On November 15, 2011, our Board of Directors declared a dividend of one preferred share purchase right (a "Right") for each outstanding share of our common stock under the terms of the Preservation Plan. The dividend is payable to the holders of common stock outstanding as of the close of business on November 15, 2011 or outstanding at any time thereafter but before the earlier of a "Distribution Date" and the date the Preservation Plan terminates. Each Right entitles the registered holder to purchase from us 1/1000 of a share of our Series C Junior Participating Preferred Stock, no par value per share ("Series C Preferred Stock"). Each 1/1000 of a share of Series C Preferred Stock has economic and voting terms similar to those of one whole share of common stock. The Rights are not exercisable and generally do not become exercisable until a person or group has acquired, subject to certain exceptions and conditions, beneficial ownership of 4.99% or more of the outstanding shares of common stock. At that time, each Right will generally entitle its holder to purchase securities of the Company at a discount of 50% to the current market price of the common stock. However, the Rights owned by the person acquiring beneficial ownership of 4.99% or more of the outstanding shares of common stock would automatically be void. The significant dilution that would result is expected to deter any person from acquiring beneficial ownership of 4.99% or more and thereby triggering the Rights.
To date, none of the Rights have been exercised or have become exercisable because no unpermitted 4.99% or more change in the beneficial ownership of the outstanding common stock has occurred. The Rights will generally expire on the earlier to occur of the close of business on November 15, 2016 and certain other events described in the Preservation Plan, including such date as our Board of Directors determines that the Preservation Plan is no longer necessary for its intended purposes.
Weighted average stock options outstanding that were not included in weighted average shares outstanding for calculation of diluted earnings per share because they were anti-dilutive totaled 0.03 million for both the three-month periods ended March 31, 2015 and 2014.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
| 7. | Derivative Financial Instruments |
We are required to record derivatives on our Condensed Consolidated Statements of Financial Condition as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.
Our derivative financial instruments according to the type of hedge in which they are designated follows:
| | | March 31, 2015 | |
| | | Notional Amount | | | Average Maturity (years) | | | Fair Value | |
| | | (Dollars in thousands) | |
| No hedge designation | | | | | | | | | |
| Rate-lock mortgage loan commitments | | $ | 28,413 | | | | 0.1 | | | $ | 825 | |
| Mandatory commitments to sell mortgage loans | | | 59,126 | | | | 0.1 | | | | (223 | ) |
| Pay-fixed interest rate swap agreements | | | 15,482 | | | | 7.1 | | | | (443 | ) |
| Pay-variable interest rate swap agreements | | | 15,482 | | | | 7.1 | | | | 443 | |
| Total | | $ | 118,503 | | | | 1.9 | | | $ | 602 | |
| | | December 31, 2014 | |
| | | Notional Amount | | | Average Maturity (years) | | | Fair Value | |
| | | (Dollars in thousands) | |
| No hedge designation | | | | | | | | | |
| Rate-lock mortgage loan commitments | | $ | 16,759 | | | | 0.1 | | | $ | 437 | |
| Mandatory commitments to sell mortgage loans | | | 38,600 | | | | 0.1 | | | | (184 | ) |
| Pay-fixed interest rate swap agreements | | | 3,300 | | | | 9.4 | | | | (182 | ) |
| Pay-variable interest rate swap agreements | | | 3,300 | | | | 9.4 | | | | 182 | |
| Total | | $ | 61,959 | | | | 1.1 | | | $ | 253 | |
We have established management objectives and strategies that include interest-rate risk parameters for maximum fluctuations in net interest income and market value of portfolio equity. We monitor our interest rate risk position via simulation modeling reports. The goal of our asset/liability management efforts is to maintain profitable financial leverage within established risk parameters.
Certain financial derivative instruments have not been designated as hedges. The fair value of these derivative financial instruments has been recorded on our Condensed Consolidated Statements of Financial Condition and is adjusted on an ongoing basis to reflect their then current fair value. The changes in fair value of derivative financial instruments not designated as hedges are recognized in earnings.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
In the ordinary course of business, we enter into rate-lock mortgage loan commitments with customers (“Rate Lock Commitments”). These commitments expose us to interest rate risk. We also enter into mandatory commitments to sell mortgage loans (“Mandatory Commitments”) to reduce the impact of price fluctuations of mortgage loans held for sale and Rate Lock Commitments. Mandatory Commitments help protect our loan sale profit margin from fluctuations in interest rates. The changes in the fair value of Rate Lock Commitments and Mandatory Commitments are recognized currently as part of net gains on mortgage loans. We obtain market prices on Mandatory Commitments and Rate Lock Commitments. Net gains on mortgage loans, as well as net income may be more volatile as a result of these derivative instruments, which are not designated as hedges.
During 2014, we began a program that allows commercial loan customers to lock in a fixed rate for a longer period of time than we would normally offer for interest rate risk reasons. We will enter into a variable rate commercial loan and an interest rate swap agreement with a customer and then enter into an offsetting interest rate swap agreement with an unrelated party. The interest rate swap agreement fair values will generally move in opposite directions resulting in little or no net impact on our Consolidated Statements of Operations. All of the interest rate swap agreements in the table above relate to this program.
The following tables illustrate the impact that the derivative financial instruments discussed above have on individual line items in the Condensed Consolidated Statements of Financial Condition for the periods presented:
Fair Values of Derivative Instruments
| | Asset Derivatives | | Liability Derivatives | |
| | March 31, 2015 | | December 31, 2014 | | March 31, 2015 | | December 31, 2014 | |
| | Balance Sheet Location | | Fair Value | | Balance Sheet Location | | Fair Value | | Balance Sheet Location | | Fair Value | | Balance Sheet Location | | Fair Value | |
| | (In thousands) | |
| Derivatives not designated as hedging instruments | | | | | | | | | | | | | | | | |
| Rate-lock mortgage loan commitments | Other assets | | $ | 825 | | Other assets | | $ | 437 | | Other liabilities | | $ | - | | Other liabilities | | $ | - | |
| Mandatory commitments to sell mortgage loans | Other assets | | | - | | Other assets | | | - | | Other liabilities | | | 223 | | Other liabilities | | | 184 | |
| Pay-fixed interest rate swap agreements | Other assets | | | - | | Other assets | | | - | | Other liabilities | | | 443 | | Other liabilities | | | 182 | |
| Pay-variable interest rate swap agreements | Other assets | | | 443 | | Other assets | | | 182 | | Other liabilities | | | - | | Other liabilities | | | - | |
| Total derivatives | | | $ | 1,268 | | | | $ | 619 | | | | $ | 666 | | | | $ | 366 | |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The effect of derivative financial instruments on the Condensed Consolidated Statements of Operations follows:
| Three Month Periods Ended March 31, | |
| | | Gain (Loss) Recognized in Other Comprehensive Income (Loss) (Effective Portion) | | Location of Gain (Loss) Reclassified from Accumulated Other Comprehensive Income into Income (Effective Portion) | | Gain (Loss) Reclassified from Accumulated Other Comprehensive Loss into Income (Effective Portion) | | Location of Gain (Loss) Recognized in Income (1) | | Gain (Loss) Recognized in Income | |
| | | 2015 | | | 2014 | | | 2015 | | | 2014 | | | 2015 | | | 2014 | |
| | | | | | | | | | (In thousands) | | | | | | | | |
| Cash Flow Hedges | | | | | | | | | | | | | | | | | | | | |
| Pay-fixed interest rate swap agreements (2) | | $ | - | | | $ | - | | Interest expense | | $ | - | | | $ | (95 | ) | | | $ | - | | | $ | - | |
| Total | | $ | - | | | $ | - | | | | $ | - | | | $ | (95 | ) | | | $ | - | | | $ | - | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| No hedge designation | | | | | | | | | | | | | | | | | | | | | | | |
| Rate-lock mortgage loan commitments | | | | | | | | | | | | | | | | | | Net mortgage loan gains | | $ | 388 | | | $ | (14 | ) |
| Mandatory commitments to sell mortgage loans | | | | | | | | | | | | | | | | | | Net mortgage loan gains | | | (39 | ) | | | (83 | ) |
| Pay-fixed interest rate swap agreements | | | | | | | | | | | | | | | | | | Interest income | | | (261 | ) | | | - | |
| Pay-variable interest rate swap agreements | | | | | | | | | | | | | | | | | | Interest income | | | 261 | | | | - | |
| Total | | | | | | | | | | | | | | | | | | | | $ | 349 | | | $ | (97 | ) |
| (1) | For cash flow hedges, this location and amount refers to the ineffective portion. |
| (2) | Relates to a terminated pay-fixed interest rate swap whose termination fee was included in accumulated other comprehensive income and was being amortized into earnings through December 31, 2014. |
The following table summarizes intangible assets, net of amortization:
| | | March 31, 2015 | | | December 31, 2014 | |
| | | Gross Carrying Amount | | | Accumulated Amortization | | | Gross Carrying Amount | | | Accumulated Amortization | |
| | | (In thousands) | |
| | | | | | | | | | | | | |
| Amortized intangible assets - core deposits | | $ | 6,118 | | | $ | 3,578 | | | $ | 6,118 | | | $ | 3,491 | |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Amortization of other intangibles has been estimated through 2020 and thereafter in the following table.
| | | (In thousands) | |
| | | | |
| | | | |
| Nine months ending December 31, 2015 | | $ | 260 | |
| 2016 | | | 347 | |
| 2017 | | | 346 | |
| 2018 | | | 346 | |
| 2019 | | | 346 | |
| 2020 and thereafter | | | 895 | |
| Total | | $ | 2,540 | |
| 9. | Share Based Compensation |
We maintain share based payment plans that include a non-employee director stock purchase plan and a long-term incentive plan that permits the issuance of share based compensation, including stock options and non-vested share awards. The long-term incentive plan, which is shareholder approved, permits the grant of additional share based awards for up to 0.3 million shares of common stock as of March 31, 2015. The non-employee director stock purchase plan permits the issuance of additional share based payments for up to 0.2 million shares of common stock as of March 31, 2015. Share based awards and payments are measured at fair value at the date of grant and are expensed over the requisite service period. Common shares issued upon exercise of stock options come from currently authorized but unissued shares.
During each three month period ended March 31, 2015 and 2014, pursuant to our long-term incentive plan, we granted 0.07 million shares of restricted stock and 0.03 million performance stock units (“PSU”) to certain officers. The shares of restricted stock issued during 2015 cliff vest after a period of three years, the shares of restricted stock issued during 2014 vest ratably over three years and the PSUs issued in both periods cliff vest after a period of three years. The performance feature of the PSUs is based on a comparison of our total shareholder return over the three year period starting on the grant date to the total shareholder return over that period for an index of our peers in the banking industry.
Our directors may elect to receive a portion of their quarterly cash retainer fees in the form of common stock (either on a current basis or on a deferred basis pursuant to the non-employee director stock purchase plan referenced above). Shares equal in value to that portion of each director’s fees that he or she has elected to receive in stock are issued each quarter and vest immediately. We issued 0.001 million shares and 0.004 million shares to directors during the first quarter of 2015 and 2014, respectively and expensed their value during those same periods.
Total compensation expense recognized for grants pursuant to our long-term incentive plan was $0.4 million and $0.2 million during the three months ended March 31, 2015 and 2014 respectively. The corresponding tax benefit relating to this expense was $0.1 million for each period. Total expense recognized for non-employee director share based payments was $0.02 million and $0.05 million during the three months ended March 31, 2015 and 2014, respectively. The corresponding tax benefit relating to this expense was $0.01 million and $0.02 million for each respective period.
At March 31, 2015, the total expected compensation cost related to non-vested stock options, restricted stock, PSUs and restricted stock unit awards not yet recognized was $2.5 million. The weighted-average period over which this amount will be recognized is 2.1 years.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
A summary of outstanding stock option grants and related transactions follows:
| | | Number of Shares | | | Average Exercise Price | | | Weighted- Average Remaining Contractual Term (Years) | | | Aggregated Intrinsic Value | |
| | | | | | | | | | | | (In thousands) | |
| Outstanding at January 1, 2015 | | | 281,820 | | | $ | 4.69 | | | | | | | |
| Granted | | | - | | | | | | | | | | | |
| Exercised | | | (5,764 | ) | | | 2.65 | | | | | | | |
| Forfeited | | | (1,132 | ) | | | 4.89 | | | | | | | |
| Expired | | | (167 | ) | | | 6.42 | | | | | | | |
| Outstanding at March 31, 2015 | | | 274,757 | | | $ | 4.73 | | | | 6.87 | | | $ | 2,306 | |
| | | | | | | | | | | | | | | | | |
| Vested and expected to vest at March 31, 2015 | | | 271,678 | | | $ | 4.73 | | | | 6.85 | | | $ | 2,283 | |
| Exercisable at March 31, 2015 | | | 195,452 | | | $ | 4.68 | | | | 6.46 | | | $ | 1,675 | |
A summary of outstanding non-vested restricted stock, restricted stock units and PSUs and related transactions follows:
| | | Number of Shares | | | Grant Date Fair Value | |
| Outstanding at January 1, 2015 | | | 407,130 | | | $ | 6.31 | |
| Granted | | | 105,757 | | | | 13.04 | |
| Vested | | | (22,119 | ) | | | 12.78 | |
| Forfeited | | | (2,198 | ) | | | 13.05 | |
| Outstanding at March 31, 2015 | | | 488,570 | | | $ | 7.45 | |
Certain information regarding options exercised during the periods follows:
| | | Three Months Ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (In thousands) | |
| Intrinsic value | | $ | 56 | | | $ | 15 | |
| Cash proceeds received | | $ | 15 | | | $ | 10 | |
| Tax benefit realized | | $ | 20 | | | $ | 5 | |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Income tax expense was $1.8 million and $1.5 million during the three months ended March 31, 2015 and 2014, respectively.
We assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. The ultimate realization of this asset is primarily based on generating future income. We concluded at both March 31, 2015 and 2014, that the realization of substantially all of our deferred tax assets continues to be more likely than not.
We did maintain a valuation allowance against our deferred tax assets of approximately $1.0 million at both March 31, 2015 and December 31, 2014. This valuation allowance on our deferred tax assets primarily relates to state income taxes at our Mepco segment. In this instance, we determined that the future realization of these particular deferred tax assets was not more likely than not. This conclusion was primarily based on the uncertainty of Mepco’s future earnings attributable to particular states (given the various apportionment criteria) and the significant reduction in the size of Mepco’s business.
At both March 31, 2015 and December 31, 2014, we had approximately $1.1 million of gross unrecognized tax benefits. We do not expect the total amount of unrecognized tax benefits to significantly increase or decrease during the balance of 2015.
Capital guidelines adopted by Federal and State regulatory agencies and restrictions imposed by law limit the amount of cash dividends our Bank can pay to us. Under these guidelines, the amount of dividends that may be paid in any calendar year is limited to the Bank’s current year’s net profits, combined with the retained net profits of the preceding two years. Further, the Bank cannot pay a dividend at any time that it has negative undivided profits. As of March 31, 2015, the Bank had negative undivided profits of $27.1 million. We can request regulatory approval for a return of capital from the Bank to the parent company. During the first quarter of 2014, we requested regulatory approval for a $15.0 million return of capital from the Bank to the parent company. This return of capital request was approved by our banking regulators on March 28, 2014 and the Bank returned $15.0 million of capital to the parent company on April 9, 2014. During January of 2015, we requested regulatory approval for an additional $18.5 million return of capital from the Bank to the parent company. This return of capital request was approved by our banking regulators on February 13, 2015, and the Bank returned $18.5 million of capital to the parent company on February 17, 2015. It is not our intent to have dividends paid in amounts that would reduce the capital of our Bank to levels below those which we consider prudent and in accordance with guidelines of regulatory authorities.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
We are also subject to various regulatory capital requirements. The prompt corrective action regulations establish quantitative measures to ensure capital adequacy and require minimum amounts and ratios of total, Tier 1, and common equity Tier 1 (as of January 1, 2015) capital to risk-weighted assets and Tier 1 capital to average assets. Failure to meet minimum capital requirements can result in certain mandatory, and possibly discretionary, actions by regulators that could have a material effect on our consolidated financial statements. Under capital adequacy guidelines, we must meet specific capital requirements that involve quantitative measures as well as qualitative judgments by the regulators. The most recent regulatory filings as of March 31, 2015 and December 31, 2014 categorized our Bank as well capitalized. Management is not aware of any conditions or events that would have changed the most recent Federal Deposit Insurance Corporation (“FDIC”) categorization.
On July 2, 2013, the Federal Reserve approved a final rule that establishes an integrated regulatory capital framework (the “New Capital Rules”). The rule implements in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. In general, under the New Capital Rules, minimum requirements have increased for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the New Capital Rules include a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets that applies to all supervised financial institutions. The rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations. As to the quality of capital, the New Capital Rules emphasize common equity Tier 1 capital, the most loss-absorbing form of capital, and implement strict eligibility criteria for regulatory capital instruments. The New Capital Rules also change the methodology for calculating risk-weighted assets to enhance risk sensitivity. The New Capital Rules became effective for us on January 1, 2015.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Our actual capital amounts and ratios follow:
| | | Actual | | | Minimum for Adequately Capitalized Institutions | | | Minimum for Well-Capitalized Institutions | |
| | | Amount | | | Ratio | | | Amount | | | Ratio | | | Amount | | | Ratio | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | | | | | | | |
| March 31, 2015 | | | | | | | | | | | | | | | | | | |
| Total capital to risk-weighted assets | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 271,391 | | | | 17.28 | % | | $ | 125,611 | | | | 8.00 | % | | NA | | | NA | |
| Independent Bank | | | 237,073 | | | | 15.12 | | | | 125,456 | | | | 8.00 | | | $ | 156,820 | | | | 10.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Tier 1 capital to risk-weighted assets | | | | | | | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 251,443 | | | | 16.01 | % | | $ | 94,208 | | | | 6.00 | % | | NA | | | NA | |
| Independent Bank | | | 217,216 | | | | 13.85 | | | | 94,092 | | | | 6.00 | | | $ | 125,456 | | | | 8.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Common equity tier 1 capital to risk-weighted assets | | | | | | | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 237,386 | | | | 15.12 | % | | $ | 62,806 | | | | 4.50 | % | | NA | | | NA | |
| Independent Bank | | | 217,216 | | | | 13.85 | | | | 70,569 | | | | 4.50 | | | $ | 101,933 | | | | 6.50 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Tier 1 capital to average assets | | | | | | | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 251,443 | | | | 11.22 | % | | $ | 89,647 | | | | 4.00 | % | | NA | | | NA | |
| Independent Bank | | | 217,216 | | | | 9.70 | | | | 89,576 | | | | 4.00 | | | $ | 111,970 | | | | 5.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2014 | | | | | | | | | | | | | | | | | | | | | | | | |
| Total capital to risk-weighted assets | | | | | | | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 265,163 | | | | 18.06 | % | | $ | 117,427 | | | | 8.00 | % | | NA | | | NA | |
| Independent Bank | | | 247,883 | | | | 16.90 | | | | 117,374 | | | | 8.00 | | | $ | 146,718 | | | | 10.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Tier 1 capital to risk-weighted assets | | | | | | | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 246,628 | | | | 16.80 | % | | $ | 58,714 | | | | 4.00 | % | | NA | | | NA | |
| Independent Bank | | | 229,361 | | | | 15.63 | | | | 58,687 | | | | 4.00 | | | $ | 88,031 | | | | 6.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Tier 1 capital to average assets | | | | | | | | | | | | | | | | | | | | | | | | |
| Consolidated | | $ | 246,628 | | | | 11.18 | % | | $ | 88,206 | | | | 4.00 | % | | NA | | | NA | |
| Independent Bank | | | 229,361 | | | | 10.46 | | | | 87,687 | | | | 4.00 | | | $ | 109,609 | | | | 5.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| NA - Not applicable | | | | | | | | | | | | | | | | | | | | | | | | |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The components of our regulatory capital are as follows:
| | | Consolidated | | | Independent Bank | |
| | | March 31, 2015 | | | December 31, 2014 | | | March 31, 2015 | | | December 31, 2014 | |
| | | (In thousands) | |
| Total shareholders' equity | | $ | 253,625 | | | $ | 250,371 | | | $ | 244,807 | | | $ | 257,832 | |
| Add (deduct) | | | | | | | | | | | | | | | | |
| Accumulated other comprehensive (gain) loss for regulatory purposes | | | (1,596 | ) | | | 5,636 | | | | (1,596 | ) | | | 5,636 | |
| Intangible assets | | | (1,016 | ) | | | (2,627 | ) | | | (1,016 | ) | | | (2,627 | ) |
| Disallowed deferred tax assets | | | (13,627 | ) | | | (40,500 | ) | | | (24,979 | ) | | | (30,728 | ) |
| Disallowed capitalized mortgage loan servicing rights | | | - | | | | (752 | ) | | | - | | | | (752 | ) |
| Common equity tier 1 capital | | | 237,386 | | | | 212,128 | | | | 217,216 | | | | 229,361 | |
| Qualifying trust preferred securities | | | 34,500 | | | | 34,500 | | | | - | | | | - | |
| Disallowed deferred tax assets | | | (20,443 | ) | | | - | | | | - | | | | - | |
| Tier 1 capital | | | 251,443 | | | | 246,628 | | | | 217,216 | | | | 229,361 | |
| Allowance for loan losses and allowance for unfunded lending commitments limited to 1.25% of total risk-weighted assets | | | 19,948 | | | | 18,535 | | | | 19,857 | | | | 18,522 | |
| Total risk-based capital | | $ | 271,391 | | | $ | 265,163 | | | $ | 237,073 | | | $ | 247,883 | |
| 12. | Fair Value Disclosures |
FASB ASC topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC topic 820 also 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 standard describes three levels of inputs that may be used to measure fair value:
Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments include securities traded on active exchange markets, such as the New York Stock Exchange, as well as U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets.
Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 instruments include securities traded in less active dealer or broker markets.
Level 3: Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
We used the following methods and significant assumptions to estimate fair value:
Securities: Where quoted market prices are available in an active market, securities (trading or available for sale) are classified as Level 1 of the valuation hierarchy. Level 1 securities include certain preferred stocks included in our trading portfolio for which there are quoted prices in active markets. If quoted market prices are not available for the specific security, then fair values are estimated by (1) using quoted market prices of securities with similar characteristics, (2) matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices, or (3) a discounted cash flow analysis whose significant fair value inputs can generally be verified and do not typically involve judgment by management. These securities are classified as Level 2 of the valuation hierarchy and include agency securities, private label residential mortgage-backed securities, other asset backed securities, municipal securities, trust preferred securities and corporate securities.
Loans held for sale: The fair value of mortgage loans held for sale is based on mortgage backed security pricing for comparable assets (recurring Level 2).
Impaired loans with specific loss allocations based on collateral value: From time to time, certain loans are considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. We measure our investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2015 and December 31, 2014, all of our total impaired loans were evaluated based on either the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. When the fair value of the collateral is based on an appraised value or when an appraised value is not available we record the impaired loan as nonrecurring Level 3. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and thus will typically result in a Level 3 classification of the inputs for determining fair value.
Other real estate: At the time of acquisition, other real estate is recorded at fair value, less estimated costs to sell, which becomes the property’s new basis. Subsequent write-downs to reflect declines in value since the time of acquisition may occur from time to time and are recorded in net (gain) loss on other real estate and repossessed assets in the Condensed Consolidated Statements of Operations. The fair value of the property used at and subsequent to the time of acquisition is typically determined by a third party appraisal of the property. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and typically result in a Level 3 classification of the inputs for determining fair value.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, an independent third party (for commercial properties over $0.25 million) or a member of our Collateral Evaluation Department (for commercial properties under $0.25 million) or a member of our Special Assets Group (for retail properties) reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. We compare the actual selling price of collateral that has been sold to the most recent appraised value of our properties to determine what additional adjustment, if any, should be made to the appraisal value to arrive at fair value. For commercial and retail properties we typically discount an appraisal to account for various factors that the appraisal excludes in its assumptions. These additional discounts generally do not result in material adjustments to the appraised value. In addition, we will adjust the appraised values for expected liquidation costs including sales commissions and transfer taxes.
Capitalized mortgage loan servicing rights: The fair value of capitalized mortgage loan servicing rights is based on a valuation model used by an independent third party 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. Certain model assumptions are generally unobservable and are based upon the best information available including data relating to our own servicing portfolio, reviews of mortgage servicing assumption and valuation surveys and input from various mortgage servicers and, therefore, are recorded as nonrecurring Level 3. Management evaluates the third party valuation for reasonableness each quarter as part of our financial reporting control processes.
Derivatives: The fair value of rate-lock mortgage loan commitments and mandatory commitments to sell mortgage loans is based on mortgage backed security pricing for comparable assets (recurring Level 2). The fair value of interest rate swap agreements is based on a discounted cash flow analysis whose significant fair value inputs can generally be observed in the market place and do not typically involve judgment by management (recurring Level 2).
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Assets and liabilities measured at fair value, including financial assets for which we have elected the fair value option, were as follows:
| | | | | | Fair Value Measurements Using | |
| | | Fair Value Measure- ments | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Un- observable Inputs (Level 3) | |
| | | (In thousands) | |
| March 31, 2015: | |
| Measured at Fair Value on a Recurring Basis: | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | |
| Trading securities | | $ | 213 | | | $ | 213 | | | $ | - | | | $ | - | |
| Securities available for sale | | | | | | | | | | | | | | | | |
| U.S. agency | | | 35,529 | | | | - | | | | 35,529 | | | | - | |
| U.S. agency residential mortgage-backed | | | 234,254 | | | | - | | | | 234,254 | | | | - | |
| U.S. agency commercial mortgage-backed | | | 33,081 | | | | - | | | | 33,081 | | | | - | |
| Private label residential mortgage-backed | | | 5,820 | | | | - | | | | 5,820 | | | | - | |
| Other asset backed | | | 95,191 | | | | - | | | | 95,191 | | | | - | |
| Obligations of states and political subdivisions | | | 142,788 | | | | - | | | | 142,788 | | | | - | |
| Corporate | | | 22,661 | | | | - | | | | 22,661 | | | | - | |
| Trust preferred | | | 2,438 | | | | - | | | | 2,438 | | | | - | |
| Loans held for sale | | | 30,932 | | | | - | | | | 30,932 | | | | - | |
| Derivatives (1) | | | 1,268 | | | | - | | | | 1,268 | | | | - | |
| Liabilities | | | | | | | | | | | | | | | | |
| Derivatives (2) | | | 666 | | | | - | | | | 666 | | | | - | |
| | | | | | | | | | | | | | | | | |
| Measured at Fair Value on a Non-recurring basis: | | | | | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | | | | | |
| Capitalized mortgage loan servicing rights (3) | | | 8,129 | | | | - | | | | - | | | | 8,129 | |
| Impaired loans (4) | | | | | | | | | | | | | | | | |
| Commercial | | | | | | | | | | | | | | | | |
| Income producing - real estate | | | 786 | | | | - | | | | - | | | | 786 | |
| Land, land development & construction-real estate | | | 142 | | | | - | | | | - | | | | 142 | |
| Commercial and industrial | | | 2,511 | | | | - | | | | - | | | | 2,511 | |
| Mortgage | | | | | | | | | | | | | | | | |
| 1-4 Family | | | 1,217 | | | | - | | | | - | | | | 1,217 | |
| Resort Lending | | | 139 | | | | - | | | | - | | | | 139 | |
| Other real estate (5) | | | | | | | | | | | | | | | | |
| Commercial | | | | | | | | | | | | | | | | |
| Land, land development & construction-real estate | | | 677 | | | | - | | | | - | | | | 677 | |
| Mortgage | | | | | | | | | | | | | | | | |
| 1-4 Family | | | 102 | | | | - | | | | - | | | | 102 | |
| Resort Lending | | | 427 | | | | - | | | | - | | | | 427 | |
| (1) | Included in accrued income and other assets |
| (2) | Included in accrued expenses and other liabilities |
| (3) | Only includes servicing rights that are carried at fair value due to recognition of a valuation allowance. |
| (4) | Only includes impaired loans with specific loss allocations based on collateral value. |
| (5) | Only includes other real estate with subsequent write downs to fair value. |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
| | | | | | Fair Value Measurements Using | |
| | | Fair Value Measure- ments | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Un- observable Inputs (Level 3) | |
| | | (In thousands) | |
| December 31, 2014: | |
| Measured at Fair Value on a Recurring Basis: | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | |
| Trading securities | | $ | 203 | | | $ | 203 | | | $ | - | | | $ | - | |
| Securities available for sale | | | | | | | | | | | | | | | | |
| U.S. agency | | | 35,006 | | | | - | | | | 35,006 | | | | - | |
| U.S. agency residential mortgage-backed | | | 257,558 | | | | - | | | | 257,558 | | | | - | |
| U.S. agency commercial mortgage-backed | | | 33,728 | | | | - | | | | 33,728 | | | | - | |
| Private label residential mortgage-backed | | | 6,013 | | | | - | | | | 6,013 | | | | - | |
| Other asset backed | | | 32,353 | | | | - | | | | 32,353 | | | | - | |
| Obligations of states and political subdivisions | | | 143,415 | | | | - | | | | 143,415 | | | | - | |
| Corporate | | | 22,664 | | | | - | | | | 22,664 | | | | - | |
| Trust preferred | | | 2,441 | | | | - | | | | 2,441 | | | | - | |
| Loans held for sale | | | 23,662 | | | | - | | | | 23,662 | | | | - | |
| Derivatives (1) | | | 619 | | | | - | | | | 619 | | | | - | |
| Liabilities | | | | | | | | | | | | | | | | |
| Derivatives (2) | | | 366 | | | | - | | | | 366 | | | | - | |
| | | | | | | | | | | | | | | | | |
| Measured at Fair Value on a Non-recurring basis: | | | | | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | | | | | |
| Capitalized mortgage loan servicing rights (3) | | | 9,197 | | | | - | | | | - | | | | 9,197 | |
| Impaired loans (4) | | | | | | | | | | | | | | | | |
| Commercial | | | | | | | | | | | | | | | | |
| Income producing - real estate | | | 869 | | | | - | | | | - | | | | 869 | |
| Land, land development & construction-real estate | | | 354 | | | | - | | | | - | | | | 354 | |
| Commercial and industrial | | | 2,601 | | | | - | | | | - | | | | 2,601 | |
| Mortgage | | | | | | | | | | | | | | | | |
| 1-4 Family | | | 1,306 | | | | - | | | | - | | | | 1,306 | |
| Other real estate (5) | | | | | | | | | | | | | | | | |
| Commercial | | | | | | | | | | | | | | | | |
| Income producing - real estate | | | 479 | | | | - | | | | - | | | | 479 | |
| Land, land development & construction-real estate | | | 737 | | | | - | | | | - | | | | 737 | |
| Mortgage | | | | | | | | | | | | | | | | |
| 1-4 Family | | | 102 | | | | - | | | | - | | | | 102 | |
| Resort Lending | | | 575 | | | | - | | | | - | | | | 575 | |
| Installment | | | | | | | | | | | | | | | | |
| Home equity - 1st lien | | | 13 | | | | - | | | | - | | | | 13 | |
| (1) | Included in accrued income and other assets |
| (2) | Included in accrued expenses and other liabilities |
| (3) | Only includes servicing rights that are carried at fair value due to recognition of a valuation allowance. |
| (4) | Only includes impaired loans with specific loss allocations based on collateral value. |
| (5) | Only includes other real estate with subsequent write downs to fair value. |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
There were no transfers between Level 1 and Level 2 during the three months ended March 31, 2015 and 2014.
Changes in fair values for financial assets which we have elected the fair value option for the periods presented were as follows:
| | | Changes in Fair Values for the Three-Month Periods Ended March 31 for Items Measured at Fair Value Pursuant to Election of the Fair Value Option | |
| | | 2015 | | | 2014 | |
| | | Net Gains (Losses) on Assets | | | Total Change in Fair Values Included in Current Period | | | Net Gains (Losses) on Assets | | | Total Change in Fair Values Included in Current Period | |
| | | Securities | | | Loans | | | Earnings | | | Securities | | | Loans | | | Earnings | |
| | (In thousands) | |
| Trading securities | | $ | 10 | | | $ | - | | | $ | 10 | | | $ | 112 | | | $ | - | | | $ | 112 | |
| Loans held for sale | | | - | | | | 209 | | | | 209 | | | | - | | | | 30 | | | | 30 | |
For those items measured at fair value pursuant to our election of the fair value option, interest income is recorded within the Condensed Consolidated Statements of Operations based on the contractual amount of interest income earned on these financial assets and dividend income is recorded based on cash dividends.
The following represent impairment charges recognized during the three month periods ended March 31, 2015 and 2014 relating to assets measured at fair value on a non-recurring basis:
| · | Capitalized mortgage loan servicing rights, whose individual strata are measured at fair value, had a carrying amount of $8.1 million which is net of a valuation allowance of $4.5 million at March 31, 2015 and had a carrying amount of $9.2 million which is net of a valuation allowance of $3.8 million at December 31, 2014. An additional charge relating to capitalized mortgage loan servicing rights measured at fair value of $0.7 million and $0.3 million was included in our results of operations for the three month periods ending March 31, 2015 and 2014, respectively. |
| · | Loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a carrying amount of $7.6 million, with a valuation allowance of $2.8 million at March 31, 2015 and had a carrying amount of $8.2 million, with a valuation allowance of $3.1 million at December 31, 2014. The provision for loan losses included in our results of operations relating to impaired loans was an expense of $0.6 million and an expense of $1.5 million for the three month periods ending March 31, 2015 and 2014, respectively. |
| · | Other real estate, which is measured using the fair value of the property, had a carrying amount of $1.2 million which is net of a valuation allowance of $2.5 million at March 31, 2015 and a carrying amount of $1.9 million which is net of a valuation allowance of $2.5 million at December 31, 2014. An additional charge relating to ORE measured at fair value of $0.2 million and $0.1 million was included in our results of operations during the three month periods ended March 31, 2015 and 2014, respectively. |
We had no assets or liabilities measured at fair value on a recurring basis that used significant unobservable inputs (Level 3) during the three months ended March 31, 2015 and 2014.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Quantitative information about Level 3 fair value measurements measured on a non-recurring basis follows:
| | | Asset (Liability) Fair Value | | Valuation Technique | | Unobservable Inputs | | Weighted Average | |
| | | (In thousands) | | | | | |
| March 31, 2015 | | | | | | | | | |
| Capitalized mortgage loan servicing rights | | $ | 8,129 | | Present value of net servicing revenue | | Discount rate | | | 10.02 | % |
| | | | | Cost to service | | $ | 80 | |
| | | | | Ancillary income | | | 25 | |
| | | | | Float rate | | | 1.53 | % |
| | | | | | | | | | | | |
| Impaired loans | | | | | | | | | | | |
| Commercial (1) | | | 2,406 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | (3.7 | )% |
| | | | | | Income approach | | Capitalization rate | | | 9.3 | |
| | | | | | | | | | | | |
| Mortgage | | | 1,356 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | 9.1 | |
| | | | | | | | | | | | |
| Other real estate | | | | | | | | | | | |
| Commercial | | | 677 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | (5.3 | ) |
| | | | | | | | | | | | |
| Mortgage | | | 529 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | 16.0 | |
| | | | | | | | | | | | |
| December 31, 2014 | | | | | | | | | | | |
| Capitalized mortgage loan servicing rights | | $ | 9,197 | | Present value of net servicing revenue | | Discount rate | | | 10.07 | % |
| | | | | Cost to service | | $ | 82 | |
| | | | | Ancillary income | | | 25 | |
| | | | | Float rate | | | 1.77 | % |
| | | | | | | | | | | | |
| Impaired loans | | | | | | | | | | | |
| Commercial (1) | | | 2,751 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | (3.8 | )% |
| | | | | | Income approach | | Capitalization rate | | | 9.3 | |
| | | | | | | | | | | | |
| Mortgage | | | 1,306 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | 8.6 | |
| | | | | | | | | | | | |
| Other real estate | | | | | | | | | | | |
| Commercial | | | 1,216 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | (9.0 | ) |
| | | | | | | | | | | | |
| Mortgage and installment | | | 690 | | Sales comparison approach | | Adjustment for differences between comparable sales | | | 34.3 | |
| (1) | In addition to the valuation techniques and unobservable inputs discussed above, at March 31, 2015 and December 31, 2014 we had an impaired collateral dependent commercial relationship that totaled $1.0 million and $1.1 million, respectively that was primarily secured by collateral other than real estate. Collateral securing this relationship primarily included machinery and equipment, accounts receivable, inventory and company stock. Valuation techniques at March 31, 2015 included discounting restructuring firm valuations based on estimates of value recovery of each particular asset type. Discount rates used ranged from 20% to 100% of stated values while valuation techniques at December 31, 2014 included discounting cost and financial statement value approaches based on estimates of value recovery of each particular asset type. Discount rates used ranged from 35% to 100% of stated values. |
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The following table reflects the difference between the aggregate fair value and the aggregate remaining contractual principal balance outstanding for loans held for sale for which the fair value option has been elected for the periods presented.
| | | Aggregate Fair Value | | | Difference | | | Contractual Principal | |
| | | (In thousands) | |
| Loans held for sale | | | | | | | | | |
| March 31, 2015 | | $ | 30,932 | | | $ | 833 | | | $ | 30,099 | |
| December 31, 2014 | | | 23,662 | | | | 624 | | | | 23,038 | |
| 13. | Fair Values of Financial Instruments |
Most of our assets and liabilities are considered financial instruments. Many of these financial instruments lack an available trading market and it is our general practice and intent to hold the majority of our financial instruments to maturity. Significant estimates and assumptions were used to determine the fair value of financial instruments. These estimates are subjective in nature, involving uncertainties and matters of judgment, and therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Estimated fair values have been determined using available data and methodologies that are considered suitable for each category of financial instrument. For instruments with adjustable-interest rates which reprice frequently and without significant credit risk, it is presumed that estimated fair values approximate the recorded book balances.
Cash and due from banks and interest bearing deposits: The recorded book balance of cash and due from banks and interest bearing deposits approximate fair value and are classified as Level 1.
Interest bearing deposits - time: Interest bearing deposits - time have been valued based on a model using a benchmark yield curve plus a base spread and are classified as Level 2.
Securities: Financial instrument assets actively traded in a secondary market have been valued using quoted market prices. Trading securities are classified as Level 1 while securities available for sale are classified as Level 2 as described in Note #12.
Federal Home Loan Bank and Federal Reserve Bank Stock: It is not practicable to determine the fair value of FHLB and FRB Stock due to restrictions placed on transferability.
Net loans and loans held for sale: The fair value of loans is calculated by discounting estimated future cash flows using estimated market discount rates that reflect credit and interest-rate risk inherent in the loans resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described in Note #12. Loans held for sale are classified as Level 2 as described in Note #12.
Accrued interest receivable and payable: The recorded book balance of accrued interest receivable and payable approximate fair value and are classified at the same Level as the asset and liability they are associated with.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Derivative financial instruments: The fair value of rate-lock mortgage loan commitments and mandatory commitments to sell mortgage loans is based on mortgage backed security pricing for comparable assets, while the fair value of interest rate swap agreements is based on a discounted cash flow analysis whose significant fair value inputs can generally be observed in the market place and do not typically involve judgment by management. Each of these instruments has been classified as Level 2 as described in note #12.
Deposits: Deposits without a stated maturity, including demand deposits, savings, NOW and money market accounts, have a fair value equal to the amount payable on demand. Each of these instruments is classified as Level 1. Deposits with a stated maturity, such as certificates of deposit have generally been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates for liabilities with a similar maturity resulting in a Level 2 classification.
Other borrowings: Other borrowings have been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates for liabilities with a similar maturity resulting in a Level 2 classification.
Subordinated debentures: Subordinated debentures have generally been valued based on a quoted market price of similar instruments resulting in a Level 2 classification.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The estimated recorded book balances and fair values follow:
| | | | | | | | | Fair Value Using | |
| | | Recorded Book Balance | | | Fair Value | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Un- observable Inputs (Level 3) | |
| | | (In thousands) | |
| March 31, 2015 | | | | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | | | | |
| Cash and due from banks | | $ | 46,435 | | | $ | 46,435 | | | $ | 46,435 | | | $ | - | | | $ | - | |
| Interest bearing deposits | | | 55,117 | | | | 55,117 | | | | 55,117 | | | | - | | | | - | |
| Interest bearing deposits - time | | | 11,575 | | | | 11,575 | | | | - | | | | 11,575 | | | | - | |
| Trading securities | | | 213 | | | | 213 | | | | 213 | | | | - | | | | - | |
| Securities available for sale | | | 571,762 | | | | 571,762 | | | | - | | | | 571,762 | | | | - | |
| Federal Home Loan Bank and Federal | | | | | | | | | | | | | | | | | | | | |
| Reserve Bank Stock | | | 20,051 | | | | NA | | | | NA | | | | NA | | | | NA | |
| Net loans and loans held for sale | | | 1,429,212 | | | | 1,416,980 | | | | - | | | | 30,932 | | | | 1,386,048 | |
| Accrued interest receivable | | | 6,250 | | | | 6,250 | | | | 5 | | | | 1,808 | | | | 4,437 | |
| Derivative financial instruments | | | 1,268 | | | | 1,268 | | | | - | | | | 1,268 | | | | - | |
| | | | | | | | | | | | | | | | | | | | | |
| Liabilities | | | | | | | | | | | | | | | | | | | | |
| Deposits with no stated maturity (1) | | $ | 1,626,558 | | | $ | 1,626,558 | | | $ | 1,626,558 | | | $ | - | | | $ | - | |
| Deposits with stated maturity (1) | | | 373,915 | | | | 373,144 | | | | - | | | | 373,144 | | | | - | |
| Other borrowings | | | 12,468 | | | | 14,508 | | | | - | | | | 14,508 | | | | - | |
| Subordinated debentures | | | 35,569 | | | | 21,974 | | | | - | | | | 21,974 | | | | - | |
| Accrued interest payable | | | 364 | | | | 364 | | | | 20 | | | | 344 | | | | - | |
| Derivative financial instruments | | | 666 | | | | 666 | | | | - | | | | 666 | | | | - | |
| | | | | | | | | | | | | | | | | | | | | |
| December 31, 2014 | | | | | | | | | | | | | | | | | | | | |
| Assets | | | | | | | | | | | | | | | | | | | | |
| Cash and due from banks | | $ | 48,326 | | | $ | 48,326 | | | $ | 48,326 | | | $ | - | | | $ | - | |
| Interest bearing deposits | | | 25,690 | | | | 25,690 | | | | 25,690 | | | | - | | | | - | |
| Interest bearing deposits - time | | | 13,561 | | | | 13,585 | | | | - | | | | 13,585 | | | | - | |
| Trading securities | | | 203 | | | | 203 | | | | 203 | | | | - | | | | - | |
| Securities available for sale | | | 533,178 | | | | 533,178 | | | | - | | | | 533,178 | | | | - | |
| Federal Home Loan Bank and Federal | | | | | | | | | | | | | | | | | | | | |
| Reserve Bank Stock | | | 19,919 | | | | NA | | | | NA | | | | NA | | | | NA | |
| Net loans and loans held for sale | | | 1,407,634 | | | | 1,394,424 | | | | - | | | | 23,662 | | | | 1,370,762 | |
| Accrued interest receivable | | | 5,995 | | | | 5,995 | | | | 2 | | | | 1,599 | | | | 4,394 | |
| Derivative financial instruments | | | 619 | | | | 619 | | | | - | | | | 619 | | | | - | |
| | | | | | | | | | | | | | | | | | | | | |
| Liabilities | | | | | | | | | | | | | | | | | | | | |
| Deposits with no stated maturity (1) | | $ | 1,534,175 | | | $ | 1,534,175 | | | $ | 1,534,175 | | | $ | - | | | $ | - | |
| Deposits with stated maturity (1) | | | 390,127 | | | | 389,139 | | | | - | | | | 389,139 | | | | - | |
| Other borrowings | | | 12,470 | | | | 14,560 | | | | - | | | | 14,560 | | | | - | |
| Subordinated debentures | | | 35,569 | | | | 23,328 | | | | - | | | | 23,328 | | | | - | |
| Accrued interest payable | | | 380 | | | | 380 | | | | 21 | | | | 359 | | | | - | |
| Derivative financial instruments | | | 366 | | | | 366 | | | | - | | | | 366 | | | | - | |
| (1) | Deposits with no stated maturity include reciprocal deposits with a recorded book balance of $17.2 million and $13.6 million at March 31, 2015 and December 31, 2014, respectively. Deposits with a stated maturity include reciprocal deposits with a recorded book balance of $41.5 million and $40.1 million at March 31, 2015 and December 31, 2014, respectively. |
The fair values for commitments to extend credit and standby letters of credit are estimated to approximate their aggregate book balance, which is nominal and therefore are not disclosed.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale the entire holdings of a particular financial instrument.
Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business, the value of future earnings attributable to off-balance sheet activities and the value of assets and liabilities that are not considered financial instruments.
Fair value estimates for deposit accounts do not include the value of the core deposit intangible asset resulting from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.
| 14. | Contingent Liabilities |
We are involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our consolidated financial position or results of operations. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued. At this time, we estimate the maximum amount of additional losses that are reasonably possible is approximately $0.5 million. However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages, this maximum amount may change in the future.
The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans or vehicle service contract counterparty receivables). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, but we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote. Risks associated with the likelihood that we will not collect the full amount owed to us, net of reserves, are disclosed elsewhere in this report.
Our Mepco segment conducts its payment plan business activities across the United States. Mepco acquires the payment plans from companies (which we refer to as Mepco’s “counterparties”) at a discount from the face amount of the payment plan. Each payment plan (which are classified as payment plan receivables in our Condensed Consolidated Statements of Financial Condition) permits a consumer to purchase a vehicle service contract by making installment payments, generally for a term of 12 to 24 months, to the sellers of those contracts (one of the “counterparties”). Mepco thereafter collects the payments from consumers. In acquiring the payment plan, Mepco generally funds a portion of the cost to the seller of the service contract and a portion of the cost to the administrator of the service contract. The administrator, in turn, pays the necessary contractual liability insurance policy (“CLIP”) premium to the insurer or risk retention group.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Consumers are allowed to voluntarily cancel the service contract at any time and are generally entitled to receive a refund from the administrator of the unearned portion of the service contract at the time of cancellation. As a result, while Mepco does not owe any refund to the consumer, it also does not have any recourse against the consumer for nonpayment of a payment plan and therefore does not evaluate the creditworthiness of the individual consumer. If a consumer stops making payments on a payment plan or exercises the right to voluntarily cancel the service contract, the service contract seller and administrator are each obligated to refund to Mepco the amount necessary to make Mepco whole as a result of its funding of the service contract. In addition, the insurer or risk retention group that issued the CLIP for the service contract often guarantees all or a portion of the refund to Mepco. See note #4 above for a breakdown of Mepco’s payment plan receivables by the level of recourse Mepco has against various counterparties.
Upon the cancellation of a service contract and the completion of the billing process to the counterparties for amounts due to Mepco, there is a decrease in the amount of “payment plan receivables” and an increase in the amount of “vehicle service contract counterparty receivables” until such time as the amount due from the counterparty is collected. These amounts represent funds actually due to Mepco from its counterparties for cancelled service contracts. At March 31, 2015 and December 31, 2014, the aggregate amount of such obligations owing to Mepco by counterparties, net of write-downs and reserves made through the recognition of vehicle service contract counterparty contingencies expense, totaled $7.2 million. Mepco is currently in the process of working to recover these receivables, primarily through litigation against counterparties.
In some cases, Mepco requires collateral or guaranties by the principals of the counterparties to secure these refund obligations; however, this is generally only the case when no rated insurance company is involved to guarantee the repayment obligation of the seller and administrator counterparties. In most cases, there is no collateral to secure the counterparties’ refund obligations to Mepco, but Mepco has the contractual right to offset unpaid refund obligations against amounts Mepco would otherwise be obligated to fund to the counterparties. In addition, even when collateral is involved, the refund obligations of these counterparties are not fully secured. Mepco incurs losses when it is unable to fully recover funds owing to it by counterparties upon cancellation of the underlying service contracts. The sudden failure of one of Mepco’s major counterparties (an insurance company, administrator, or seller/dealer) could expose us to significant losses.
When counterparties do not honor their contractual obligations to Mepco to repay funds, we recognize estimated losses. Mepco pursues collection (including commencing legal action if necessary) of funds due to it under its various contracts with counterparties. Mepco has had to initiate litigation against certain counterparties, including third party insurers, to collect amounts owed to Mepco as a result of those parties' dispute of their contractual obligations to Mepco. Charges related to estimated losses for vehicle service contract counterparty contingencies included in non-interest expense totaled $0.03 million and $0.07 million for the three month periods ended March 31, 2015 and 2014, respectively. These charges are being classified in non-interest expense because they are associated with a default or potential default of a contractual obligation under our counterparty contracts as opposed to loss on the administration of the payment plan itself.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Our estimate of probable incurred losses from vehicle service contract counterparty contingencies requires a significant amount of judgment because a number of factors can influence the amount of loss that we may ultimately incur. These factors include our estimate of future cancellations of vehicle service contracts, our evaluation of collateral that may be available to recover funds due from our counterparties, and our assessment of the amount that may ultimately be collected from counterparties in connection with their contractual obligations. We apply a rigorous process, based upon historical payment plan activity and past experience, to estimate probable incurred losses and quantify the necessary reserves for our vehicle service contract counterparty contingencies, but there can be no assurance that our modeling process will successfully identify all such losses.
We believe our assumptions regarding the collection of vehicle service contract counterparty receivables are reasonable, and we based them on our good faith judgments using data currently available. We also believe the current amount of reserves we have established and the vehicle service contract counterparty contingencies expense that we have recorded are appropriate given our estimate of probable incurred losses at the applicable Condensed Consolidated Statement of Financial Condition date. However, because of the uncertainty surrounding the numerous and complex assumptions made, actual losses could exceed the charges we have taken to date.
The provision for loss reimbursement on sold loans represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae and Freddie Mac). Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. The provision for loss reimbursement on sold loans was a credit of $0.1 million and a credit of $0.5 million in the first quarters of 2015 and 2014, respectively. The credit provision in the first quarter of 2015 is due primarily to the settlement of certain loss reimbursement claims at slightly lower amounts than what had been specifically reserved for at the end of 2014. The credit provision in the first quarter of 2014 is due primarily to the rescission of certain loss reimbursement requests by Freddie Mac that had been pending and accrued for at the end of 2013. The reserve for loss reimbursements on sold mortgage loans totaled $0.6 million and $0.7 million at March 31, 2015 and December 31, 2014, respectively. This reserve is included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition. This reserve is based on an analysis of mortgage loans that we have sold which are further categorized by delinquency status, loan to value, and year of origination. The calculation includes factors such as probability of default, probability of loss reimbursement (breach of representation or warranty) and estimated loss severity. The reserve levels at March 31, 2015 and December 31, 2014 also reflect the resolution of the mortgage loan origination years of 2000 to 2008 with Fannie Mae and Freddie Mac. We believe that the amounts that we have accrued for incurred losses on sold mortgage loans are appropriate given our analyses. However, future losses could exceed our current estimate.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
| 15. | Accumulated Other Comprehensive Loss (“AOCL”) |
A summary of changes in AOCL follows:
| | | Unrealized Gains (Losses) on Available for Sale Securities | | | Dispropor- tionate Tax Effects from Securities Available for Sale | | | Unrealized Losses on Settled Derivatives | | | Total | |
| For the three months ended March 31, 2015 | | | | | | | | | | | | |
| Balances at beginning of period | | $ | 162 | | | $ | (5,798 | ) | | $ | - | | | $ | (5,636 | ) |
| Other comprehensive income before reclassifications | | | 1,483 | | | | - | | | | - | | | | 1,483 | |
| Amounts reclassified from AOCL | | | (49 | ) | | | - | | | | - | | | | (49 | ) |
| Net current period other comprehensive income | | | 1,434 | | | | - | | | | - | | | | 1,434 | |
| Balances at end of period | | $ | 1,596 | | | $ | (5,798 | ) | | $ | - | | | $ | (4,202 | ) |
| | | | | | | | | | | | | | | | | |
| For the three months ended March 31, 2014 | | | | | | | | | | | | | | | | |
| Balances at beginning of period | | $ | (3,200 | ) | | $ | (5,798 | ) | | $ | (247 | ) | | $ | (9,245 | ) |
| Other comprehensive income before reclassifications | | | 1,539 | | | | - | | | | - | | | | 1,539 | |
| Amounts reclassified from AOCL | | | - | | | | - | | | | 62 | | | | 62 | |
| Net current period other comprehensive income | | | 1,539 | | | | - | | | | 62 | | | | 1,601 | |
| Balances at end of period | | $ | (1,661 | ) | | $ | (5,798 | ) | | $ | (185 | ) | | $ | (7,644 | ) |
The disproportionate tax effects from securities available for sale arose due to tax effects of other comprehensive income (“OCI”) in the presence of a valuation allowance against our deferred tax assets and a pretax loss from operations. Generally, the amount of income tax expense or benefit allocated to operations is determined without regard to the tax effects of other categories of income or loss, such as OCI. However, an exception to the general rule is provided when, in the presence of a valuation allowance against deferred tax assets, there is a pretax loss from operations and pretax income from other categories in the current period. In such instances, income from other categories must offset the current loss from operations, the tax benefit of such offset being reflected in operations.
NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
A summary of reclassifications out of each component of AOCL for the three months ended March 31 follows:
| AOCL Component | | Amount Reclassified From AOCL | | Affected Line Item in Condensed Consolidated Statements of Operations |
| | | (In thousands) | | |
| 2015 | | | | |
| Unrealized gains on available for sale securities | | | | |
| | | $ | 75 | | Net gains on securities |
| | | | - | | Net impairment loss recognized in earnings |
| | | | 75 | | Total reclassifications before tax |
| | | | 26 | | Tax expense |
| | | $ | 49 | | Reclassifications, net of tax |
| | | | | | |
| 2014 | | | | | |
| Unrealized gains on settled derivatives | | | | | |
| | | $ | (95 | ) | Interest expense |
| | | | (33 | ) | Tax benefit |
| | | $ | (62 | ) | Reclassification, net of tax |
ITEM 2.
Management’s Discussion and Analysis
of Financial Condition and Results of Operations
Introduction. The following section presents additional information to assess the financial condition and results of operations of Independent Bank Corporation, its wholly-owned bank, Independent Bank (the "Bank"), and their subsidiaries. This section should be read in conjunction with the Condensed Consolidated Financial Statements. We also encourage you to read our 2014 Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission ("SEC"). That report includes a list of risk factors that you should consider in connection with any decision to buy or sell our securities.
Overview. We provide banking services to customers located primarily in Michigan’s Lower Peninsula. As a result, our success depends to a great extent upon the economic conditions in Michigan’s Lower Peninsula. We have in general experienced a difficult economy in Michigan since 2001, which has had at times, a significant adverse effect on our performance. As a result of the recession, we incurred net losses from 2008 through 2011 and found it necessary to take certain steps to preserve capital and maintain our regulatory capital ratios.
Economic conditions in Michigan began to show signs of improvement during 2010. Generally, these improvements have continued into 2015, albeit at an uneven pace. There has been an overall decline in the unemployment rate, although Michigan’s unemployment rate has been consistently above the national average. In addition, housing prices and other related statistics (such as home sales and new building permits) have generally been improving. In addition, since early- to mid-2009, we have seen an improvement in our asset quality metrics. In particular, since early 2012, we have generally experienced a decline in non-performing assets, reduced levels of new loan defaults, and reduced levels of loan net charge-offs. As a result of the foregoing factors and others, we returned to profitability in 2012 and have now been profitable for 13 consecutive quarters. In addition, we completed various transactions to improve our capital structure.
Recent Developments. In January 2015, we adopted a plan to consolidate certain branch offices. This consolidation reflects our ongoing cost reduction initiatives and undertakings to further improve the overall efficiency of our operations. The consolidation resulted in the closing of six of our branch offices on April 30, 2015. It is expected that the aggregate, annual reduction in non-interest expenses resulting from this consolidation will amount to approximately $1.6 million. We also estimate a potential annual loss of revenue of approximately $0.3 million to $0.4 million due to possible customer attrition. We also undertook certain additional staffing reductions related to our retail banking operations. In connection with the consolidation and these staffing reductions, we recorded $0.2 million of severance expenses in the first quarter of 2015. We do not expect any material loss related to the sale or disposition of real property or other fixed assets.
Regulation. On July 2, 2013, the Federal Reserve Board (the "FRB") approved a final rule that establishes an integrated regulatory capital framework (the "New Capital Rules"). The rule implements in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). In general, under the New Capital Rules, minimum requirements have increased for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the New Capital Rules include a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5% and a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets that applies to all supervised financial institutions. The 2.5% capital conservation buffer is being phased in over a four-year period beginning in 2016. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations. As to the quality of capital, the New Capital Rules emphasize common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The New Capital Rules also change the methodology for calculating risk-weighted assets to enhance risk sensitivity. Under the New Capital Rules our existing trust preferred securities are grandfathered as qualifying regulatory capital. We were subject to the New Capital Rules beginning on January 1, 2015 and as of March 31, 2015 we exceeded all of the capital ratio requirements of the New Capital Rules.
It is against this backdrop that we discuss our results of operations and financial condition in the first quarter of 2015 as compared to 2014.
Results of Operations
Summary. We recorded net income of $3.8 million during the three months ended March 31, 2015, compared to net income of $3.1 million during the three months ended March 31, 2014. The increase in net income is primarily due to decreases in the provision for loan losses and in non-interest expenses that were partially offset by a decline in net interest income and an increase in income tax expense.
| Key performance ratios | | | |
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| Net income (annualized) to | | | | | | |
| Average assets | | | 0.67 | % | | | 0.57 | % |
| Average common shareholders’ equity | | | 6.05 | | | | 5.41 | |
| | | | | | | | | |
| Net income per common share | | | | | | | | |
| Basic | | $ | 0.16 | | | $ | 0.14 | |
| Diluted | | | 0.16 | | | | 0.13 | |
Net interest income. Net interest income is the most important source of our earnings and thus is critical in evaluating our results of operations. Changes in our net interest income are primarily influenced by our level of interest-earning assets and the income or yield that we earn on those assets and the manner and cost of funding our interest-earning assets. Certain macro-economic factors can also influence our net interest income such as the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in which we are doing business. Finally, risk management plays an important role in our level of net interest income. The ineffective management of credit risk and interest-rate risk in particular can adversely impact our net interest income.
Net interest income totaled $18.1 million during the first quarter of 2015, which represents a $0.4 million, or 2.1% decrease, from the comparable quarter one year earlier. The decrease in net interest income in 2015 compared to 2014 primarily reflects a 22 basis point decrease in our tax equivalent net interest income as a percent of average interest-earning assets (the “net interest margin”) that was partially offset by a $70.7 million increase in average interest-earning assets.
The decline in our net interest margin is primarily due to the prolonged low interest rate environment that has pushed our average yield on loans lower.
Interest rates have generally been at extremely low levels since 2008 due primarily to the FRB’s monetary policies and its efforts to stimulate the U.S. economy. This very low interest rate environment has had an adverse impact on our interest income and net interest income. Based on recent announcements by the FRB, short-term interest rates are expected to remain extremely low until at least mid- to late-2015. Given the repricing characteristics of our interest-earning assets and interest-bearing liabilities (and our level of non-interest bearing demand deposits), we would expect that our net interest margin will generally benefit on a long-term basis from rising interest rates.
Our net interest income is also adversely impacted by our level of non-accrual loans. In the first quarter of 2015 non-accrual loans averaged $15.1 million compared to $18.6 million in the first quarter of 2014.
| Average Balances and Rates | | | |
| | | Three Months Ended March 31, | |
| | | 2015 | | | 2014 | |
| | | | | | Interest | | | Rate(3) | | | | | | Interest | | | Rate(3) | |
Assets (1) | | (Dollars in thousands) | |
| Taxable loans | | $ | 1,420,272 | | | $ | 17,195 | | | | 4.88 | % | | $ | 1,369,065 | | | $ | 18,162 | | | | 5.36 | % |
Tax-exempt loans(2) | | | 4,360 | | | | 68 | | | | 6.33 | | | | 5,193 | | | | 82 | | | | 6.40 | |
| Taxable securities | | | 506,411 | | | | 1,758 | | | | 1.39 | | | | 441,783 | | | | 1,383 | | | | 1.27 | |
Tax-exempt securities(2) | | | 33,877 | | | | 333 | | | | 3.93 | | | | 41,023 | | | | 399 | | | | 3.94 | |
| Cash – interest bearing | | | 75,171 | | | | 70 | | | | 0.38 | | | | 108,855 | | | | 91 | | | | 0.34 | |
| Other investments | | | 19,991 | | | | 268 | | | | 5.44 | | | | 23,419 | | | | 332 | | | | 5.75 | |
| Interest Earning Assets | | | 2,060,082 | | | | 19,692 | | | | 3.86 | | | | 1,989,338 | | | | 20,449 | | | | 4.16 | |
| Cash and due from banks | | | 46,035 | | | | | | | | | | | | 45,439 | | | | | | | | | |
| Other assets, net | | | 171,878 | | | | | | | | | | | | 188,246 | | | | | | | | | |
| Total Assets | | $ | 2,277,995 | | | | | | | | | | | $ | 2,223,023 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Liabilities | | | | | | | | | | | | | | | | | | | | | | | | |
| Savings and interest-bearing checking | | $ | 985,482 | | | | 266 | | | | 0.11 | | | $ | 946,295 | | | | 263 | | | | 0.11 | |
| Time deposits | | | 376,958 | | | | 741 | | | | 0.80 | | | | 443,630 | | | | 1,030 | | | | 0.94 | |
| Other borrowings | | | 48,038 | | | | 454 | | | | 3.83 | | | | 54,329 | | | | 512 | | | | 3.82 | |
| Interest Bearing Liabilities | | | 1,410,478 | | | | 1,461 | | | | 0.42 | | | | 1,444,254 | | | | 1,805 | | | | 0.51 | |
| Non-interest bearing deposits | | | 590,088 | | | | | | | | | | | | 511,463 | | | | | | | | | |
| Other liabilities | | | 23,955 | | | | | | | | | | | | 32,284 | | | | | | | | | |
| Shareholders’ equity | | | 253,474 | | | | | | | | | | | | 235,022 | | | | | | | | | |
| Total liabilities and shareholders’ equity | | $ | 2,277,995 | | | | | | | | | | | $ | 2,223,023 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net Interest Income | | | | | | $ | 18,231 | | | | | | | | | | | $ | 18,644 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net Interest Income as a Percent of Average Interest Earning Assets | | | | | | | | | | | 3.57 | % | | | | | | | | | | | 3.79 | % |
| (2) | Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 35%. |
Provision for loan losses. The provision for loan losses was a credit of $0.7 million and an expense of $0.4 million in the first quarters of 2015 and 2014, respectively. The provision reflects our assessment of the allowance for loan losses taking into consideration factors such as loan mix, levels of non-performing and classified loans and loan net charge-offs. While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors. See “Portfolio Loans and asset quality” for a discussion of the various components of the allowance for loan losses and their impact on the provision for loan losses in the first quarter of 2015.
Non-interest income. Non-interest income is a significant element in assessing our results of operations. We regard net gains on mortgage loans as a core recurring source of revenue but they are quite cyclical and thus can be volatile. We regard net gains (losses) on securities as a “non-operating” component of non-interest income.
Non-interest income totaled $9.0 million during both the first three months of 2015 and 2014.
| Non-Interest Income | | | |
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (In thousands) | |
| Service charges on deposit accounts | | $ | 2,850 | | | $ | 3,055 | |
| Interchange income | | | 2,142 | | | | 1,941 | |
| Net gains on assets | | | | | | | | |
| Mortgage loans | | | 2,139 | | | | 1,144 | |
| Securities | | | 85 | | | | 112 | |
| Mortgage loan servicing | | | (420 | ) | | | 264 | |
| Investment and insurance commissions | | | 446 | | | | 402 | |
| Bank owned life insurance | | | 350 | | | | 319 | |
| Title insurance fees | | | 256 | | | | 274 | |
| Other | | | 1,114 | | | | 1,444 | |
| Total non-interest income | | $ | 8,962 | | | $ | 8,955 | |
Service charges on deposit accounts totaled $2.9 million in the first quarter of 2015, a $0.2 million, or 6.7%, decrease from the comparable period in 2014. The decrease in such service charges in 2015 principally results from a decline in non-sufficient funds (“NSF”) occurrences and related NSF fees. We believe the decline in NSF occurrences is principally due to our customers managing their finances more closely in order to reduce NSF activity and avoid the associated fees.
Interchange income increased by $0.2 million, or 10.4%, in the first quarter of 2015 compared to the year ago period. The increase in interchange income in 2015 as compared to 2014 primarily results from a new Debit Brand Agreement with MasterCard (which replaced our former agreement with VISA) that we executed in January 2014. We began converting our debit card base to MasterCard in June 2014 and completed the conversion in September 2014.
The Dodd-Frank Act includes a provision under which interchange fees for debit cards are set by the FRB under a restrictive “reasonable and proportional cost” per transaction standard. On June 29, 2011, the FRB issued final rules (that were effective October 1, 2011) on interchange fees for debit cards. Overall, these final rules established price caps for debit card interchange fees that were significantly lower than previous averages. However, debit card issuers with less than $10 billion in assets (like us) are exempt from this rule. On a long-term basis, it is not clear how competitive market factors may impact debit card issuers who are exempt from the rule. However, we have been experiencing some reduction in per transaction interchange revenue due to certain transaction routing changes, particularly at large merchants.
Net gains on mortgage loans were $2.1 million and $1.1 million in the first quarters of 2015 and 2014, respectively. Mortgage loan sales totaled $68.7 million in the first quarter of 2015 compared to $47.1 million in the first quarter of 2014. Mortgage loans originated totaled $79.8 million in the first quarter of 2015 compared to $44.2 million in the comparable quarter of 2014. The increases in mortgage loan originations, sales and net gains in 2015 as compared to 2014 is due primarily to a decrease in mortgage loan interest rates that increased mortgage loan refinance volumes.
| Mortgage Loan Activity | | | |
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (Dollars in thousands) | |
| Mortgage loans originated | | $ | 79,790 | | | $ | 44,241 | |
| Mortgage loans sold | | | 68,727 | | | | 47,118 | |
| Mortgage loans sold with servicing rights released | | | 2,669 | | | | 7,861 | |
| Net gains on the sale of mortgage loans | | | 2,139 | | | | 1,144 | |
| Net gains as a percentage of mortgage loans sold (“Loan Sales Margin”) | | | 3.11 | % | | | 2.43 | % |
| Fair value adjustments included in the Loan Sales Margin | | | 0.81 | | | | (0.14 | ) |
The volume of loans sold is dependent upon our ability to originate mortgage loans as well as the demand for fixed-rate obligations and other loans that we choose to not put into portfolio because of our established interest-rate risk parameters. (See “Portfolio Loans and asset quality.”) Net gains on mortgage loans are also dependent upon economic and competitive factors as well as our ability to effectively manage exposure to changes in interest rates and thus can often be a volatile part of our overall revenues.
Net gains as a percentage of mortgage loans sold (our “Loan Sales Margin”) are impacted by several factors including competition and the manner in which the loan is sold (with servicing rights retained or released). Our decision to sell or retain mortgage loan servicing rights is primarily influenced by an evaluation of the price being paid for mortgage loan servicing by outside third parties compared to our calculation of the economic value of retaining such servicing. Net gains on mortgage loans are also impacted by recording fair value accounting adjustments. Excluding these fair value accounting adjustments, the Loan Sales Margin would have been 2.30% and 2.57% in the first quarters of 2015 and 2014, respectively. The decrease in the Loan Sales Margin (excluding fair value adjustments) in 2015 was generally due to a narrowing of primary-to-secondary market pricing spreads reflecting increased price competition.
We recorded securities net gains of approximately $0.1 million in both the first quarter of 2015 and 2014. The first quarter 2015 securities net gains are due primarily to the sale of U.S. agency residential mortgage-backed securities. The first quarter 2014 securities net gains were due to an increase in the fair value of our trading securities.
We recorded no net impairment losses in either the first quarter of 2015 or 2014, for other than temporary impairment of securities available for sale. (See “Securities.”)
Mortgage loan servicing generated a loss of $0.4 million and income of $0.3 million in the first quarters of 2015 and 2014, respectively. This quarterly comparative variance is primarily due to changes in the valuation allowance on and the amortization of capitalized mortgage loan servicing rights. The period end valuation allowance is based on the valuation of the mortgage loan servicing portfolio. Activity related to capitalized mortgage loan servicing rights is as follows:
| Capitalized Mortgage Loan Servicing Rights | | | |
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (In thousands) | |
| Balance at beginning of period | | $ | 12,106 | | | $ | 13,710 | |
| Originated servicing rights capitalized | | | 663 | | | | 382 | |
| Amortization | | | (759 | ) | | | (534 | ) |
| (Increase) decrease in valuation allowance | | | (692 | ) | | | (285 | ) |
| Balance at end of period | | $ | 11,318 | | | $ | 13,273 | |
| | | | | | | | | |
| Valuation allowance at end of period | | $ | 4,465 | | | $ | 3,140 | |
At March 31, 2015 we were servicing approximately $1.65 billion in mortgage loans for others on which servicing rights have been capitalized. This servicing portfolio had a weighted average coupon rate of 4.41% and a weighted average service fee of approximately 25.3 basis points. Remaining capitalized mortgage loan servicing rights at March 31, 2015 totaled $11.3 million, representing approximately 69 basis points on the related amount of mortgage loans serviced for others. The capitalized mortgage loan servicing had an estimated fair market value of $11.6 million at March 31, 2015.
Investment and insurance commissions increased modestly (by $0.04 million) during the first quarter of 2015 as compared to the year ago period due primarily to an increase in sales.
We earned $0.4 million and $0.3 million in the first quarters of 2015 and 2014, respectively, principally as a result of increases in the cash surrender value of our separate account bank owned life insurance. Our separate account is primarily invested in agency mortgage-backed securities and managed by PIMCO. The crediting rate (on which the earnings are based) reflects the performance of the separate account. The total cash surrender value of our bank owned life insurance was $54.0 million and $53.6 million at March 31, 2015 and December 31, 2014, respectively.
Title insurance fees totaled $0.3 million in both the first quarter of 2015 and 2014. During 2015, an increase in title insurance revenues related to mortgage loans was offset by a decline in title insurance revenues related to commercial loans and a lower retention bonus as compared to 2014.
Other non-interest income totaled $1.1 million and $1.4 million during the first quarters of 2015 and 2014, respectively. This decrease is primarily due to a decline in rental income on other real estate owned (“ORE”).
Non-interest expense. Non-interest expense is an important component of our results of operations. We strive to efficiently manage our cost structure and management is focused on a number of initiatives to reduce and contain non-interest expenses.
Non-interest expense totaled $22.2 million in the first quarter of 2015 compared to $22.4 million in the year ago period.
| Non-Interest Expense | | | |
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (In thousands) | |
| Compensation | | $ | 8,330 | | | $ | 8,308 | |
| Performance-based compensation | | | 1,288 | | | | 912 | |
| Payroll taxes and employee benefits | | | 2,167 | | | | 2,018 | |
| Compensation and employee benefits | | | 11,785 | | | | 11,238 | |
| Occupancy, net | | | 2,419 | | | | 2,483 | |
| Data processing | | | 1,930 | | | | 2,086 | |
| Loan and collection | | | 1,155 | | | | 1,465 | |
| Furniture, fixtures and equipment | | | 952 | | | | 1,069 | |
| Communications | | | 736 | | | | 789 | |
| Advertising | | | 484 | | | | 519 | |
| Legal and professional fees | | | 380 | | | | 401 | |
| FDIC deposit insurance | | | 343 | | | | 417 | |
| Interchange expense | | | 291 | | | | 402 | |
| Supplies | | | 213 | | | | 239 | |
| Credit card and bank service fees | | | 202 | | | | 263 | |
| Amortization of intangible assets | | | 87 | | | | 134 | |
| Vehicle service contract counterparty contingencies | | | 29 | | | | 68 | |
| Costs related to unfunded lending commitments | | | 16 | | | | 10 | |
| Net gains on other real estate and repossessed assets | | | (39 | ) | | | (87 | ) |
| Provision for loss reimbursement on sold loans | | | (69 | ) | | | (481 | ) |
| Other | | | 1,237 | | | | 1,385 | |
| Total non-interest expense | | $ | 22,151 | | | $ | 22,400 | |
Compensation and employee benefits expenses, in total, increased by $0.5 million, or 4.9%, in the first quarter of 2015, due primarily to severance expense incurred in 2015 and an increase in performance-based compensation.
Compensation expense increased by $0.02 million, or 0.03%. Average full-time equivalent employees (“FTE’s”) were reduced by 24.0, or 2.9%, during the first quarter of 2015 compared to the year ago quarter. However, the impact of the FTE reductions was offset by a $0.2 million increase in severance expenses in connection with the branch consolidation and other staffing reductions as well as merit pay increases that were effective January 1, 2015.
Performance-based compensation increased by $0.4 million in 2015 due primarily to a higher accrual for anticipated incentive compensation based on our estimated 2015 performance as compared to goals.
Payroll taxes and employee benefits increased $0.1 million in 2015 due primarily to an increase in medical insurance costs.
Occupancy, net, decreased slightly in the first quarter of 2015 compared to 2014 primarily because of a decrease in snow removal costs.
Data processing expense decreased $0.2 million, or 7.5%, and interchange expense decreased $0.1 million, or 27.6%, in the first quarter of 2015 compared to the year earlier period. These declines in 2015 are due primarily to the impact of a new seven-year core data processing contract that we executed in March 2014. Under the terms of the new contract, we have reduced core data processing and interchange costs by approximately $1 million annually.
Loan and collection expenses primarily reflect costs related to the management and collection of non-performing loans and other problem credits. These expenses have further declined in 2015, which primarily reflects the overall year-over-year decrease in non-performing assets and “watch” credits. (See “Portfolio Loans and asset quality.”)
Furniture, fixtures and equipment, communications, advertising, and supplies expenses collectively declined by approximately $0.2 million, or 8.8%, in the first quarter of 2015 as compared to 2014 due primarily to our efforts to reduce non-interest expenses.
Legal and professional fees were relatively unchanged in the first quarter of 2015 as compared to the year earlier period.
FDIC deposit insurance expense totaled $0.3 million and $0.4 million in the first quarters of 2015 and 2014, respectively. The decline in 2015 principally reflects a reduction in the Bank’s risk based premium rate due to our continued improving financial metrics.
Credit card and bank service fees decreased primarily due to a decline in the number of payment plans being serviced by Mepco in the first quarter of 2015 compared to the first quarter of 2014.
The amortization of intangible assets primarily relates to branch acquisitions and the amortization of the deposit customer relationship value, including core deposit value, which was acquired in connection with those acquisitions. We had remaining unamortized intangible assets of $2.5 million and $2.6 million at March 31, 2015 and December 31, 2014, respectively. See Note #8 to the Condensed Consolidated Financial Statements for a schedule of future amortization of intangible assets.
We record estimated incurred losses associated with Mepco’s vehicle service contract payment plan receivables in our provision for loan losses and establish a related allowance for loan losses. (See “Portfolio Loans and asset quality.”) We record estimated incurred losses associated with defaults by Mepco’s counterparties as “vehicle service contract counterparty contingencies expense,” which is included in non-interest expenses in our Condensed Consolidated Statements of Operations. Such expenses totaled $0.03 million and $0.07 million in the first quarters of 2015 and 2014, respectively.
Our estimate of probable incurred losses from vehicle service contract counterparty contingencies requires a significant amount of judgment because a number of factors can influence the amount of loss that we may ultimately incur. These factors include our estimate of future cancellations of vehicle service contracts, our evaluation of collateral that may be available to recover funds due from our counterparties, and our assessment of the amount that may ultimately be collected from counterparties in connection with their contractual obligations. We apply a rigorous process, based upon historical payment plan activity and past experience, to estimate probable incurred losses and quantify the necessary reserves for our vehicle service contract counterparty contingencies, but there can be no assurance that our modeling process will successfully identify all such losses.
In particular, as noted in our Risk Factors included in Part I - Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2014, Mepco has had to initiate litigation against certain counterparties, including third party insurers, to collect amounts owed to Mepco as a result of those parties' dispute of their contractual obligations to Mepco. In addition, see Note #14 to the Condensed Consolidated Financial Statements included within this report for more information about Mepco's business, certain risks and difficulties we currently face with respect to that business, and reserves we have established (through vehicle service contract counterparty contingencies expense) for losses related to the business.
The changes in cost related to unfunded lending commitments are primarily impacted by changes in the amounts of such commitments to originate portfolio loans as well as (for commercial loan commitments) the grade (pursuant to our loan rating system) of such commitments.
Net gains on ORE and repossessed assets primarily represent the net gains and losses on the sale of and additional write downs on these assets subsequent to the transfer of the asset from our loan portfolio. This transfer occurs at the time we acquire the collateral that secured the loan. At the time of acquisition, the other real estate or repossessed asset is valued at fair value, less estimated costs to sell, which becomes the new basis for the asset. Any write-downs at the time of acquisition are charged to the allowance for loan losses. The net gains of $0.04 million and $0.09 million in the first quarters of 2015 and 2014, respectively, primarily reflect greater stability in real estate prices with some markets even experiencing price increases.
The provision for loss reimbursement on sold loans was a credit of $0.07 million and a credit of $0.5 million in the first quarters of 2015 and 2014, respectively, and represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae and Freddie Mac). The credit provision in the first quarter of 2015 is due primarily to the settlement of certain loss reimbursement claims at slightly lower amounts than what had been specifically reserved for at the end of 2014. The credit provision in the first quarter of 2014 is due primarily to the rescission of certain loss reimbursement requests by Freddie Mac that had been pending and accrued for at the end of 2013. Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. The reserve for loss reimbursements on sold mortgage loans totaled $0.6 million and $0.7 million at March 31, 2015 and December 31, 2014, respectively. This reserve is included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition. This reserve is based on an analysis of mortgage loans that we have sold which are further categorized by delinquency status, loan to value, and year of origination. The calculation includes factors such as probability of default, probability of loss reimbursement (breach of representation or warranty) and estimated loss severity. The reserve levels at March 31, 2015 and December 31, 2014 also reflect the resolution of the mortgage loan origination years of 2000 to 2008 with Fannie Mae and Freddie Mac. We believe that the amounts that we have accrued for incurred losses on sold mortgage loans are appropriate given our analyses. However, future losses could exceed our current estimate.
Other non-interest expenses decreased by $0.1 million in the first quarter of 2015 compared to 2014 due primarily to a decrease in fraud related costs.
Income tax expense. We recorded an income tax expense of $1.8 million and $1.5 million in the first quarters of 2015 and 2014, respectively.
Our actual federal income tax expense is different than the amount computed by applying our statutory federal income tax rate to our pre-tax income primarily due to tax-exempt interest income and tax-exempt income from the increase in the cash surrender value on life insurance.
We assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. The ultimate realization of this asset is primarily based on generating future income. We concluded at both March 31, 2015 and 2014, that the realization of substantially all of our deferred tax assets continues to be more likely than not.
We did maintain a valuation allowance against our deferred tax assets of approximately $1.0 million at both March 31, 2015 and December 31, 2014. This valuation allowance on our deferred tax assets primarily relates to state income taxes at our Mepco segment. In this instance, we determined that the future realization of these particular deferred tax assets was not more likely than not. This conclusion was primarily based on the uncertainty of Mepco’s future earnings attributable to particular states (given the various apportionment criteria) and the significant reduction in the size of Mepco’s business.
Because of our net operating loss and tax credit carryforwards, we are still subject to the rules of Section 382 of the Internal Revenue Code of 1986, as amended. An ownership change, as defined by these rules, would negatively affect our ability to utilize our net operating loss carryforwards and other deferred tax assets in the future. If such an ownership change were to occur, we may suffer higher-than-anticipated tax expense, and consequently lower net income and cash flow, in those future years. Although we cannot control market purchases or sales of our common stock, we have in place a Tax Benefits Preservation Plan to dissuade any movement in our stock that would trigger an ownership change to avoid triggering any Section 382 limitations.
Business Segments. Our reportable segments are based upon legal entities. We currently have two reportable segments: Independent Bank and Mepco. These business segments are also differentiated based on the products and services provided. We evaluate performance based principally on net income (loss) of the respective reportable segments.
The following table presents net income (loss) by business segment.
| Business Segments | | | |
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (In thousands) | |
| Independent Bank | | $ | 4,233 | | | $ | 3,182 | |
| Mepco | | | (192 | ) | | | 243 | |
Other(1) | | | (244 | ) | | | (263 | ) |
| Elimination | | | (16 | ) | | | (24 | ) |
| Net income | | $ | 3,781 | | | $ | 3,138 | |
| (1) | Includes amounts relating to our parent company and certain insignificant operations. |
The increase in net income at Independent Bank in 2015 compared to 2014 is primarily due to a decrease in the provision for loan losses and increases in net interest income and non-interest income that were partially offset by an increase in income tax expense. (See “Net interest income,” “Non-interest income,” “Provision for loan losses,” “Income tax expense,” and “Portfolio Loans and asset quality.”)
The change in Mepco’s results (a net loss of $0.2 million in the first quarter of 2015 compared to net income of $0.2 million in the first quarter of 2014) is due to a decrease in net interest income as a result of the reduction in payment plan receivables and a decrease in non-interest income due to a decline in rental income on ORE that were partially offset by a decrease in non-interest expense. All of Mepco’s funding is provided by Independent Bank through an intercompany loan (that is eliminated in consolidation). The rate on this intercompany loan is based on the Prime Rate (currently 3.25%). Mepco might not be able to obtain such favorable funding costs on its own in the open market.
Financial Condition
Summary. Our total assets increased by $80.6 million during the first three months of 2015 due primarily to increases in cash and cash equivalents, securities available for sale and loans. Loans, excluding loans held for sale ("Portfolio Loans"), totaled $1.42 billion at March 31, 2015, an increase of $13.0 million, or 0.9%, from December 31, 2014. (See "Portfolio Loans and asset quality.")
Deposits totaled $2.00 billion at March 31, 2015, compared to $1.92 billion at December 31, 2014. The $76.2 million increase in total deposits during the period is primarily due to growth in checking and savings account balances.
Securities. We maintain diversified securities portfolios, which include obligations of U.S. government-sponsored agencies, securities issued by states and political subdivisions, residential and commercial mortgage-backed securities, asset-backed securities, corporate securities and trust preferred securities. We regularly evaluate asset/liability management needs and attempt to maintain a portfolio structure that provides sufficient liquidity and cash flow. Except as discussed below, we believe that the unrealized losses on securities available for sale are temporary in nature and are expected to be recovered within a reasonable time period. We believe that we have the ability to hold securities with unrealized losses to maturity or until such time as the unrealized losses reverse. (See “Asset/liability management.”)
| Securities | | | | | | | | | |
| | | | | | Unrealized | | | | |
| | | Amortized Cost | | | Gains | | | Losses | | | Fair Value | |
| | | | | | (In thousands) | | | | |
| Securities available for sale | | | | | | | | | | | | |
| March 31, 2015 | | $ | 569,308 | | | $ | 4,544 | | | $ | 2,090 | | | $ | 571,762 | |
| December 31, 2014 | | | 532,930 | | | | 3,317 | | | | 3,069 | | | | 533,178 | |
| | | | | | | | | | | | | | | | | |
Securities available for sale increased during 2015 due primarily to the purchase of U.S. government-sponsored agency mortgage-backed securities, asset-backed securities, and municipal securities. The securities were purchased to utilize cash and cash equivalents as well as to utilize funds generated from the increase in total deposits. (See “Deposits” and “Liquidity and capital resources.”)
Our portfolio of available-for-sale securities is reviewed quarterly for impairment in value. In performing this review, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet these recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income or loss.
Sales of securities were as follows (See “Non-interest income.”):
| | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | (In thousands) | |
| | | | | | | |
| Proceeds | | $ | 11,786 | | | $ | - | |
| | | | | | | | | |
| Gross gains | | $ | 75 | | | $ | - | |
| Gross losses | | | - | | | | - | |
| Net impairment charges | | | - | | | | - | |
| Fair value adjustments | | | 10 | | | | 112 | |
| Net gains | | $ | 85 | | | $ | 112 | |
Portfolio Loans and asset quality. In addition to the communities served by our Bank branch network, our principal lending markets also include nearby communities and metropolitan areas. Subject to established underwriting criteria, we also may participate in commercial lending transactions with certain non-affiliated banks.
The senior management and board of directors of our Bank retain authority and responsibility for credit decisions and we have adopted uniform underwriting standards. Our loan committee structure and the loan review process attempt to provide requisite controls and promote compliance with such established underwriting standards. However, there can be no assurance that our lending procedures and the use of uniform underwriting standards will prevent us from incurring significant credit losses in our lending activities.
We generally retain loans that may be profitably funded within established risk parameters. (See “Asset/liability management.”) As a result, we may hold adjustable-rate mortgage loans as Portfolio Loans, while 15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure to changes in interest rates. (See “Non-interest income.”)
Non-performing assets(1) | | | | | | |
| | | March 31, 2015 | | | December 31, 2014 | |
| | | (Dollars in thousands) | |
| Non-accrual loans | | $ | 14,593 | | | $ | 15,231 | |
| Loans 90 days or more past due and still accruing interest | | | 194 | | | | 7 | |
| Total non-performing loans | | | 14,787 | | | | 15,238 | |
| Other real estate and repossessed assets | | | 5,662 | | | | 6,454 | |
| Total non-performing assets | | $ | 20,449 | | | $ | 21,692 | |
| As a percent of Portfolio Loans | | | | | | | | |
| Non-performing loans | | | 1.04 | % | | | 1.08 | % |
| Allowance for loan losses | | | 1.73 | | | | 1.84 | |
| Non-performing assets to total assets | | | 0.88 | | | | 0.96 | |
| Allowance for loan losses as a percent of non-performing loans | | | 166.90 | | | | 170.56 | |
| | (1) | Excludes loans classified as “troubled debt restructured” that are not past due and vehicle service contract counterparty receivables, net. |
| Troubled debt restructurings (“TDR”) | |
| | | | | | | | | | |
| | | March 31, 2015 | |
| | | Commercial | | | Retail | | | Total | |
| | | (In thousands) | |
| Performing TDRs | | $ | 27,904 | | | $ | 71,477 | | | $ | 99,381 | |
Non-performing TDRs (1) | | | 1,935 | | | | 5,194 | (2) | | | 7,129 | |
| Total | | $ | 29,839 | | | $ | 76,671 | | | $ | 106,510 | |
| | | December 31, 2014 | |
| | | Commercial | | | Retail | | | Total | |
| | | (In thousands) | |
| Performing TDRs | | $ | 29,475 | | | $ | 73,496 | | | $ | 102,971 | |
Non-performing TDRs (1) | | | 1,978 | | | | 5,225 | (2) | | | 7,203 | |
| Total | | $ | 31,453 | | | $ | 78,721 | | | $ | 110,174 | |
| | (1) | Included in the “Non-performing assets” table above. |
| | (2) | Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis. |
Non-performing loans decreased by $0.5 million, or 3.0%, during the first quarter of 2015 due principally to decreases in non-performing mortgage and consumer/installment loans. These declines primarily reflect reduced levels of new loan defaults as well as loan charge-offs, pay-offs, negotiated transactions, and the migration of loans into ORE. In general, improving economic conditions in our market areas, as well as our collection and resolution efforts, have resulted in a downward trend in non-performing loans. However, we are still experiencing some loan defaults, particularly related to commercial loans secured by income-producing property and mortgage loans secured by resort/vacation property.
Non-performing loans exclude performing loans that are classified as troubled debt restructurings (“TDRs”). Performing TDRs totaled $99.4 million, or 7.0% of total Portfolio Loans, and $103.0 million, or 7.3% of total Portfolio Loans, at March 31, 2015 and December 31, 2014, respectively. The decrease in the amount of performing TDRs in the first quarter of 2015 reflects declines in both commercial loan and retail loan TDRs.
ORE and repossessed assets totaled $5.7 million at March 31, 2015, compared to $6.5 million at December 31, 2014. This decrease is primarily the result of sales of ORE being in excess of the migration of non-performing loans secured by real estate into ORE as the foreclosure process is completed.
We will place a loan that is 90 days or more past due on non-accrual, unless we believe the loan is both well secured and in the process of collection. Accordingly, we have determined that the collection of the accrued and unpaid interest on any loans that are 90 days or more past due and still accruing interest is probable.
The ratio of loan net charge-offs to average Portfolio Loans was 0.19% on an annualized basis in the first quarter of 2015 compared to 0.69% in the first quarter of 2014. The $1.7 million decline in loan net charge-offs is primarily due to a decline in commercial loan net charge-offs that was partially offset by a slight increase in mortgage and consumer/installment loan net charge-offs. The overall decrease in loan net charge-offs primarily reflects a year-over-year reduction in non-performing loans and improvement in collateral liquidation values.
| Allowance for loan losses | | Three months ended March 31, | |
| | | 2015 | | | 2014 | |
| | | Loans | | | Unfunded Commitments | | | Loans | | | Unfunded Commitments | |
| | | (Dollars in thousands) | |
| Balance at beginning of period | | $ | 25,990 | | | $ | 539 | | | $ | 32,325 | | | $ | 508 | |
| Additions (deduction) | | | | | | | | | | | | | | | | |
| Provision for loan losses | | | (659 | ) | | | - | | | | 428 | | | | - | |
| Recoveries credited to allowance | | | 990 | | | | - | | | | 1,068 | | | | - | |
| Loans charged against the allowance | | | (1,642 | ) | | | - | | | | (3,384 | ) | | | - | |
| Additions (deductions) included in non-interest expense | | | - | | | | 16 | | | | - | | | | 10 | |
| Balance at end of period | | $ | 24,679 | | | $ | 555 | | | $ | 30,437 | | | $ | 518 | |
| | | | | | | | | | | | | | | | | |
| Net loans charged against the allowance to average Portfolio Loans (annualized) | | | 0.19 | % | | | | | | | 0.69 | % | | | | |
| Allocation of the Allowance for Loan Losses | | | | | | |
| | | March 31, 2015 | | | December 31, 2014 | |
| | | (In thousands) | |
| Specific allocations | | $ | 12,480 | | | $ | 13,233 | |
| Other adversely rated commercial loans | | | 1,033 | | | | 761 | |
| Historical loss allocations | | | 6,110 | | | | 6,773 | |
| Additional allocations based on subjective factors | | | 5,056 | | | | 5,223 | |
| Total | | $ | 24,679 | | | $ | 25,990 | |
Some loans will not be repaid in full. Therefore, an allowance for loan losses (“AFLL”) is maintained at a level which represents our best estimate of losses incurred. In determining the AFLL and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated commercial loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allowances based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size and/or the general terms of the loan portfolios.
The first AFLL element (specific allocations) reflects our estimate of probable incurred losses based upon our systematic review of specific loans. These estimates are based upon a number of factors, such as payment history, financial condition of the borrower, discounted collateral exposure and discounted cash flow analysis. Impaired commercial, mortgage and installment loans are allocated allowance amounts using this first element. The second AFLL element (other adversely rated commercial loans) reflects the application of our commercial loan rating system. This rating system is similar to those employed by state and federal banking regulators. Commercial loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan classification category that is based upon a historical analysis of both the probability of default and the expected loss rate (“loss given default”). The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied. The third AFLL element (historical loss allocations) is determined by assigning allocations to higher rated (“non-watch credit”) commercial loans using a probability of default and loss given default similar to the second AFLL element and to homogenous mortgage and installment loan groups based upon borrower credit score and portfolio segment. For homogenous mortgage and installment loans a probability of default for each homogenous pool is calculated by way of credit score migration. Historical loss data for each homogenous pool coupled with the associated probability of default is utilized to calculate an expected loss allocation rate. The fourth AFLL element (additional allocations based on subjective factors) is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining this fourth element, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the overall loan portfolio.
Increases in the AFLL are recorded by a provision for loan losses charged to expense. Although we periodically allocate portions of the AFLL to specific loans and loan portfolios, the entire AFLL is available for incurred losses. We generally charge-off commercial, homogenous residential mortgage, and installment loans and payment plan receivables when they are deemed uncollectible or reach a predetermined number of days past due based on product, industry practice and other factors. Collection efforts may continue and recoveries may occur after a loan is charged against the allowance.
While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors.
Mepco’s allowance for losses is determined in a similar manner as discussed above, and primarily takes into account historical loss experience and other subjective factors deemed relevant to Mepco’s payment plan business. Estimated incurred losses associated with Mepco’s outstanding vehicle service contract payment plans are included in the provision for loan losses. Mepco recorded a $0.003 million credit and a $0.015 million credit in the first quarters of 2015 and 2014, respectively, for its provision for loan losses. Mepco’s allowance for loan losses totaled $0.1 million at both March 31, 2015 and December 31, 2014. Mepco has established procedures for vehicle service contract payment plan servicing, administration and collections, including the timely cancellation of the vehicle service contract, in order to protect our position in the event of payment default or voluntary cancellation by the customer. Mepco has also established procedures to attempt to prevent and detect fraud since the payment plan origination activities and initial customer contacts are done entirely through unrelated third parties (vehicle service contract administrators and sellers or automobile dealerships). However, there can be no assurance that the aforementioned risk management policies and procedures will prevent us from the possibility of incurring significant credit or fraud related losses in this business segment. The estimated incurred losses described in this paragraph should be distinguished from the possible losses we may incur from counterparties failing to pay their obligations to Mepco. See Note #14 to the Condensed Consolidated Financial Statements included within this report.
The allowance for loan losses decreased $1.3 million to $24.7 million at March 31, 2015 from $26.0 million at December 31, 2014 and was equal to 1.73% of total Portfolio Loans at March 31, 2015 compared to 1.84% at December 31, 2014. Three of the four components of the allowance for loan losses outlined above declined in the first quarter of 2015. The allowance for loan losses related to specific loans decreased $0.8 million in 2015 due primarily to a decline in the balance of individually impaired loans as well as charge-offs. The allowance for loan losses related to other adversely rated commercial loans increased $0.3 million in 2015 primarily due to an increase in the balance of such loans included in this component to $32.1 million at March 31, 2015 from $30.6 million at December 31, 2014. The allowance for loan losses related to historical losses decreased $0.7 million during 2015 due principally to the use of a lower estimated probability of default for homogenous mortgage and installment loans (resulting from lower loan net charge-offs and reduced levels of new defaults on loans). The allowance for loan losses related to subjective factors decreased $0.2 million during 2015 primarily due to the improvement of various economic indicators used in computing this portion of the allowance.
Deposits and borrowings. Historically, the loyalty of our customer base has allowed us to price deposits competitively, contributing to a net interest margin that compares favorably to our peers. However, we still face a significant amount of competition for deposits within many of the markets served by our branch network, which limits our ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits.
To attract new core deposits, we have implemented various account acquisition strategies as well as branch staff sales training. Account acquisition initiatives have historically generated increases in customer relationships. Over the past several years, we have also expanded our treasury management products and services for commercial businesses and municipalities or other governmental units and have also increased our sales calling efforts in order to attract additional deposit relationships from these sectors. We view long-term core deposit growth as an important objective. Core deposits generally provide a more stable and lower cost source of funds than alternative sources such as short-term borrowings. (See “Liquidity and capital resources.”)
Deposits totaled $2.00 billion and $1.92 billion at March 31, 2015 and December 31, 2014, respectively. The $76.2 million increase in deposits in the first quarter of 2015 is due to growth in checking and savings deposit account balances. Reciprocal deposits totaled $58.7 million and $53.7 million at March 31, 2015 and December 31, 2014, respectively. These deposits represent demand, money market and time deposits from our customers that have been placed through Promontory Interfinancial Network’s Insured Cash Sweep® service and Certificate of Deposit Account Registry Service®. These services allow our customers to access multi-million dollar FDIC deposit insurance on deposit balances greater than the standard FDIC insurance maximum.
We cannot be sure that we will be able to maintain our current level of core deposits. In particular, those deposits that are uninsured may be susceptible to outflow. At March 31, 2015, we had approximately $431.6 million of uninsured deposits. A reduction in core deposits would likely increase our need to rely on wholesale funding sources.
We have also implemented strategies that incorporate using federal funds purchased, other borrowings and Brokered CDs to fund a portion of our interest-earning assets. The use of such alternate sources of funds supplements our core deposits and is also an integral part of our asset/liability management efforts.
Other borrowings, comprised almost entirely of advances from the Federal Home Loan Bank (the “FHLB”), totaled $12.5 million at both March 31, 2015 and December 31, 2014.
As described above, we utilize wholesale funding, including FHLB borrowings and Brokered CDs to augment our core deposits and fund a portion of our assets. At March 31, 2015, our use of such wholesale funding sources (including reciprocal deposits) amounted to approximately $72.5 million, or 3.6% of total funding (deposits and total borrowings, excluding subordinated debentures). Because wholesale funding sources are affected by general market conditions, the availability of such funding may be dependent on the confidence these sources have in our financial condition and operations. The continued availability to us of these funding sources is not certain, and Brokered CDs may be difficult for us to retain or replace at attractive rates as they mature. Our liquidity may be constrained if we are unable to renew our wholesale funding sources or if adequate financing is not available in the future at acceptable rates of interest or at all. Our financial performance could also be affected if we are unable to maintain our access to funding sources or if we are required to rely more heavily on more expensive funding sources. In such case, our net interest income and results of operations could be adversely affected.
We historically employed derivative financial instruments to manage our exposure to changes in interest rates. We discontinued the active use of derivative financial instruments during 2008. We began to again utilize interest-rate swaps in 2014, relating to our commercial lending activities. During the first quarters of 2015 and 2014, we entered into $24.4 million and zero (aggregate notional amounts), respectively, of interest rate swaps with commercial loan customers, which were offset with interest rate swaps that the Bank entered into with a broker-dealer. We recorded $0.2 million and zero of fee income related to these transactions during the first quarters of 2015 and 2014, respectively.
Liquidity and capital resources. Liquidity risk is the risk of being unable to timely meet obligations as they come due at a reasonable funding cost or without incurring unacceptable losses. Our liquidity management involves the measurement and monitoring of a variety of sources and uses of funds. Our Condensed Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus our liquidity management on maintaining adequate levels of liquid assets (primarily funds on deposit with the FRB and certain investment securities) as well as developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for purchasing investment securities or originating Portfolio Loans as well as to be able to respond to unforeseen liquidity needs.
Our primary sources of funds include our deposit base, secured advances from the FHLB, a federal funds purchased borrowing facility with another commercial bank, and access to the capital markets (for Brokered CDs).
At March 31, 2015, we had $224.7 million of time deposits that mature in the next 12 months. Historically, a majority of these maturing time deposits are renewed by our customers. Additionally, $1.63 billion of our deposits at March 31, 2015, were in account types from which the customer could withdraw the funds on demand. Changes in the balances of deposits that can be withdrawn upon demand are usually predictable and the total balances of these accounts have generally grown or have been stable over time as a result of our marketing and promotional activities. However, there can be no assurance that historical patterns of renewing time deposits or overall growth or stability in deposits will continue in the future.
We have developed contingency funding plans that stress test our liquidity needs that may arise from certain events such as an adverse change in our financial metrics (for example, credit quality or regulatory capital ratios). Our liquidity management also includes periodic monitoring that measures quick assets (defined generally as short-term assets with maturities less than 30 days and loans held for sale) to total assets, short-term liability dependence and basic surplus (defined as quick assets compared to short-term liabilities). Policy limits have been established for our various liquidity measurements and are monitored on a monthly basis. In addition, we also prepare cash flow forecasts that include a variety of different scenarios.
We believe that we currently have adequate liquidity at our Bank because of our cash and cash equivalents, our portfolio of securities available for sale, our access to secured advances from the FHLB, our ability to issue Brokered CDs and our improved financial metrics.
We also believe that the available cash on hand at the parent company (including time deposits) of approximately $33.5 million as of March 31, 2015 provides sufficient liquidity resources at the parent company to meet operating expenses, to make interest payments on the subordinated debentures and to pay a cash dividend on our common stock for the foreseeable future.
Effective management of capital resources is critical to our mission to create value for our shareholders. In addition to common stock, our capital structure also currently includes cumulative trust preferred securities.
| Capitalization | | | | | | |
| | | March 31, 2015 | | | December 31, 2014 | |
| | | (In thousands) | |
| Subordinated debentures | | $ | 35,569 | | | $ | 35,569 | |
| Amount not qualifying as regulatory capital | | | (1,069 | ) | | | (1,069 | ) |
| Amount qualifying as regulatory capital | | | 34,500 | | | | 34,500 | |
| Shareholders’ equity | | | | | | | | |
| Common stock | | | 351,881 | | | | 352,462 | |
| Accumulated deficit | | | (94,054 | ) | | | (96,455 | ) |
| Accumulated other comprehensive loss | | | (4,202 | ) | | | (5,636 | ) |
| Total shareholders’ equity | | | 253,625 | | | | 250,371 | |
| Total capitalization | | $ | 288,125 | | | $ | 284,871 | |
We currently have three special purpose entities that originally issued $39.5 million of cumulative trust preferred securities. These special purpose entities issued common securities and provided cash to our parent company that in turn issued subordinated debentures to these special purpose entities equal to the trust preferred securities and common securities. The subordinated debentures represent the sole asset of the special purpose entities. The common securities and subordinated debentures are included in our Condensed Consolidated Statements of Financial Condition.
On December 1, 2014, we purchased 5,000 shares of trust preferred securities (liquidation amount of $1,000 per security, representing a total of $5.0 million) that were issued by IBC Capital Finance IV. The trust preferred securities have been retired along with certain related common stock issued by IBC Capital Finance IV and subordinated debentures issued by us.
The FRB has issued rules regarding trust preferred securities as a component of the Tier 1 capital of bank holding companies. The aggregate amount of trust preferred securities (and certain other capital elements) are limited to 25 percent of Tier 1 capital elements, net of goodwill (net of any associated deferred tax liability). The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital, subject to restrictions. At the parent company, all of these securities qualified as Tier 1 capital at March 31, 2015 and December 31, 2014. Although the Dodd-Frank Act further limited Tier 1 treatment for trust preferred securities, those new limits did not apply to our outstanding trust preferred securities. Further, the New Capital Rules grandfathered the treatment of our trust preferred securities as qualifying regulatory capital.
Common shareholders’ equity increased to $253.6 million at March 31, 2015 from $250.4 million at December 31, 2014 due primarily to our net income in the first quarter of 2015 as well as a decline in our accumulated other comprehensive loss. Our tangible common equity (“TCE”) totaled $251.1 million and $247.7 million, respectively, at those same dates. Our ratio of TCE to tangible assets was 10.79% and 11.03% at March 31, 2015 and December 31, 2014, respectively.
Because the Bank currently has negative “undivided profits” (i.e. a retained deficit) of $27.1 million at March 31, 2015, under Michigan banking regulations, the Bank is not currently permitted to pay a dividend. We can request regulatory approval for a return of capital from the Bank to the parent company. During the first quarter of 2015, we requested regulatory approval for an $18.5 million return of capital from the Bank to the parent company. This return of capital request was approved by our banking regulators on February 13, 2015 and the Bank returned $18.5 million of capital to the parent company on February 17, 2015. Also see note #11 to the Condensed Consolidated Financial Statements included within this report.
On January 21, 2015, our Board of Directors authorized a share repurchase plan. Under the terms of the share repurchase plan, we are authorized to buy back up to 5% of our outstanding common stock. The repurchase plan is authorized to last through December 31, 2015. We intend and expect to accomplish the repurchases through open market transactions, though we could effect repurchases through other means, such as privately negotiated transactions. The timing and amount of any share repurchases will depend on a variety of factors, including, among others, securities law restrictions, the trading price of our common stock, other regulatory requirements, potential alternative uses for capital, and our financial performance. The repurchase program does not obligate us to acquire any particular amount of common stock, and it may be modified or suspended at any time at our discretion. During the first quarter of 2015 we repurchased 70,643 shares of our comment stock pursuant to this plan at an average price of $12.77 per share.
We resumed a quarterly cash dividend on our common stock of six cents per share in May 2014.
As of March 31, 2015 and December 31, 2014, our Bank (and holding company) continued to meet the requirements to be considered “well-capitalized” under federal regulatory standards (also see note #11 to the Condensed Consolidated Financial Statements included within this report).
Asset/liability management. Interest-rate risk is created by differences in the cash flow characteristics of our assets and liabilities. Options embedded in certain financial instruments, including caps on adjustable-rate loans as well as borrowers’ rights to prepay fixed-rate loans, also create interest-rate risk.
Our asset/liability management efforts identify and evaluate opportunities to structure our statement of financial condition in a manner that is consistent with our mission to maintain profitable financial leverage within established risk parameters. We evaluate various opportunities and alternate asset/liability management strategies carefully and consider the likely impact on our risk profile as well as the anticipated contribution to earnings. The marginal cost of funds is a principal consideration in the implementation of our asset/liability management strategies, but such evaluations further consider interest-rate and liquidity risk as well as other pertinent factors. We have established parameters for interest-rate risk. We regularly monitor our interest-rate risk and report at least quarterly to our board of directors.
We employ simulation analyses to monitor our interest-rate risk profile and evaluate potential changes in our net interest income and market value of portfolio equity that result from changes in interest rates. The purpose of these simulations is to identify sources of interest-rate risk. The simulations do not anticipate any actions that we might initiate in response to changes in interest rates and, accordingly, the simulations do not provide a reliable forecast of anticipated results. The simulations are predicated on immediate, permanent and parallel shifts in interest rates and generally assume that current loan and deposit pricing relationships remain constant. The simulations further incorporate assumptions relating to changes in customer behavior, including changes in prepayment rates on certain assets and liabilities.
| Changes in Market Value of Portfolio Equity and Net Interest Income | |
Change in Interest Rates | | | | | | | | | | | | |
| | | (Dollars in thousands) | |
| March 31, 2015 | | | | | | | | | | | | |
| 200 basis point rise | | $ | 425,300 | | | | 10.96 | % | | $ | 78,500 | | | | 7.68 | % |
| 100 basis point rise | | | 408,100 | | | | 6.47 | | | | 75,900 | | | | 4.12 | |
| Base-rate scenario | | | 383,300 | | | | - | | | | 72,900 | | | | - | |
| 100 basis point decline | | | 350,100 | | | | (8.66 | ) | | | 70,300 | | | | (3.57 | ) |
| | | | | | | | | | | | | | | | | |
| December 31, 2014 | | | | | | | | | | | | | | | | |
| 200 basis point rise | | $ | 421,700 | | | | 9.56 | % | | $ | 75,600 | | | | 6.03 | % |
| 100 basis point rise | | | 406,800 | | | | 5.69 | | | | 73,600 | | | | 3.23 | |
| Base-rate scenario | | | 384,900 | | | | - | | | | 71,300 | | | | - | |
| 100 basis point decline | | | 355,000 | | | | (7.77 | ) | | | 69,200 | | | | (2.95 | ) |
| (1) | Simulation analyses calculate the change in the net present value of our assets and liabilities, including debt and related financial derivative instruments, under parallel shifts in interest rates by discounting the estimated future cash flows using a market-based discount rate. Cash flow estimates incorporate anticipated changes in prepayment speeds and other embedded options. |
| (2) | Simulation analyses calculate the change in net interest income under immediate parallel shifts in interest rates over the next twelve months, based upon a static statement of financial condition, which includes debt and related financial derivative instruments, and do not consider loan fees. |
Accounting standards update. See Note #2 to the Condensed Consolidated Financial Statements included elsewhere in this report for details on recently issued accounting pronouncements and their impact on our financial statements.
Fair valuation of financial instruments. Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) topic 820 - “Fair Value Measurements and Disclosures” (“FASB ASC topic 820”) defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
We utilize fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. FASB ASC topic 820 differentiates between those assets and liabilities required to be carried at fair value at every reporting period (“recurring”) and those assets and liabilities that are only required to be adjusted to fair value under certain circumstances (“nonrecurring”). Trading securities, securities available-for-sale, loans held for sale, and derivatives are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial assets on a nonrecurring basis, such as loans held for investment, capitalized mortgage loan servicing rights and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. See Note #12 to the Condensed Consolidated Financial Statements included within this report for a complete discussion on our use of fair valuation of financial instruments and the related measurement techniques.
Litigation Matters
We are involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our consolidated financial position or results of operations. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued. At this time, we estimate the maximum amount of additional losses that are reasonably possible is approximately $0.5 million. However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages, this maximum amount may change in the future.
The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans or vehicle service contract counterparty receivables). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, but we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote. Risks associated with the likelihood that we will not collect the full amount owed to us, net of reserves, are disclosed elsewhere in this report.
Critical Accounting Policies
Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for other than temporary impairment of investment securities, the allowance for loan losses, originated mortgage loan servicing rights, vehicle service contract payment plan counterparty contingencies, and income taxes are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those that we have used could result in material changes in our consolidated financial position or results of operations. There have been no material changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2014.
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
See applicable disclosurers set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2 under the caption “Asset/liability management.”
Item 4.
| (a) | Evaluation of Disclosure Controls and Procedures. |
With the participation of management, our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a – 15(e) and 15d – 15(e)) for the period ended March 31, 2015, have concluded that, as of such date, our disclosure controls and procedures were effective.
| (b) | Changes in Internal Controls. |
During the quarter ended March 31, 2015, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Part II
There have been no material changes to the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2014.
| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
The Company maintains a Deferred Compensation and Stock Purchase Plan for Non-Employee Directors (the "Plan") pursuant to which non-employee directors can elect to receive shares of the Company's common stock in lieu of fees otherwise payable to the director for his or her service as a director. A director can elect to receive shares on a current basis or to defer receipt of the shares, in which case the shares are issued to a trust to be held for the account of the director and then generally distributed to the director after his or her retirement from the Board. Pursuant to this Plan, during the first quarter of 2015, the Company issued 706 shares of common stock to non-employee directors on a current basis and 491 shares of common stock to the trust for distribution to directors on a deferred basis. The shares were issued on January 1, 2015, at a price of $13.05 per share, representing aggregate fees of $0.02 million. The price per share was the consolidated closing bid price per share of the Company's common stock as of the date of issuance, as determined in accordance with NASDAQ Marketplace Rules. The Company issued the shares pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933 due to the fact that the issuance of the shares was made on a private basis pursuant to the Plan.
The following table shows certain information relating to repurchases of common stock for the three-months ended March 31, 2015:
| Period | | Total Number of Shares Purchased (1) | | | Average Price Paid Per Share | | | Total Number of Shares Purchased as Part of a Publicly Announced Plan | | | | |
| January 2015 | | | - | | | $ | - | | | | - | | | | 1,147,930 | |
| February 2015 | | | 66,669 | | | | 12.93 | | | | 10,900 | | | | 1,137,030 | |
| March 2015 | | | 59,743 | | | | 12.80 | | | | 59,743 | | | | 1,077,287 | |
| Total | | | 126,412 | | | $ | 12.87 | | | | 70,643 | | | | 1,077,287 | |
| (1) | Represents (i) 50,568 shares of our common stock purchased in the open market by the Independent Bank Corporation Employee Stock Ownership Trust as part of our employee stock ownership plan, (ii) 5,201 shares withheld from the shares that would otherwise have been issued to certain officers in order to satisfy tax withholding obligations resulting from vesting of restricted stock and (iii) 70,643 shares purchased in the open market pursuant to a publicly announced plan. |
| (a) | The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report: |
| | 11. | Computation of Earnings Per Share. |
| | 31.1 | Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). |
| | 31.2 | Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). |
| | 32.1 | Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). |
| | 32.2 | Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350). |
| 101.SCH | XBRL Taxonomy Extension Schema Document |
| 101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |
| 101.DEF | XBRL Taxonomy Extension Definition Linkbase Document |
| 101.LAB | XBRL Taxonomy Extension Label Linkbase Document |
| 101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |
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.
| Date | May 6, 2015 | | By | /s/ Robert N. Shuster |
| | | | | Robert N. Shuster, Principal Financial Officer |
| | | | | |
| Date | May 6, 2015 | | By | /s/ James J. Twarozynski |
| | | | | James J. Twarozynski, Principal Accounting Officer |
