UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
{X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
OR
{ } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________________ to ____________________
Commission file number 0-8679
BAYLAKE CORP.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Wisconsin 39-1268055
- --------------------------------------------------------------------------------
(State or other jurisdiction of incorporation (Identification No.)
or organization)
217 North Fourth Avenue, Sturgeon Bay, WI 54235
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(920)-743-5551
- --------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
None
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes {X} No { }
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes {X} No { }
Applicable Only to Corporate Issuers:
Number of outstanding shares of each of common stock, par value $5.00 per share,
as of May 11, 2004: 7,627,477 shares
BAYLAKE CORP. AND SUBSIDIARIES
INDEX
PAGE NUMBER
PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Condensed Balance Sheet as of March 31, 2004 3 - 4
and December 31, 2003
Consolidated Condensed Statement of Income for the three 5 - 6
months ended March 31, 2004 and 2003
Consolidated Statement of Comprehensive Income for the three 7
months ended March 31, 2004 and 2003
Consolidated Statement of Cash Flows for the three months ended 8 - 9
March 31, 2004 and 2003
Notes to Consolidated Condensed Financial Statements 10 - 11
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12 - 34
Item 3. Quantitative and Qualitative Disclosures About Market Risk 34 - 35
Item 4. Controls and Procedures 35
PART II - OTHER INFORMATION 35
Item 1. Legal Proceedings
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matter to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
Signatures 36
EXHIBIT INDEX 36
Exhibit 15 Letter re: unaudited interim financial information 41
Exhibit 31.1 Certification pursuant to Section 302 37
Exhibit 31.2 Certification pursuant to Section 302 38
Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 39
Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 40
2
PART 1 - FINANCIAL INFORMATION
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEET (UNAUDITED)
(dollars in thousands)
MARCH 31 DECEMBER 31,
2004 2003
------------ ------------
ASSETS
Cash and due from banks $ 17,223 $ 24,226
Federal funds sold 0 0
------------ ------------
Cash and cash equivalents 17,223 24,226
Investment securities available for sale (at market) 184,414 176,815
Investment securities held to maturity (market
value $17,706 and $19,314 at March 31, 2004 and
December 31, 2003, respectively) 16,685 19,032
Loans held for sale 1,654 165
Loans 713,052 695,990
Less: Allowance for loan losses 12,651 12,159
------------ ------------
Loan, net of allowance for loan losses 700,401 683,831
Bank premises and equipment 23,574 21,958
Federal Home Loan Bank stock (at cost) 7,364 7,247
Accrued interest receivable 4,375 3,959
Income taxes receivable 0 636
Deferred income taxes 2,355 3,148
Goodwill 4,969 4,969
Other Assets 30,018 29,252
------------ ------------
Total Assets $ 993,032 $ 975,238
============ ============
LIABILITIES
Domestic deposits
Non-interest bearing $ 95,276 $ 106,642
Interest bearing
NOW 82,350 92,308
Savings 195,199 204,252
Time, $100,000 and over 210,449 180,568
Other time 190,788 199,522
------------ ------------
Total interest bearing 678,786 676,650
------------ ------------
Total deposits 774,062 783,292
Short-term borrowings
Federal funds purchased, repurchase agreements
and Federal Home Loan Bank advances 39,382 23,359
Accrued expenses and other liabilities 5,748 6,155
Dividends payable 0 1,061
Other borrowings 85,091 75,092
3
Long-term debt 0 53
Junior subordinated debentures issued to
Unconsolidated subsidiary trust 16,598 16,598
------------ ------------
Total liabilities 920,881 905,610
------------ ------------
STOCKHOLDERS' EQUITY
Common stock, $5 par value: authorized 10,000,000
shares issued 7,650,636 shares as of March 31, 2004 and 7,628,135 as of
December 31, 2003; outstanding 7,627,477 as of March 31, 2004 and
7,604,976 as of December 31, 2003 38,253 38,141
Additional paid-in capital 8,334 8,163
Retained earnings 22,694 21,864
Treasury Stock (625) (625)
Net unrealized gain on securities available for
sale, net of tax of $1,887 as of March 31, 2004
and $1,094 as of December 31, 2003 3,495 2,085
------------ ------------
Total stockholders' equity 72,151 69,628
------------ ------------
Total liabilities and stockholders'
equity $ 993,032 $ 975,238
============ ============
4
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(dollars in thousands, except per share amounts)
THREE MONTHS ENDED MARCH 31
2004 2003
------------ ------------
Interest income
Interest and fees on loans $ 9,732 $ 10,196
Interest on investment securities
Taxable 1,576 1,051
Exempt from federal income taxes 550 645
Other interest income 3 6
------------ ------------
Total interest income 11,861 11,898
Interest expense
Interest on deposits 3,018 4,096
Interest on short-term borrowings 112 24
Interest on other borrowings 479 555
Interest on long-term debt 0 1
Interest on junior subordinated debentures
of unconsolidated subsidiary 424 411
------------ ------------
Total interest expense 4,033 5,087
------------ ------------
Net interest income 7,828 6,811
Provision for loan losses 775 893
------------ ------------
Net interest income after provision for
loan losses 7,053 5,918
------------ ------------
Other income
Fees from fiduciary activities 174 134
Fees from loan servicing 338 462
Fees for other services to customers 970 1,074
Gains from sales of loans 213 425
Gains from sale of subsidiary 0 350
Other income 287 199
------------ ------------
Total other income 1,982 2,644
------------ ------------
Other expenses
Salaries and employee benefits 3,865 3,701
Occupancy expense 522 469
Equipment expense 369 393
Data processing and courier 283 272
Operation of other real estate 125 103
Other operating expenses 1,208 1,094
------------ ------------
Total other expenses 6,372 6,032
------------ ------------
Income before income taxes 2,663 2,530
5
Income tax expense 767 704
------------ ------------
Net Income $ 1,896 $ 1,826
============ ============
Basic earnings per common share (1) $ 0.25 $ 0.24
Diluted earnings per common share (1) $ 0.25 $ 0.24
Cash dividends per share $ 0.14 $ 0.13
(1) Based on 7,612,356 average shares outstanding in 2004 and 7,492,374 in 2003.
6
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)
(dollars in thousands)
THREE MONTHS ENDED
MARCH 31
2004 2003
------------ ------------
Net Income $ 1,896 $ 1,826
------------ ------------
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized gains (losses) arising during period 1,410 (153)
------------ ------------
Comprehensive income $ 3,306 $ 1,673
============ ============
7
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED)
(dollars in thousands)
THREE MONTHS ENDED MARCH 31
2004 2003
------------ ------------
Cash flows from operating activities:
Interest received from:
Loans $ 9,423 $ 9,848
Investments 2,236 1,986
Fees and service charges 1,634 2,295
Interest paid to depositors (3,139) (3,463)
Interest paid to others (1,005) (1,000)
Cash paid to suppliers and employees (6,295) (5,559)
Income taxes paid (25) 16
------------ ------------
Net cash provided by operating activities 2,829 4,123
Cash flows from investing activities:
Principal payments received on investments 9,342 24,978
Purchase of investments (12,642) (26,815)
Proceeds from sale of other real estate owned 283 350
Proceeds from sale of subsidiary's assets 0 1,884
Loans made to customers in excess of principal collected (19,690) (16,015)
Capital expenditures (2,020) (651)
------------ ------------
Net cash used in investing activities (24,727) (16,269)
Cash flows from financing activities:
Net decrease in demand deposits, NOW accounts, and savings
Accounts (30,477) (14,317)
Net increase (decrease) in short term borrowing 16,023 (995)
Net increase in time deposits 21,247 16,650
Proceeds from other borrowings and long-term debt 9,999 0
Payments on other borrowings and long term debt (53) (53)
Net proceeds from exercise of stock options issued pursuant to plan 283 337
Dividends paid (2,127) (1,947)
------------ ------------
Net cash provided by (used in ) financing activities 14,895 (325)
------------ ------------
Net decrease in cash and cash equivalents (7,003) (12,471)
Cash and cash equivalents, beginning 24,226 33,300
------------ ------------
Cash and cash equivalents, ending $ 17,223 $ 20,829
============ ============
8
MARCH 31
2004 2003
------------ ------------
Reconciliation of net income to net cash provided by operating activities:
Net income $ 1,896 $ 1,826
Adjustments to reconcile net income to net cash provided by operating
Activities:
Depreciation 404 431
Provision for losses on loans and real estate owned 775 893
Amortization of premium on investments 167 231
Accretion of discount on investments (32) (49)
Cash surrender value increase (198) (142)
(Gain) Loss from disposal of ORE (52) 10
Gain on sale of loans (213) (425)
Proceeds from sale of loans held for sale 18,124 33,705
Originations of loans held for sale (17,911) (33,280)
Gain on sale of subsidiary 0 (350)
Equity in income of service center (55) (27)
Amortization of core deposit intangible 19 0
Amortization of mortgage servicing rights 66 90
Mortgage servicing rights booked (95) (91)
Deferred compensation 71 98
Changes in assets and liabilities:
Interest receivable (416) (239)
Prepaids and other assets 41 477
Unearned income 80 (6)
Interest payable (111) 624
Taxes payable 741 721
Other liabilities (472) (374)
------------ ------------
Total adjustments 933 2,297
------------ ------------
Net cash provided by operating activities $ 2,829 $ 4,123
============ ============
9
BAYLAKE CORP. AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2004
1. The accompanying unaudited consolidated financial statements should be
read in conjunction with Baylake Corp.'s 2003 annual report on Form 10-K.
In the opinion of management, the unaudited financial information included
in this report reflects all adjustments, consisting only of normal
recurring accruals, which are necessary for a fair statement of the
financial position as of March 31, 2004 and December 31, 2003. The results
of operations for the three months ended March 31, 2004 and 2003 are not
necessarily indicative of results to be expected for the entire year.
2. The book value of investment securities, by type, held by Baylake Corp.
are as follows:
MARCH 31, DECEMBER 31,
2004 2003
------------ ------------
(dollars in thousands)
Investment securities held to maturity:
Obligations of state and political subdivisions $ 16,685 $ 19,032
------------ ------------
Investment securities held to maturity $ 16,685 $ 19,032
============ ============
Investment securities available for sale:
U.S. Treasury and other U.S. government agencies $ 44,589 $ 39,696
Obligations of states and political subdivisions 35,025 35,015
Mortgage-backed securities 102,084 99,148
Other 2,716 2,956
------------ ------------
Investment securities available for sale $ 184,414 $ 176,815
============ ============
3. At March 31, 2004 and December 31, 2003, loans were as follows:
MARCH 31, DECEMBER 31,
2004 2003
------------ ------------
(dollars in thousands)
Commercial, financial and agricultural $ 88,625 $ 91,009
Real estate-commercial 398,723 387,820
Real estate - construction 83,453 77,350
Real estate - mortgage 128,556 125,700
Installment 14,124 14,460
Less: Deferred loan origination fees, net of costs (429) (349)
------------ ------------
$ 713,052 $ 695,990
Less allowance for loan losses (12,651) (12,159)
------------ ------------
Net loans $ 700,401 $ 683,831
============ ============
10
4. Baylake Corp. declared a cash dividend of $0.14 per share payable on March
15, 2004 to shareholders of record as of March 1, 2004.
5. Diluted earnings per share, which reflects the potential dilution that
could occur if outstanding stock options were exercised and stock awards
were fully vested and resulted in the issuance of common stock that then
shared in the earnings of the Company, is computed by dividing net income
by weighted average number of common shares and common stock equivalents.
The following table shows the computation of the basic and diluted
earnings per share for the three months ended March 31 (dollars in
thousands, except per share amounts):
Weighted average number
Net income of shares Earnings per share
- -----------------------------------------------------------------------------------------
3/31/04
Earnings per share, basic $ 1,896 7,612,356 $ 0.25
Effect of stock options-net 122,326
-------
Earnings per share, diluted $ 1,896 7,734,683 $ 0.25
3/31/03
Earnings per share, basic $ 1,826 7,492,374 $ 0.24
Effect of stock options-net 125,139
-------
Earnings per share, diluted $ 1,826 7,617,513 $ 0.24
6. The Company has a non-qualified stock option plan, which is described more
fully in the Company's December 31, 2003 Annual Report on Form 10-K. The
Company accounts for this plan under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted under
these plans had an exercise price at least equal to the fair market value
of the underlying common stock on the grant date. The following table
illustrates the effect on net income and earnings per share if the Company
had applied the fair value provisions of SFAS 123 "Accounting for
Stock-Based Compensation," to stock-based employee compensation.
Three months ended March 31,
2004 2003
---- ----
(In thousands, except per share amounts)
- -----------------------------------------------------------------------------
Net income, as reported $ 1,896 $ 1,826
Less: total stock-based employee
compensation cost determined
under the fair value based
method, net of income taxes (46) (44)
----------- ----------
Pro forma net income 1,850 1,782
Earnings per share:
Basic - as reported $ 0.25 $ 0.24
Basic - pro forma $ 0.24 $ 0.24
Diluted - as reported $ 0.25 $ 0.24
Diluted - pro forma $ 0.24 $ 0.23
11
PART 1 - FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
The following sets forth management's discussion and analysis of the
consolidated financial condition and results of operations of Baylake Corp.
("Baylake" or the "Company") for the three months ended March 31, 2004 and 2003
which may not be otherwise apparent from the consolidated financial statements
included in this report. Unless otherwise stated, the "Company" or "Baylake"
refers to this entity and to its subsidiaries on a consolidated basis when the
context indicates. For a more complete understanding, this discussion and
analysis should be read in conjunction with the financial statements, related
notes, the selected financial data and the statistical information presented
elsewhere in this report.
On October 1, 1998, the Company acquired Evergreen Bank, N.A. ("Evergreen"),
which was later merged into Baylake Bank. Prior to the acquisition, Evergreen
was under the active supervision of the Office of the Comptroller of the
Currency ("OCC") due to its designation of Evergreen as a "troubled institution"
and "critically under capitalized". In the acquisition, the Company was required
to contribute capital to Evergreen, but no payment to the seller of Evergreen
have been made by the Company and no payments are presently due. However, the
Company may become obligated for certain contingent payments that may become
payable in the future, not to exceed $2 million. Such contingent payments are
not accrued at March 31, 2004, since that amount, if any, is not estimable.
Forward-Looking Information
This discussion and analysis of financial condition and results of operations,
and other sections of this report, may contain forward-looking statements that
are based on the current expectations of management. Such expressions of
expectations are not historical in nature and are forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
Words such as "anticipates," "believes," "estimates," "expects," "forecasts,"
"intends," "is likely," "plans," "projects," and other such words are intended
to identify in such forward-looking statements. The statements contained herein
and in such forward-looking statements involve or may involve certain
assumptions, risks and uncertainties, many of which are beyond the control of
the Company, that may cause actual future results to differ materially from what
may be expressed or forecasted in such forward-looking statements. Readers
should not place undue expectations on any forward-looking statements. In
addition to the assumptions and other factors referenced specifically in
connection with such statements, the following factors could impact the business
and financial prospects of the relationships; demand for financial products and
financial services; the degree of competition by traditional and non-traditional
financial services competitors; changes in banking legislation or regulations;
changes in tax laws; changes in interest rates; changes in prices; the impact of
technological advances; governmental and regulatory policy changes; trends in
customer behavior as well as their ability to repay loans; and changes in the
general economic conditions, nationally or in the State of Wisconsin.
Critical Accounting Policies
In the course of the Company's normal business activity, management must select
and apply many accounting policies and methodologies that lead to the financial
results presented in the consolidated financial statements of the Company. Some
of these policies are more critical than others.
12
Allowance for Loan Losses: Management considers the accounting policy relating
to the allowance for loan losses to be a critical accounting policy because of
the uncertainty and subjectivity inherent in estimating the levels of allowance
needed to cover probable credit losses within the loan portfolio and the
material effect that these estimates can have on the Company's results of
operations. While management's evaluation of the allowance for loan losses as of
March 31, 2004 considers the allowance to be adequate, under adversely different
conditions or assumptions, the Company would need to increase the allowance. In
addition, the assumptions and estimates used in the internal reviews of the
Company's non-performing loans and potential problem loans, as well as the
associated evaluation of the related collateral coverage for these loans, has a
significant impact on the overall analysis of the adequacy of the allowance for
loan losses. Though management has concluded that the current evaluation of
collateral values is reasonable under the circumstances, if collateral
evaluation were significantly lowered, the Company's allowance for loan losses
policy would also require making additional provisions for loan losses.
Management reviews the adequacy of the Allowance for Loan Losses ("allowance" or
"ALL") on a quarterly basis to determine whether, in management's estimate, the
allowance is adequate to provide for possible losses inherent in the loan
portfolio as of the balance sheet date. Management's evaluation of the adequacy
of the ALL is based primarily on management's periodic assessment and grading of
the loan portfolio as described below. Additional factors considered by
management include the consideration of past loan loss experience, trends in
past due and non-performing loans, risk characteristics of the various
classifications of loans, current economic conditions, the fair value of
underlying collateral, and other regulatory or legal issues that could affect
credit losses.
Loans are initially graded when originated. They are re-graded as they are
renewed, when there is a loan to the same borrower, when identified facts
demonstrate heightened risk of nonpayment, or if they become delinquent. The
loan review, or, grading process attempts to identify and measure problem and
watch list loans. Problem loans are those loans that management determines have
a higher than average risk for default, with workout and/or legal action
probable within one year. These loans are reported at least quarterly to the
directors' loan committee and reviewed at the officers' loan committee for
action to be taken. Watch list loans are those loans considered as having
weakness detected in either character, capacity to repay or balance sheet
concerns and prompt management to take corrective action at the earliest
opportunity. Problem and watch list loans generally exhibit one or more of the
following characteristics:
1. Adverse financial trends and condition
2. Decline in the entire industry
3. Managerial problems
4. Customer's failure to provide financial information or other collateral
documentation
5. Repeated delinquency, overdrafts or renewals
Every significant problem credit is reviewed by the loan review process and
assessments are performed quarterly to confirm the risk rating, proper
accounting and the adequacy of loan loss reserve assigned. In addition to this
quarterly management review, all problem loans are monitored and evaluated on a
monthly basis by a designated review committee. Depending on the change in
condition, loans may be reassessed concerning allocation of risk, probable
disposition, and potential loss, including changes to the ALL.
After reviewing the gradings in the loan portfolio, management will allocate or
assign a portion of the ALL to categories of loans and individual loans to cover
management's estimate of probable loss. Allocation is related to the grade of
the loan and includes a component resulting from the application of the
measurement criteria of Statements of Financial Accounting Standards No. 114,
"Accounting by Creditors for Impairment of a Loan" ("SFAS 114") and No. 118,
"Accounting by Creditors for Impairment of a Loan-Income Recognition and
Disclosures" ("SFAS 118"). Allocations also are made for unrated loans, such as
credit card loans, based on historical loss experience adjusted for portfolio
activity. The indirect risk in the form of off-balance sheet unfunded
commitments are also taken into consideration. These allocated reserves are
further supplemented by unallocated reserves based on management's estimate
regarding risk of error, local economic conditions and any other relevant
factors. Management then compares the
13
amounts allocated for probable losses to the current allowance. To the extent
that the current allowance is insufficient to cover management's best estimate
of probable losses, management records additional provision for credit loss. If
the allowance is greater than required at that point in time, provision expense
is adjusted accordingly.
Mortgage servicing rights: Another valuation that requires management's judgment
relates to mortgage servicing rights. Essentially, mortgage servicing rights are
established on residential mortgage loans and guaranteed commercial loans that
the Company originate and sell. A portion of the loan's book basis is allocated
to mortgage servicing rights which are retained when a loan is sold, based upon
its relative fair value. The fair value of mortgage servicing rights is the
present value of estimated future net cash flows from the servicing relationship
using current market assumptions for prepayments, servicing costs and other
factors. As the loans are repaid and net servicing revenue is earned, mortgage
servicing rights are amortized against servicing revenue. Net servicing rights
are expected to exceed this amortization expense. However, if the actual
prepayment experience exceeds what was originally anticipated, net servicing
revenues may be less than expected and mortgage servicing rights may be
impaired. This impairment would be recorded as a charge to earnings in the
period in which it became impaired.
Core deposit intangibles: Judgment is used in the valuation of other intangible
assets such as core deposit base intangibles. Core deposit base intangibles
assets of $361,000 have been recorded for core deposits (defined as checking,
money market, savings and time deposits) that have been acquired as a result of
the Kewaunee branch acquisition from M&I Bank. The core deposit base intangible
assets have been recorded using the assumption that they provide a more
favorable source of funding than more expensive wholesale borrowings. An
intangible asset has been recorded for the present value of the difference
between the expected interest expense to be incurred on these deposits and
interest expense that would be expected if these deposits were replaced by
wholesale borrowings, over the expected lives of the core deposits. The Company
currently estimates that the underlying core deposits have lives of seven years.
If future analysis shows these deposits to have a shorter life, then the Company
will write down the asset by expensing the amount that is impaired.
Goodwill: The Company has goodwill assets on the books as a result of two prior
acquisitions. In July 2001, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill
and Other Intangible Assets." SFAS No. 142 requires that goodwill and intangible
assets with indefinite lives no longer be amortized, but instead tested for
impairment as least annually. SFAS No. 142 requires that intangible assets with
definite useful lives be amortized over their respective estimated useful lives
to their estimated residual values, and be reviewed for impairment in accordance
with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets."
Those tests inherently involve management's judgment as to factors such as an
estimation of the fair value of a reporting unit; screening for potential
impairment and measuring the amount of the impairment. There was no impairment
of goodwill in 2003 or to date in 2004. In the event of goodwill impairment,
that amount would be charged to earnings in the period in which the impairment
is determined.
Income tax accounting: The assessment of tax assets and liabilities involves the
use of estimates, assumptions, interpretations, and judgments concerning certain
accounting pronouncements and federal and state tax codes. There can be no
assurance that future events, such as court decisions or positions of federal
and state taxing authorities, will not differ from management's current
assessment, the impact of which could be significant to the consolidated results
of the Company's operations and reported earnings. The Company believes that the
tax assets and liabilities are adequate and properly recorded in the
consolidated financial statements. See Section on "Income Taxes."
Results of Operations
For the three months ended March 31, 2004, earnings increased $70,000, or 3.8%,
to $1.9 million from $1.8 million for the first quarter last year. Basic and
fully diluted earnings per share of $0.25 was reported for the quarter ended
March 31, 2004 compared to $0.24 for the same period last year, an increase of
4.2%.
14
TABLE 1
SUMMARY RESULTS OF OPERATIONS
($ in Thousands, except per share data)
Three months ended March 31, Three months ended March 31,
2004 2003
- ------------------------------------------------------------------------------------------------
Net income, as reported $ 1,896 $ 1,826
EPS-basic, as reported 0.25 0.24
EPS-diluted, as reported 0.25 0.24
Return on average assets, as
reported 0.78% 0.82%
Return on average equity, as
reported 10.80% 11.23%
Efficiency ratio, as reported (1) 63.13% 61.63%
(1) Noninterest expense divided by sum of taxable equivalent net
interest income plus noninterest income, excluding investment
securities gains, net
The annualized return on average assets and return on average equity for the
three months ended March 31, 2004 were 0.78% and 10.80%, respectively, compared
to 0.82% and 11.23%, respectively, for the same period a year ago.
The increase in net income for the period is primarily due to increased net
interest income and a reduction in the provision for loan losses. This was
offset partially by a decrease in other income (primarily stemming from the
slowdown in mortgage activity and Arborview activities in 2003 that were not
repeated in 2004) and an increase in other expenses.
Cash dividends declared in the first quarter of 2004 increased 7.7% to $0.14 per
share compared with $0.13 for the same period in 2003.
Net Interest Income
Net interest income is the largest component of the Company's operating income
(net interest income plus other non-interest income) accounting for 80.4% of
total operating income for the first three months of 2004, as compared to 73.0%
for the same period in 2003. Net interest income represents the difference
between interest earned on loans, investments and other interest earning assets
offset by the interest expense attributable to the deposits and the borrowings
that fund such assets. Interest fluctuations together with changes in the volume
and types of earning assets and interest-bearing liabilities combine to affect
total net interest income. This analysis discusses net interest income on a
tax-equivalent basis in order to provide comparability among the various types
of earned interest income. Tax-exempt interest income is adjusted to a level
that reflects such income as if it were fully taxable.
Net interest income on a tax equivalent basis for the three months ended March
31, 2004 increased $968,000, or 13.6%, to $8.1 million from $7.1 million over
the comparable period a year ago. As indicated in Table 2, the increase in
taxable equivalent net interest income was attributable to favorable volume
variances (with balance sheet growth and differences in the mix of average
earning assets and average interest-bearing liabilities adding $806,000 to
equivalent net interest income) and favorable rate variances (as the impact of
changes in the interest rate environment added taxable equivalent net interest
income by $162,000).
Net interest margin is tax-equivalent net interest income expressed as a
percentage of average earning assets. The net interest margin exceeds the
interest rate spread because of the use of non-interest bearing
15
sources of funds to fund a portion of earning assets. As a result, the level of
funds available without interest cost (demand deposits and equity capital) is an
important component increasing net interest margin.
The net interest margin for the first three months for 2004 was 3.62%, up 9
basis points ("bps") from 3.53% for the comparable period in 2003. This
comparable period increase was attributable to a 13 bps increase in interest
rate spread (the net of a 75 bps reduction in the cost of interest-bearing
liabilities offset partially by a 62 bps reduction in the yield on earning
assets) and a 4 bps lower contribution from the net free funds (reflecting the
lower interest rate environment in 2004).
Interest rates were relatively stable and historically low, with one interest
rate decrease of 25 bps between the comparable three-months periods. The Federal
funds rate was 1.00% throughout the first quarter of 2004 versus 1.25%
throughout the same period in 2003. The Company had positioned the balance sheet
to be slightly asset sensitive (which means that assets will re-price faster
than liabilities); thus, the prolonged lower interest rate environment favorably
lowered the cost of funding, but also lowered yields on earning assets, putting
pressure on the net interest margin. If prevailing interest rates increase, we
expect that to have a positive impact on net interest income.
For the three months ended March 31, 2004, average-earning assets increased
$80.0 million, or 9.7%, when compared to the same period last year. The Company
recorded an increase in average loans of $34.0 million, or 5.1%, for the first
quarter of 2004 compared to the same period a year ago. Loans have typically
resulted in higher rates of interest income to the Company than have investment
securities.
Interest rate spread is the difference between the tax-equivalent rate earned on
average earning assets and the rate paid on average interest-bearing
liabilities. The interest rate spread increased for the quarter ended March 31,
2004 when compared to the same period a year ago. The interest rate spread
increased 13 bps to 3.42% at March 31, 2004 from 3.29% in the same quarter in
2003. While the average yield on earning assets decreased 62 bps during the
period, the average rate paid on interest-bearing liabilities decreased 75 bps
over the same period as a result of a lower cost of funding from deposits and
other wholesale funding such as federal funds purchased and loans from the
Federal Home Loan Bank.
TABLE 2
NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS
($ In Thousands)
Three months ended March 31,
2004 2003
-------------------------------------- --------------------------------------
Average Interest Average Average Interest Average
Balance income/exp yield/rate Balance income/exp yield/rate
--------- ---------- ---------- --------- ---------- ----------
ASSETS
Earning assets:
Loans, net (1)(2)(3) $ 707,684 $ 673,660
Less: non-accrual loans (11,420) (12,361)
--------- ---------
Loans, net 696,264 $ 9,732 5.62% 661,299 $ 10,196 6.25%
Investments 204,849 2,412 4.75% 158,909 2,030 5.18%
Other earning assets 56 0 0.00% 1,185 4 1.37%
--------- -------- ---- --------- -------- ----
Total earning assets $ 901,169 $ 12,144 5.42% $ 821,393 $ 12,230 6.04%
Allowance for loan losses (12,364) (11,838)
Non-accrual loans 11,420 12,361
Cash and due from banks 17,002 19,246
16
Other assets 66,376 59,423
--------- ---------
Total assets $ 983,603 $ 900,585
--------- ---------
LIABILITIES AND
STOCKHOLDER'S EQUITY
Interest-bearing
liabilities:
NOW accounts $ 87,456 $ 175 0.80% $ 64,133 $ 164 1.04%
Savings accounts 200,729 373 0.75% 196,513 521 1.08%
Time deposits > $100M 193,290 1,271 2.64% 183,990 1,556 3.43%
Time deposits < $100M 196,715 1,199 2.45% 216,547 1,855 3.47%
--------- -------- ---- --------- -------- -----
Total interest-bearing
deposits 678,190 3,018 1.79% 661,183 4,096 2.51%
Short-term borrowings 33,172 110 1.33% 5,345 19 1.44%
Customer repurchase
agreements 1,024 2 0.79% 1,680 5 1.21%
Other borrowings 82,784 479 2.33% 65,000 555 3.46%
Long term debt 0 0 0.00% 53 1 7.65%
Trust preferred
securities 16,598 424 10.27% 16,100 411 10.35%
Total interest-bearing
liabilities $ 811,768 $ 4,033 2.00% $ 749,361 $ 5,087 2.75%
--------- -------- ---- --------- -------- -----
Demand deposits 94,625 77,083
Accrued expenses and
other liabilities 6,602 8,208
Stockholders' equity 70,608 65,933
--------- ---------
Total liabilities and
stockholders' equity $ 983,603 $ 900,585
--------- ---------
Interest rate spread $ 8,111 3.42% $ 7,143 3.29%
Contribution of free
funds 0.20% 0.24%
---- ----
Net interest margin 3.62% 3.53%
---- ----
The ratio of average earning assets to average total assets measures
management's ability to employ overall assets for the production of interest
income. This ratio was 91.6% and 91.2% for the first quarter of 2004 and 2003,
respectively. The ratio increased as a result of a decrease in the volume of
average non-accrual loans for the first quarter of 2004 compared to a year
earlier.
Provision for Loan Losses
The provision for loan losses ("PFLL") is the periodic cost (not less than
quarterly) of providing an allowance for anticipated future loan losses. In any
accounting period, the PFLL is based on the methodology used and management's
evaluation of the loan portfolio, especially non-performing and other potential
problem loans, taking into consideration many factors, including loan growth,
net charge-offs,
17
changes in the composition of the loan portfolio, delinquencies, management's
evaluation of loan quality, general economic factors and collateral values.
The Company's loan review department performs a risk rating analysis as an
integral part of the review of each loan portfolio. For the commercial and
commercial real estate portfolios, the risk rating analysis includes a grading
system following a standard risk-rating matrix. Based upon this matrix, the
Company determines a risk rating assignment an appropriate measure to each loan
examined. As a result, the Company has provided $775,000 in PFLL for the first
quarter in 2004.
The PFLL for the first quarter of 2004 at $775,000 compares to a PFLL of
$893,000 for the first quarter in 2003. Net loan charge-offs in the first
quarter of 2004 were $283,000 compared with net charge-offs of $132,000 for the
same period in 2003. Net charge-offs as a percentage of average loans is a key
measure of asset quality. Net charge-offs to average loans were 0.16% for the
first quarter of 2004 compared to 0.08% for the same period in 2003. The
increase in net charge-offs relates primarily to a $200,000 commercial loan
charge-off stemming from a loan to a business services company. This loan had
been previously been allocated a PFLL in the amount of 80% of the loan amount.
Management believes that the current provision conforms to the Company's loan
loss reserve policy and is adequate in view of the present condition of the
Company's loan portfolio. However, a decline in the quality of our loan
portfolio, as a result of general economic conditions, factors affecting
particular borrowers or our market area, or otherwise, could affect the adequacy
of the allowance. If there are significant charge-offs against the allowance, or
we otherwise determine that the allowance is inadequate, we will need to make
higher provisions in the future. See "Risk Management and the Allowance for Loan
Losses" below for more information related to non-performing loans.
Non-Interest Income
Total non-interest income decreased $662,000, or 25.0%, to $2.0 million for the
first quarter of 2004 when compared to the first quarter of 2003. This decrease
occurred as a result of decreased gains from sales of loans, decreased fees from
loan servicing, decreased deposit service charge income, decreased non-bank
subsidiary income and a decrease in gains from sale of subsidiary. These were
offset partially by an increased trust revenue, increased brokerage income and
increased income from business owned life insurance.
TABLE 3
NONINTEREST INCOME
($ in Thousands)
Three months ended Three months ended
March 31, 2004 March 31, 2003 Percent change
------------------ ------------------ --------------
Trust revenues $ 174 $ 134 29.9%
Service charges on deposit accounts 655 706 (7.2%)
Other fee income 167 163 2.5%
Loan servicing income 338 462 (26.8%)
Financial services income 148 80 85.0%
Business owned life insurance 198 142 39.4%
Non-bank subsidiary income 0 125 NA
Gains from sale of loans 213 425 (49.9%)
Gains on sale of non-bank subsidiary's
assets 0 350 NA
Other income 89 57 56.1%
18
------ ------ -----
Total non-interest income $1,982 $2,644 (25.0%)
====== ====== =====
Loan servicing fees and gains from sales of loans were affected by a slowdown in
refinancing activity throughout the industry due to higher mortgage rates. Loan
servicing fees decreased $224,000 and gains from sales of loans decreased
$212,000 between the comparable quarters of 2004 and 2003. The decrease was
driven primarily by secondary mortgage and commercial loan production (loan
production to be sold to the secondary market) and resultant sales. Secondary
loan production declined 46.2% between the comparable first quarter periods
($17.9 million in the first quarter of 2004 versus $33.3 million in the first
quarter of 2003). The lower production levels impacted both gains on sales of
loans and volume-related fees, collectively down $336,000. Mortgages serviced
for secondary market placements (primarily Federal Home Loan Mortgage
Corporation "FHLMC") were $119.4 million and $81.9 million at March 31, 2004 and
2003, respectively.
Financial service income increased $68,000, or 85.0%, as a result of additional
business generated and aided by stronger financial markets performance. Income
from business owned life insurance ("BOLI") amounted to $198,000 for the first
quarter of 2004 compared to $142,000 a year earlier. A $13 million purchase of
BOLI made in the second quarter of 2002 and an additional $4 million purchase
made in the second quarter of 2003 impacted those results.
Revenues generated from the operation of Arborview LLC ("Arborview") (a
subsidiary formed in 2002 to manage a community based residential facility and
sold in the first quarter of 2003) as a result of the sale were$0 and $125,000
for the first quarter of 2004 and 2003, respectively. Gain on sale of Arborview
in the first quarter of 2003 amounted to $350,000.
Non-Interest Expense
Non-interest expense increased $340,000, or 5.6%, for the three months ended
March 31, 2004 compared to the same period in 2003 as indicated in Table 4.
Salaries and employee benefits showed an increase of $174,000, or 5.0%, for the
period as a result of additional staffing to operate new facilities.
Salary-related expenses increased $74,000, or 2.4%, due principally to merit
increases between the years. Full time equivalent staff increased to 300 persons
from 296 a year earlier. Benefit costs, principally for health insurance and
pension costs, represent the remaining increase in personnel-related costs. The
increase in health insurance costs is expected to continue for the balance of
2004. These costs were up $98,000, or 16.2%. Management will continue its
efforts to control salaries and employee benefits expense, although increases in
these expenses are likely to continue in future years.
TABLE 4
NONINTEREST EXPENSE
($ in Thousands)
Three months ended Three months ended
March 31, 2004 March 31, 2003 Percent change
------------------ ------------------ --------------
Personnel expense $ 3,865 $ 3,701 4.4%
Occupancy 522 469 11.3%
Equipment 369 393 (6.1%)
Data processing/courier 283 272 4.0%
Stationary and supplies 109 103 5.8%
Business development and advertising 127 117 8.5%
FDIC expense 29 29 0.00%
19
Director fees 98 94 4.3%
Mortgage servicing rights expense 66 90 (26.7%)
Legal and professional expense 92 101 (8.9%)
Operation of other real estate owned 125 103 21.4%
Other 687 560 22.7%
------- ------ -----
Total non-interest expense $ 6,372 $6,032 5.6%
======= ====== =====
Expenses related to the operation of other real estate owned increased $22,000
to $125,000 for the quarter ended March 31, 2004 compared to the same period in
2003. Included in these expenses were net gains taken on the sale of other real
estate owned amounting to $52,000 for the first quarter of 2004 compared to net
losses taken on sale of $8,000 for the same period in 2003. In addition, costs
related to the holding of other real estate owned properties increased $82,000
to $177,000 for the first quarter of 2004.
Other operating expenses increased $127,000 to $687,000 for the quarter ended
March 31, 2004. Included in those increases are employee acquisition expenses
which increased $38,000 for the three months ended March 31, 2004 as a result of
additional efforts to acquire sales staff in the markets served. In addition,
dues expense increased $33,000 as a result of additional corporate affiliations
in the various markets served.
Other items (such as supplies, marketing, telephone, postage and director fees)
comprising other operating expense show an increase of $56,000 or 10.1% in the
first quarter of 2004 when compared to the same quarter in 2003. The overhead
ratio, which is computed by subtracting non-interest income from non-interest
expense and dividing by average total assets, was 1.80% for the three months
ended March 31, 2004 compared to 1.53% for the same period in 2003.
Income Taxes
Income tax expense for the Company for the three months ended March 31, 2004 was
$767,000, an increase of $63,000, or 8.9%, compared to the same period in 2003.
The higher tax expense in 2004 reflected the Company's increase in before tax
earnings offset partially by a decrease in tax-exempt interest income.
The Company's effective tax rate (income tax expense divided by income before
taxes) was 28.8% for the three months ended March 31, 2004 compared with 27.8%
for the same period in 2003. The effective tax rate of 28.8% consisted of a
federal effective tax rate of 24.8% and Wisconsin State effective tax rate of
4.0%.
Income tax expense recorded in the consolidated statements of income involves
the interpretation and application of certain accounting pronouncements and
federal and state tax codes, and is, therefore, considered a critical accounting
policy. The Company undergoes examination by varying taxing authorities. Such
taxing authorities may require that changes in the amount of income tax or
valuation allowance be recognized when their interpretations differ from those
of management, based on their judgments about information available to them at
the time of their examinations. See section titled "Critical Accounting
Policies."
Future income taxes may be affected by recent developments in the state of
Wisconsin. Like many financial institutions that are located in Wisconsin, a
subsidiary of the Bank located in the state of Nevada holds and manages various
investment securities. Due to that fact that these subsidiaries are out of
state, income from their operations has not been subject to Wisconsin state
taxation. Although the Wisconsin Department of Revenue issued favorable tax
rulings regarding Nevada subsidiaries of Wisconsin financial
20
institutions, the Department representatives have recently stated that the
Department intends to revoke those rulings and tax some or all these
subsidiaries' income, even though there has been no intervening change in the
law. The Department has also implemented a program for the audit of Wisconsin
financial institutions who have formed and contributed assets to subsidiaries
located in Nevada, and presumably will seek to impose Wisconsin state income
taxes on income from those operations, at least on a going forward basis.
Although there will likely be challenges to the Department's actions and
interpretations, the Bank's net income would be reduced if the Department would
succeed in those actions. The Bank could also incur costs in the future to
address any action taken against it by the Department.
Balance Sheet Analysis
Loans
At March 31, 2004, total loans increased $17.1 million, or 2.5%, to $713.1
million from $696.0 million at December 31, 2003. Growth in the Company's loan
portfolio resulted primarily from an increase in real estate commercial loans to
$398.7 million at March 31, 2004 compared to $387.8 million at December 31,
2003.
Growth in commercial real estate mortgages and commercial loans occurred
principally as a result of the Company's expansion efforts (primarily in the
Green Bay market) and the strong economic growth existing in that market.
The following table reflects the composition (mix) of the loan portfolio
(dollars in thousands):
TABLE 5
LOAN PORTFOLIO ANALYSIS
($ in Thousands)
March 31, December Percent
2004 31, 2003 change
--------- -------- -------
Amount of loans by type (dollars in thousands)
Real estate-mortgage
Commercial $398,723 $387,820 2.82%
1-4 family residential
First liens 76,001 72,494 4.84%
Junior liens 19,719 21,443 (8.04%)
Home equity 32,836 31,763 3.38%
Commercial, financial and agricultural 88,625 91,009 (2.62%)
Real estate-construction 83,453 77,350 7.89%
Installment
Credit cards and related plans 2,126 2,145 (0.88%)
Other 11,998 12,315 (2.57%)
Less: deferred origination fees, net of costs 429 349 22.93%
-------- -------- ------
Total $713,052 $695,990 2.46%
======== ======== ======
Risk Management and the Allowance for Loan Losses
The loan portfolio is the Company's primary asset subject to credit risk. To
reflect this credit risk, the Company sets aside an allowance or reserve for
credit losses through periodic charges to earnings. These charges are shown in
the Company's consolidated income statement as provision for loan losses. See
"Provision for Loan Losses" above. Credit risk is managed and monitored through
the use of lending standards, a thorough review of potential borrowers, and an
on-going review of payment performance.
21
Asset quality administration, including early identification of problem loans
and timely resolution of problems, further enhances management of credit risk
and minimization of loan losses. All specifically identifiable and quantifiable
losses are immediately charged off against the allowance. Charged-off loans are
subject to periodic review, and specific efforts are taken to achieve maximum
recovery of principal and interest.
As the following table indicates, the ALL at March 31, 2004 was $12.7 million
compared with $12.2 million at the end of 2003. Loans increased 2.5% from
December 31, 2003 to March 31, 2004, while the allowance as a percent of total
loans increased due to the loan loss provision being higher in comparison to
loan growth for the first three months of 2004. Based on management's analysis
of the loan portfolio risk at March 31, 2004, a provision expense of $775,000
was recorded for the three months ended March 31, 2004, a decrease of $118,000
or 13.2% compared to the same period in 2003. Commercial loans represented 85.2%
of the net charge-offs for the first three months of 2004.
TABLE 6
ALLOWANCE FOR LOAN LOSSES AND NONPERFORMING ASSETS
($ in thousands)
At or for the period
At or for the period At or for the period ended December 31,
ended March 31, 2004 ended March 31, 2003 2003
-------------------- -------------------- --------------------
Allowance for Loan Losses ("ALL")
Balance at beginning of period $ 12,159 $ 11,410 $ 11,410
Provision for loan losses 775 893 5,650
Charge-offs 410 209 6,345
Recoveries 127 77 1,444
-------- -------- --------
Balance at end of period 12,651 12,171 12,159
Net charge-offs ("NCOs") 283 132 4,901
Nonperforming Assets:
Nonaccrual loans $ 10,574 $ 12,629 $ 11,079
Accruing loans past due 90 days or
more 0 0 0
Restructured loans 5,163 8,971 5,144
-------- -------- --------
Total nonperforming loans ("NPLs") $ 15,737 $ 21,600 $ 16,223
Other real estate owned 2,816 626 2,271
-------- -------- --------
Total nonperforming assets ("NPAs") $ 18,553 $ 22,226 $ 18,494
Ratios:
ALL to NCO's (annualized) 11.11 23.05 2.48
NCO's to average loans (annualized) 0.16% 0.08% 0.72%
ALL to total loans 1.77% 1.79% 1.75%
NPL's to total loans 2.21% 3.17% 2.33%
NPA's to total assets 1.87% 2.45% 1.90%
ALL to NPL's 80.39% 56.35% 74.95%
22
While management uses available information to recognize losses on loans, future
adjustments to the ALL may be necessary based on changes in economic conditions
and the impact of such change on the Company's borrowers.
Table 7 shows the amount of the ALL allocated for the time periods indicated to
each loan type as described. It also shows the percentage of balances for each
loan type to total loans. Management continues to target and maintain the ALL
equal to the allocation methodology plus an unallocated portion, as determined
by economic conditions on the Company's borrowers. In general, it would be
expected that those types of loans which have historically more loss associated
with them, will have a proportionally larger amount of the allowance allocated
to them than do loans which have less risk.
Consideration for making such allocations is consistent with the factors
discussed above, and all of the factors are subject to change; thus, the
allocation is not necessarily indicative of the loan categories in which future
loan losses will occur. It would also be expected that the amount allocated for
any particular type of loan will increase or decrease proportionately to both
the changes in the loan balances and to increases or decreases in the estimated
loss in loans of that type. In other words, changes in the risk profile of the
various parts of the loan portfolio should be reflected in the allowance
allocated.
TABLE 7
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
($ in thousands)
March 31, 2004 March 31, 2003 Dec 31, 2003
---------------------- ------------------------- -----------------------
Percent of Percent of Percent of
loans to loans to loans to
Amount total loans Amount total loans Amount total loans
------ ----------- --------- ----------- -------- -----------
Commercial, financial &
agricultural $ 2,290 12.43% $ 3,800 13.53% $ 2,386 13.08%
Commercial real estate 6,937 55.86% 5,150 55.45% 6,772 55.67%
Real Estate:
Construction 1,168 11.70% 780 9.41% 702 11.11%
Residential 1,116 13.43% 1,420 15.47% 1,246 13.50%
Home equity lines 82 4.60% 225 3.95% 79 4.56%
Consumer 120 1.68% 150 1.88% 235 1.77%
Credit card 119 0.30% 68 0.31% 111 0.31%
Loan commitments 247 278 276
Not specifically allocated 572 300 352
-------- --------- ---------
Total allowance $ 12,651 100.00% $ 12,171 100.00% $ 12,159 100.00%
Allowance for credit loss
as a percentage of total
loans 1.77% 1.79% 1.75%
Period end loans $713,052 $ 680,728 $ 695,990
While there exists probable asset quality problems in the loan portfolio,
management believes sufficient reserves have been provided in the ALL to absorb
probable losses in the loan portfolio at March 31, 2004. Ongoing efforts are
being made to collect these loans, and the Company involves the legal process
when necessary to minimize the risk of further deterioration of these loans for
full collection.
23
While management uses available information to recognize losses on loans, future
adjustments to the ALL may be necessary based on changes in economic conditions
and the impact of such change on the Company's borrowers. As an integral part of
their examination process, various regulatory agencies also review the Company's
ALL. Such agencies may require that changes in the ALL be recognized when their
credit evaluations differ from those of management, based on their judgments
about information available to them at the time of their examination.
Non-Performing Loans, Potential Problem Loans and Other Real Estate
Management encourages early identification of non-accrual and problem loans in
order to minimize the risk of loss. This is accomplished by monitoring and
reviewing credit policies and procedures on a regular basis.
Non-performing loans remain a leading indicator of future loan loss potential.
Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days
or more past due but still accruing, and restructured loans. Additionally,
whenever management becomes aware of facts or circumstances that may adversely
impact on the collection of principal or interest on loans, it is the practice
of management to place such loans on non-accrual status immediately rather than
waiting until the loans become 90 days past due. The accrual of interest income
is discontinued when a loan becomes 90 days past due as to principal or
interest. When interest accruals are discontinued, interest credited to income
is reversed. If collection is in doubt, cash receipts on non-accrual loans are
used to reduce principal rather than recorded as interest income.
Restructuring loans involve the granting of some concession to the borrower
involving a loan modification, such as payment schedule or interest rate
changes.
The accrual of interest income is discontinued when a loan becomes 90 days past
due as to principal or interest. When interest accruals are discontinued,
interest credited to income is reversed. If collectibility is in doubt, cash
receipts on non-accrual loans are used to reduce principal rather than recorded
as interest income.
As indicated in Table 6, non-performing loans at March 31, 2004 were $15.7
million compared to $16.2 million at December 31, 2003. Impacting the decrease
in non-performing loans was a shift, as a result of foreclosure, of
approximately $775,000 in loans to other real estate owned during 2004.
Non-accrual loans represented $10.5 million of the total non-performing loans.
Real estate non-accrual loans accounted for $9.4 million of the total, of which
$3.1 million was residential real estate and $6.2 million was commercial real
estate, while commercial and industrial non-accrual loans total $1.1 million.
Management believes collateral is sufficient to offset losses in the event
additional legal action would be warranted to collect these non-accrual loans.
Restructured loans were $5.2 million at March 31, 2004 compared with $5.1
million at year-end 2003. Of the restructured loans at March 31, 2004,
approximately $4.3 million consisted of two commercial credits and conditional
loans as to which the Bank has granted various concessions as a result of the
borrowers' past cash flow problems. A loan credit totaling $2.7 million was
current at March 31, 2004, while the other loan credit totaling $1.6 million was
31 days past due at March 31, 2004. Although management believes that collateral
for these loans is generally sufficient if there were to be a default,
management has allocated a loan loss provision of $672,000. This allocation
relates to the commercial credit of $1.6 million, which is the net amount
remaining after a loan charge-off of $2.6 million in 2003. As a result of the
cash flow problems of the debtor, management is continuing to specially monitor
this loan on a monthly basis and is working with the borrower to minimize any
additional loss exposure. If the loan becomes not current or other factors
change, this loan may become a non-performing loan and be subject to further
charge-off. As a result the ratio of non-performing loans to total loans at
March 31, 2004 was 2.21% compared to 2.33% at end of year 2003. The Company's
ALL was 80.4% of total non-performing loans at March 31, 2004 compared to 75.0%
at end of year 2003.
As indicated in Table 6, non-performing assets (non-performing loans plus other
real estate owned assets) at March 31, 2004 were $18.6 million compared to $18.5
million at December 31, 2003. Other real estate owned, which represents property
that the Company acquired through foreclosure or in satisfaction of debt,
24
consisted of eight residential and sixteen commercial properties totaling $2.8
million. Other real estate owned at December 31, 2003 totaled $2.3 million and
consisted of nineteen properties.
Potential problem loans are currently performing loans that management believes
may incur difficulties in complying with loan repayment terms. Management's
decision to place loans in this category does not necessarily mean that the
Company expects to take losses on such loans, but that management needs to be
more vigilant in its efforts to oversee the loans and recognize that a higher
degree of risk is associated with these potential problem loans. At March 31,
2004, potential problem loans amounted to $5.8 million compared to a total of
$5.7 million at December 31, 2003. $5.3 million of the problem loans stem from
one commercial credit experiencing cash flow concerns. Various commercial loans
totaling $500,000 make up the balance of the total potential problem loans. With
the exceptions of the $5.3 million commercial credit noted above, potential
problem loans are not concentrated in a particular industry but rather cover a
diverse range of businesses. Except as noted above, management does not
presently expect significant losses from credits in the potential problem loan
category.
Investment Portfolio
The investment portfolio is intended to provide the Company with adequate
liquidity, flexibility in asset/liability management and, lastly, its earning
potential.
At March 31, 2004, the investment portfolio (which includes investment
securities available for sale and held to maturity) increased $5.3 million, or
2.7%, to $201.1 million from $195.8 million at December 31, 2003. At March 31,
2004, the investment portfolio represented 20.3% of total assets compared with
20.1% at December 31, 2003.
Securities held to maturity and securities available for sale consist of the
following:
TABLE 8
INVESTMENT SECURITY ANALYSIS
At March 31, 2004
($ in Thousands)
Gross Unrealized Gross Unrealized Estimated Market
Amortized Cost Gains Losses Value
-------------- ---------------- ---------------- ----------------
Securities held to maturity
Obligations of states &
political subdivisions $ 16,685 $ 321 $ 0 $ 17,006
-------- ------- ----- --------
Securities available for sale
Obligations of U.S. Treasury
& other U.S. agencies 42,346 2,243 0 44,589
Mortgage-backed securities 101,501 882 299 102,084
Obligations of states &
political subdivisions 32,547 2,478 0 35,025
Other securities 2,637 79 0 2,716
-------- ------- ----- --------
Total securities available for sale $179,031 $ 5,682 $ 299 $184,414
25
At December 31, 2003
($ in Thousands)
Gross Unrealized Gross Unrealized Estimated Market
Amortized Cost Gains Losses Value
-------------- ---------------- ---------------- ----------------
Securities held to maturity
Obligations of states & political
subdivisions $ 19,032 $ 282 $ 0 $ 19,314
--------- ------- ------- ---------
Securities available for sale
Obligations of U.S. Treasury
& other U.S. Agencies $ 37,942 $ 1,760 $ 6 $ 39,696
Mortgage-backed securities 99,970 204 1,026 99,148
Obligations of states &
political subdivisions 32,848 2,167 0 35,015
Other securities 2,877 79 0 2,956
--------- ------- ------- ---------
Total securities available for sale $ 173,637 $ 4,210 $ 1,032 $ 176,815
At March 31, 2004, the contractual maturities of securities held to maturity and
securities available for sale are as follows:
TABLE 9
INVESTMENT PORTFOLIO MATURITY
($ in Thousands)
Securities held to Maturity Securities Available for Sale
------------------------------------- -------------------------------------
Amortized Cost Market Value Amortized Cost Market Value
-------------- ------------ -------------- ------------
Within 1 year $ 2,760 $ 2,769 $ 9,438 $ 9,495
After 1 but within 5 years 6,397 6,634 128,467 131,697
After 5 but within 10 years 3,030 3,104 28,113 29,318
After 10 years 4,498 4,499 10,377 11,188
Equity securities 0 0 2,636 2,716
-------- -------- --------- ---------
Total $ 16,685 $ 17,006 $ 179,031 $ 184,414
-------- -------- --------- ---------
Deposits
Total deposits at March 31, 2004 decreased $9.2 million, or 1.2%, to $774.1
million from $783.3 million at December 31, 2003. Non-interest bearing deposits
at March 31, 2004 decreased $11.4 million, or 10.7%, to $95.3 million from
$106.6 million at December 31, 2003. Interest-bearing deposits at March 31, 2004
increased $2.1 million, or 0.3%, to $678.8 million from $676.7 million at
December 31, 2003. Interest-bearing transaction accounts (NOW deposits)
decreased $10.0 million, primarily in public fund deposits. Savings deposits
decreased $9.1 million, or 4.4%, to $195.2 million at March 31, 2004, when
compared to $204.3 million at December 31, 2003. Time deposits (including time,
$100,000 and over and other time) increased $21.1 million (includes increase of
$29.9 million in time deposits over $100,000), or 5.6%, to $401.2 million at
March 31, 2004, when compared to $380.1 million at December 31, 2003. Brokered
26
CD's totaled $125.7 million at March 31, 2004 compared to $97.8 million at
December 31, 2003. Time deposits greater than $100,000 and brokered time
deposits were priced within the framework of the Company's rate structure and
did not materially increase the average rates on deposit liabilities. Although
the use of brokered deposits has increased, Management views these as a stable
source of funds. If liquidity concerns arose, the Company has alternative
sources of funds such as lines with correspondent banks and borrowing
arrangements with FHLB should the need present itself. Increased competition for
consumer deposits and customer awareness of interest rates continues to limit
the Company's core deposit growth in these types of deposits. Typically, overall
deposits for the first six months tend to decline slightly as a result of the
seasonality of the Company's customer base as customers draw down deposits
during the early first half of the year in anticipation of the summer tourist
season.
Emphasis has been, and will continue to be, placed on generating additional core
deposits in 2004 through competitive pricing of deposit products and through the
branch delivery systems that have already been established. The Company will
also attempt to attract and retain core deposit accounts through new product
offerings and quality customer service. The Company also may increase brokered
time deposits during the remainder of the year 2004 as an additional source of
funds to provide for loan growth in the event that core deposit growth goals
would not be accomplished. Under that scenario, the Company will continue to
look at other wholesale sources of funds, if the brokered CD market became
illiquid or more costly in terms of interest rate.
Short Term Borrowings and Other Borrowings
Short-term borrowings at March 31, 2004 consist of federal funds purchased and
securities under agreements to repurchase. Total short-term borrowings at March
31, 2004 increased $16.0 million to $39.4 million from $23.4 million at December
31, 2003. Federal funds purchased increased from $23.3 million at December 31,
2003 to $39.3 million at March 31, 2004 accounting for the balance of the
increase in the balance of short-term borrowings. These have increased as a
result of growth in the loan portfolio coupled with a decrease in core deposits
during the quarter ended March 31, 2004.
Other borrowings consist of term loans with FHLB. These borrowings totaled $85.1
million at March 31, 2004 compared to $75.1 million at December 31, 2003.
Typically, short-term borrowings and other borrowings increase in order to fund
growth in the loan portfolio. The Company will borrow monies if borrowing is a
less costly form of funding loans compared to the cost of acquiring deposits.
Additionally, the availability of deposits also determines the amount of funds
the Company needs to borrow in order to fund loan demand. In the quarter ended
March 31, 2004, borrowings were also required in lieu of the decrease in
deposits. The Company anticipates it will continue to use wholesale funding
sources of this nature, if these borrowings add incrementally to overall
profitability.
Long Term Debt
In connection with the issuance of Trust Preferred Securities in 2001 (see
"Capital Resources"), the Company issued long-term subordinated debentures to
Baylake Capital Trust I, a Delaware Business Trust subsidiary of the Company.
The aggregate principal amount of the debentures due 2031, to the trust
subsidiary is $16,597,940. For additional details, please make reference to the
Consolidated Financial Statements and the accompanying footnotes on the
Company's Form 10-K for the year 2003.
Contractual obligations, commitments, off-balance sheet risk, and contingent
liabilities
The Company utilizes a variety of financial instruments in the normal course of
business to meet the financial needs of its customers. These financial
instruments include commitments to extend credit, commitments to originate
residential mortgage loans held for sale, commercial letters of credit, standby
letters of credit, and forward commitments to sell residential mortgage loans.
Please refer to the
27
Company's Annual Report on Form 10-K for the year ended December 31, 2003 for
discussion with respect to the Company's quantitative and qualitative
disclosures about its fixed and determinable contractual obligations. Items
disclosed on Form 10-K have not materially changed since that report was filed.
The following is a summary of lending-related commitments at March 31:
TABLE 10
LENDING RELATED COMMITMENTS
($ in Thousands)
March 31, 2004 March 31, 2003
-------------- --------------
Commitments to fund home equity line loans $ 29,378 $ 38,624
Commitments to fund commercial real estate loans 12,314 11,028
Commitments unused on various other lines of credit loans 111,286 95,060
--------- ---------
Total commitments to extend credit $ 152,978 $ 144,712
Financial standby letters of credit $ 21,867 $ 17,652
Liquidity
Liquidity management refers to the ability of the Company to ensure that cash is
available in at timely manner to meet loan demand and depositors' needs, and to
service other liabilities as they become due, without undue cost or risk, and
without causing a disruption to normal operating activities. The Company and the
Bank have different liquidity considerations.
The Company's primary sources of funds are dividends from the Bank; investment
income, and net proceeds from borrowings and the offerings of junior
subordinated obligations, in addition to the issuance of its common stock
securities. The Company manages its liquidity position in order to provide funds
necessary to pay dividends to its shareholders. Dividends received from Bank
totaled $1.0 million for the first quarter of 2004 and will continue to be the
Company's main source of long-term liquidity. The dividends from the Bank along
with existing cash were sufficient to pay cash dividends to the Company's
shareholders of $2.1 million in the first quarter of 2004.
The Bank meets its cash flow needs by having funding sources available to it to
satisfy the credit needs of customers as well as having available funds to
satisfy deposit withdrawal requests. Liquidity at the Bank is derived from
deposit growth, maturing loans, the maturity of the investment portfolio, access
to other funding sources, marketability of certain of its assets; the ability to
use its loan and investment portfolios as collateral for secured borrowings and
strong capital positions.
Maturing investments have been a primary source of liquidity at the Bank. For
the three months ended March 31, 2004, principal payments totaling $9.3 million
were received on investments. $12.6 million in investments were purchased in the
first three months of 2004. This resulted in net cash of $3.3 million used in
investing activities for the first three months of 2004. At March 31, 2004, the
carrying or book value of investment securities maturing within one year
amounted to $12.4 million or 6.2% of the total investment securities portfolio.
This compares to 6.1% level for investment securities with one year or less
maturities as of December 31, 2003. Within the investing activities of the
statement of cash flows, sales and maturities of investment securities during
the first three months of 2004 totaled $9.3 million. At March 31, 2004, the
investment portfolio contained $146.7 million of U.S. Treasury and federal
agency backed securities representing 72.9% of the total investment portfolio.
These securities tend to be highly marketable and had a market value above
amortized cost at March 31, 2004 amounting to $2.8 million.
28
Deposit growth is typically another source of liquidity for the Bank. As a
financing activity reflected in the March 31, 2004 Consolidated Statements of
Cash Flows, deposits decreased and resulted in $9.2 million of cash outflow
during the first three months of 2004. The Company's overall deposit base
decreased 1.2% for the three months ended March 31, 2004. Deposit growth is the
most stable source of liquidity for the Bank, although brokered deposits are
inherently less stable than locally generated core deposits. Affecting liquidity
are core deposit growth levels, certificate of deposit maturity structure and
retention, and characteristics and diversification of wholesale funding sources
affecting the channels by which brokered deposits are acquired. Conversely,
deposit outflow will cause the Bank to develop alternative sources of funds
which may not be as liquid and potentially a more costly alternative.
The scheduled maturity of loans can provide a source of additional liquidity.
The Bank has $237.2 million, or 33.3%, of loans maturing within one year.
Factors affecting liquidity relative to loans are loan origination volumes, loan
prepayment rates and the maturity structure of existing loans. The Bank's
liquidity position is influenced by changes in interest rates, economic
conditions and competition. Conversely, loan demand as a need for liquidity will
cause the Company to acquire other sources of funding which could be harder to
find; therefore more costly to acquire.
Within the classification of short-term borrowings and other borrowings at March
31, 2004, federal funds purchased and securities sold under agreements to
repurchase totaled $39.4 million compared to $23.4 million at the end of 2003.
Federal funds are purchased from various upstream correspondent banks while
securities sold under agreements to repurchase are obtained from a base of
business customers. Borrowings from FHLB, short-term or term, are another source
of funds. They total $85.1 million at March 31, 2004 and $75.1 million at
December 31, 2003.
The Bank's liquidity resources were sufficient in the first three months of 2004
to fund the growth in loans and investments, increase the volume of interest
earning assets and meet other cash needs when necessary.
Management expects that deposit growth will continue to be the primary funding
source of the Bank's liquidity on a long-term basis, along with a stable
earnings base, the resulting cash generated by operating activities, and a
strong capital position. Although federal funds purchased and borrowings from
the FHLB provided funds in the first three months of 2004, management expects
deposit growth to be a reliable funding source in the future as a result of
branch expansion efforts and marketing efforts to attract and retain core
deposits. In addition, Bank may acquire additional brokered deposits as funding
for short-term liquidity needs. Shorter-term liquidity needs will mainly be
derived from growth in short-term borrowings, maturing federal funds sold and
portfolio investments, loan maturities and access to other funding sources.
In assessing liquidity, historical information such as seasonality (loan
demand's affect on liquidity which starts before and during the tourist season
and deposit draw down which affects liquidity shortly before and during the
early part of the tourist season), local economic cycles and the economy in
general are considered along with the current ratios, management goals and the
unique characteristics of the Company. Management believes that, in the current
economic environment, the Company's and the Bank's liquidity position is
adequate. To management's knowledge, there are no known trends nor any known
demands, commitments, events or uncertainties that will result or are reasonably
likely to result in a material increase or decrease in the Bank's or the
Company's liquidity.
Interest Rate Risk
Interest rate risk is the exposure to a bank's earnings and capital arising from
changes in future interest rates. All banks assume interest rate risk as an
integral part of normal banking operations. Control and monitoring of interest
rate risk is a primary objective of asset/liability management. The Bank uses an
Asset/Liability Committee ("ALCO") to manage risks associated with changing
interest rates, changing asset and liability mixes, and measuring the impact of
such changes on earnings. The sensitivity of net interest income to market rate
changes is evaluated monthly by ALCO.
29
In order to limit exposure to interest rate risk, the Company has developed
strategies to manage its liquidity, shorten the effective maturities of certain
interest-earning assets, and increase the effective maturities of certain
interest-bearing liabilities. The Company has focused on the establishment of
adjustable rate mortgages ("ARM's") in its residential lending product line; the
concerted efforts made to attract and sell core deposit products through the use
of Company's branching and delivery systems and marketing efforts; and the use
of other available sources of funding to provide longer term funding
possibilities.
Interest rate sensitivity analysis can be performed in several different ways.
The traditional method of measuring interest sensitivity is called "gap"
analysis. The mismatch between asset and liability repricing characteristics in
specific time intervals is referred to as "interest rate sensitivity gap." If
more liabilities than assets reprice in a given time interval a liability
sensitive gap position exists. In general, liability sensitive gap positions in
a declining interest rate environment increase net interest income.
Alternatively asset sensitive positions, where assets reprice more quickly than
liabilities, negatively impact the net interest income in a declining rate
environment. In the event of an increasing rate environment, opposite results
would occur such that a liability sensitivity gap position would decrease net
interest income and an asset sensitivity gap position would increase net
interest income. The sensitivity of net interest income to changing interest
rates can be reduced by matching the repricing characteristics of assets and
liabilities.
The following table entitled "Asset and Liability Maturity Re-pricing Schedule"
indicates that the Company is in an asset sensitive position, which means within
a one-year time frame that assets will re-price more quickly than liabilities.
The analysis considers money market index accounts and 25% of NOW accounts to be
rate sensitive within three months. Regular savings, money market deposit
accounts and 75% of NOW accounts are considered to be rate sensitive within one
to five years. While these accounts are contractually short-term in nature, it
is the Company's experience that re-pricing occurs over a longer period of time.
The Company views its savings and NOW accounts to be core deposits and
relatively non-price sensitive, as it believes it could make re-pricing
adjustments for these types of accounts in small increments without a material
decrease in balances. All other earning categories, including loans and
investments as well as other paying liability categories such as time deposits,
are scheduled according to their contractual maturities. The "static gap
analysis" provides a representation of the Company's earnings sensitivity to
changes in interest rates. It is a static indicator and does not reflect various
re-pricing characteristics. Accordingly, a "static gap analysis" may not
necessarily be indicative of the sensitivity of net interest income in a
changing rate environment.
TABLE 11
ASSET AND LIABILITY MATURITY REPRICING SCHEDULE
AS OF March 31, 2004
Within Four to Seven to One Year Over
Three Six Twelve To Five Five
Months Months Months Years Years Total
--------- -------- -------- --------- -------- --------
(In thousands)
Earning assets:
Investment securities $ 14,671 $ 210 $ 4 151 $ 138 566 $ 50 865 $208 463
Loans and leases
Variable rate 423 842 6 285 12 571 13 261 0 455 959
Fixed rate 36 939 29 527 58 558 122 658 491 248 173
--------- -------- -------- --------- -------- --------
Total loans and leases $ 460 781 $ 35 812 $ 71 129 $ 135 919 $ 491 $704 132
--------- -------- -------- --------- -------- --------
Total earning assets $ 475 452 $ 36 022 $ 75 280 $ 274 485 $ 51 356 $912 595
========= ======== ======== ========= ======== ========
Interest bearing liabilities:
NOW Accounts $ 20 587 $ 0 $ 0 $ 61 763 $ 0 $ 82 350
Savings Deposits 146 765 0 0 48 434 0 195 199
Time Deposits 113 843 82 907 99 448 105 024 15 401 237
30
Borrowed Funds 89 382 0 0 35 091 0 124 473
Trust Preferred Stock 0 0 0 0 16 598 16 598
========= ======== ======== ========= ======== ========
Total interest bearing Liabilities $ 370 577 $ 82 907 $ 99 448 $ 250 312 $ 16 613 $819 857
========= ======== ======== ========= ======== ========
Interest sensitivity gap (within
periods) $ 104 875 $(46 885) $(24 168) $ 24 173 $ 34 743 $ 92 738
Cumulative interest sensitivity gap $ 104 875 $ 57 990 $ 33 822 $ 57 995 $ 92 738
Ratio of cumulative interest
Sensitivity gap to rate
Sensitive assets 11.49% 6.35% 3.71% 6.35% 10.16%
Ratio of rate sensitive assets To
rate sensitive Liabilities 128.30% 43.45% 75.70% 109.66% 309.13%
Cumulative ratio of rate Sensitive
assets to rate Sensitive
liabilities 128.30% 112.79% 106.12% 107.22% 111.31%
In addition to the "static gap analysis", determining the sensitivity of future
earnings to a hypothetical plus or minus 100 basis point parallel rate shock can
be accomplished through the use of simulation modeling. Simulation of earnings
includes the modeling of the balance sheet as an ongoing entity. Balance sheet
items are modeled to project income based on a hypothetical change in interest
rates. The resulting net income for the next twelve-month period is compared to
the net income amount calculated using flat rates. This difference represents
the Company's earnings sensitivity to a plus or minus 100 basis point parallel
rate shock. The resulting simulations indicated that net interest income would
increase by approximately 4.8% if rates rose by a 100 basis point shock, and
projected that net interest income would decrease by approximately 5.7% if rates
fell by a 100 basis point shock under these scenarios for the period ended March
31, 2005. These results are within the policy limits established by the Company.
For an immediate 200 basis point increase in the Fed Funds rate, the estimated
change in net interest income from the steady rate scenario would be an increase
of 6.8% for the period ended March 31, 2005. The presentation is limited to a
100 basis point decline due to the currently historically low interest rate
environment. The magnitude of the effects of the declining rate scenario are
impacted by the absolute level of rates, and the inability of the Company to
reduce its core deposit funding costs by the entire amount of the change
assumed. This impact is also exacerbated by the expected increase in prepayments
on higher yielding loans and mortgage-backed securities under the declining rate
scenario.
In addition, the results of the simulations are also impacted by the assumption
that the slope of the yield curve will change with an increase or decrease in
the Fed Funds rate. In the rising rate scenarios, the model will reflect a
greater increase in short-term rates than long-term rates, thereby resulting in
a decrease in the slope of the curve. In the falling rate scenario the slope is
predicted to increase which means that short-term rates would fall further than
long-term rates. Also impacting the modeling results is the assumption that the
rates on certain types of accounts will not change to the same degree as the
yield curve. In particular, the adjustment in rates on money market accounts,
savings accounts and NOW accounts will be less than the adjustment in the Fed
Funds rate.
There can be no assurance that the results of operations would be impacted as
indicated if interest rates did move by the amounts discussed above. Management
continually reviews its interest risk position through the ALCO process.
Management's philosophy is to maintain relatively matched rate sensitive asset
and liability positions within the range described above in order to provide
earnings stability in the event of significant interest rate changes.
Capital Resources
31
Stockholders' equity at March 31, 2004 increased $2.5 million or 3.6% to $72.2
million, compared with $69.6 million at end of year 2003. The increase in
stockholders' equity in 2004 was primarily composed of the retention of earnings
and the exercise of stock options with offsetting decreases to stockholders'
equity from the payment of dividends. Additionally, stockholders' equity at
March 31, 2004 included $3.5 million of accumulated other comprehensive income,
related to unrealized gains on securities. At December 31, 2003, stockholders'
equity included $2.1 million of comprehensive income related to unrealized gains
on securities. Stockholders' equity to assets at March 31, 2004 was 7.27%
compared to 7.14% at the end of 2003.
In 2001, the Company formed Baylake Capital Trust I ("the Trust") as a statutory
business trust organized for the sole purpose of issuing trust preferred
securities and investing the proceeds thereof in junior subordinated debentures
of the Company, the sole asset of the Trust. The trust preferred securities
enhanced regulatory capital and added liquidity. The common securities of the
Trust are wholly-owned by the Company. The trust preferred securities and common
securities of the trust represent preferred undivided beneficial interests as
the assets of Baylake Capital Trust I, and the holder of the preferred
securities will be entitled to a preference over the common securities of the
Trust upon an event of default with respect to distributions and amounts payable
on redemption or liquidation. These trust preferred securities are
tax-advantaged issues for the Company that qualify for Tier 1 capital treatment
to the Company. Distributions on these securities are included in interest
expense on guaranteed preferred beneficial interest. The preferred securities
are traded on the American Stock Exchange under the symbol BYL_p.
As of December 31, 2003, the Company deconsolidated the Trust, which had issued
the trust preferred securities (discussed above), and replaced the presentation
of such instruments with the Company's junior subordinated debentures issued to
the Trust. Such presentation reflects adoption of FASB Interpretation No. 46
(FIN 46 R) issued in December 2003.
The Company had $16.6 million of junior subordinated debentures outstanding to
the Trust and the Trust had $16.1 million of trust preferred securities
outstanding at March 31, 2004 and December 31, 2003, respectively. Under
applicable regulatory guidelines, the Trust Preferred Securities qualify as Tier
1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion of
Trust Preferred Securities would qualify as Tier 2 capital. As of March 31,
2004, all $16.1 million of the Trust Preferred Securities qualify as Tier 1
Capital.
The Company's capital base (before SFAS 115 change) increased primarily due to
the retention of earnings. The Company's dividend reinvestment plan typically
provides capital improvement, as the holders of approximately 23% of Company's
Common Stock participate in the plan.
Cash dividends paid in the first three months of 2004 were $0.14 per share
compared with $0.13 in 2003. The Company provided a 7.7% increase in normal
dividends per share in 2004 over 2003 as a result of earnings for 2004.
In 1997, the Company's Board of Directors authorized management, in its
discretion, to repurchase up to 7,000 shares of the Company's common stock each
calendar quarter in the market. The shares repurchased would be used to fill its
needs for the dividend reinvestment program, any future benefit plans, and the
Company's stock purchase plan. Shares repurchased are held as treasury stock and
accordingly, are accounted for as a reduction of stockholders' equity. The
Company repurchased none of its common shares in the first three months of 2004.
The adequacy of the Company's capital is regularly reviewed to ensure that
sufficient capital is available for current and future needs and is in
compliance with regulatory guidelines. The assessment of overall capital
adequacy depends upon a variety of factors, including asset quality, liquidity,
stability of earnings, changing competitive forces, economic conditions in
markets served and strength of management. Management is confident that because
of current capital levels and projected earnings levels, capital levels are more
than adequate to meet the ongoing and future concerns of the Company.
32
The Federal Reserve Board has established capital adequacy rules which take into
account risk attributable to balance sheet assets and off-balance sheet
activities. All banks and bank holding companies must meet a minimum total
risk-based capital ratio of 8%. Of the 8% required, at least half must be
comprised of core capital elements defined as Tier 1 capital. The federal
banking agencies also have adopted leverage capital guidelines which banking
organizations must meet. Under these guidelines, the most highly rated banking
organizations must meet a leverage ratio of at least 3% Tier 1 capital to
assets, while lower rated banking organizations must maintain a ratio of at
least 4% to 5%. Failure to meet minimum capital requirements can initiate
certain mandatory - and possible additional discretionary- actions by regulators
that, if undertaken, could have a direct material effect on the consolidated
financial statements.
At March 31, 2004 and December 31, 2003, the Company was categorized as "well
capitalized" under the regulatory framework for prompt corrective action. There
are no conditions or events since that notification that management believes
have changed the Company's category.
To be "well capitalized" under the regulatory framework, the Tier 1 capital
ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10%
and the leverage ratio must meet or exceed 5%.
The following table presents the Company's and the Bank's capital ratios as of
March 31, 2004 and December 31, 2003:
TABLE 12
CAPITAL RATIOS
($ in Thousands)
To Be Well
Actual Capitalized under
------------------ For Capital Adequacy Prompt Corrective
($ in Thousands) Purposes Action Provisions
------------------ -------------------- -----------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
As of March 31, 2004
Total Capital (to Risk Weighted
Assets)
Company 90,296 10.82% 66,753 8.00% 83,441 10.00%
Bank 84,771 10.33% 65,630 8.00% 82,038 10.00%
Tier 1 Capital (to Risk Weighted
Assets)
Company 79,838 9.57% 33,377 4.00% 50,065 6.00%
Bank 74,493 9.08% 32,815 4.00% 49,223 6.00%
Tier 1 Capital (to Average
Assets)
Company 79,838 8.18% 39,029 4.00% N/A N/A
Bank 74,493 7.64% 39,029 4.00% 48,787 5.00%
As of December 31, 2003
Total Capital (to Risk Weighted
Assets)
Company 88,493 10.78% 65,650 8.00% 82,090 10.00%
Bank 84,771 10.33% 65,647 8.00% 82,059 10.00%
Tier 1 Capital (to Risk Weighted
Assets)
Company 78,212 9.52% 32,845 4.00% 49,293 6.00%
Bank 74,493 9.08% 32,823 4.00% 49,235 6.00%
33
Tier 1 Capital (to Average
Assets)
Company 78,212 8.38% 37,331 4.00% N/A N/A
Bank 74,493 7.98% 37,331 4.00% 46,664 5.00%
Management believes that a strong capital position is necessary to take
advantage of opportunities for profitable expansion of product and market share,
and to provide depositor and investor confidence. The Company's capital level is
strong, but also must be maintained at an appropriate level to provide the
opportunity for an adequate return on the capital employed. Management actively
reviews capital strategies for the Company to ensure that capital levels are
appropriate based on the perceived business risks, further growth opportunities,
industry standards, and regulatory requirements.
Recent Accounting Pronouncements
In January 2003, the FASB issued FASB Interpretations No. 46 ("FIN 46"),
Consolidation of Variable Interest Entities." The objective of this
interpretation is to provide guidance on how to identify a variable interest
entity ("VIE") and determine when the assets, liabilities, non-controlling
interests and results of operations of a VIE need to be included in a company's
consolidated financial statements. A company that holds variable interests in an
entity will need to consolidate the entity if the company's interest in the VIE
is such that the company will absorb a majority of the VIE's expected losses
and/or receive a majority of the entity's expected residual returns, if they
occur. FIN 46 also requires additional disclosures by primary beneficiaries and
other significant variable interest holders. FIN 46 was effective for all VIE's
created after January 31, 2003. However, the FASB has postponed that effective
date to December 31, 2003. In December 2003, the FASB issued a revised FIN 46
(FIN 46 R), which further delayed this effective date until March 31, 2004 for
VIE's created prior to February 1, 2003, except for special purpose entities,
which must adopt either FIN 46 or FIN 46 R as of December 31, 2003. The
requirements of FIN 46 resulted in the deconsolidation of the Company's wholly
owned subsidiary trusts, formed to issue mandatorily redeemable preferred
securities ("trust preferred securities"). The deconsolidation, as of December
31, 2003, results in the recognition of the trust preferred securities as junior
subordinated obligations on the related consolidated statement of financial
condition. The junior subordinated obligations of the trusts also include common
interests, which aggregate $497,940, and are offset by an identical amount
representing the Company's investment and included in other assets. The
provisions of FIN 46 R had no impact on the Company's consolidated statements of
income or cash flows.
On March 9, 2004, the SEC issued Staff Accounting Bulletin No. 105, "Application
of Accounting Principles to Loan Commitments." According to the release, the
fair value of the loan commitment is determined without considering the value of
future cash flows related to servicing the loan, and thus the fair value
represents the value of having to make a loan at what may become a below-market
rate. This guidance is applicable for mortgage loan commitments where the loans
are to be sold entered into April 1, 2004 or later. In management's opinion, the
adoption of Staff Accounting Bulletin No. 105 will not have a material effect on
the Company's consolidated financial statements.
Item 3 Quantitative and Qualitative Disclosure about Market Risk.
The Company's financial performance is affected by, among other factors, credit
risk and interest rate risk. The Company does not use derivatives to mitigate
its interest rate risk or credit risk, relying instead on loan review and its
loan loss reserve.
The Company's earnings are derived from the operations of its direct and
indirect subsidiaries with particular reliance on net interest income,
calculated as the difference between interest earned on loans and investments
and the interest expense paid on deposits and other interest bearing
liabilities, including advances from FHLB and other borrowings. Like other
financial institutions, the Company's interest income and interest expense are
affected by general economic conditions and by the policies of regulatory
authorities, including the monetary policies of the Board of Governors of the
Federal Reserve System. Changes in the economic environment may influence, among
other matters, the growth rate of loans and
34
deposits, the quality of the loan portfolio and loan and deposit pricing.
Fluctuations in interest rates are not predictable or controllable.
As of March 31, 2004, the Company was in compliance with its management policies
with respect to interest rate risk. The Company has not experienced any material
changes to its market risk position since December 31, 2003, as described in the
Company's 2003 Form 10-K Annual Report.
Item 4. Controls and Procedures
DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the
participation of the Company's Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Company's disclosure controls
and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of March
31, 2004. Based on such evaluation, the Company's Chief Executive Officer and
Chief Financial Officer have concluded that, as of the end of such period, the
Company's disclosure controls and procedures are effective in timely alerting
them to material information relating to the Company's disclosure controls and
procedures to the Company required to be included in this quarterly report on
Form 10-Q.
INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in
the Company's internal control over financial reporting (as such term is defined
in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal
quarter to which this report relates that have materially affected, or are
reasonably likely to materially affect, the Company's internal controls
subsequent to the date of such evaluation.
Part II - Other Information
Item 1. Legal Proceedings
Baylake and its subsidiaries may be involved from time to time in various
routine legal proceedings incidental to its business. Neither Baylake nor any of
its subsidiaries is currently engaged in any legal proceedings that are expected
to have a material adverse effect on the results of operations or financial
position of Baylake.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a). The following exhibits are furnished herewith:
35
EXHIBIT NUMBER DESCRIPTION
- -------------- --------------------------------------------------------------
15 Letter re: unaudited interim financial information
31.1 Certification under Section 302 of Sarbanes-Oxley by Thomas L.
Herlache, Chief Executive Officer, is attached hereto.
31.2 Certification under Section 302 of Sarbanes-Oxley by Steven D.
Jennerjohn, Chief Financial Officer, is attached hereto.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of
Sarbanes-Oxley is attached hereto.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of
Sarbenes-Oxley is attached hereto.
(b). Report on Form 8-K:
None filed, However, a report on Form 8-K dated February 9, 2004 was submitted
under Item 12, Results of Operations and Financial Condition, reporting Baylake
Corp released its earnings for the year ended December 31, 2003; that report is
not incorporated by reference into other filings.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
BAYLAKE CORP.
---------------------------------------
Date: May 14, 2004 /s/ Thomas L. Herlache
-----------------------------------------------
Thomas L. Herlache
President (CEO)
Date: May 14, 2004 /s/ Steven D. Jennerjohn
-----------------------------------------------
Steven D. Jennerjohn
Treasurer (CFO)
36