7) changes in legal and regulatory requirements, 8) unemployment and inflation statistics, and 9) changes in underlying collateral values.

There was no PFLL for the quarter ended June 30, 2014 compared to $0.6 million for the second quarter of 2013. There were three impairments totaling $0.9 million during the second quarter of 2014 on loans not previously identified as being impaired. Loan charge-offs for the three months ended June 30, 2014 and 2013 were $0.1 million and $0.2 million, respectively.

There was no PFLL for the six months ended June 30, 2014 compared to $1.2 million for the same period in 2013. Loan charge-offs for the six months ended June 30, 2014 and 2013 were $0.5 million and $1.9 million, respectively. Net annualized charge-offs to average loans improved to 0.07% for the six months ended June 30, 2014 compared to 0.52% for the same period in 2013. For the six months ended June 30, 2014, nonperforming loans increased by $0.4 million (5.9%) to $7.1 million from $6.7 million at December 31, 2013. Refer to the “Financial Condition - Risk Management and the Allowance for Loan Losses” and “Financial Condition - Nonperforming Loans, Potential Problem Loans and Other Real Estate Owned” sections following for more information related to nonperforming loans.

Our management believes that the ALL at June 30, 2014 is 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.

39

Noninterest Income:

The following table reflects the various components of noninterest income for the three and six month periods ended June 30, 2014 and 2013, respectively.

NONINTEREST INCOME
(Dollar amounts in thousands)

	Three months ended								Six months ended
	June 30, 2014			June 30, 2013			% Change		June 30, 2014			June 30, 2013			% Change
Fees from fiduciary services	$	252		$	286			(11.9)%	$	504		$	537			(6.1)%
Fees from loan servicing		138			143			(3.5)%		300			293			2.4%
Service charges on deposit accounts		718			699			2.7%		1,349			1,326			1.7%
Other fee income		149			153			(2.6)%		315			316			(0.3)%
Financial services income		252			244			3.3%		518			557			(7.0)%
Net gains on sales of loans		126			440			(71.4)%		253			1,034			(75.5)%
Net change in valuation of mortgage servicing		(57	)		(118	)		51.7%		(134	)		(120	)		(11.7)%
Net gains from sale of securities		92			221			(58.4)%		161			209			(23.0)%
Gains from sale of fixed assets		5			5			0.0%		5			5			0.0%
Increase in cash surrender value of life insurance		124			91			36.3%		202			169			19.5%
Equity in income of UFS subsidiary		288			198			45.5%		582			433			34.4%
Other income		79			(3	)		2,733.3%		127			99			28.3%
Total Noninterest Income	$	2,166		$	2,359			(8.2)%	$	4,182		$	4,858			(13.9)%

Noninterest income decreased $0.2 million (8.2%) for the three months ended June 30, 2014 versus the comparable period in 2013 primarily due to a decrease in gain from sale of loans of $0.3 million (71.4%) offset in part by an increase of $0.1 million (45.5%) in equity income of UFS subsidiary.

Included in the fees for other services to customers in noninterest income on our consolidated statements of operations are service charges on deposit accounts, other fee income and financial services income.

Noninterest income decreased $0.7 million (13.9%) for the six months ended June 30, 2014 versus the comparable period in 2013 primarily due to a decrease in gain on sale of loans of $0.8 million (75.5%) offset in part by an increase of $0.1 million (34.4%) in equity income of UFS subsidiary.

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Noninterest Expense:

The following table reflects the various components of noninterest expense for the three and six months ended June 30, 2014 and 2013.

NONINTEREST EXPENSE
(Dollar amounts in thousands)

	Three months ended						Six months ended
	June 30, 2014		June 30, 2013		% Change		June 30, 2014		June 30, 2013		% Change
Salaries and employee benefits	$	4,389	$	3,908		12.3%	$	8,456	$	8,093		4.5%
Occupancy		514		483		6.4%		1,074		1,007		6.7%
Equipment		341		294		16.0%		654		589		11.0%
Data processing and courier		195		213		(8.5)%		403		420		(4.0)%
Operation of other real estate owned		141		364		(61.3)%		307		563		(45.5)%
Business development and advertising		171		190		(10.0)%		309		347		(11.0)%
Charitable contributions		14		16		(12.5)%		29		34		(14.7)%
Stationery and supplies		147		112		31.3%		252		214		17.8%
Director fees		97		93		4.3%		196		187		4.8%
FDIC insurance		151		178		(15.2)%		300		369		(18.7)%
Legal and professional		152		168		(9.5)%		329		343		(4.1)%
Loan and collection		18		52		(65.4)%		37		147		(74.8)%
Other outside services		291		185		57.3%		626		384		63.0%
Other operating expenses		373		423		(11.8)%		790		790		0.0%
Total Noninterest Expense	$	6,994	$	6,679		4.7%	$	13,762	$	13,487		2.0%

Total noninterest expense increased to $7.0 million for the three-month period ended June 30, 2014 from $6.7 million for the comparable period ended June 30, 2013. The noninterest expense to average assets ratio was 2.9% for the three months ended June 30, 2014 compared to 2.8% for the same period in 2013.

Total noninterest expense increased to $13.8 million for the six months ended June 30, 2014 from $13.5 million for the comparable period ended June 30, 2013. The noninterest expense to average assets ratio was 2.9% for the six months ended June 30, 2014 compared to 2.8% for the same period in 2013.

Net overhead expense is total noninterest expense less total noninterest income. The net overhead expense to average assets ratio was at 2.0% for the three months ended June 30, 2014 compared to 1.8% for the three months ended June 30, 2013. 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, premises and equipment, branch sales, and land held for sale). The efficiency ratio rose slightly from 68.5% for the quarter ended June 30, 2013 to 68.7% for the quarter ended June 30, 2014, and from 67.8% for the six months ended June 30, 2013 to 68.9% for the six months ended June 30, 2014.

Salaries and employee benefits were $8.5 million for the six months ended June 30, 2014, compared to $8.1 million for the six months ended June 30, 2013. Although the number of full-time equivalent employees decreased from 264 at June 30, 2013 to 258 at June 30, 2014 primarily related to the closing of three branches in the second and fourth quarters of 2013, these salary and benefit reductions were offset in part by the purchase of one additional branch in the first quarter of 2014 and investment in additional, higher compensated personnel in key areas of the bank. Commission expense for commissioned salespersons, including financial advisors and mortgage originators, may impact future salary expense based on the levels of production attained. Included in 2014 salary expense is $0.2 million of expense related to our long-term equity incentive plan and $0.2 million related to our performance-based incentive program.

Included in noninterest expense are FDIC insurance premiums of $0.3 million for the six months ended June 30, 2014 compared to $0.4 million for the same period a year ago, a decrease of $0.1 million. This decrease is attributable to a reduction by the FDIC in the assessment rate applied in the calculation of our premium reflecting our improved financial health and asset quality. Other outside services increased $0.2 million from $0.4 million for the six months ended June 30, 2013 to $0.6 million for the comparable period this year, primarily resulting from fees associated with cost, revenue and efficiency studies and fees incurred in connection with our NASDAQ Stock Market LLC presence and $0.1 million of cancellation costs associated with termination of a data processing contract.

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Income Taxes:

We recorded an income tax expense of $0.9 million for the three months ended June 30, 2014 versus an expense of $0.7 million for the same period in 2013. The increase in tax expense is primarily attributable to a year-over-year increase in pre-tax income for the second quarter of 2014 versus the comparable period of 2013. The effective tax rate for the three months ended June 30, 2014 decreased to 28.5% compared to 28.7% for the same period in 2013.

Income tax expense recorded for the six months ended June 30, 2014 was $1.6 million compared to $1.4 million for the same period in 2013. The increase in tax expense is primarily attributable to an increase in pre-tax income for the first six months of 2014 versus the same period in 2013. The effective tax rate for the six months ended June 30, 2014 and 2013 was 27.9% and 28.5%, respectively.

We maintain net deferred income tax assets for deductible temporary tax differences, such as allowance for loan losses, nonaccrual loan interest, and other real estate owned valuations as well as net operating loss carry forwards. Our determination of the amount of our deferred income tax assets to be realized is highly subjective and is based on several factors, including projected future income, income tax planning strategies, and federal and state income tax rules and regulations. At June 30, 2014, we determined that no valuation allowance was required to be taken against our net deferred income tax assets. We assess the amount of tax benefits we may realize in future periods in determining the necessity for any valuation allowance.

Financial Condition

Loans:

The following table reflects the composition (mix) of the loan portfolio:

	June 30, 2014			December 31, 2013			Percent Change
Amount of Loans by Type:
Real estate-mortgage:
Commercial	$	291,031		$	287,815			1.1%
1-4 family residential
First liens		102,257			97,859			4.5%
Junior liens		6,116			6,269			(2.4)%
Home equity		38,228			38,270			(0.1)%
Commercial, financial and agricultural		129,936			125,290			3.7%
Real estate-construction		38,047			36,948			3.0%
Installment
Credit cards and related plans		1,332			1,307			1.9%
Other		4,833			5,188			(6.8)%
Obligations of states and political subdivisions		18,420			19,435			(5.2)%
Less: Deferred origination fees, net of costs		(378	)		(421	)		10.2%
Less: Allowance for loan losses		(7,443	)		(7,658	)		2.8%
Total	$	622,379		$	610,302			2.0%

Net loans increased $12.1 million (2.0%) from $610.3 million at December 31, 2013 to $622.4 million at June 30, 2014. In addition to originating loans, we buy and sell loan participations with other financial institutions located in markets we serve. These loans are underwritten to the same lending standards as the loans we originate. Additionally, we purchase syndicated loans in the national market that represent small portions of large national credits. These credits are also subject to our normal underwriting guidelines and represent $56.7 million and $45.6 million in loan balances outstanding at June 30, 2014 and December 31, 2013, respectively.

Real estate-mortgage, 1-4 family first lien loans totaled $102.3 million at June 30, 2014, an increase of $4.4 million (4.5%) from December 31, 2013. Commercial, financial and agricultural loans totaled $129.9 million at June 30, 2014, an increase of $4.6 million (3.7%) from December 31, 2013. Both categories of loans have been an area of emphasis during the first six months of 2014 as we attempt to attain overall loan growth without significant increases in commercial real estate loans, which totaled $291.0 million at June 30, 2014 and comprised 46.8% of our loan portfolio, down from $287.8 million, or 47.2% of our loan portfolio, at December 31, 2013.

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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 the “Provision for Loan Losses” section discussed earlier. 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, 2014 was $7.4 million, compared to $7.7 million at December 31, 2013. On a quarterly basis, management reviews the adequacy of the ALL. The analysis of the ALL consists of three components: (i) specific reserves established for expected losses relating to impaired loans for which the recorded investment in the loans exceeds its fair value; (ii) general reserves based on historical loan loss experience for significant loan classes; and (iii) general reserves based on qualitative factors such as concentrations and changes in portfolio mix and volume. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized.

On a regular basis, loan officers review all commercial credit relationships. The loan officers grade commercial credits and the loan review function validates the grades assigned. In the event that the loan review function downgrades a loan, it is included in the ALL analysis process at the lower grade. This grading system is in compliance with regulatory classifications. At least quarterly, all commercial loans that have been deemed impaired are evaluated. In compliance with accounting guidance for impaired loans, the fair value of the loan is determined based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the market price of the loan or, if the loan is collateral dependent, the fair value of the underlying collateral less the estimated costs to sell. This evaluation may include obtaining supplemental market data and/or routine site visits to offer support to the evaluation process. If the carrying value of the loan exceeds the fair value less estimated cost to sell, a specific reserve is established. Such reserves are reviewed by the Delinquent Account Review Team.

We have two other major components of the ALL that do not pertain to specific loans: “General Reserves – Historical” and “General Reserves – Other.” We determine General Reserves – Historical based on our historical recorded charge-offs of loans in particular classes, analyzed as a group. We determine General Reserves – Other by taking into account such qualitative factors as 1) changes in the nature, volume and terms of loans, 2) changes in lending personnel, 3) changes in the quality of the loan review function, 4) changes in nature and volume of past-due, nonaccrual and/or classified loans, 5) changes in concentration of credit risk, 6) changes in economic and industry conditions, 7) changes in legal and regulatory requirements, 8) unemployment and inflation statistics, and 9) changes in underlying collateral values.

Nonperforming Loans, Potential Problem Loans and Other Real Estate Owned:

Management encourages early identification of nonaccrual and problem loans in order to minimize the risk of loss. Nonperforming loans are defined as nonaccrual loans, loans 90 days or more past due but still accruing, and nonaccrual loans restructured in a troubled debt restructuring that have not 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 received on nonaccrual loans is 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.

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NONPERFORMING ASSETS
(Dollars amounts in thousands)

	June 30,2014		March 31,2014		December 31,2013		September 30, 2013		June 30, 2013
Nonperforming Assets:
Nonaccrual loans	$	6,794	$	6,686	$	6,403	$	6,215	$	8,231
Nonaccrual loans, restructured		256		255		255		299		114
Total nonperforming loans (“NPLs”)	$	7,050	$	6,941	$	6,658	$	6,514	$	8,345
Other real estate owned, net		5,053		5,479		6,298		6,884		7,553
Total nonperforming assets (“NPAs”)	$	12,103	$	12,420	$	12,956	$	13,398	$	15,898
Restructured loans, accruing(1)	$	8,472	$	8,370	$	9,009	$	9,020	$	3,959

Ratios:
ALL to Net Charge-offs (“NCOs”) (annualized)	17.17x	8.94x	2.63x	2.21x	2.84x
NCOs to average loans (annualized)	0.07%	0.13%	0.48%	0.60%	0.52%
ALL to total loans	1.18%	1.18%	1.24%	1.29%	1.47%
NPLs to total loans	1.12%	1.10%	1.08%	1.06%	1.39%
NPAs to total assets	1.20%	1.27%	1.30%	1.36%	1.68%
ALL to NPLs	105.58%	107.37%	115.02%	121.19%	105.73%

⁽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.

During the quarter ended June 30, 2014, other real estate owned declined by $0.4 million. Contributing to the decrease in other real estate owned, $0.5 million of such real estate was sold during the second quarter of 2014 with $0.1 million in write-downs taken. Two properties totaling $0.1 million were transferred into other real estate owned during the quarter ended June 30, 2014.

Restructured loans accruing at June 30, 2014 were $8.5 million. No accruing restructured loans were transferred to nonaccrual during the second quarter of 2014. One restructured loan with modified terms totaling $0.7 million was transferred out of the restructured loan category during the six months ended June 30, 2014 as a result of it complying with the modified terms for a sufficient period of time, generally six months, whereas one loan for less than $0.1 million was added to the restructured loans accruing category during the three months ended June 30, 2014.

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The following table presents an analysis of our past due loans, excluding nonaccrual loans:

PAST DUE LOANS (EXCLUDING NONACCRUALS)
30-89 DAYS PAST DUE

	June 30, 2014			March 31, 2014			December 31, 2013			September 30, 2013			June 30, 2013
Secured by real estate	$	2,026		$	1,553		$	1,039		$	2,621		$	3,346
Commercial and industrial loans		222			130			15			707			700
Loans to individuals		29			16			26			16			24
Total	$	2,277		$	1,699		$	1,080		$	3,344		$	4,070
Percentage of total loans		0.36	%		0.27	%		0.17	%		0.55	%		0.69	%

As reflected above, loan balances 30-89 days past due have decreased $1.8 million when compared to June 30, 2013, but increased $1.2 million from December 31, 2013. In the six months from June 30, 2013 to December 31, 2013, the $3.0 million reduction in past due loans resulted from $1.2 million of past due loans moved to non-accrual and $2.4 million of loans brought current, offset by $0.8 million of loans that became 30-89 days past due. From December 31, 2013 to June 30, 2014, $0.8 million of these loans were brought current but $2.1 million of additional loans, representing no individually significant relationship, became past due 30-89 days.

Information regarding other real estate owned is as follows:

	Six months ended June 30, 2014			Twelve months ended December 31, 2013			Six months ended June 30, 2013
Beginning balance	$	8,566		$	14,334		$	14,334
Transfer of loans to other real estate owned		75			1,606			696
Sales proceeds, net		(1,162	)		(5,040	)		(3,302	)
Net gain from sale of other real estate owned		43			202			128
Valuation allowance recovered upon disposition of other real estate owned		(646	)		(2,536	)		(1,382	)
Total other real estate owned, net		6,876			8,566			10,474
Valuation allowance for losses		(1,823	)		(2,268	)		(2,921	)
Total other real estate owned, net	$	5,053		$	6,298		$	7,553

VALUATION ALLOWANCE ON OTHER REAL ESTATE OWNED

	Six months ended June 30, 2014			Twelve months ended December 31, 2013			Six months ended June 30, 2013
Beginning balance	$	2,268		$	3,858		$	3,858
Provision charged to operations		201			946			445
Valuation allowance recovered upon disposition of other real estate owned		(646	)		(2,536	)		(1,382	)
Ending balance	$	1,823		$	2,268		$	2,921

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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, 2014, the investment portfolio comprising investment securities available for sale (“AFS”) decreased $14.3 million (6.5%) to $206.3 million compared to $220.6 million at December 31, 2013. At June 30, 2014, the AFS investment portfolio represented 20.5% of total assets compared to 22.1% at December 31, 2013. For the six months ended June 30, 2014, principal payments of $16.3 million were received on investments, including $2.0 million from the maturity of a security. For the six months ended June 30, 2014, we purchased $4.0 million of AFS securities and sold $3.8 million of AFS securities at a $0.2 million gain. Additionally, securities decreased by $0.8 million due to net amortization of premiums and discounts originated at the time the securities were purchased and a $2.4 million increase in the market value of the AFS investment portfolio during the six months ended June 30, 2014.

At June 30, 2014, the held to maturity (“HTM”) investment portfolio comprised two securities totaling $20.7 million versus one security classified as HTM totaling $10.3 million at December 31, 2013.

We closely monitor securities we hold in both our investment portfolios that remain in an unrealized loss position for twelve months or greater. There were no unrealized losses at June 30, 2014 in the HTM securities portfolio. Total gross unrealized losses on AFS securities in such a loss position for twelve months or greater were $1.0 million at June 30, 2014, representing 76.7% of total gross unrealized securities losses. AFS securities in such a loss position for twelve months or greater represented 14.9% of the total AFS investment portfolio. Based on an in-depth analysis of the specific instruments, which may include ratings from external rating agencies and/or brokers, as well as the creditworthiness of the related issuers, including their ability to continue payments under the terms of the security agreements, no unrealized losses were deemed to be other-than-temporary. Additionally, we do not have the intent to sell the securities and it is not more likely than not that we will be required to sell these securities before their anticipated recovery. If at any point in time any losses are considered other-than-temporary, we would be required to recognize other-than-temporary impairment. This would require us to assess the cash flows expected to be collected from the security. The difference between 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, 2014 and December 31, 2013, we did not hold securities of any one issuer, other than the Federal National Mortgage Association (“FNMA”), Government National Mortgage Association (“GNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”), or United States Department of Veterans Affairs (“VA”), each an agency or corporation of the United States government, in an amount greater than 10% of our stockholders’ equity. As of June 30, 2014, the highest concentration of loans underlying mortgage-backed securities issued in any state was issued in California, representing approximately 22.0% of the total amount invested in residential mortgage-backed securities.

Deposits:

Total deposits at June 30, 2014 decreased $8.0 million (1.1%) from $744.2 million at December 31, 2013 to $736.2 million at June 30, 2014. The decrease for the six months was a result of an $11.6 million (3.5%) decrease in our savings deposits and a decrease of $2.7 million (1.8%) in our time deposits during the six months ended June 30, 2014, offset in part by an increase in our non-interest bearing demand deposits of $6.3 million (2.4%) for the period. Total interest-bearing deposits decreased $19.0 million (3.1%) and non-interest-bearing deposits increased $11.0 million (8.6%) from December 31, 2013 to June 30, 2014. During the six months ended June 2014, we did not hold any traditional brokered certificates of deposits, but we held $9.4 million of NOW balances that were considered brokered deposits. These balances have increased $1.4 million since December 31, 2013. Deposits where our customers direct their funds with us to be exchanged with deposits of another participating institution through a depository network (“Reciprocal Deposits”) are considered brokered deposits. At June 30, 2014 we held $1.9 million of such Reciprocal Deposits, a decrease of $1.6 million from December 31, 2013.

We continue to focus on expanding and retaining customer relationships and attracting core deposit accounts by emphasizing customer service while maintaining competitive pricing. If liquidity concerns arise, we have alternative sources of funds such as lines of credit with correspondent banks and borrowing arrangements with the FHLB and through the discount window at the Federal Reserve.

Other Funding Sources:

Securities sold under agreements to repurchase decreased $17.7 million (30.2%) from $58.5 million at December 31, 2013 to $40.8 million at June 30, 2014. We did not have any federal funds purchased at either June 30, 2014 or December 31, 2013. The decline in repurchase agreements during the second quarter of 2014 is due to usual fluctuations relating to a significant commercial customer. These fluctuations are consistent with declines in cash balances during the same period.

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FHLB advances were $99.0 million at June 30, 2014, up from $66.7 million at December 31, 2013 due to $50.3 million of new FHLB advances during the six months ended June 30, 2014 offset by maturity of $18.0 million of prior advances. During the second quarter of 2014, only $15 million of new FHLB advances were taken. During the second quarter of 2014, $0.6 million of FHLB stock was required to be purchased in order to facilitate the taking of these advances. Subsequent to June 30, 2014, $18.0 million of fixed rate FHLB advances matured and were not renewed. The availability of deposits also determines the amount of funds we need to borrow in order to fund loan demand. FHLB continues to be available as a source of borrowing for future funding needs as we manage our liquidity needs. During the fourth quarter of 2013 and the first half of 2014 we utilized FHLB advances of varying terms and maturities to maximize and enhance our net interest margin. At June 30, 2014, $52.5 million of the $99.0 million FHLB advances outstanding were fixed rate while $46.5 million were variable rate. Additionally, we have committed to take $20.0 million of fixed rate advances, at rates already determined in the next twelve months to replace $20.0 million of variable rate advances maturing in that same period.

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 and mature on June 30, 2036. At June 30, 2014, the interest rate on these securities was 1.58%. 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. At June 30, 2014, we are current on all interest payments on the TruPS.

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 June 30, 2014 was $8.2 million and December 31, 2013 was $9.4 million.

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 (the “Conversion Ratio”). Prior to the quarterly interest date preceding the fifth anniversary of issuance of the Convertible Notes, 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. Beginning on the quarterly interest date prior to the fifth anniversary of the Convertible Notes, we may redeem the notes in whole or in part. A notice of redemption supersedes and takes priority over any notice of conversion. On October 1, 2014, one-half of the original principal amounts of the Convertible Notes are mandatorily convertible at the Conversion Ratio if voluntary conversion has not yet 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, 2013 for quantitative and qualitative disclosures about our fixed and determinable contractual obligations. Contractual obligations disclosed in the 2013 Annual Report on Form 10-K have not materially changed since that report was filed.

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The following table summarizes our significant contractual obligations and commitments at June 30, 2014:

CONTRACTUAL OBLIGATIONS

	Within 1 Year		1-3 Years		3-5 Years		After 5 Years		Total
Certificates of deposit and other time deposit obligations	$	110,845	$	38,425	$	3,158	$	—	$	152,428
Repurchase agreements		40,770		—		—		—		40,770
Federal Home Loan Bank advances		50,800		19,700		17,985		10,500		98,985
Subordinated debentures		—		—		—		16,100		16,100
Operating leases		32,715		65,430		19,084		—		117,229
Total	$	235,130	$	123,555	$	40,227	$	26,600	$	425,512

The Convertible Notes are not reflected in the preceding table as we expect all of the Convertible Notes outstanding at June 30, 2014 to be converted to common stock, with no outlay of cash, on or before April 1, 2015.

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Off- Balance Sheet Arrangements:

We do not use interest rate contracts (i.e. swaps), forward loans sales or other derivatives to manage interest rate risk and do not have any of these instruments outstanding. The Bank does have, through its normal operations, loan commitments and standby letters of credit outstanding as of June 30, 2014, and 2013 in the amount of $247.2 million and $237.7 million, respectively. These are further explained in Note 15 of the Notes to Consolidated Financial Statements.

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. We and the Bank have different liquidity considerations.

Our primary sources of funds are dividends from the Bank and net proceeds from borrowings, including offerings of subordinated debentures and convertible promissory notes. We may also undertake offerings of debt and issue our common stock if and when we deem it prudent to do so, subject to regulatory approval. We generally manage our liquidity position in order to provide funds necessary to meet interest obligations of our TruPS and Convertible Notes, pay dividends to our shareholders, subject to regulatory restrictions, and repurchase shares. Restrictions, which govern all state chartered banks, preclude the payment of dividends by the Bank without the prior written consent of the Wisconsin Department of Financial Institutions if dividends declared and paid by the Bank in either of the two immediately preceding years exceeded the Bank’s net income for those years, which was not the case.

The Bank meets its cash flow needs by having funding sources available to satisfy the credit needs of customers as well as having available funds to satisfy deposit withdrawal requests. Liquidity is derived from deposit growth, payments on and maturities of loans, payments on and maturities of the investment portfolio, access to other funding sources, marketability of certain assets, the ability to use loan and investment portfolios as collateral for secured borrowings and a strong capital position.

Maturing investments have historically been a primary source of liquidity. For the six months ended June 30, 2014, principal payments totaling $14.3 million were received on investments as well as $2.0 million from maturities. We purchased $14.4 million in investments in the same period. Approximately 8.3%, or $13.0 million, of the mortgage-backed securities outstanding at June 30, 2014 were issued and guaranteed by GNMA, the VA or the FHA; agencies of the United States government. An additional 79.3%, or $124.7 million, of the mortgage-backed securities outstanding at June 30, 2014 were issued by either FNMA or FHLMC, United States government-sponsored agencies. Non-agency mortgage-backed securities present a level of credit risk that does not exist currently with United States government agency-backed securities, and comprised approximately 12.4%, or $19.6 million, of the outstanding mortgage-backed securities at June 30, 2014. Management evaluates these non-agency mortgage-backed securities at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. These securities tend to be highly marketable.

Deposit decreases, reflected as a financing activity in the June 30, 2014 unaudited consolidated statements of cash flows, resulted in $21.7 million of cash outflow during the first six months of 2014 but increases in deposits during the second quarter of 2014 resulted in a $14.9 million cash inflow since end of the first quarter of 2014. 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 certificates of deposit was eliminated by September 30, 2013, due to our decision not to renew brokered certificate of deposits in 2013. However we have $9.4 million in brokered NOW accounts at June 30, 2014 compared to $8.0 million of such deposits at December 31, 2013. If at any point in the future we fall below the “well capitalized” regulatory capital threshold, it will become more difficult for us to obtain brokered deposits. Also affecting liquidity are core deposit growth levels, certificate of deposit maturity structure and retention, and characteristics and diversification of wholesale funding sources affecting the channels by which brokered deposits are acquired. Conversely, deposit outflow will cause a need to develop alternative sources of funds, which may not be as liquid and potentially a more costly alternative.

The scheduled payments and maturities of loans can provide a source of additional liquidity. There are $174.8 million, or 27.7% of total loans, maturing within one year of June 30, 2014. 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, 2014, securities sold under agreements to repurchase totaled $40.8 million compared to $58.4 million at the end of 2013. Securities sold under agreements to repurchase are obtained from a base of business customers. The decline in such repurchase agreements from December 31, 2013 to June 30, 2014 is primarily due to usual fluctuations relating to a significant commercial customer. These fluctuations are consistent with changes in cash balances between December 31, 2013 and June 30, 2014. Short-term and long-term borrowings from the FHLB are another source of funds and totaled $99.0 million and $66.7 million at June 30, 2014 and December 31, 2013, respectively. During the fourth quarter of 2013 and the first quarter of 2014, we utilized FHLB advances of varying terms and maturities, to maximize and manage our net interest margin.

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We continue to focus on expanding customer deposit relationships and attracting core deposit accounts by emphasizing customer service while maintaining competitive pricing. In the event that core deposit growth goals are not accomplished, we will continue to look at other wholesale sources of funds. In addition, we may acquire additional brokered deposits as funding for short-term liquidity needs. Short-term liquidity needs will also be addressed by growth in short-term borrowings, maturing federal funds sold and portfolio investments, and loan maturities and prepayments.

In assessing liquidity, historical information such as seasonality, local economic cycles and the economy in general are considered along with our current financial position and projections. We believe that in the current economic environment our liquidity position is adequate. To our knowledge, there are no known trends nor any known demands, commitments, events, or uncertainties that will result or are reasonably likely to result in material increases or decreases in our liquidity.

Capital Resources:

Stockholders’ equity at June 30, 2014 and December 31, 2013 was $97.1 million and $93.9 million, respectively, reflecting an increase of $3.2 million (3.4%) during the first six months of 2014. The increase in stockholders’ equity primarily resulted from net income of $4.2 million and an increase in comprehensive income of $1.5 million for the six months, and the conversion of debentures during the first half of 2014 of $1.2 million, partially offset by cash dividends of $1.1 million and the repurchase of 228,500 common shares during the first half of 2014 for $2.8 million under the Repurchase Program (the “Repurchase Program”) approved by our Board of Directors on May 23, 2013. Dividends of $0.14 per share were declared and paid during the six months ended June 30, 2014. The ratio of stockholders’ equity to assets was 9.7% and 9.4% at June 30, 2014 and December 31, 2013, respectively.

In July of 2014, we declared an $0.08 per share dividend. Our ability to pay dividends is subject to various factors including, among other things, sufficient earnings, available capital, board discretion and regulatory compliance.

On May 23, 2013, our board of directors approved the Repurchase Program, which was designed to allow us to proactively manage our capital position and return excess capital to shareholders. Pursuant to the Repurchase Program, we may buy up to 400,000 shares of our common stock, representing approximately 5.0% of our outstanding common shares. During the second quarter of 2014, we repurchased 92,000 shares pursuant to the Repurchase Program. See Part II, Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds, included elsewhere in this report for details of the stock repurchases during the quarter. On April 15, 2014, our board of directors approved an amendment to and extension of the Repurchase Program to authorize the repurchase of up to an additional 400,000 shares and extended the time period for the Repurchase Program through May 30, 2015.

We regularly review the adequacy of our capital to ensure that sufficient capital is available for our current and future needs and it is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends upon a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management.

The Federal Reserve has established capital adequacy rules which take into account risk attributable to balance sheet assets and off-balance sheet activities. All banks and bank holding companies must meet a minimum total risk-based capital ratio of 8% of which at least half must comprise core capital elements defined as Tier 1 capital. The federal banking agencies also have adopted leverage capital guidelines that banks and bank holding companies must meet. Under these guidelines, the most highly rated banking organizations must meet a leverage ratio of at least 3% Tier 1 capital to assets, while lower rated banking organizations must maintain a minimum ratio of 4% or 5%, depending on their rating. Failure to meet minimum capital requirements can initiate certain mandatory, as well as possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements. At June 30, 2014, we maintained capital in excess of the minimum ratios required to be categorized as “well capitalized” under the regulatory framework for the prompt corrective action categorization. There are no conditions or events since that date that we believe have changed our category. To be “well capitalized” under the regulatory framework, the Tier 1 capital ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10% and the leverage ratio must meet or exceed 5%.

On July 2, 2013, the Federal Reserve Board approved a final rule that implements changes to the regulatory capital framework for all banking organizations. The rule, Basel III, implements the reforms proposed by the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and will increase minimum requirements as to the quantity and quality of capital required to be held by banking organizations. We are in the process of evaluating the full impact of the new regulation to which we will be subject beginning January 1, 2015, but believe we would be considered “well capitalized” under the new regulation if it were in effect as of June 30, 2014.

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The total capital ratios for the previous four quarters are as follows:

	June 30, 2014	March 31, 2014	December 31, 2013	September 30, 2013
Company	16.35%	16.16%	16.71%	16.54%
Bank	16.19%	15.94%	16.30%	16.18%

A strong capital position is necessary to take advantage of opportunities for profitable expansion of product and market share and to provide depositor and investor confidence. We believe our capital level is strong, but also must be maintained at an appropriate level to provide the opportunity for an adequate return on the capital employed. We actively review our capital strategies to ensure that capital levels are appropriate based on the perceived business risks, further growth opportunities, industry standards, and regulatory requirements.

The following tables present our and the Bank’s capital ratios as of June 30, 2014 and December 31, 2013:

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, 2014
Total Capital (to Risk-Weighted Assets)
Company	$	116,531		16.35%	$	57,010		8.00%	$	N/A		N/A
Bank		115,264		16.19%		56,972		8.00%		71,215		10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Company	$	100,913		14.16%	$	28,505		4.00%	$	N/A		N/A
Bank		107,821		15.14%		28,486		4.00%		42,729		6.00%
Tier 1 Capital (to Average Assets)
Company	$	100,913		10.41%	$	38,765		4.00%	$	N/A		N/A
Bank		107,821		11.21%		38,774		4.00%		48,467		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, 2013
Total Capital (to Risk-Weighted Assets)
Company	$	116,195	16.71%	$	55,616	8.00%	$	N/A	N/A
Bank		113,254	16.30%		55,571	8.00%		69,464	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Company	$	99,137	14.26%	$	27,808	4.00%	$	N/A	N/A
Bank		105,596	15.20%		27,786	4.00%		41,678	6.00%
Tier 1 Capital (to Average Assets)
Company	$	99,137	10.48%	$	37,834	4.00%	$	N/A	N/A
Bank		105,596	11.16%		37,836	4.00%		47,295	5.00%

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, convertible promissory notes and 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.

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As of June 30, 2014, 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, 2013, as described in our 2013 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 and 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, 2014.

INTEREST SENSITIVITY

	Change in Net Interest Income Over One Year Horizon
	At June 30, 2014					At December 31, 2013
	Dollar change (in thousands)			Percentage change		Dollar change (in thousands)			Percentage change
Change in levels of interest rates
+200 bp	$	(269	)		(0.9)%	$	(1,623	)		(5.2)%
+100 bp		(280	)		(0.9)%		(1,262	)		(4.0)%
Base		—			—		—			—
-100 bp		(1,166	)		(3.8)%		(1,013	)		(3.3)%
-200 bp		(1,756	)		(5.8)%		(1,812	)		(5.8)%

As shown above, at June 30, 2014, the effect of an immediate 200 bp increase in interest rates would have decreased our net interest income by $0.3 million or 0.9% versus by $1.6 million or 5.2% at December 31, 2013. The decrease in the impact of an immediate 200 bp increase in interest rates from December 31, 2013 to June 30, 2014 was the reevaluation of the interest sensitivity of interest-bearing deposit liabilities. The effect of an immediate 200 bp reduction in rates would have decreased our net interest income by $1.8 million or 5.8% consistent with $1.8 million or 5.8% at December 31, 2013. It is projected that rates paid on interest-bearing liabilities in the current low interest rate environment have less ability to continue to decline compared to interest-earning assets. However, a 200 bp reduction in rates is not considered realistic given the low interest rate environment that currently exists. An interest rate floor of zero is used rather than assuming a negative interest rate.

Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the relative levels of market interest rates and loan prepayments, and should not be relied upon as indicative of actual results. Actual values may differ from those projections set forth above, should market conditions vary from the assumptions used in preparing the analyses. Further, the computations do not contemplate any actions we may undertake in response to changes in interest rates.

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, 2014. 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.

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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

See “Risk Factors” in Item 1A of our annual report on Form 10-K for the year ended December 31, 2013. There have been no material changes to the risk factors since then.

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

During the quarter ended June 30, 2014, we did not sell any equity securities which were not registered under the Securities Act of 1933, as amended. We repurchased 92,000 shares of our common stock during the second quarter of 2014 at an average price of $12.54 per share. A total of 391,500 shares have been purchased since May 23, 2013 at an average price of $11.66 per share.

	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publically Announced Plans or Programs(1)		Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
April 1 - April 30, 2014		15,000	$	12.57		15,000		485,500
May 1 - May 31, 2014		60,000		12.53		60,000		425,500
June 1 – June 30, 2014		17,000		12.57		17,000		408,500
Three Months Ended June 30, 2014		92,000		12.54		92,000
Six Months Ended June 30, 2014		228,500		12.51		228,500		408,500
Since May 23, 2013		391,500	$	11.66		391,500		408,500

On May 23, 2013, our Board of Directors approved the Repurchase Program, which authorized us to repurchase up to 400,000 shares of our stock through May 30, 2014. We repurchased 10,000, 143,000 and 10,000 shares on the open market during the second, third and fourth quarters of 2013 at an average price of $9.95, $10.45 and $11.31 per share respectively.

(1) On April 15, 2014 our Board of Directors amended the Repurchase Program to increase the applicable shares that we could repurchase from 400,000 shares to 800,000 shares and extend the date through which those shares could be repurchased to May 30, 2015.

We have several limitations on our ability to pay dividends. The Federal Reserve has adopted regulations that deal with the measure of capitalization for bank holding companies. The Federal Reserve has also issued a policy statement on the payment of cash dividends by bank holding companies, wherein the Federal Reserve has stated that a bank holding company experiencing earnings weaknesses should not pay cash dividends exceeding its net income or which could only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.

Our ability to pay dividends on our common stock is largely dependent upon the Bank’s ability to pay dividends on its stock held by us. The Bank’s ability to pay dividends is restricted by both state and federal laws and regulations. The Bank is subject to policies and regulations issued by the Federal Reserve, as the Bank’s primary federal regulator, and the Division of Banking of the WDFI, which, in part, establish minimum acceptable capital requirements for banks, thereby limiting the ability of such banks to pay dividends. In addition, Wisconsin law provides that state chartered banks may declare and pay dividends out of undivided profits but only after provision has been made for all expenses, losses, required reserves, taxes and interest accrued or due from the bank.

Item 3.Defaults Upon Senior Securities

Not applicable.

Item 4.Mine Safety Disclosures

Not applicable.

Item 5.Other Information

Not applicable.

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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.
101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statement of Comprehensive Income, (iv) Consolidated Statement of Changes in Stockholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements tagged as blocks of text.

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 1, 2014	/s/ Robert J. Cera
		Robert J. Cera
		President and Chief Executive Officer
Date:	August 1, 2014	/s/ Kevin L. LaLuzerne
		Kevin L. LaLuzerne
		Treasurer and Chief Financial Officer

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