NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Dollar amounts in thousands except per share data)
NOTE 1 - - BASIS OF PRESENTATION
The significant accounting policies followed by MainSource Financial Group, Inc. (“Company”) for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. The consolidated interim financial statements have been prepared according to accounting principles generally accepted in the United States of America and in accordance with the instructions for Form 10-Q. The interim statements do not include all information and footnotes normally included in the annual financial statements. All adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the periods reported have been included in the accompanying unaudited consolidated financial statements and all such adjustments are of a normal recurring nature. Some items in prior period financial statements were reclassified to conform to current presentation. It is suggested that these consolidated financial statements and notes be read in conjunction with the financial statements and notes thereto in the MainSource Financial Group, Inc. December 31, 2006 Annual Report on Form 10-K.
Recently Issued Accounting Standards:
The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), on January 1, 2007 and recognized a cumulative effect adjustment of $411 as a reduction to the balance of retained earnings and an increase in liabilities of $411. The amount of unrecognized tax benefits as of January 1, 2007 and June 30, 2007 totaled $911 and $1,010, respectively, all of which would increase income from continuing operations, and thus impact the Company’s effective tax rate, if ultimately recognized into income. Unrecognized state income tax benefits are reported net of their related deferred federal income tax benefit.
It is the Company’s policy to recognize interest and penalties accrued relative to unrecognized tax benefits in their respective federal or state income tax expense accounts. As of January 1, 2007, $75 in interest and penalties had been accrued.
The Company and its corporate subsidiaries file a consolidated U.S. federal income tax return and combined Indiana and Illinois income tax returns. These returns are subject to examination by taxing authorities for all years after 2002. We are currently under audit by the Indiana Department of Revenue for the 2004 and 2005 tax years. The anticipated effect on unrecognized tax benefits resulting from this audit cannot be determined at this time.
Additionally, the Company anticipates that the statute of limitations will close during 2007 on a tax position taken in the federal income tax return. Should this statute close on the position as taken in the return, the Company will recognize previously unrecognized tax benefits, which will reduce income tax expense.
In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance — Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance ). This Issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis. Lastly, the Issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy. EITF 06-5 became effective for the Company on January 1, 2007 and had no impact on the financial statements.
In February 2007, the FASB issued Statement No. 159 — The Fair Value Option for Financial Assets and Financial Liabilities. The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The new standard is effective for the Company on January 1, 2008. The Company does not expect the adoption of SFAS No. 159 to have a material impact on the financial statements.
6
NOTE 2 - STOCK PLANS AND STOCK BASED COMPENSATION
Options to buy stock were granted to directors and officers of the Company under the Company’s 2003 Stock Option Plan, which provides for the issuance of options to purchase up to 607,754 shares of common stock of the Company. At June 30, 2007, options to purchase 177,240 shares of common stock were outstanding pursuant to the 2003 Plan. Effective upon the shareholders approval of the 2007 Stock Incentive Plan (discussed below), the 2003 Plan was frozen and no further options will be granted pursuant to the 2003 Plan. All stock options have an exercise price that is at least equal to the fair market value of the Company’s stock on the date the options were granted. The maximum option term is ten years, and options vest immediately for the directors’ grant and over four years for the officers’ grant. It is the Company’s intent that shares issued under the above mentioned plan will come from treasury shares.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share Based Payment.” The Company elected to utilize the modified prospective transition method, therefore, prior period results were not restated. Prior to the adoption of SFAS 123R, stock-based compensation expense related to stock options was not recognized in the results of operations if the exercise price was at least equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”
SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values. For options with graded vesting, we value the stock option grants and recognize compensation expense as if each vesting portion of the award was a single award. Under the modified prospective method, unvested awards, and awards that were granted, modified, or settled on or after January 1, 2006 are measured and accounted for in accordance with SFAS 123R.
The following table summarizes stock option activity:
| | Six Months Ended
June 30, 2007 | |
| | Shares | | Weighted
Average
Exercise Price | |
Outstanding, beginning of year | | 263,345 | | $ | 17.93 | |
Granted | | 75,055 | | 17.01 | |
Exercised | | (30,863 | ) | 11.29 | |
Forfeited or expired | | (31,700 | ) | 21.01 | |
Outstanding, end of period | | 275,837 | | $ | 18.07 | |
Options exercisable at period end | | 177,240 | | $ | 18.47 | |
7
The following table details stock options outstanding:
| | June 30, 2007 | | December 31, 2006 | |
Stock options vested and currently exercisable: | | | | | |
Number | | 177,240 | | 228,806 | |
Weighted average exercise price | | $ | 18.47 | | $ | 17.92 | |
Aggregate intrinsic value | | $ | 170 | | $ | 352 | |
Weighted average remaining life (in years) | | 7.0 | | 6.5 | |
The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date. The Company recorded $30 in stock compensation expense during the three months ended June 30, 2007 to salaries and employee benefits. There were 75,055 options granted in the first quarter of 2007. In order to calculate the fair value of this option grant, the following weighted-average assumptions were used as of the grant date: risk-free interest rate 4.67%, expected option life 6.8 years, expected stock price volatility 19.7%, and dividend yield 3.00%. The resulting weighted average fair value of the options granted in the first quarter of 2007 was $3.47 for each option granted.
The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes based stock option valuation model. This model requires the input of subjective assumptions that will usually have a significant impact on the fair value estimate. Expected volatilities are based on historical volatility of the Company’s stock, and other factors. Expected dividends are based on dividend trends and the market price of the Company’s stock price at grant. The Company uses historical data to estimate option exercises within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
SFAS 123R requires the recognition of stock based compensation for the number of awards that are ultimately expected to vest. The Company reduced its compensation expense for estimated forfeitures prior to vesting in the second quarter of 2007. Estimated forfeitures will be reassessed in subsequent periods and may change based on new facts and circumstances.
Unrecognized stock option compensation expense related to unvested awards (net of estimated forfeitures) for the remainder of 2007 and beyond is estimated as follows:
Year | | | |
July 2007–December 2007 | | $ | 46 | |
2008 | | 91 | |
2009 | | 90 | |
2010 | | 61 | |
2011 | | 29 | |
2012 | | — | |
| | | | |
On January 16, 2007, the Company’s Board of Directors adopted and approved the MainSource Financial Group, Inc. 2007 Stock Incentive Plan (the “2007 Stock Incentive Plan”) effective upon the approval of the plan by the Company’s shareholders, which occurred on April 26, 2007 at the Company’s annual meeting of shareholders. The 2007 Stock Incentive Plan provides for the grant of incentive stock options, nonstatutory stock options, stock bonuses and restricted stock awards. Incentive stock options may be granted only to employees. An aggregate of 650,000 shares of common stock are reserved for issuance under the 2007 Stock Incentive Plan. Shares issuable under the 2007 Stock Incentive Plan will be authorized and unissued shares of common stock or treasury shares. The 2007 Stock Incentive Plan will be in addition to, and not in replacement of, the 2003 Plan. However, no further awards of options will be made under the 2003 Plan. Unexercised options, which were previously issued under the 2003 Plan, will not be terminated, but will otherwise continue in accordance with the 2003 Plan and the agreements pursuant to which the options were issued.
8
NOTE 3 - SECURITIES
The fair value of securities available for sale and related urealized gains/losses recognized in accumulated other comprehensive income (loss) were as follows:
| | | | Gross | | Gross | |
| | Fair | | Unrealized | | Unrealized | |
| | Value | | Gains | | Losses | |
As of June 30, 2007 | | | | | | | |
Available for Sale | | | | | | | |
Federal agencies | | $ | 76,318 | | $ | 21 | | $ | (1,004 | ) |
State and municipal | | 118,662 | | 509 | | (2,265 | ) |
Mortgage-backed securities | | 287,325 | | 19 | | (9,123 | ) |
Equity and other securities | | 7,500 | | 146 | | — | |
Total available for sale | | $ | 489,805 | | $ | 695 | | $ | (12,392 | ) |
| | | | | | | |
As of December 31, 2006 | | | | | | | |
Available for Sale | | | | | | | |
Federal agencies | | $ | 90,285 | | $ | 104 | | $ | (481 | ) |
State and municipal | | 122,343 | | 1,752 | | (436 | ) |
Mortgage-backed securities | | 263,006 | | 716 | | (4,127 | ) |
Equity and other securities | | 9,625 | | 181 | | — | |
Total available for sale | | $ | 485,259 | | $ | 2,753 | | $ | (5,044 | ) |
Unrealized losses on available for sale securities have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the securities approach their maturity dates.
9
NOTE 4 - LOANS AND ALLOWANCE
| | June 30,
2007 | | December 31,
2006 | |
| | | | | |
Commercial and industrial loans | | $ | 194,215 | | $ | 173,557 | |
Agricultural production financing | | 28,447 | | 25,588 | |
Farm real estate | | 51,121 | | 46,051 | |
Commercial real estate | | 305,840 | | 286,603 | |
Hotel | | 37,115 | | 42,681 | |
Residential real estate | | 779,639 | | 790,962 | |
Construction and development | | 86,526 | | 79,261 | |
Consumer | | 129,301 | | 129,681 | |
Total loans | | 1,612,204 | | 1,574,384 | |
Allowance for loan losses | | (13,112 | ) | (12,792 | ) |
Net loans | | $ | 1,599,092 | | $ | 1,561,592 | |
| | June 30, | |
| | 2007 | | 2006 | |
Allowance for loan losses | | | | | |
Balances, January 1 | | $ | 12,792 | | $ | 10,441 | |
Addition resulting from acquisition | | — | | 4,474 | |
Adjustments to prior acquisition | | — | | (110 | ) |
Provision for losses | | 1,595 | | 723 | |
Recoveries on loans | | 419 | | 241 | |
Loans charged off | | (1,694 | ) | (1,343 | ) |
Balances, June 30 | | $ | 13,112 | | $ | 14,426 | |
The Company has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination, and it was probable, at acquisition, that all contractually required payments would not be collected. The outstanding balance and carrying amount of those loans is as follows:
| | June 30,
2007 | | Dec. 31,
2006 | |
Commercial real estate | | $ | 7,145 | | $ | 7,747 | |
Construction | | 1,408 | | 1,452 | |
Mortgage | | 361 | | 527 | |
Consumer | | 254 | | 269 | |
Outstanding balance | | $ | 9,168 | | $ | 9,995 | |
Carrying amount, net of allowance of $230 and $0 | | $ | 7,872 | | $ | 8,907 | |
For those purchased loans disclosed above, the Company increased the allowance for loan losses by $230 during the first six months of 2007 and $0 during the first six months of 2006.
10
NOTE 5 - DEPOSITS
| | June 30,
2007 | | December 31,
2006 | |
| | | | | |
Noninterest-bearing demand | | $ | 203,638 | | $ | 193,513 | |
Interest-bearing demand | | 440,086 | | 466,212 | |
Savings | | 340,342 | | 335,405 | |
Certificates of deposit of $100 or more | | 282,022 | | 285,262 | |
Other certificates and time deposits | | 574,124 | | 579,297 | |
Total deposits | | $ | 1,840,212 | | $ | 1,859,689 | |
NOTE 6 - EARNINGS PER SHARE
Earnings per share (EPS) were computed as follows:
For the three months ended | | June 30, 2007 | | June 30, 2006 | |
| | | | Weighted | | Per | | | | Weighted | | Per | |
| | Net | | Average | | Share | | Net | | Average | | Share | |
| | Income | | Shares | | Amount | | Income | | Shares | | Amount | |
Basic earnings per share: | | | | | | | | | | | | | |
Income available to common shareholders | | $ | 6,003 | | 18,740,752 | | $ | 0.32 | | $ | 5,482 | | 16,561,087 | | $ | 0.33 | |
Effect of dilutive shares | | | | 9,420 | | | | | | 13,905 | | | |
Diluted earnings per share | | $ | 6,003 | | 18,750,172 | | $ | 0.32 | | $ | 5,482 | | 16,574,992 | | $ | 0.33 | |
For the six months ended | | June 30, 2007 | | June 30, 2006 | |
| | | | Weighted | | Per | | | | Weighted | | Per | |
| | Net | | Average | | Share | | Net | | Average | | Share | |
| | Income | | Shares | | Amount | | Income | | Shares | | Amount | |
Basic earnings per share: | | | | | | | | | | | | | |
Income available to common shareholders | | $ | 11,418 | | 18,744,317 | | $ | 0.61 | | $ | 10,268 | | 15,488,432 | | $ | 0.66 | |
Effect of dilutive shares | | | | 9,238 | | | | | | 12,808 | | | |
Diluted earnings per share | | $ | 11,418 | | 18,753,555 | | $ | 0.61 | | $ | 10,268 | | 15,501,240 | | $ | 0.66 | |
Stock options for 230,350 and 169,339 shares of common stock were not considered in computing diluted earnings per share for 2007 and 2006 because they were antidilutive.
11
MAINSOURCE FINANCIAL GROUP, INC.
FORM 10-Q
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
(Dollar amounts in thousands except per share data)
Overview
MainSource Financial Group, Inc. (“Company”) is a multi-bank, financial holding company that provides an array of financial services and is headquartered in Greensburg, Indiana. The Company’s shares trade on the NASDAQ national securities exchange under the symbol MSFG. On June 30, 2007, the Company controlled four bank subsidiaries, MainSource Bank, MainSource Bank of Illinois, MainSource Bank - Crawfordsville, and MainSource Bank - Ohio. In addition to the banking subsidiaries, the Company owned the following subsidiaries: MainSource Insurance, LLC, MainSource Statutory Trust I, MainSource Statutory Trust II, MainSource Statutory Trust III, MainSource Statutory Trust IV, MSB Investments of Nevada, Inc., and MainSource Title, LLC. As required by current accounting guidance, the trusts are no longer consolidated with the Company. Accordingly, the Company does not report the securities issued by the trusts as liabilities, and instead reports as liabilities the subordinated debentures issued by the Company.
Forward-Looking Statements
Except for historical information contained herein, the following discussion and analysis includes certain statements which constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve risks and uncertainties, including anticipated financial performance, business prospects and other similar matters, which reflect management’s best judgment based on factors currently known. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. Factors which might cause such a difference include, but are not limited to, general economic conditions, monetary and fiscal policies of the federal government, demand for loan products, and other factors discussed in our Annual Report on 10K for the year ended December 31, 2006, under ITEM 1A “Risk Factors”, and our other filings with the Securities and Exchange Commission. The Company does not undertake, and specifically disclaims, any obligation to update any forward-looking statements to reflect the occurrence of events or circumstances after the date of such statements.
Results of Operations
Net income for the second quarter of 2007 was $6,003 compared to $5,482 for the second quarter of 2006. The increase in net income was primarily attributable to a full quarter’s effect of the acquisitions made in 2006. Diluted earnings per share for the second quarter totaled $0.32 in 2007, a slight decrease from the $0.33 reported in the same period a year ago. Key measures of the financial performance of the Company are return on average shareholders’ equity and return on average assets. Return on average shareholders’ equity was 9.14% for the second quarter of 2007 while return on average assets was .98% for the same period, compared to 11.11% and 1.10% in the second quarter of 2006. Return on equity and earnings per share have been impacted by shares issued in connection with the acquisitions completed in the first half of 2006.
For the six months ended June 30, 2007, net income was $11,418 compared to $10,268 for the same period a year ago. Earnings per share decreased to $0.61 in 2007 from $0.66 in 2006. Return on average shareholders’ equity was 8.97% for the first six months of 2007 while return on average assets was .96% for the same period, compared to 11.44% and 1.13% in the first six months of 2006.
Net Interest Income
The volume and yield of earning assets and interest-bearing liabilities influence net interest income. Net interest income reflects the mix of interest-bearing and non-interest-bearing liabilities that fund earning assets, as well as interest spreads between the rates earned on these assets and the rates paid on interest-bearing liabilities. Second quarter net interest income of $18,750 in 2007 was an increase of 14.3% versus the second quarter of 2006. Average earning assets increased 19.2% while net interest margin, on a fully-taxable equivalent basis, decreased to 3.65% for the second quarter of 2007 compared to 3.82% for the same period a year ago. The full year’s effect of the acquisitions of the thrift institutions in the first and second quarters of 2006 and their corresponding lower net interest margins were the primary cause for the decrease in the Company’s net interest margin. In addition, the Company has seen a shift in its existing deposit mix as many customers have
12
moved their balances from lower-cost transactional accounts to higher-yielding time and money market accounts. This shift, coupled with the increase in short-term borrowing rates, has resulted in a higher than expected increase in the overall cost of funds. For the first six months of 2007, the Company’s net interest margin was 3.68% compared to 3.92% for the first six months of 2006.
Provision for Loan Losses
See “Loans, Credit Risk and the Allowance and provision for Probable Loan Losses” below.
Non-interest Income
Second quarter non-interest income for 2007 was $7,467 compared to $5,895 for the second quarter of 2006. Service charges on deposit accounts increased $1,103 due primarily to the increase in the number of deposit accounts from the 2006 acquisition activity. Offsetting the increase in service charges was a decrease in other income. In June 2006, the Company settled its interest rate swap agreement and realized a pre-tax gain of $483, which was reported as other income in that period.
For the six months ended June 30, 2007, non-interest income was $13,558 compared to $10,794 for the same period a year ago. The aforementioned increase in service charge income was the primary contributor to the increase.
Non-interest Expense
The Company’s non-interest expense was $17,097 for the second quarter of 2007 compared to $14,602 for the same period in 2006. Increases in employee costs, occupancy expenses, equipment expenses, intangibles amortization, telecommunications, and supplies were primarily attributable to the additional physical locations and increased staffing levels related to the acquisitions. In total, the 2006 acquisitions increased the Company’s physical locations by 18, taking its total to 80 full-service offices, and increased its full-time equivalent staffing level by 170 to approximately 800. The increase in other expenses was due to $300 of expenses related to the conversion of the core operating system at the Company’s Hobart, Indiana affiliate. The Company’s efficiency ratio was 63.9% for the second quarter of 2007 and 63.9% for the same period a year ago.
For the six months ended June 30, 2007, non-interest expense was $33,967 compared to $27,003 for the same period a year ago. The aforementioned acquisition activity was the primary reason for the increase. The Company’s efficiency ratio was 65.3% for the first six months of 2007 compared to 63.4% for the same period a year ago.
Income Taxes
The effective tax rate for the first six months was 25.6% for 2007 compared to 25.1% for the same period a year ago. The increase in the Company’s effective tax rate was primarily attributable to the increase in taxable income. The Company and its subsidiaries file consolidated income tax returns.
Financial Condition
Total assets at June 30, 2007 were $2,452,571 compared to $2,429,773 as of December 31, 2006. The slight increase in assets from year-end 2006 was primarily attributable to an increase in commercial loans. Average earning assets represented 87.8% of average total assets for the first six months of 2007 and 89.5% for the same period in 2006. Average loans represented 86.9% of average deposits in the first six months of 2007 and 78.5% for the comparable period in 2006. Management continues to emphasize quality loan growth to increase these averages. Average loans as a percent of average assets were 65.7% and 62.1% for the six-month periods ended June 30, 2007 and 2006 respectively.
The decrease in deposits of $19,477 from December 31, 2006 to June 30, 2007 was due primarily to a reduction of public fund deposits, which tend to be seasonal. Noninterest bearing deposits increased $10,125 from December 31, 2006.
Shareholders’ equity was $252,626 on June 30, 2007 compared to $253,247 on December 31, 2006. Book value (shareholders’ equity) per common share was $13.49 at June 30, 2007 versus $13.50 at year-end 2006. Accumulated other comprehensive income/loss decreased book value per share by $0.40 at June 30, 2007 and $0.08 at December 31, 2006. Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders’ equity. The increase in the Company’s accumulated other comprehensive loss since the end of 2006 was due to
13
an increase in the unrealized loss on the Company’s investment securities portfolio. The increase in unrealized loss on the portfolio was due to the rise in market investment rates from year-end.
Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses
Loans remain the Company’s largest concentration of assets and, by their nature, carry a higher degree of risk. The loan underwriting standards observed by the Company’s subsidiaries are viewed by management as a means of controlling problem loans and the resulting charge-offs. The Company believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company’s Board of Directors regularly monitors such concentrations to determine compliance with its loan allocation policy. The Company believes it has no undue concentrations of loans.
Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 48.4% of total loans at June 30, 2007 and 50.2% at December 31, 2006. The Company anticipates this category of loans to decrease as a large portion of future residential real estate loan originations will be sold to the secondary market. On June 30, 2007, the Company had $1,271 of residential real estate loans held for sale, which was a decrease from the year-end balance of $2,162. The Company generally retains the servicing rights on mortgages sold.
Non-performing loans totaled $15,857, or ..98% of total loans, as of June 30, 2007, compared to $16,860, or 1.08% of total loans, as of June 30, 2006, and $17,481, or 1.11% of loans at December 31, 2006. The decrease in non-performing loans since year-end was due to an increased focus on collecting troubled loans. The allowance for loan losses was $13,112 as of June 30, 2007 and represented 0.81% of total outstanding loans compared to $12,792 as of December 31, 2006 or ..81% of total outstanding loans. Because of the acquisition of the three thrift institutions in the first six months of 2006 and their large residential real estate loan portfolios, the percentage of loan loss to total outstanding loans is lower than historical amounts.
The provision for loan losses was $899 in the second quarter of 2007 compared to $363 for the same period in 2006 and $696 for the first quarter of 2007. The provision remained relatively flat on a linked quarter basis as the increase in net loan losses was mitigated by the decrease in specific allocations for certain non-performing and watch list loans. Net loan losses were $906 for the second quarter of 2007 compared to $695 for the same period a year ago. For the six months ended June 30, 2007, net loan losses were $1,275, or 0.16% of average loans outstanding, compared to $1,102 of net loan losses for the six months ended June 30, 2006, which represented 0.20% of average loans outstanding for that period. The adequacy of the allowance for loan losses in each subsidiary is reviewed at least quarterly. The determination of the provision amount in any period is based on management’s continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, current economic conditions, the amount of loans presently outstanding, and information about specific borrower situations. The allowance for loan losses as of June 30, 2007 was considered adequate by management.
Investment Securities
Investment securities offer flexibility in the Company’s management of interest rate risk and are an important source of liquidity as a response to changing characteristics of assets and liabilities. The Company’s investment policy prohibits trading activities and does not allow investment in high-risk derivative products, junk bonds or foreign investments.
As of June 30, 2007, the Company had $489,805 of investment securities. All of these securities were classified as “available for sale” (“AFS”) and were carried at fair value with unrealized gains and losses, net of taxes, reported as a separate component of shareholders’ equity. An unrealized pre-tax loss of $11,697 was recorded to adjust the AFS portfolio to current market value at June 30, 2007, compared to an unrealized pre-tax loss of $2,291 at December 31, 2006. Unrealized losses on AFS securities have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the securities approach their maturity dates.
Sources of Funds
The Company relies primarily on customer deposits, securities sold under agreements to repurchase and shareholders’ equity to fund earning assets. FHLB advances are also used to provide additional funding.
Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits funded 86.1% and 88.4% of total average earning assets for the six-month periods ending June 30, 2007 and 2006. Total
14
interest-bearing deposits averaged 89.7% and 89.1% of average total deposits for the six-month periods ending June 30, 2007 and 2006, respectively. Management constantly strives to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.
The Company had FHLB advances of $207,285 outstanding at June 30, 2007. These advances have interest rates ranging from 2.36% to 6.50%. Approximately $5,000 of these advances were obtained for short-term liquidity needs and had original maturities of six months or less. The remaining advances were originally long-term advances with approximately $19,000 maturing in 2007, $29,000 maturing in 2008, $10,000 maturing in 2009, $73,000 maturing in 2010, $20,000 maturing in 2011, and $51,000 maturing in 2012 and beyond.
Capital Resources
Total shareholders’ equity was $252,626 at June 30, 2007, which was a slight decrease of $621 compared to the $253,247 of shareholders’ equity at December 31, 2006. The increase in retained earnings was more than offset by the change in accumulated other comprehensive loss related to the investment securities.
The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company’s core capital consists of shareholders’ equity, excluding accumulated other comprehensive income/loss, while Tier 1 capital consists of core capital less goodwill and intangibles. Trust preferred securities qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Company. Consequently, the amount of trust preferred securities in excess of the 25% limitation constitutes Tier 2 capital of the Company. Total regulatory capital consists of Tier 1, certain debt instruments and a portion of the allowance for loan losses. At June 30, 2007, Tier 1 capital to total average assets was 7.2%. Tier 1 capital to risk-adjusted assets was 10.3%. Total capital to risk-adjusted assets was 11.1%. All three ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Company’s subsidiary banks exceed regulatory definitions of well-capitalized institutions.
The Company declared and paid common dividends of $0.14 per share in the second quarter of 2007 versus $0.13 for the second quarter of 2006. For the six months of 2007, the Company declared and paid common dividends of $0.28 per share compared to $0.26 for the first six months of 2006.
Liquidity
Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year, and money market instruments. In addition, the Company holds AFS securities maturing after one year, which can be sold to meet liquidity needs.
Maintaining a relatively stable funding base, which is achieved by diversifying funding sources and extending the contractual maturity of liabilities, supports liquidity and limits reliance on volatile short-term purchased funds. Short-term funding needs arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company’s strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and low-cost funds. Average core deposits funded approximately 72.3% of total earning assets for the six months ended June 30, 2007 and 76.5% for the same period in 2006.
Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. In addition, the Company’s affiliates have access to the Federal Home Loan Bank for borrowing purposes.
Interest Rate Risk
Asset/liability management strategies are developed by the Company to manage market risk. Market risk is the risk of loss in financial instruments including investments, loans, deposits and borrowings arising from adverse changes in prices/rates. Interest rate risk is the Company’s primary market risk exposure, and represents the sensitivity of earnings to changes in market interest rates.
15
Effective asset/liability management requires the maintenance of a proper ratio between maturing or repriceable interest-earning assets and interest-bearing liabilities. It is the policy of the Company that the cumulative gap divided by total assets must be not greater than plus or minus 20% at the 3-month, 6-month, and 1-year time horizons.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk of the Company encompasses exposure to both liquidity and interest rate risk and is reviewed monthly by the Asset/Liability Committee and the Board of Directors. There have been no material changes in the quantitative and qualitative disclosures about market risks as of June 30, 2007 from the analysis and disclosures provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.
Item 4. Controls and Procedures
As of the end of the quarterly period covered by this report, an evaluation was carried out under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)). Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms as of such date.
There was no change in the Company’s internal control over financial reporting that occurred during the Company’s second fiscal quarter of 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
16
