UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to __________.
Commission file number: 0-24611
CFS Bancorp, Inc.
(Exact name of registrant as specified in its charter)
Delaware 35-2042093
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
707 Ridge Road, Munster, Indiana 46321
(Address of principal executive offices)
(219) 836-5500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports 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 Exchange Act). YES [X] NO [ ]
The Registrant had 12,341,822 shares of Common Stock issued and outstanding as
of November 5, 2004.
CFS BANCORP, INC.
TABLE OF CONTENTS
Page No.
--------
PART I FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)..................................... 3
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................ 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk........... 31
Item 4. Controls and Procedures.............................................. 32
PART II OTHER INFORMATION
Item 1. Legal Proceedings.................................................... 33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.......... 33
Item 3. Defaults upon Senior Securities...................................... 33
Item 4. Submission of Matters to a Vote of Security Holders.................. 34
Item 5. Other Information.................................................... 34
Item 6. Exhibits............................................................. 35
Signature Page................................................................ 36
Certifications for Principal Executive Officer and Principal Financial Officer 37
2
CFS BANCORP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30, 2004 DECEMBER 31, 2003
------------------ -----------------
(Unaudited)
(Dollars in thousands)
ASSETS
Cash and amounts due from depository institutions.................... $ 17,770 $ 18,213
Interest-bearing deposits............................................ 39,852 149,577
Federal funds sold................................................... 6,343 9,961
-------------- --------------
Cash and cash equivalents......................................... 63,965 177,751
Securities available-for-sale, at fair value......................... 284,939 326,304
Investment in Federal Home Loan Bank stock, at cost.................. 27,374 26,766
Loans receivable, net of unearned fees............................... 1,000,424 982,579
Allowance for losses on loans..................................... (16,506) (10,453)
--------------- ---------------
Net loans....................................................... 983,918 972,126
Accrued interest receivable.......................................... 5,966 6,624
Real estate owned.................................................... 590 206
Office properties and equipment...................................... 16,676 13,738
Investment in Bank-owned life insurance.............................. 33,001 31,926
Prepaid expenses and other assets.................................... 12,046 12,335
Intangible assets.................................................... 1,446 1,494
-------------- --------------
Total assets.................................................... $ 1,429,921 $ 1,569,270
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits............................................................. $ 847,353 $ 978,440
Borrowed money....................................................... 411,829 418,490
Advance payments by borrowers for taxes and insurance................ 8,206 5,595
Other liabilities.................................................... 10,131 10,792
-------------- --------------
Total liabilities................................................. 1,277,519 1,413,317
Stockholders' equity:
Preferred stock, $0.01 par value; 15,000,000 shares authorized....... - -
Common stock, $0.01 par value; 85,000,000 shares authorized;
23,423,306 shares issued as of September 30, 2004 and December 31,
2003; 12,310,222 and 12,200,015 shares outstanding as of
September 30, 2004 and December 31, 2003, respectively............ 234 234
Additional paid-in capital........................................... 189,701 189,879
Retained earnings, substantially restricted.......................... 100,813 106,354
Treasury stock, at cost: 11,113,084 and 11,223,291 shares as of
September 30, 2004 and December 31, 2003, respectively............ (131,578) (132,741)
Unallocated common stock held by ESOP................................ (7,158) (7,158)
Unearned common stock acquired by RRP................................ (148) (1,523)
Accumulated other comprehensive income, net of tax................... 538 908
-------------- --------------
Total stockholders' equity........................................ 152,402 155,953
-------------- --------------
Total liabilities and stockholders' equity...................... $ 1,429,921 $ 1,569,270
============== ==============
See accompanying notes.
3
CFS BANCORP, INC.
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------
2004 2003 2004 2003
------------ ------------ ------------ --------
(Unaudited)
(Dollars in thousands, except share and per share data)
Interest income:
Loans................................................ $ 14,541 $ 14,628 $ 42,388 $ 44,818
Securities........................................... 2,712 1,631 7,983 5,844
Other................................................ 338 745 1,514 2,683
---------- ---------- ---------- ----------
Total interest income.............................. 17,591 17,004 51,885 53,345
Interest expense:
Deposits............................................. 2,818 3,603 9,839 13,367
Borrowings........................................... 6,340 6,730 18,866 20,002
---------- ---------- ---------- ----------
Total interest expense............................. 9,158 10,333 28,705 33,369
---------- ---------- ---------- ----------
Net interest income before provision for losses on loans 8,433 6,671 23,180 19,976
Provision for losses on loans........................... 6,172 502 8,829 1,489
---------- ---------- ---------- ----------
Net interest income after provision for losses on loans. 2,261 6,169 14,351 18,487
Non-interest income:
Service charges and other fees....................... 1,922 1,906 5,474 5,207
Commission income.................................... 204 202 527 520
Net realized gains on available-for-sale securities.. 126 326 81 325
Net gain (loss) on sale of office properties......... - 4 (1) 28
Income from Bank-owned life insurance................ 355 363 1,078 1,092
Other income......................................... 453 403 1,583 1,449
---------- ---------- ---------- ----------
Total non-interest income.......................... 3,060 3,204 8,742 8,621
Non-interest expense:
Compensation and employee benefits................... 5,772 4,666 15,235 13,467
Net occupancy expense................................ 501 562 1,759 1,764
Professional fees.................................... 775 393 2,420 1,353
Data processing...................................... 644 542 2,096 1,654
Furniture and equipment expense...................... 258 461 1,176 1,416
Marketing............................................ 229 262 812 726
Amortization of core deposit intangibles............. 16 - 49 -
Other general and administrative expenses............ 2,488 1,205 4,948 3,523
---------- ---------- ---------- ----------
Total non-interest expense......................... 10,683 8,091 28,495 23,903
---------- ---------- ---------- ----------
Income (loss) before income taxes....................... (5,362) 1,282 (5,402) 3,205
Income tax expense (benefit)............................ (2,581) 315 (3,508) 886
----------- ---------- ----------- ----------
Net income (loss).................................. $ (2,781) $ 967 $ (1,894) $ 2,319
=========== ========== =========== ==========
Comprehensive income (loss)........................ $ (1,146) $ 1,151 $ (2,264) $ 3,567
=========== ========== =========== ==========
Per share data:
Basic earnings (loss) per share...................... $ (0.24) $ 0.09 $ (0.16) $ 0.21
Diluted earnings (loss) per share.................... (0.24) 0.08 (0.16) 0.20
Cash dividends declared per share.................... 0.11 0.11 0.33 0.33
Weighted average shares outstanding..................... 11,648,808 11,251,705 11,555,801 11,285,488
Weighted average diluted shares outstanding............. 11,905,252 11,658,617 11,866,131 11,705,965
See accompanying notes.
4
CFS BANCORP, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
ADDITIONAL
COMMON PAID IN RETAINED TREASURY
STOCK CAPITAL EARNINGS STOCK
----- ------- -------- -----
(Unaudited)
(Dollars in thousands, except per share data)
Balance January 1, 2003.............. $ 234 $ 189,786 $ 107,598 $(125,650)
Net income........................... - - 2,319 -
Other comprehensive income, net of tax:
Change in unrealized appreciation
on available-for-sale securities,
net of reclassification adjustment
Total comprehensive income...........
Purchase of treasury stock........... - - - (9,203)
Amortization or award under RRP...... - (47) - -
Exercise of stock options............ - (258) - 1,559
Tax benefit related to stock options
exercised............................ - 27 - -
Dividends declared on common stock
($0.33 per share)................... - - (3,583) -
--------- --------- ---------- ---------
Balance September 30, 2003........... $ 234 $ 189,508 $ 106,334 $(133,294)
========= ========= ========= ==========
Balance January 1, 2004.............. $ 234 $ 189,879 $ 106,354 $(132,741)
Net loss............................. - - (1,894) -
Other comprehensive loss, net of tax:
Change in unrealized appreciation
on available-for-sale securities,
net of reclassification adjustment
Total comprehensive loss.............
Purchase of treasury stock........... - - - (869)
Amortization or award under RRP...... - (20) - -
Exercise of stock options............ - (296) - 2,032
Tax benefit related to stock options
exercised............................ - 138 - -
Dividends declared on common stock ($0.
33 per share)...................... - - (3,647) -
--------- --------- ---------- ---------
Balance September 30, 2004........... $ 234 $ 189,701 $ 100,813 $(131,578)
========= ========= ========= ==========
UNALLOC. UNEARNED ACCUM.
COMMON COMMON OTHER
STOCK STOCK COMPRE-
HELD ACQUIRED HENSIVE
BY ESOP BY RRP INCOME TOTAL
------- ------ ------ -----
(Dollars in thousands, except per share data)
Balance January 1, 2003.............. $ (8,356) $ (2,827) $ (123) $ 160,662
Net income........................... - - - 2,319
Other comprehensive income, net of tax:
Change in unrealized appreciation
on available-for-sale securities,
net of reclassification adjustment 1,248 1,248
---------
Total comprehensive income........... 3,567
Purchase of treasury stock........... - - - (9,203)
Amortization or award under RRP...... - 1,302 - 1,255
Exercise of stock options............ - - - 1,301
Tax benefit related to stock options
exercised............................ - - - 27
Dividends declared on common stock
($0.33 per share)................... - - - (3,583)
--------- --------- --------- ---------
Balance September 30, 2003........... $ (8,356) $ (1,525) $ 1,125 $ 154,026
========== ========== ========= =========
Balance January 1, 2004.............. $ (7,158) $ (1,523) $ 908 $ 155,953
Net loss............................. - - - (1,894)
Other comprehensive loss, net of tax:
Change in unrealized appreciation
on available-for-sale securities,
net of reclassification adjustment (370) (370)
---------
Total comprehensive loss............. (2,264)
Purchase of treasury stock........... - - - (869)
Amortization or award under RRP...... - 1,375 - 1,355
Exercise of stock options............ - - - 1,736
Tax benefit related to stock options
exercised............................ - - - 138
Dividends declared on common stock
($0.33 per share)................... - - - (3,647)
--------- --------- --------- ---------
Balance September 30, 2004........... $ (7,158) $ (148) $ 538 $ 152,402
========== ========== ========= =========
See accompanying notes.
5
CFS BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
2004 2003
---- ----
(Unaudited)
(Dollars in thousands)
Operating activities:
Net income (loss).................................................. $ (1,894) $ 2,319
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Provision for losses on loans................................... 8,829 1,489
Depreciation and amortization................................... 1,150 1,202
Net premium amortization on securities available-for-sale 2,044 5,358
Deferred income tax benefit..................................... (3,551) 925
Amortization of cost of stock benefit plans..................... 1,355 1,255
Tax benefit from exercises of nonqualified stock options........ 138 27
Proceeds from sale of loans held-for-sale....................... 9,415 8,707
Origination of loans held-for-sale.............................. (8,073) (11,576)
Net gain realized on securities available-for-sale.............. (81) (325)
Dividends received on Federal Home Loan Bank Stock.............. (933) (675)
Increase in cash surrender value of Bank owned life insurance... (1,078) (574)
Decrease (increase) in prepaid expenses and other assets........ 4,673 (3,755)
(Decrease) increase in other liabilities........................ (431) 3,550
Other........................................................... 71 182
---------- ----------
Net cash provided by operating activities..................... 11,634 8,109
---------- ----------
Investing activities:
Proceeds from maturities, paydowns and sales of securities.......... 205,032 456,273
Purchases of securities available-for-sale.......................... (166,193) (386,586)
Redemption of Federal Home Loan Bank stock.......................... 325 17
Net loan originations and principal payments received............... (26,234) (49,576)
Proceeds from sale of real estate owned............................. 3,585 1,644
Purchases of property and equipment................................. (4,068) (1,810)
Disposal of property and equipment.................................. 29 630
---------- ----------
Net cash provided by investing activities......................... 12,476 20,592
---------- ----------
Financing activities:
Proceeds from exercise of stock options............................. 1,736 1,301
Dividends paid on common stock...................................... (3,626) (3,518)
Purchase of treasury stock.......................................... (869) (9,203)
Net decrease in deposit accounts.................................... (131,087) (70,238)
Net increase in advance payments by borrowers for taxes and
Insurance......................................................... 2,611 635
Net decrease in borrowed funds...................................... (6,661) (30,898)
----------- -----------
Net cash flows used for financing activities.................... (137,896) (111,921)
----------- -----------
Decrease in cash and cash equivalents.................................. (113,786) (83,220)
Cash and cash equivalents at beginning of period....................... 177,751 204,504
---------- ----------
Cash and cash equivalents at end of period............................. $ 63,965 $ 121,284
========== ==========
Supplemental disclosure of non-cash activities:
Loans transferred to real estate owned.............................. $ 3,919 $ 1,115
Cash paid for interest on deposits.................................. 10,103 13,579
Cash paid for interest on borrowings................................ 1,183 1,187
Cash paid for taxes................................................. - 1,439
6
CFS BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF FINANCIAL STATEMENTS PRESENTATION
The consolidated financial statements of CFS Bancorp, Inc. (including its
consolidated subsidiaries, the Company) included herein are unaudited; however,
such information reflects all adjustments (consisting only of normal recurring
adjustments), which are, in the opinion of management, necessary for a fair
presentation for the interim periods. The financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to
Form 10-Q and Article 10 of Regulation S-X.
The results of operations for the three and nine months ended September
30, 2004 are not necessarily indicative of the results expected for the full
year ending December 31, 2004. The accompanying consolidated financial
statements are unaudited and do not include information or footnotes necessary
for a complete presentation of financial condition, results of operations or
cash flows in accordance with accounting principles generally accepted in the
United States. The September 30, 2004 consolidated financial statements should
be read in conjunction with the consolidated financial statements and notes for
the year ended December 31, 2003 included in the Company's Annual Report on Form
10-K.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of income and expense during
the reported period. Actual results could differ from these estimates.
Certain reclassifications have been made to prior period's consolidated
financial statements to conform to the current period's consolidated financial
statements.
2. STOCK-BASED COMPENSATION
The Company accounts for its stock options in accordance with Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued by Employees (APB
No. 25). Under APB No. 25, because the exercise price of each of the Company's
employees' stock options which have been granted equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized at
the time of grant. Compensation expense for shares granted under the Recognition
and Retention Plan (RRP) is ratably recognized over the period of service,
usually the vesting period, based on the fair value of the stock on the date of
grant.
7
Pursuant to Financial Accounting Standards Board (FASB) Statement No. 123,
Accounting for Stock-Based Compensation (FAS No. 123), pro forma net income and
pro forma earnings per share are presented in the following table as if the fair
value method of accounting for stock-based compensation plans had been utilized.
The effects of applying FAS No. 123 in this pro forma disclosure are not
indicative of future amounts.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- ------------------
2004 2003 2004 2003
---- ---- ---- ----
(Dollars in thousands except per share data)
Net income (loss) (as reported)...................... $ (2,781) $ 967 $ (1,894) $ 2,319
Stock-based compensation expense determined
using fair value method, net of tax.......... (125) (213) (417) (578)
---------- ----------- ----------- -----------
Pro forma net income (loss)..................... $ (2,906) $ 754 $ (2,311) $ 1,741
========== ========== =========== ==========
Basic earnings (loss) per share (as reported)... $ (0.24) $ 0.09 $ (0.16) $ 0.21
Pro forma basic earnings (loss) per share....... (0.25) 0.07 (0.20) 0.15
Diluted earnings (loss) per share (as reported). (0.24) 0.08 (0.16) 0.20
Pro forma diluted earnings (loss) per share..... (0.25) 0.06 (0.20) 0.15
The fair value of the option grants for the three and nine months ended
September 30, 2004 and 2003 was estimated using the Black-Scholes option value
model, with the following assumptions:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- ------------------
2004 2003 2004 2003
---- ---- ---- ----
Dividend yield.................................. 3.2% 3.1% 3.2% 3.1%
Expected volatility............................. 27.0 30.2 27.0 30.2
Risk-free interest.............................. 3.8 3.9 3.8 3.9
Original expected life.......................... 7 years 7 years 7 years 7 years
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. Option valuation models such as the Black-Scholes
require the input of highly subjective assumptions including the expected stock
price volatility.
3. COMPREHENSIVE INCOME
Change in the fair value of securities available-for-sale is presented on
a net basis on the Consolidated Statement of Changes in Stockholders' Equity.
The following tables disclose the changes in the components of other accumulated
comprehensive income (loss) for the nine months ended September 30, 2004 and
2003.
8
SEPTEMBER 30, 2004
--------------------------------------------
BEFORE TAX TAX AFTER TAX
AMOUNT EFFECT AMOUNT
---------- ------ ---------
(Dollars in thousands)
Unrealized holding losses on securities
available-for-sale:
Unrealized holding losses, net.................... $ (458) $ 154 $ (304)
Less: reclassification adjustment for net gains
included in net losses.......................... 81 (15) 66
--------- --------- ---------
Unrealized losses, net.............................. $ (539) $ 169 $ (370)
========= ========= =========
SEPTEMBER 30, 2003
--------------------------------------------
BEFORE TAX TAX AFTER TAX
AMOUNT EFFECT AMOUNT
---------- ------ ---------
(Dollars in thousands)
Unrealized holding gains on securities
available-for-sale:
Unrealized holding gains, net..................... $ 2,136 $ (676) $ 1,460
Less: reclassification adjustment for net gains
included in net income.......................... 325 (113) 212
--------- ---------- ---------
Unrealized gains, net............................... $ 1,811 $ (563) $ 1,248
========= ========== =========
4. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share for the three and nine months ended September 30, 2004 and
2003:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2004 2003 2004 2003
---- ---- ---- ----
(Dollars in thousands, except per share data)
Net income (loss)................................... $ (2,781) $ 967 $ (1,894) $ 2,319
=========== =========== ============ ===========
Weighted average common shares outstanding.......... 11,648,808 11,251,705 11,555,801 11,285,488
Common share equivalents (1)........................ 256,444 406,912 310,330 420,477
----------- ----------- ------------ -----------
Weighted average common shares and common
share equivalents outstanding..................... 11,905,252 11,658,617 11,866,131 11,705,965
=========== =========== ============ ===========
Basic earnings (loss) per share..................... $ (0.24) $ 0.09 $ (0.16) $ 0.21
Diluted earnings (loss) per share................... (0.24) 0.08 (0.16) 0.20
- ------------------
(1) Assumes exercise of dilutive stock options and also a portion of the
unearned awards under the RRP.
5. NEW ACCOUNTING PRONOUNCEMENTS
The Meaning of Other-Than-Temporary and Its Application to Certain Investments
In January 2003, the Emerging Issues Task Force (EITF) began a project to
provide additional guidance on when a market value decline on debt and
marketable equity securities should be considered other-than-temporary.
Currently, declines in market value that are considered to be
other-than-temporary require that a loss be recognized through the income
9
statement. The EITF issued additional guidance in March 2004 establishing
criteria for recognition and measurement under this pronouncement to be
effective for reporting periods beginning after June 15, 2004. However, in
September 2004, the effective date of these provisions was delayed until the
finalization of a FASB Staff Position (FSP) to provide additional implementation
guidance. This additional guidance could have an impact on the Company's
unrealized losses on securities available-for-sale. Currently, the FASB expects
to issue the FSP no later than December 2004.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD LOOKING STATEMENTS
When used in this Form 10-Q or future filings by the Company with the SEC,
in the Company's press releases or other public or stockholder communications,
the words or phrases "would be," "will allow," "intends to," "will likely
result," "are expected to," "will continue," "is anticipated," "estimate,"
"project," or similar expressions, or the negative thereof, are intended to
identify "forward-looking statements" within the meaning of the Private
Litigation Reform Act of 1995.
The Company wishes to caution readers not to place undue reliance on any
such forward-looking statements, which speak only as of the date made, and to
advise readers that various factors, including regional and national economic
conditions, changes in levels of market interest rates, credit and other risks
which are inherent in the Company's lending and investment activities,
legislative changes, changes in operations, changes in the cost of funds, demand
for loan products and financial services, changes in accounting principles and
competitive and regulatory factors, could affect the Company's financial
performance and could cause the Company's actual results for future periods to
differ materially from those anticipated or projected. Such forward-looking
statements are not guarantees of future performance. The Company does not
undertake, and specifically disclaims any obligation, to update any
forward-looking statements to reflect occurrences or unanticipated events or
circumstances after the date of such statements.
OVERVIEW
During the third quarter of 2004, the Company's net interest income
continued to improve increasing 26.4% to $8.4 million from $6.7 million for the
third quarter of 2003. Net interest income for the nine months ended September
30, 2004 increased 16.0% to $23.2 million from $20.0 million for the comparable
period in the prior year. The annualized net interest margin increased 33.5% to
2.43% from 1.82% for the third quarter of 2003 which was mainly a result of
higher yields earned on securities coupled with a decrease in the interest rate
paid on deposits. For the nine months ended September 30, 2004, the annualized
net interest margin was 2.16%, up from 1.79% for the same period in 2003.
Offsetting the increased net interest income was an increase in the
provision for losses on loans. In connection with the Company's third quarter
evaluation of the adequacy of its allowance for losses on loans, management
identified eight loans with an estimated aggregate
10
impairment of $10.3 million. The estimated impairment along with management's
assessment of the adequacy of the Company's allowance for losses on loans
resulted in an additional $6.2 million provision for losses on loans during the
third quarter of 2004 as compared to $502,000 for the same period in 2003. For
the nine months ended September 30, 2004, the provision for losses on loans was
$8.8 million, an increase from the provision for losses on loans of $1.5 million
for the nine months ended September 30, 2003.
As previously communicated, management of the Company continues to explore
the possibility of refinancing its outstanding fixed-rate Federal Home Loan Bank
(FHLB) borrowings. During the third quarter of 2004, the Company identified an
opportunity to partially reduce the negative impact of these borrowings by
prepaying $6.5 million of such borrowings which bore a 5.26% fixed interest
rate. This prepayment resulted in a $485,000 charge to other non-interest
expense.
In addition to the above, the Company's financial results for the third
quarter of 2004 were also adversely impacted by the following:
- additional compensation expense of $1.0 million incurred as a result
of the resignation of a senior executive officer;
- an additional $585,000 impairment in the cost basis of a trust
preferred security deemed to be other than temporarily impaired
during the quarter;
- the write-down of $421,000 in viatical receivables held by the Bank
that were determined to be impaired;
- additional legal expenses of $381,000 related to the Company's
goodwill litigation; and
- an increase in loan collection expenses of $231,000 compared to the
third quarter of 2003.
As a result, the Company reported a net loss of $2.8 million for the third
quarter of 2004 as compared to net income of $967,000 reported for the third
quarter of 2003. For the nine months ended September 30, 2004, the Company
reported a net loss of $1.9 million as compared to net income of $2.3 million
for the nine months ended September 30, 2003.
The Company continued to increase its commercial loan portfolio. Loan
originations remained high with over $107.0 million in new loans and lines of
credit being originated during the three months ended September 30, 2004. Total
loan originations for the nine months ended September 30, 2004 were $317.3
million.
After strong growth in the Company's average core deposits of 5.1% during
the second quarter of 2004, the Company had modest success in the continued
growth of average core deposits, which growth amounted to 0.8%, during the third
quarter of 2004 as the rise in general interest rates caused disintermediation
in the Company's money market deposit accounts.
Also during the third quarter of 2004, the Company opened two new Bank
branch offices increasing its footprint in northwest Indiana and Chicago's
southwestern suburbs. The Dyer, Indiana branch was opened on August 30 and
provides additional convenience for our Dyer customers. On September 30, 2004,
the Company opened a new Darien, Illinois branch facility
11
which included only the building and furniture and fixtures acquired from a
Chicago-based bank. The Company has planned several marketing campaigns to
generate new customers at both of these offices.
CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance
with accounting principles generally accepted in the United States and follow
general practices within the industry in which it operates. Application of these
principles requires management to make estimates or judgments that affect the
amounts reported in the financial statements and accompanying notes. These
estimates are based on information available as of the date of the financial
statements; accordingly, as this information changes, the financial statements
could reflect different estimates or judgments. Certain policies inherently have
a greater reliance on the use of estimates, and as such have a greater
possibility of producing results that could be materially different than
originally reported. Estimates or judgments are necessary when assets and
liabilities are required to be recorded at fair value, when a decline in the
value of an asset not carried on the financial statements at fair value warrants
an impairment write-down or valuation reserve to be established, or when an
asset or liability needs to be recorded contingent upon a future event. Carrying
assets and liabilities at fair value inherently results in more financial
statement volatility. The fair values and the information used to record
valuation adjustments for certain assets and liabilities are based either on
quoted market prices or are provided by other third-party sources, when
available. When third-party information is not available, valuation adjustments
are estimated in good faith by management primarily through the use of internal
cash flow and other modeling techniques.
The most significant accounting policies followed by the Company are
presented in Note 1 to the consolidated financial statements. These policies
along with the disclosures presented in the other financial statement notes and
in this Management's Discussion and Analysis provide information on the
methodology and policies relating to the valuation of significant assets and
liabilities. Management views critical accounting policies to be those which are
highly dependent on subjective or complex judgments, estimates and assumptions,
and where changes in those estimates and assumptions could have a significant
impact on the financial statements. Management currently views the determination
of the allowance for losses on loans to be a critical accounting policy.
Allowance for Losses on Loans. The Company maintains an allowance for
losses on loans at a level management believes is sufficient to absorb credit
losses inherent in the loan portfolio. The allowance for losses on loans
represents the Company's estimate of probable losses in the loan portfolio at
each balance sheet date and is based on the review of available and relevant
information.
The allowance for losses on loans contains allocations for probable losses
that have been identified relating to specific borrowing relationships pursuant
to Statement of Financial Accounting Standards No. (SFAS) 114, Accounting by
Creditors for Impairment of a Loan, as well as probable losses for pools of
loans pursuant to SFAS 5, Accounting for Contingencies. One component of the
Company's allowance for losses on loans consists of expected losses resulting in
specific credit allocations for individual loans. These specific credit
allocations are based on regular analyses of all loans over a fixed-dollar
amount where the internal credit rating
12
is at or below a predetermined classification. These analyses involve a high
degree of judgment in estimating the amount of the loss associated with specific
loans, including the estimation of the amount and timing of future cash flows
and collateral values.
Another component of the allowance for losses on loans reflects
management's estimates of probable inherent but undetected losses within various
pools of loans with similar characteristics. This component is based in part on
certain loss factors applied to various loan pools as stratified by the Company.
In determining the appropriate loss factors for these loan pools, management
considers historical charge-offs and recoveries; levels of and trends in
delinquencies, impaired loans and other classified loans; concentrations of
credit within the commercial loan portfolios; volume and type of lending; and
current and anticipated economic conditions. The allowance for losses on loans
may also include a relatively small portion that remains unallocated.
Loan losses are charged off against the allowance, while recoveries of
amounts previously charged off are credited to the allowance. The Company
assesses the adequacy of the allowance for losses on loans on a quarterly basis
and adjusts the allowance for losses on loans by recording a provision for
losses on loans in an amount sufficient to maintain the allowance at an
appropriate level. The evaluation of the adequacy of the allowance for losses on
loans is inherently subjective as it requires estimates that are susceptible to
significant revision as more information becomes available or as future events
occur. To the extent that actual outcomes differ from management estimates, an
additional provision for losses on loans could be required that could adversely
affect earnings or the Company's financial position in future periods. In
addition, various regulatory agencies, as an integral part of their examination
processes, periodically review the provision for losses on loans for Citizens
Financial Services, FSB (the Bank or Citizens) and the carrying value of its
other non-performing assets, based on information available to them at the time
of their examinations. Any of these agencies could require the Bank to make
additional provisions for losses on loans in the future.
AVERAGE BALANCES, NET INTEREST INCOME, YIELDS EARNED AND RATES PAID
The following tables provide information regarding (i) the Company's
interest income recognized from interest-earning assets and their related
average yields; (ii) the amount of interest expense realized on interest-bearing
liabilities and their related average rates; (iii) net interest income; (iv)
interest rate spread; and (v) net interest margin. Information is based on
average daily balances during the indicated periods.
13
THREE MONTHS ENDED SEPTEMBER 30,
-------------------------------------------------------------------------------------
2004 2003
---------------------------------------- -------------------------------------------
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST
------- -------- ---------- ------- -------- ----------
(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)........... $ 1,004,586 $ 14,541 5.76% $ 976,415 $ 14,628 5.94%
Securities (2)................. 322,772 2,712 3.34 277,000 1,631 2.34
Other interest-earning assets(3) 51,293 338 2.62 200,526 745 1.47
----------- ----------- ----------- -----------
Total interest-earning assets 1,378,651 17,591 5.08 1,453,941 17,004 4.64
Non-interest earning assets....... 71,589 69,373
----------- -----------
Total assets...................... $ 1,450,240 $ 1,523,314
=========== ===========
Interest-bearing liabilities:
Deposits:
Checking accounts............ $ 95,373 58 0.24% $ 94,156 71 0.30%
Money market accounts........ 141,040 329 0.93 140,054 328 0.93
Savings accounts............. 207,144 175 0.34 214,158 231 0.43
Certificates of deposit...... 365,699 2,256 2.45 416,700 2,973 2.83
----------- ----------- ----------- -----------
Total deposits............. 809,256 2,818 1.39 865,068 3,603 1.65
Borrowings..................... 420,312 6,340 6.00 448,093 6,730 5.96
----------- ----------- ----------- -----------
Total interest-bearing
liabilities................ 1,229,568 9,158 2.96 1,313,161 10,333 3.12
----------- -----------
Non-interest bearing deposits..... 46,121 36,987
Non-interest bearing liabilities.. 19,054 18,846
----------- -----------
Total liabilities................. 1,294,743 1,368,994
Stockholders' equity.............. 155,497 154,320
----------- -----------
Total liabilities and
stockholders' equity.............. $ 1,450,240 $ 1,523,314
=========== ===========
Net interest-earning assets....... $ 149,083 $ 140,780
=========== ===========
Net interest income / interest
rate spread..................... $ 8,433 2.12% $ 6,671 1.52%
=========== ========== =========== ==========
Net interest margin............... 2.43% 1.82%
========== ==========
Ratio of average interest-earning
assets to average
interest-bearing liabilities... 112.12% 110.72%
========== ==========
- ----------------------
(1) The average balance of loans receivable is net of unearned fees and
includes non-performing loans, interest on which is recognized on a cash
basis.
(2) Average balances of securities are based on historical costs.
(3) Includes money market accounts, federal funds sold, interest-earning bank
deposits and FHLB stock.
14
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------------------------------------------------------------
2004 2003
----------------------------------------- ------------------------------------------
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST
------- -------- ---------- ------- -------- ----------
(Dollars in thousands)
Interest-earning assets:
Loans receivable (1).............. $ 996,515 $ 42,388 5.68% $ 958,413 $ 44,818 6.25%
Securities (2).................... 331,704 7,983 3.21 311,627 5,844 2.51
Other interest-earning assets (3). 106,866 1,514 1.89 220,006 2,683 1.63
----------- ----------- ----------- -----------
Total interest-earning assets 1,435,085 51,885 4.83 1,490,046 53,345 4.79
Non-interest earning assets.......... 72,722 68,873
----------- -----------
Total assets......................... $ 1,507,807 $ 1,558,919
=========== ===========
Interest-bearing liabilities:
Deposits:
Checking accounts............... $ 95,135 182 0.26% $ 92,636 359 0.52%
Money market accounts........... 134,602 922 0.91 140,788 1,398 1.33
Savings accounts................ 207,358 560 0.36 214,368 1,119 0.70
Certificates of deposit......... 432,502 8,175 2.52 451,663 10,491 3.11
----------- ----------- ----------- -----------
Total deposits................ 869,597 9,839 1.51 899,455 13,367 1.99
Borrowings........................ 419,075 18,866 6.01 448,954 20,002 5.96
----------- ----------- ----------- -----------
Total interest-bearing
liabilities................... 1,288,672 28,705 2.98 1,348,409 33,369 3.31
----------- -----------
Non-interest bearing deposits........ 43,232 35,721
Non-interest bearing liabilities..... 18,593 19,125
----------- -----------
Total liabilities.................... 1,350,497 1,403,255
Stockholders' equity................. 157,310 155,664
----------- -----------
Total liabilities and
stockholders' equity ................ $ 1,507,807 $ 1,558,919
=========== ===========
Net interest-earning assets.......... $ 146,413 $ 141,637
=========== ===========
Net interest income / interest
rate spread........................ $ 23,180 1.85% $ 19,976 1.48%
=========== ========== =========== ==========
Net interest margin.................. 2.16% 1.79%
========== ==========
Ratio of average interest-earning
assets to average
interest-bearing liabilities...... 111.36% 110.50%
========== ==========
(1) The average balance of loans receivable is net of unearned fees and
includes non-performing loans, interest on which is recognized on a cash
basis.
(2) Average balances of securities are based on historical costs.
(3) Includes money market accounts, federal funds sold, interest-earning bank
deposits and FHLB stock.
15
RATE /VOLUME ANALYSIS
The following tables detail the effects of changing rates and volumes on
the Company's net interest income. Information is provided with respect to (i)
effects on interest income attributable to changes in rate (changes in rate
multiplied by prior volume); (ii) effects on interest income attributable to
changes in volume (changes in volume multiplied by prior rate); and (iii)
changes in rate/volume (changes in rate multiplied by changes in volume).
THREE MONTHS ENDED SEPTEMBER 30,
2004 COMPARED TO 2003
------------------------------------------------------------
INCREASE (DECREASE) DUE TO
------------------------------------------------------------
TOTAL NET
RATE/ INCREASE /
RATE VOLUME VOLUME (DECREASE)
---- ------ ------ ----------
(Dollars in thousands)
Interest-earning assets:
Loans receivable............................ $ (495) $ 422 $ (14) $ (87)
Securities.................................. 696 270 115 1,081
Other interest-earning assets............... 576 (554) (429) (407)
---------- ---------- ---------- ----------
Total net change in income on
interest-earning assets................. 777 138 (328) 587
Interest-bearing liabilities:
Deposits:
Checking accounts......................... (14) 1 - (13)
Money market accounts..................... (1) 2 - 1
Savings accounts.......................... (50) (8) 2 (56)
Certificates of deposit................... (402) (364) 49 (717)
---------- ---------- ---------- ----------
Total deposits.......................... (467) (369) 51 (785)
Borrowings.................................. 29 (417) (2) (390)
---------- ---------- ---------- ----------
Total net change in expense on
interest-bearing liabilities............ (438) (786) 49 (1,175)
---------- ---------- ---------- ----------
Net change in net interest income.............. $ 1,215 $ 924 $ (377) $ 1,762
========== ========== ========== ==========
16
NINE MONTHS ENDED SEPTEMBER 30,
2004 COMPARED TO 2003
------------------------------------------------------------
INCREASE (DECREASE) DUE TO
------------------------------------------------------------
TOTAL NET
RATE/ INCREASE /
RATE VOLUME VOLUME (DECREASE)
---- ------ ------ ----------
(Dollars in thousands)
Interest-earning assets:
Loans receivable............................ $ (4,051) $ 1,782 $ (161) $ (2,430)
Securities.................................. 1,655 377 107 2,139
Other interest-earning assets............... 434 (1,380) (223) (1,169)
---------- ----------- ----------- -----------
Total net change in income on
interest-earning assets................. (1,962) 779 (277) (1,460)
Interest-bearing liabilities:
Deposits:
Checking accounts......................... (182) 10 (5) (177)
Money market accounts..................... (434) (61) 19 (476)
Savings accounts.......................... (540) (37) 18 (559)
Certificates of deposit................... (1,954) (445) 83 (2,316)
----------- ----------- ---------- -----------
Total deposits.......................... (3,110) (533) 115 (3,528)
Borrowings.................................. 209 (1,331) (14) (1,136)
---------- ----------- ----------- -----------
Total net change in expense on
interest-bearing liabilities............ (2,901) (1,864) 101 (4,664)
----------- ----------- ---------- -----------
Net change in net interest income.............. $ 939 $ 2,643 $ (378) $ 3,204
========== ========== =========== ==========
RESULTS OF OPERATIONS
Net Income (Loss). The Company had a net loss for the third quarter of
2004 totaling $2.8 million, as compared to net income of $967,000 reported in
the comparable quarter of the previous year. The Company's net loss for the nine
months ended September 30, 2004 was $1.9 million, as compared to net income of
$2.3 million for the first nine months of 2003. The reduced net income levels
from the comparable periods in the prior year were primarily the result of the
impact of the increased provision for losses on loans and non-recurring charges
recorded during the third quarter of 2004.
Net Interest Income. Net interest income is the principal source of
earnings for the Company and consists of interest income earned on loans and
investment securities less interest expense paid on deposits and borrowed funds.
Net interest income is a function of the Company's interest rate spread, which
is the difference between the average yield earned on the Company's
interest-earning assets and the average rate paid on its interest-bearing
liabilities, and the relative amounts of interest-earning assets and
interest-bearing liabilities.
The Company's net interest margin (which is net interest income as a
percentage of average interest-earning assets) improved to 2.43% for the three
months ended September 30, 2004 as compared to 1.82% for the same period in
2003. Net interest margin for the first nine months of 2004 was 2.16%, up from
1.79% during the first nine months of 2003.
17
The Company's net interest income for the third quarter of 2004 increased
26.4% to $8.4 million from $6.7 million for the third quarter of 2003. Net
interest income for the nine months ended September 30, 2004 increased 16.0% to
$23.2 million from $20.0 million for the comparable period in the prior year.
The increase in net interest income was primarily due to higher yields on
securities and other interest-earning assets along with a reduction in the
average cost of deposits. The Company expects its net interest income and net
interest margin to modestly improve during the remainder of 2004 as a result of
continued loan growth, increased core deposits and higher interest rates.
Interest Income. Total interest income of $17.6 million for the three
months ended September 30, 2004 increased by $587,000 from $17.0 million for the
third quarter of 2003. Interest income for the first nine months of 2004 totaled
$51.9 million compared to $53.3 million for the first nine months of 2003.
Although the average balance of interest-earning assets decreased 5.2% and 3.7%,
respectively, for the quarter and nine months ended September 30, 2004 from the
comparable previous year periods, interest income increased for the same periods
as a result of reduced premium amortization on the Company's securities
portfolio combined with a decrease in total funds invested in low-yielding
overnight funds.
The Company's average yield on interest-earning assets increased 9.5%
during the third quarter of 2004 to 5.08% from 4.64% during the third quarter of
2003. For the nine months ended September 30, 2004, the average yield on
interest-earning assets was 4.83%, slightly up from 4.79% for the comparable
prior year period.
The average yields on loans receivable decreased 18 basis points during
the third quarter of 2004 from the third quarter of 2003 and 57 basis points
during the first nine months of 2004 from the first nine months of 2003. The
main reason for the decreased loan yields was a result of the lower interest
rate environment experienced during 2003 which caused borrowers to refinance at
lower rates coupled with the effects of the increase in non-accrual loans during
2004 from 2003. This decrease in average yields on loans was partially offset by
an increase in the average yields on the Company's securities and other
interest-earning assets.
The average yield on securities increased to 3.34% for the three months
ended September 30, 2004 from 2.34% from the comparable prior year period. For
the nine months ended September 30, 2004, the average yield on securities
increased to 3.21% from 2.51% from the nine months ended September 30, 2003.
These increases were mainly a result of reduced levels of premium amortization
during 2004 as the prepayments of mortgage loans underlying the mortgage-related
securities slowed significantly.
The average yields on other interest-earning assets increased to 2.62% for
the three months ended September 30, 2004 from 1.47% for the comparable prior
year period and to 1.89% for the nine months ended September 30, 2004 from 1.63%
for the comparable prior year period. These increases were a direct result of a
decrease in total funds invested in lower-yielding overnight funds during the
2004 periods.
Interest Expense. Total interest expense of $9.2 million for the three
months ended September 30, 2004 represented a decrease of $1.2 million from
$10.3 million incurred for the third quarter of 2003. Interest expense was $28.7
million for the nine months ended September
18
30, 2004, a decrease of $4.7 million from $33.4 million for the nine months
ended September 30, 2003.
The average balance of interest-bearing liabilities decreased 6.4% and the
average cost of interest-bearing liabilities decreased 16 basis points during
the third quarter of 2004 as compared to the third quarter of 2003. For the nine
months ended September 30, 2004, the average balance of interest-bearing
liabilities decreased 4.4% and the average cost of interest-bearing liabilities
decreased 33 basis points as compared to the nine months ended September 30,
2003.
The average cost of interest-bearing deposits for the quarter ended
September 30, 2004 was down 26 basis points to 1.39% from 1.65% for the third
quarter of 2003. The average cost of these deposits was also down 48 basis
points to 1.51% for the nine months ended September 30, 2004 from 1.99% for the
same period in 2003. The lower cost of deposits for the third quarter of 2004
was mainly a result of higher cost deposits repricing at lower rates. The
decrease for the nine months ended September 30, 2004 was mainly a result of
over $180 million of above-market rate certificates of deposit either being
repriced to lower current market rates or withdrawn at maturity during 2004.
Also contributing to the lower cost of deposits was a 4.4% increase in the
average balance of low-cost core deposits for the three months ended September
30, 2004 from the levels existing at December 31, 2003.
Provision for losses on loans. The Company's provision for losses on loans
was $6.2 million for the third quarter of 2004 as compared to $502,000 for the
third quarter of 2003. The provision for the nine months ended September 30,
2004 was $8.8 million, up from $1.5 million for the comparable period in 2003.
In connection with the Company's third quarter evaluation of the adequacy of its
allowance for losses on loans, the Company obtained updated information,
including in some instances new appraisals, on its non-performing loans. Based
on the new information, management identified eight loans that required a
reserve allocation because of a change in either the borrower's ability to
perform their obligations under the terms and conditions of the loan agreements
or the estimated value of the collateral. The total principal amount of these
eight loans was $31.9 million. With respect to these eight loans, the Company
identified an impairment reserve of $10.3 million, an increase from the $3.8
million reserve in the aggregate for these loans at June 30, 2004.
Non-interest income. Non-interest income was $3.1 million for the quarter
ended September 30, 2004, a decrease of $144,000 from the third quarter of 2003.
The Company's non-interest income for the third quarter of 2003 included
$326,000 of net realized gains on securities available-for-sale compared to
$126,000 for the third quarter of 2004. Due primarily to increased usage of the
Company's ATMs and check cards, the Company realized a $36,000 increase in other
income during the third quarter of 2004 from the quarter ended September 30,
2003. Service charges and other fees were also up by $16,000 during the quarter
ended September 30, 2004 compared to quarter ended September 30, 2003 as a
result of the Company modifying certain fees on deposit accounts. This
modification went into effect on September 1, 2004.
Non-interest income was $8.7 million for the first nine months of 2004, up
$121,000 from $8.6 million for the first nine months of 2003. Non-interest
income for the first nine months of 2003 included $325,000 in net realized gains
on securities available-for-sale compared to $81,000 for the first nine months
of 2004. The increase in non-interest income from the 2003
19
period was primarily related to an increase in service charges and other fees as
a result of fees realized from the Company's Overdraft Protection Program.
Net realized gains on available-for-sale securities were $126,000 for the
third quarter of 2004, down $200,000 from the third quarter of 2003. During the
2004 quarter, the Company sold approximately $55 million in securities
available-for-sale resulting in a realized gain of $711,000. The assets were
sold to take advantage of a rapid flattening of the yield curve. A portion of
the proceeds were used for the early repayment of FHLB Chicago advances with the
remainder to be used for general bank purposes including, but not limited to,
loan growth, reinvestment in other securities, and possible repayment or
refinancing of additional FHLB advances. Partially offsetting these realized
gains, the Company identified an additional $585,000 impairment in the cost
basis of a $764,000 trust preferred security that was deemed to be other than
temporarily impaired. For further discussion related to this impaired security,
see the "Securities" section in this Form 10-Q.
For the nine months ended September 30, 2004, net realized gains on
available-for-sale securities were $81,000, compared to $325,000 for the same
prior year period. The decrease in the gains was mainly a result of the
write-downs in the cost basis of the trust preferred security previously
mentioned which offset the net realized gains on the sale of over $128 million
in securities for the nine months ended September 30, 2004.
Non-interest expense. Non-interest expense for the third quarter and first
nine months of 2004 was $10.7 million and $28.5 million, respectively,
representing increases of $2.6 million and $4.6 million, respectively, from the
third quarter and first nine months of 2003. Included in the increase were the
legal expenses associated with the Company's goodwill litigation case that went
to trial during June 2004. The legal expenses incurred during the third quarter
and first nine months of 2004 related to this case were $381,000 and $1.2
million, respectively, which were significantly higher than those incurred for
the same periods in 2003. The Company estimates that the legal expenses related
to this case will be less than $100,000 for the remainder of 2004. See Item 1 of
Part II in this Form 10-Q for a discussion of the status of the litigation.
Also adding to the increase in non-interest expense for the quarter and
nine months ended September 30, 2004, the Company incurred charges as follows:
- compensation expense of $1.0 million related to the resignation of a
senior executive officer;
- a prepayment penalty of $485,000 for the early repayment of $6.5
million in FHLB Chicago advances;
- the write-down of $421,000 in viatical receivables to $537,000 held
by the Bank that were determined to be impaired; and
- an increase in loan collection expenses of $231,000.
The prepayment penalty, write-down of the viatical receivables, and increased
loan collection expenses are included in other general and administrative
expenses.
Income Tax Expense. The Company's income tax benefit for the three months
ended September 30, 2004 was $2.6 million compared to income tax expense of
$315,000 for the three
20
months ended September 30, 2003. The income tax benefit for the nine months
ended September 30, 2004 was $3.5 million compared to income tax expense of
$886,000 for the nine months ended September 30, 2003. The significant decrease
in income tax expense was a result of the lower pre-tax income for the three and
nine month periods ended September 30, 2004 combined with the application of
available tax credits, the effects of permanent tax differences on the Company's
pre-tax earnings, and the reversal of tax accruals no longer considered
necessary. The Company anticipates that these available tax credits, permanent
tax differences, and reversals of tax accruals will continue to have a favorable
impact on the income tax expense for the remainder of 2004.
CHANGES IN FINANCIAL CONDITION
General. At September 30, 2004, the Company's total assets had decreased
by $139.3 million to $1.43 billion from $1.57 billion at December 31, 2003. The
significant changes in the composition of the balance sheet during the nine
months ended September 30, 2004 included a decrease in cash and cash equivalents
of $113.8 million. This decrease was a result of a decrease in total deposits of
$131.1 million and an increase in net loans receivable of $17.8 million.
Securities. The amortized cost of the Company's securities and their fair
values were as follows at September 30, 2004 and December 31, 2003:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- ----
(Dollars in thousands)
At September 30, 2004:
Agency securities, corporate bonds, and
commercial paper................................ $ 157,600 $ 642 $ (299) $ 157,943
Mortgage-backed securities........................ 61,461 730 (74) 62,117
Collateralized mortgage obligations............... 58,218 234 (122) 58,330
Trust preferred securities........................ 5,116 - (129) 4,987
Equity securities................................. 1,725 6 (169) 1,562
----------- ----------- ------------ -----------
$ 284,120 $ 1,612 $ (793) $ 284,939
=========== =========== ============ ===========
At December 31, 2003:
Agency securities, corporate bonds, and
commercial paper................................ $ 132,127 $ 692 $ - $ 132,819
Mortgage-backed securities........................ 108,468 888 (255) 109,101
Collateralized mortgage obligations............... 75,245 626 (73) 75,798
Trust preferred securities........................ 6,148 - (562) 5,586
Equity securities................................. 2,958 178 (136) 3,000
----------- ----------- ------------ -----------
$ 324,946 $ 2,384 $ (1,026) $ 326,304
=========== =========== ============ ===========
During the third quarter of 2004, approximately $55 million of
available-for-sale securities were sold realizing a net gain on the sales of
$711,000. The assets were sold to take advantage of a flattening yield curve.
Partially offsetting the gains on sales of securities, the Company identified an
additional $585,000 impairment in a trust preferred security with a cost basis
of $764,000. The write-down to fair value was made when the issuer announced in
September 2004 the continuation of interest deferral on the trust preferred
securities coupled
21
with the sale of a significant portion of the issuer's assets, the continuing
restructuring objectives, and regulatory restrictions on the issuer.
Management does not believe that any other unrealized loss on the
Company's securities as of September 30, 2004 represents an other-than-temporary
impairment. The unrealized losses reported for the remainder of the portfolio
were attributable to changes in interest rates.
Loans. Loans receivable, net of unearned fees, and the percentage of loans
by category are presented below as of September 30, 2004 and December 31, 2003:
SEPTEMBER 30, 2004 DECEMBER 31, 2003
----------------------- -----------------------
AMOUNT PERCENTAGE AMOUNT PERCENTAGE
------ ---------- ------ ----------
(Dollars in thousands)
Commercial and construction loans:
Commercial real estate............................ $ 403,907 40.4% $ 429,883 43.7%
Construction and land development................. 156,073 15.6 125,636 12.8
Commercial and industrial......................... 51,292 5.1 36,222 3.7
----------- ------ ----------- ------
Total commercial loans............................ 611,272 61.1 591,741 60.2
Retail loans:
Single-family residential......................... 285,479 28.5 316,774 32.2
Home equity loans................................. 95,739 9.6 71,360 7.3
Other............................................. 7,934 0.8 2,704 0.3
----------- ------ ----------- ------
Total retail loans................................ 389,152 38.9 390,838 39.8
----------- ------ ----------- ------
Total loans receivable.............................. $ 1,000,424 100.0% $ 982,579 100.0%
=========== ====== =========== ======
Total loans increased 1.8% during the first nine months of 2004 as the
Company's efforts to increase total commercial loans continued. Total commercial
loans grew over 3% since December 31, 2003. Total loan originations, net of
principal repayments, for the nine months ended September 30, 2004 were $26.2
million.
Allowance for Losses on Loans. At September 30, 2004, the Bank's allowance
for losses on loans amounted to $16.5 million or 50.1% of the Bank's
non-performing loans and 1.65% of its total loans receivable. Management of the
Bank believes that, as of September 30, 2004, the allowance for losses on loans
was adequate.
The following is a summary of changes in the allowance for losses on loans
for the periods presented:
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
2004 2003
---- ----
(Dollars in thousands)
Balance at beginning of period...................... $ 10,453 $ 8,721
Provision for losses on loans....................... 8,829 1,489
Charge-offs......................................... (2,999) (473)
Recoveries.......................................... 223 173
------------ ------------
Balance at end of period............................ $ 16,506 $ 9,910
============ ============
22
See additional discussion for the increased provision for losses on loans
under the sub-heading "Provision for Losses on Loans" above.
During the third quarter of 2004, the Company charged-off two commercial
loans totaling $762,000. Prior to their charge-off, these two loans were already
classified and had combined reserve provisions totaling $513,000 at the
beginning of the third quarter of 2004.
Non-performing Assets. The following table provides information relating
to the Company's non-performing assets as of the dates indicated. The Company
has no loans past due greater than 90 days that are still accruing interest at
either date presented below.
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- ------------
(Dollars in thousands)
Non-accrual loans:
Commercial loans:
Commercial real estate.......................... $ 20,884 $ 11,460
Construction and land development............... 6,021 4,180
Commercial and industrial....................... 293 1,205
------------- -------------
Total commercial loans.......................... 27,198 16,845
Retail loans:
Single-family residential....................... 5,566 5,584
Home equity..................................... 164 272
Other........................................... 48 19
------------- -------------
Total retail loans.............................. 5,778 5,875
------------- -------------
Total non-accruing loans........................ 32,976 22,720
Other real estate owned, net......................... 590 206
------------- -------------
Total non-performing assets....................... $ 33,566 $ 22,926
============= =============
Performing troubled debt restructurings.............. $ 42 $ 296
Non-performing assets to total assets................ 2.35% 1.46%
Non-performing loans to total loans.................. 3.30 2.32
Total non-performing assets and troubled debt
restructurings to total assets.................... 2.35 1.48
The increase in non-performing commercial real estate loans from December
31, 2003 to September 30, 2004 was primarily related to the following:
- One loan totaling $8.8 million which is secured by a hotel in
Michigan and was transferred to non-accrual status during the third
quarter of 2004. The Company is negotiating a forbearance agreement
to obtain additional collateral of 15.4 acres of adjacent land along
with requiring a hotel consultant to assist with the hotel's
operation. As of September 30, 2004, the loan was considered an
impaired loan with an estimated loss allocation of $811,000.
- An $8.7 million loan which is secured by a full-service hotel in the
Chicago metropolitan area which was transferred to non-accrual
status during the second
23
quarter of 2004. Management is reviewing its options for this loan
and considering various alternatives including receiving additional
collateral or selling the loan to a third party. The loan was
considered impaired as of September 30, 2004 with an estimated loss
allocation of $3.5 million.
- Two loans totaling $2.2 million which were transferred to
non-accrual status during the second quarter of 2004. These loans
are secured by a golf course in Indiana. The Company has filed a
foreclosure action; however, management believes the loans will pay
off prior to any judicial sale. Based on the collateral value, the
Company believes there is no risk of loss related to these two loans
as of September 30, 2004.
Partially offsetting the increase in non-performing commercial real estate
loans from December 31, 2003 to September 30, 2004 were the following:
- the foreclosure on and transfer of a $4.5 million motel loan to real
estate owned prior to it being sold in the second quarter of 2004;
and
- the full payoff during the second quarter of 2004 of a $3.8 million
loan secured by a strip mall that was transferred to non-performing
status during the fourth quarter of 2003.
Included in the non-performing construction and land development loans are
the following loans:
- A $2.9 million loan participation that was transferred to
non-accrual status during the third quarter of 2004 at the direction
of the Office of Thrift Supervision (OTS). This loan was purchased
from a lending company that has filed for bankruptcy and is under
investigation for fraud. During October 2004, the underlying loan
was paid off in full; however, the proceeds are being held by the
bankruptcy trustee pending resolution of the case. A creditor's plan
has been set for confirmation in December 2004; therefore, the
Company expects resolution of the case to occur by the end of 2004
with the proceeds being received shortly thereafter. However, there
is no assurance the plan will be confirmed by that time or that the
case will be resolved by the end of 2004. The Company has identified
this loan as an impaired asset with a loss allocation estimated at
$715,000. While the Company currently believes its $2.9 million loan
is not substantially at risk of loss, the Company has nevertheless
established this loss allocation in accordance with OTS
requirements.
- A $2.8 million loan secured by a 144 unit apartment complex located
in Indiana. A receiver was appointed for this project and the
Company filed a foreclosure action prior to September 30, 2004. This
loan has been identified as an impaired asset with an estimated loss
allocation of $1.3 million.
The Company also has impaired loans that were performing as of September
30, 2004. These loans consist of the following:
- A $4.7 million commercial real estate loan secured by a hotel within
the greater Chicagoland area. Despite insufficient debt service
coverage, the loan is current due
24
to guarantor support. The Company continues to monitor the loan to
ensure the loan remains current. The loan was considered impaired as
of September 30, 2004 with an estimated loss allocation of $1.6
million.
- Three commercial real estate loans totaling $3.5 million which are
secured by a first mortgage on a golf course in northwest Indiana
and a third mortgage on a separate golf course in northwest Indiana.
Although the borrowers continue to make monthly payments, the loans
continue to be between 30 and 90 days past due. The estimated loss
allocation associated with these loans was $1.5 million as of
September 30, 2004.
- Two commercial and industrial loans, one of which was a line of
credit, to the same borrower totaling $1.0 million which are secured
by the business assets of a direct mail advertising service company
in Virginia. The Company signed a forbearance agreement to allow the
borrower time to market the business for sale. In conjunction with
the forbearance, the borrowers paid off the $150,000 line of credit
subsequent to September 30, 2004. The Company has identified an
estimated loss allocation of $790,000 associated with these loans.
Deposits and Borrowed Money. The following table sets forth the dollar
amount and the percentage of total deposits in each deposit category offered by
the Bank at the dates indicated.
SEPTEMBER 30, 2004 DECEMBER 31, 2003
--------------------------- --------------------------
AMOUNT PERCENTAGE AMOUNT PERCENTAGE
----------- ---------- ----------- ----------
(Dollars in thousands)
Checking accounts:
Non-interest bearing.............................. $ 45,576 5.4% $ 40,017 4.1%
Interest-bearing.................................. 91,049 10.7 91,385 9.3
Money market accounts................................ 137,566 16.2 123,799 12.7
Savings accounts..................................... 203,686 24.1 204,312 20.9
----------- ------ ----------- ------
Core deposits................................... 477,877 56.4 459,513 47.0
Certificates of deposit:
$100,000 or less.................................. 287,328 33.9 396,433 40.5
Over $100,000..................................... 82,148 9.7 122,494 12.5
----------- ------ ----------- ------
Time deposits................................... 369,476 43.6 518,927 53.0
----------- ------ ----------- ------
Total Deposits................................ $ 847,353 100.0% $ 978,440 100.0%
=========== ====== =========== ======
Deposits were $847.4 million at September 30, 2004 compared to $978.4
million at December 31, 2003. The decrease of $131.1 million was primarily the
result of a reduction of $149.5 million in certificates of deposit, partially
offset by an increase in core deposits of $18.4 million. The decrease in the
certificates was primarily due to the runoff of above-market rate certificates
as these certificates matured primarily during the second quarter of 2004.
The Company has made progress in reducing the cost of its deposits by
increasing its non-interest bearing deposits by 13.9% since December 31, 2003.
Total core deposits are also up 4.0% as of September 30, 2004 compared to
December 31, 2003. These increases are a direct result of the Company's
promotional efforts and retail incentive programs which focused on the
generation of low-cost core deposits.
25
Borrowed money consists of the following:
SEPTEMBER 30, 2004 DECEMBER 31, 2003
------------------- -------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
RATE AMOUNT RATE AMOUNT
-------- ---------- -------- ---------
(Dollars in thousands)
Secured advances from FHLB - Indianapolis:
Maturing in 2010 - fixed-rate 5.92% $ 400,000 5.92% $ 400,000
Maturing in 2014 - fixed-rate 6.71 1,227 6.71 1,244
Maturing in 2018 - fixed-rate 5.54 2,911 5.54 2,911
Maturing in 2019 - fixed-rate 6.32 7,691 6.32 7,835
Secured advances from FHLB - Chicago:
Maturing in 2008 - fixed-rate - - 5.26 6,500
---------- ---------
$ 411,829 $ 418,490
========== =========
Weighted-average stated interest rate 5.93% 5.92%
Advances with final maturities in 2010 contain quarterly call dates by the
FHLB through maturity. Advances maturing in 2019 are amortizing notes.
Management of the Company continues to explore the possibility of
refinancing the fixed-rate FHLB borrowings as the high cost of these advances
continued to have a significant adverse impact on the Company's net interest
margin. As such, the Company identified an opportunity to partially reduce the
negative impact of these borrowings by prepaying $6.5 million of advances
maturing in 2008 which bore a 5.26% fixed interest rate. The early repayment of
these advances resulted in a $485,000 charge to other non-interest expense
during the quarter ended September 30, 2004. The Company continues to analyze
the potential risks and rewards of prepaying all or a portion of its remaining
advances. The prepayment penalty is calculated and set by the FHLB pursuant to a
predetermined specified formula. As of September 30, 2004, the prepayment
penalty for all of the remaining $411.8 million in advances was estimated at
$46.2 million.
As part of the analysis of potential risks and rewards, the Company's
Asset/Liability Committee (ALCO) is evaluating various options to generate the
liquidity needed to pay the principal amount of the borrowings due along with
the penalty. The Committee's analysis includes the potential use of new
fixed-rate FHLB advances with maturities ranging from one to three years, new
variable-rate FHLB advances, brokered and retail deposits, and asset sales to
generate the needed liquidity.
If the advances are prepaid, the penalty would have a significant adverse
impact on the Company's financial results for the quarter and the year in which
the debt is repaid; however, the Company would begin to realize reduced interest
expense and a corresponding increase in its net interest margin. There can be no
assurances that the Company will prepay any of its remaining advances. The
Company cannot provide any assurance as to the total amount of the prepayment
penalty in the event that the Company does prepay either a portion or all of
these borrowings.
26
Pursuant to collateral agreements with the Federal Home Loan Bank of
Indianapolis (FHLB-IN), advances are secured by the following assets as of
September 30, 2004:
AMOUNT
DESCRIPTION OF COLLATERAL PLEDGED
- ------------------------- -----------
(Dollars in
thousands)
FHLB-IN stock $ 27,374
Residential first mortgage loans 290,216
Commercial first mortgage loans 231,984
Mortgage-backed securities 153,307
Agency securities 43,354
-----------
$ 746,235
===========
As of September 30, 2004, the Company had two lines of credit with a
maximum of $25.0 million and $15.0 million, respectively, in unsecured overnight
federal funds at the market rate for the purchase of federal funds at the time
of a request. During the third quarter, these lines were used for liquidity
purposes. As of September 30, 2004, these lines had a zero balance. The maximum
amount borrowed during the third quarter of 2004 was $10.5 million and the
weighted-average rate paid was 1.76%.
Capital Resources. Stockholders' equity was $152.4 million at September
30, 2004 compared to $156.0 million at December 31, 2003. The decrease was
primarily due to:
- the net loss of $1.9 million for the nine months;
- a decrease of $370,000 in unrealized gains on available-for-sale
securities, net of tax;
- dividends declared during the first nine months of 2004 totaling
$3.6 million; and
- repurchases of the Company's common stock during the first nine
months of 2004 totaling $869,000.
Partially offsetting the above decreases in stockholders' equity, the Company
also realized during the first nine months of 2004:
- vesting of $1.4 million of common stock under the Company's
Recognition and Retention Plan (RRP); and
- stock option exercises totaling $1.7 million.
At September 30, 2004, the Bank's regulatory capital was in excess of
regulatory limits set by the OTS. The current requirements and the Bank's actual
levels at September 30, 2004 and at December 31, 2003 are provided below:
27
TO BE WELL-CAPITALIZED
UNDER PROMPT
FOR CAPITAL ADEQUACY CORRECTIVE ACTION
ACTUAL PURPOSES PROVISIONS
------------------ --------------------- ----------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
-------- ------ ------- ------ -------- -----
(Dollars in thousands)
As of September 30, 2004:
Risk-based $140,337 12.82% $87,567 >8.00% $109,458 >10.00%
Tangible 128,612 9.07 21,274 >1.50 21,987 >2.00
Core 128,612 9.07 56,730 >4.00 70,913 >5.00
As of December 31, 2003:
Risk-based $141,974 13.04% $87,083 >8.00% $108,854 >10.00%
Tangible 131,521 8.46 23,307 >1.50 31,076 >2.00
Core 131,521 8.46 62,152 >4.00 77,690 >5.00
LIQUIDITY AND COMMITMENTS
The Company's liquidity, represented by cash and cash equivalents, is a
product of operating, investing and financing activities. The Company's primary
historical sources of funds are:
- deposits,
- scheduled payments of amortizing loans and mortgage-related
securities,
- prepayments and maturities of outstanding loans and mortgage-related
securities,
- maturities of investment securities and other short-term
investments,
- funds provided from operations, and o borrowings from the FHLB.
Scheduled payments from the amortization of loans, mortgage-related
securities, maturing investment securities, and short-term investments are
relatively predictable sources of funds, while deposit flows and loan
prepayments are greatly influenced by market interest rates, economic conditions
and competitive rate offerings. In addition, the Company invests excess funds in
federal funds sold and other short-term interest-earning assets which provide
liquidity to meet lending requirements.
At September 30, 2004, the Company had cash and cash equivalents of $64.0
million which was a decrease of $113.8 million from December 31, 2003. The
decrease was mainly caused by the following:
- a decrease in total deposits of $131.1 million;
- loan originations, net of principal payments received, of $26.2
million;
- decrease in borrowed funds of $6.7 million;
- purchases of property and equipment totaling $4.1 million; and
- dividends paid of $3.6 million.
28
Cash flows from operating activities also provided $11.6 million of liquidity
and net proceeds from maturities, paydowns and sales of securities provided
$38.8 million to slightly offset the above decreases in cash and cash
equivalents.
The Company uses its sources of funds primarily to meet its ongoing
commitments, fund loan commitments, pay maturing certificates of deposit and
savings withdrawals, and maintain a securities portfolio. The Company
anticipates that it will continue to have sufficient funds to meet its current
commitments. Should the Company choose to repay additional FHLB advances prior
to maturity, the Company expects that it would generate additional liquidity
through various options including using brokered certificates of deposit,
borrowing from the FHLB and utilizing the liquidity in its securities portfolio.
The liquidity needs of the parent company, CFS Bancorp, Inc., consist
primarily of operating expenses, dividend payments to stockholders and stock
repurchases. The primary sources of liquidity are cash and cash equivalents,
securities available-for-sale and dividends from the Bank. Under regulations of
the OTS, without prior approval, the dividends from the Bank are limited to the
extent of the Bank's cumulative earnings for the year plus the net earnings
(adjusted by prior distributions) of the prior two calendar years. On a parent
company-only basis, at September 30, 2004, the Company had $6.9 million in cash
and cash equivalents along with $5.4 million in securities available-for-sale.
CONTRACTUAL OBLIGATIONS. The following table presents significant fixed
and determinable contractual obligations to third parties by payment date as of
September 30, 2004.
PAYMENTS DUE BY PERIOD
---------------------------------------------------------------------
OVER ONE OVER THREE
ONE YEAR THROUGH THROUGH OVER FIVE
OR LESS THREE YEARS FIVE YEARS YEARS TOTAL
--------- ----------- ---------- --------- ---------
(Dollars in thousands)
FHLB advances (1)...... $ 218 $ 483 $ 554 $ 410,574 $ 411,829
Operating leases....... 562 767 166 - 1,495
--------- --------- --------- --------- ---------
$ 780 $ 1,250 $ 720 $ 410,574 $ 413,324
========= ========= ========= ========= =========
- ----------
(1) Does not include interest expense at the weighted-average stated rate of
5.93% for the periods presented.
See the "Deposits and Borrowed Money" section for further discussion
surrounding the Company's FHLB advances. The Company's operating lease
obligations reflected above include the future minimum rental payments, by year,
required under the lease terms for premises and equipment. Many of these leases
contain renewal options, and certain leases provide options to purchase the
leased property during or at the expiration of the lease period at specific
prices.
The Company also has commitments to fund maturing certificates of deposit
which are scheduled to mature within one year or less. These deposits totaled
$303.1 million at September
29
30, 2004. Based on historical experience and the fact that these deposits are at
current market rates, management believes that a significant portion of the
maturing deposits will remain with the Bank.
OFF-BALANCE SHEET OBLIGATIONS. The Company is a party to financial
instruments with off-balance sheet risk in the normal course of business to meet
the financing needs of its customers. These financial instruments involve, to
varying degrees, elements of credit risk in excess of the amount recognized in
the balance sheet. The Company's exposure to credit loss in the event of
non-performance by the third party for commitments to extend credit and letters
of credit is represented by the contractual notional amount of these
instruments. The Company uses the same credit policies in making commitments and
conditional obligations as it does for on-balance sheet instruments.
The following table details the amounts and expected maturities of
significant commitments as of September 30, 2004.
OVER ONE OVER THREE
ONE YEAR THROUGH THROUGH OVER FIVE
OR LESS THREE YEARS FIVE YEARS YEARS TOTAL
--------- ----------- ---------- --------- ---------
(Dollars in thousands)
Commitments to extend credit:
Commercial........................ $ 20,798 $ - $ - $ - $ 20,798
Retail............................ 14,609 - - - 14,609
Commitments to purchase loans:
Commercial........................ 28,500 - - - 28,500
Retail............................ - - - - -
Commitments to fund unused
construction loans................ 51,881 - - - 51,881
Commitments to fund unused lines of
credit:
Commercial........................ 46,378 - - - 46,378
Retail............................ 82,002 - - - 82,002
Letters of credit................... 6,962 1,016 2,866 - 10,844
Credit enhancements................. - 6,533 14,303 28,027 48,863
--------- --------- --------- --------- ---------
$ 251,130 $ 7,549 $ 17,169 $ 28,027 $ 303,875
========= ========= ========= ========= =========
The above listed commitments do not necessarily represent future cash
requirements, in that these commitments often expire without being drawn upon.
Letters of credit include credit enhancements which are related to the
issuance by municipalities of taxable and nontaxable revenue bonds. The proceeds
from the sale of such bonds are loaned to for-profit and not-for-profit
companies for economic development projects. In order for the bonds to receive a
triple-A rating which provides for a lower interest rate, the FHLB-IN issues, in
favor of the bond trustee, an Irrevocable Direct Pay Letter of Credit for the
account of the Bank. Since the Bank, in accordance with the terms and conditions
of a Reimbursement Agreement between the FHLB-IN and the Bank, would be required
to reimburse the FHLB-IN for draws against the Letter of Credit, these
facilities are analyzed, appraised, secured by real estate mortgages, and
monitored as if the Bank funded the project initially.
30
The Company has not used, and has no intention of using, any significant
off-balance sheet financing arrangements for liquidity purposes. In addition,
the Company has not had, and has no intention to have, any significant
transactions, arrangements or other relationships with any unconsolidated,
limited purpose entities that could materially affect the Company's liquidity or
capital resources. The Company has not traded in and has no intention of trading
in derivatives or commodity contracts.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Bank, like other financial institutions, is subject to interest rate
risk (IRR). IRR refers to the risk that changes in market interest rates might
adversely affect net interest income or the net portfolio value (NPV) of its
assets, liabilities, and off-balance sheet contracts. IRR is primarily the
result of an imbalance between the price sensitivity of the Bank's
interest-earning assets and its interest-bearing liabilities. These imbalances
can be caused by differences in the maturity, repricing, and coupon
characteristics of assets and liabilities as well as options (such as loan
prepayment options).
The Bank maintains a written Asset/Liability Management Policy that
establishes written guidelines for the asset/liability management function,
including the management of net interest margin and interest rate risk. The
Asset/Liability Management Policy falls under the authority of the Board of
Directors who in turn assigns its formulation, revision, and administration to
the Asset/Liability Committee (ALCO). The ALCO meets monthly and consists of
certain senior officers of the Bank and one outside director. The results of the
monthly meetings are reported to the Board of Directors. The primary duties of
the ALCO are to develop reports and establish procedures to measure and monitor
IRR, verify compliance with Board-approved IRR tolerance limits, take
appropriate actions to mitigate those risks, monitor and discuss the status and
results of implemented strategies and tactics, monitor the Bank's capital
position, review the current and prospective liquidity positions, and monitor
alternative funding sources.
While maintaining its interest rate spread objectives, the Bank attempts
to reduce interest rate risk with a variety of strategies designed to maintain
what the Bank believes to be an appropriate relationship between its assets and
liabilities. First, the Bank emphasizes the origination or purchase of real
estate mortgage loans and commercial loans with adjustable interest rates or
fixed rates of interest for an initial term of three or five years that convert
to an adjustable interest rate based on various indices plus a margin for the
remainder of the loan's contractual term. These indices include prime or the
constant maturity of United States Treasury obligations. At September 30, 2004,
the Bank had approximately $730.3 million of adjustable-rate loans in its loan
portfolio. Second, the Bank's securities portfolio consists primarily of
securities that have expected average lives of five years or less at time of
purchase. Third, the Bank has a substantial amount of savings, demand deposit
and money market accounts which the Bank believes may be less sensitive to
changes in interest rates than certificate of deposit accounts. At September 30,
2004, the Bank had $477.9 million of these types of accounts.
The Bank utilizes the OTS NPV model as its primary method of monitoring
its exposure to IRR. The NPV represents the excess of the present value of
expected cash flows from assets over the present value of expected cash flows
from liabilities. The NPV model estimates the sensitivity of the Bank's NPV over
a series of instantaneous and sustained parallel shifts in interest rates. On a
quarterly basis, the ALCO reviews the calculations of NPV as adjusted for
expected cash flows from off-balance sheets contracts, if any, for compliance
with Board-approved tolerance limits.
31
The table below presents, as of September 30, 2004 and December 31, 2003,
an analysis of the Bank's IRR as measured by changes in NPV for instantaneous
and sustained parallel shifts in the yield curve in 100 basis point (1%)
increments, up to 300 basis points (3%) and down 100 basis points in accordance
with OTS regulations. As illustrated in the table, the Bank's NPV in the base
case (0 basis point change) increased $725,000 from $138.2 million as of
December 31, 2003 to $138.9 million as of September 30, 2004.
Net Portfolio Value
---------------------------------------------------------------------
September 30, 2004 December 31, 2003
--------------------------------- ------------------------------
$ Amount $ Change % Change $ Amount $ Change % Change
-------- -------- -------- -------- -------- --------
Assumed Change in Interest
Rates (Basis Points) (dollars in thousands)
+300 $136,695 $ (2,218) (1.6%) $118,872 $(19,316) (14.0%)
+200 142,881 3,969 2.9 130,804 (7,385) (5.3)
+100 144,128 5,215 3.8 147,771 9,582 6.9
0 138,913 -- -- 138,188 -- --
-100 126,158 (12,755) (9.2) 130,281 (7,908) (5.7)
As modeled above, a decrease in interest rates of 100 basis points or an
increase in interest rates of 300 basis points would have an adverse impact on
the Bank's NPV while an increase in interest rates of 100 basis points or 200
basis points would have a positive impact on the Bank's NPV as of September 30,
2004. The changes in the interest rate risk profile of the Bank as of September
30, 2004 from December 31, 2003 is primarily due to the changes in interest
rates and changes in the mix of interest-earning assets and interest-bearing
liabilities. As of September 30, 2004 and December 31, 2003, the Bank was within
the Board-approved tolerance limits in each rate scenario.
This NPV model is a static model and does not consider potential
adjustments of strategies by management on a dynamic basis in a volatile rate
environment in order to protect or conserve equity values. As such, actual
results may vary from the modeled results. The above analysis includes the
assets and liabilities of the Bank only. Inclusion of Holding Company assets and
liabilities would increase NPV nominally at all levels.
ITEM 4. CONTROLS AND PROCEDURES
No change in the Company's internal control over financial reporting (as
defined in Rule 13a - 15(f) or 15(d) - 15(f) under the Securities Exchange Act
of 1934, as amended) occurred during the last fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
Management evaluated, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, the effectiveness of its
disclosure controls and procedures (as defined in Rules 13a - 15(e) or 15(d) -
15(e) under the Securities Exchange Act of 1934, as amended) as of the end of
the period covered by this report. Based on such evaluation, the Chief Executive
Officer and Chief Financial Officer have concluded that the Company's disclosure
controls and procedures are designed to ensure that information required to be
disclosed by the Company in the reports that it files or submits under the
Securities Exchange Act of 1934 is
32
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and regulations and are operating in an effective manner.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Bank's suit that was filed against the U.S. government during 1993
went to trial in June 2004 in the U.S. Court of Claims. The Bank had already
been granted summary judgment on its breach of contract claim, leaving for trial
the issue of damages. The trial concluded in early July 2004. The Bank
anticipates a ruling in the first half of 2005 following additional briefings.
The Bank is unable to predict the outcome of its damage claim against the United
States and the amount of damages that may be awarded to the Bank, if any, in the
event that a judgment is rendered in the Bank's favor. Consequently, the Bank
cannot give assurances as to the results of this claim or the timing of any
proceedings in relation thereto. The cost, including attorneys' fees, experts'
fees and related expenses, of the litigation was approximately $381,000 for the
third quarter of 2004. The Bank estimates that the expenses related to this case
will be less than $100,000 for the remainder of 2004.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(a) - (b) Not applicable.
(c) The following table presents information related to purchases made by
or on behalf of the Company of shares of the Company's common stock during the
indicated periods.
MAXIMUM NUMBER OF
TOTAL NUMBER OF SHARES THAT MAY YET
SHARES PURCHASED AS BE
TOTAL NUMBER PART OF PUBLICLY PURCHASED UNDER
OF SHARES AVERAGE PRICE ANNOUNCED PLANS THE PLANS OR
PERIOD PURCHASED PAID PER SHARE OR PROGRAMS PROGRAMS (8)
- -------------------- ------------ -------------- ------------------- -------------------
July 1-31, 2004 -- $ -- -- 1,181,268
August 1-31, 2004 -- -- -- 1,181,268
September 1-30, 2004 1,112 13.53 1,112 1,180,156
----- ------- ---------
Total 1,112 $ 13.53 1,112 1,180,156
===== ======= =========
- --------------
(1) The Company instituted a repurchase program for 1,200,000 shares in March
2003 which was publicly announced on March 17, 2003. Prior to July 1,
2004, a total of 18,732 shares had been repurchased under that program. A
total of 1,112 shares were purchased in September 2004 under this program.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
33
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 5. OTHER INFORMATION
Not applicable.
34
ITEM 6. EXHIBITS
(a) List of exhibits (filed herewith unless otherwise noted).
3.1 Certificate of Incorporation of CFS Bancorp, Inc.*
3.2 Bylaws of CFS Bancorp, Inc.*
4.0 Form of Stock Certificate of CFS Bancorp, Inc.*
10.1 Employment Agreement entered into between Citizens Financial
Services, FSB and Thomas F. Prisby**
10.2 Employment Agreement entered into between Citizens Financial
Services, FSB and James W. Prisby**
10.4 Employment Agreement entered into between CFS Bancorp, Inc. and
Thomas F. Prisby**
10.5 Employment Agreement entered into between CFS Bancorp, Inc. and
James W. Prisby**
10.7 CFS Bancorp, Inc. Amended and Restated 1998 Stock Option Plan***
10.8 CFS Bancorp, Inc. Amended and Restated 1998 Recognition and
Retention Plan and Trust Agreement***
10.9 CFS Bancorp, Inc. 2003 Stock Option Plan****
10.10 Employment Agreement entered into between Citizens Financial
Services, FSB and Charles V. Cole*****
10.11 Employment Agreement entered into between Citizens Financial
Services, FSB and Thomas L. Darovic*****
10.12 Employment Agreement entered into between CFS Bancorp, Inc. and
Charles V. Cole*****
10.13 Employment Agreement entered into between CFS Bancorp, Inc. and
Thomas L. Darovic*****
10.14 Separation Agreement entered into between Citizens Financial
Services, FSB, CFS Bancorp and James W. Prisby
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32.0 Section 1350 Certifications
- -------------
* Incorporated by Reference from the Company's Registration Statement on
Form S-1 filed on March 26, 1998, as amended and declared effective on May
14, 1998.
** Incorporated by Reference from the Company's quarterly report on Form 10-Q
for the quarterly period ended September 30, 2003.
*** Incorporated by Reference from the Company's Definitive Proxy Statement
for the Annual Meeting of Stockholders filed on March 23, 2001. ****
Incorporated by Reference from the Company's Definitive Proxy Statement
for the Annual Meeting of Stockholders filed on March 31, 2003.
***** Incorporated by Reference from the Company's annual report on Form 10-K
for the year ended December 31, 2003.
35
SIGNATURES
In accordance with the requirements of the Securities Exchange Act of 1934, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CFS BANCORP, INC.
Date: November 9, 2004 By: /s/ Thomas F. Prisby
-----------------------------------------
Thomas F. Prisby, Chairman and
Chief Executive Officer
Date: November 9, 2004 By: /s/ Charles V. Cole
-----------------------------------------
Charles V. Cole, Executive Vice President
and Chief Financial Officer
36