UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from __________ to __________
Commission file number 0-8679
BAYLAKE CORP.
(Exact name of registrant as specified in its charter)
Wisconsin 39-1268055
(State or other jurisdiction of (Identification No.)
incorporation or organization)
217 North Fourth Avenue, Sturgeon Bay, WI 54235
(Address of principal executive offices) (Zip Code)
(920)-743-5551
(Registrant's telephone number, including area code)
None
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes X No
----- -----
Applicable Only to Corporate Issuers:
Number of outstanding shares of each of common stock, par value $5.00 per share,
as of August 8, 2005: 7,725,777 shares
BAYLAKE CORP. AND SUBSIDIARIES
INDEX
PAGE NO.
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PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets (Unaudited) as of June 30, 2005 and
December 31, 2004 3
Consolidated Statements of Income and Comprehensive Income
(Unaudited) for the three and six months ended
June 30, 2005 and 2004 4
Consolidated Statements of Changes in Stockholders' Equity
(Unaudited) for the six months ended June 30, 2005 and 2004 5
Consolidated Statements of Cash Flows (Unaudited) for the
six months ended June 30, 2005 and 2004 6-7
Notes to Consolidated Unaudited Financial Statements 8-10
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 11-35
Item 3. Quantitative and Qualitative Disclosures About Market Risk 35-36
Item 4. Controls and Procedures 36
PART II - OTHER INFORMATION
Signatures 38
EXHIBIT INDEX
Exhibit 31.1 Certification pursuant to Section 302 39
Exhibit 31.2 Certification pursuant to Section 302 41
Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 43
Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 44
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, 2005 and December 31, 2004
(Amounts in thousands of dollars)
June 30, 2005 December 31,
(Unaudited) 2004
------------- ------------
ASSETS
Cash and due from financial institutions $ 26,064 $ 20,727
Federal funds sold -- 5,445
---------- ----------
Cash and cash equivalents 26,064 26,172
Securities available for sale 209,824 197,392
Loans held for sale 1,798 1,349
Loans, net of allowance after $9,564 and $10,445 786,221 746,783
Cash value of life insurance 22,447 21,561
Premises and equipment, net 28,085 24,777
Federal Home Loan Bank stock 7,908 7,697
Foreclosed assets, net 2,096 2,572
Goodwill 5,723 5,723
Accrued interest receivable 5,278 4,330
Other assets 9,791 9,392
---------- ----------
Total assets $1,105,235 $1,047,748
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest-bearing $ 110,981 $ 120,511
Interest-bearing 733,971 724,030
---------- ----------
Total deposits 844,952 844,541
Federal Home Loan Bank advances 115,188 100,192
Federal funds purchased and repurchase agreements 41,585 1,284
Subordinated debentures 16,100 16,100
Accrued expenses and other liabilities 8,895 8,272
Dividends payable -- 1,154
---------- ----------
Total liabilities 1,026,720 971,543
Common stock, $5 par value, authorized 50,000,000;
issued-7,748,936 shares in 2005, 7,715,936
shares in 2004; outstanding-7,725,777 shares in
2005, 7,692,777 shares in 2004 38,745 38,580
Additional paid-in capital 9,056 8,806
Retained earnings 31,110 28,275
Treasury stock (23,159 shares in 2005 and 2004) (625) (625)
Accumulated other comprehensive income 229 1,169
---------- ----------
Total stockholders' equity 78,515 76,205
---------- ----------
Total liabilities and stockholder equity $1,105,235 $1,047,748
========== ==========
See accompanying notes to Unaudited Consolidated Financial Statements.
3
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three and Six Months ended June 30, 2005 and 2004
(Amounts in thousands of dollars except per share data)
Three months ended June 30 Six months ended June 30
-------------------------- ------------------------
2005 2004 2005 2004
------- ------- ------- -------
Interest and dividend income
Loans, including fees $12,944 $10,223 $24,607 $20,113
Taxable securities 1,729 1,638 3,458 3,214
Tax exempt securities 489 374 892 766
Federal funds sold and other 16 4 33 7
------- ------- ------- -------
Total interest and dividend income 15,178 12,239 28,990 24,100
------- ------- ------- -------
Interest expense
Deposits 4,494 2,810 8,321 5,828
Federal funds purchased and repurchase agreements 318 110 491 222
Federal Home Loan Bank advances and other debt 1,014 544 1,751 1,023
Subordinated debentures 462 435 923 847
------- ------- ------- -------
Total interest expense 6,288 3,899 11,486 7,920
------- ------- ------- -------
NET INTEREST INCOME 8,890 8,340 17,504 16,180
Provision for loan losses 91 724 121 1,499
------- ------- ------- -------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 8,799 7,616 17,383 14,681
------- ------- ------- -------
Other income
Fees from fiduciary activities 184 188 363 362
Fees from loan servicing 288 234 571 477
Fees for other services to customers 1,185 1,194 2,283 2,164
Gains from sales of loans 177 317 385 625
Increase in cash surrender value of life insurance 190 194 417 392
Other income 256 649 524 726
------- ------- ------- -------
Total other income 2,280 2,776 4,543 4,746
------- ------- ------- -------
Noninterest expenses
Salaries and employee benefits 4,329 3,944 8,857 7,809
Occupancy expense 602 529 1,138 1,051
Equipment expense 340 299 647 668
Data processing and courier 298 272 576 555
Operation of other real estate 81 146 129 271
Other operating expenses 1,695 1,411 3,043 2,619
------- ------- ------- -------
Total other expenses 7,345 6,601 14,390 12,973
------- ------- ------- -------
INCOME BEFORE INCOME TAX EXPENSE 3,734 3,791 7,536 6,454
Income tax expense 1,174 1,198 2,392 1,965
------- ------- ------- -------
NET INCOME $ 2,560 $ 2,593 $ 5,144 $ 4,489
------- ------- ------- -------
COMPREHENSIVE INCOME (LOSS) $ 3,612 $(1,132) $ 4,204 $ 2,174
------- ------- ------- -------
BASIC EARNINGS PER SHARE $ 0.33 $ 0.34 $ 0.67 $ 0.59
DILUTED EARNINGS PER SHARE $ 0.33 $ 0.34 $ 0.66 $ 0.58
See accompanying notes to Unaudited Consolidated Financial Statements.
4
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
Six months ended June 30,
(Amounts in thousands of dollars except for per share data)
Accumulated
Common Stock Additional Other
------------------- Paid-in Retained Treasury Comprehensive Total
Shares Amount Capital Earnings Stock Income Equity
--------- ------- ---------- -------- -------- ------------- -------
BALANCE, JANUARY 1, 2004 7,604,977 $38,141 $8,163 $21,864 $(625) $ 2,085 $69,628
Net income for the year -- -- -- 4,489 -- -- 4,489
Net changes in unrealized gain (loss)
on securities available for sale,
net of $(1,284) deferred taxes -- -- -- -- -- (2,315) (2,315)
-------
Total comprehensive income 2,174
Stock options exercised 48,300 241 272 -- -- -- 513
Tax benefit from exercise of stock options -- -- 76 -- -- -- 76
Cash dividends declared ($0.28 per share) -- -- -- (2,136) -- -- (2,136)
--------- ------- ------ ------- ----- ------- -------
BALANCE, JUNE 30, 2004 7,653,277 $38,382 $8,511 $24,217 $(625) $ (230) $70,255
========= ======= ====== ======= ===== ======= =======
BALANCE, JANUARY 1, 2005 7,692,777 $38,580 $8,806 $28,275 $(625) $ 1,169 $76,205
Net income for the year -- -- -- 5,144 -- -- 5,144
Net changes in unrealized gain (loss)
on securities available for sale,
net of $(526) deferred taxes -- -- -- -- -- (940) (940)
-------
Total comprehensive income 4,204
Stock options exercised 33,000 165 134 -- -- -- 299
Tax benefit from exercise of stock options -- -- 116 -- -- -- 116
Cash dividends declared ($0.30 per share) -- -- -- (2,309) -- -- (2,309)
--------- ------- ------ ------- ----- ------- -------
BALANCE, JUNE 30, 2005 7,725,777 $38,745 $9,056 $31,110 $(625) $ 229 $78,515
========= ======= ====== ======= ===== ======= =======
See accompanying notes to Unaudited Consolidated Financial Statements.
5
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Six months ended June 30, 2005 and 2004
(Amounts in thousands of dollars)
2005 2004
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Reconciliation of net income to net cash provided by
operating activities:
Net income $ 5,144 $ 4,489
Adjustments to reconcile net income to net cash
provided to operating activities:
Depreciation and amortization 900 877
Provision for losses on loans 121 1,499
Net amortization of securities 314 256
Increase in cash surrender value of life insurance (417) (391)
Federal Home Loan Bank stock dividend (211) (227)
Net realized gain on sale of securities -- --
Net gain on sale of loans (385) (625)
Proceeds from sale of loans held for sale 8,572 32,189
Origination of loans held for sale (8,635) (31,399)
Net gain from disposal of other real estate 28 (64)
Net (gain) loss from disposal of bank premises and equipment 151 (482)
Changes in assets and liabilities:
Accrued interest receivable and other assets (706) (1,297)
Accrued expenses and other liabilities 623 1,329
-------- --------
Net cash provided by operating activities 5,498 6,154
CASH FLOWS FROM INVESTING ACTIVITIES:
Principal payments on securities available-for-sale 6,675 17,013
Purchase of securities available-for-sale (20,886) (24,454)
Proceeds from sale of other real estate owned 828 1,170
Proceeds from sale of premises and equipment 290 --
Loan originations and payments, net (39,939) (30,680)
Additions to premises and equipment (4,649) (2,166)
Investment in bank-owned life insurance (469) --
-------- --------
Net cash used in investing activities (58,150) (39,117)
See accompanying notes to Unaudited Consolidated Financial Statements.
6
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six months ended June 30, 2005 and 2004
(Amounts in thousands of dollars)
2005 2004
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits $ 411 $(3,668)
Net change in federal funds purchased and
repurchase agreements 40,301 10,219
Proceeds from Federal Home Loan Bank advances 15,000 25,105
Repayments on Federal Home Loan Bank advances (4) (2)
Payments on other borrowings and long-term debt -- (53)
Proceeds from exercise of stock options 299 513
Cash dividends paid (3,463) (3,197)
------- -------
Net cash provided by financing activities 52,544 28,917
------- -------
Net change in cash and cash equivalents (108) (4,046)
Beginning cash and cash equivalents 26,172 24,226
------- -------
ENDING CASH AND CASH EQUIVALENTS $26,064 $20,180
======= =======
See accompanying notes to Unaudited Consolidated Financial Statements.
7
BAYLAKE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
JUNE 30, 2005
1. The accompanying consolidated financial statements should be read in
conjunction with Baylake Corp.'s 2004 annual report on Form 10-K. The
accompanying consolidated financial statements are unaudited. These interim
financial statements are prepared in accordance with the requirements of
Form 10-Q, and accordingly do not include all of the information and
footnotes required by U.S. generally accepted accounting principles for
complete financial statements. In the opinion of management, the unaudited
financial information included in this report reflects all adjustments,
consisting of normal recurring accruals, which are necessary for a fair
statement of the financial position as of June 30, 2005 and December 31,
2004. The results of operations for the three and six months ended June 30,
2005 are not necessarily indicative of results to be expected for the
entire year.
2. To prepare financial statements in conformity with U.S. generally accepted
accounting principles, management makes estimates and assumptions based on
available information. These estimates and assumptions affect the amounts
reported in the financial statements and the disclosures provided, and
actual results could differ. The allowance for loan losses, foreclosed
assets, and fair values of financial instruments are particularly subject
to change.
3. Diluted earnings per share, which reflects the potential dilution that
could occur if outstanding stock options were exercised and stock awards
were fully vested and resulted in the issuance of common stock that then
shared in the earnings of the Company, is computed by dividing net income
by weighted average number of common shares and common stock equivalents.
The following table shows the computation of the basic and diluted earnings
per share for the three and six months ended June 30 (dollars in thousands,
except per share amounts):
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
(Net income in thousands)
2005 2004 2005 2004
---------- ---------- ---------- ----------
(NUMERATOR):
Net income $ 2,560 $ 2,593 $ 5,144 $ 4,489
(DENOMINATOR):
Weighted average number of common
shares outstanding-basic 7,700,952 7,631,002 7,698,351 7,621,679
Dilutive effect of stock options 97,143 76,390 94,323 73,140
---------- ---------- ---------- ----------
Weighted average number of common
shares outstanding-diluted 7,798,095 7,707,392 7,792,674 7,694,819
BASIC EPS $ 0.33 $ 0.34 $ 0.67 $ 0.59
DILUTED EPS $ 0.33 $ 0.34 $ 0.66 $ 0.58
8
BAYLAKE CORP. AND SUBSIDIARIES
4. Baylake Corp. declared a cash dividend of $0.15 per share paid on June 15,
2005 to shareholders of record as of June 1, 2005.
5. The Company has a non-qualified stock option plan, which is described more
fully in the Company's December 31, 2004 Annual Report on Form 10-K. The
Company accounts for this plan under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted under
these plans had an exercise price at least equal to the fair market value
of the underlying common stock on the grant date. The following table
illustrates the effect on net income and earnings per share if the Company
had applied the fair value provisions of SFAS 123 "Accounting for
Stock-Based Compensation," to stock-based employee compensation.
Three months ended Six months ended
June 30, June 30,
------------------ ----------------
(In thousands, except
per share amounts)
2005 2004 2005 2004
------ ------ ------ ------
Net income, as reported $2,560 $2,593 $5,144 $4,489
Less: Total stock-based
compensation cost determined
under the fair value based
method, net of income taxes (15) (28) (29) (55)
------ ------ ------ ------
Pro forma net income 2,545 2,565 5,115 4,434
Basic-as reported $ 0.33 $ 0.34 $ 0.67 $ 0.59
Basic-pro forma $ 0.33 $ 0.34 $ 0.66 $ 0.58
Diluted-as reported $ 0.33 $ 0.34 $ 0.66 $ 0.58
Diluted-pro forma $ 0.33 $ 0.33 $ 0.66 $ 0.58
The fair value of each option granted was estimated as of the date of grant
using the Black-Scholes option pricing model. The resulting compensation
cost was amortized over the vesting period.
6. Certain amounts reported in the June 30, 2004 Form 10-Q have been
reclassified to conform to the June 30, 2005 presentation.
7. Included in the totals for Premises and Equipment is $5.9 million related
to the construction project for Baylake City Center LLC. The $5.9 million
relates to the purchase and remodeling costs of an existing retail building
purchased by Baylake Bank's subsidiary, Baylake City Center LLC and totals
139,000 square feet. At June 2005, the completion of the project relative
to a bank branch were completed and the office became open for business.
Costs for this project have amounted to $2.4 million to date. The space
occupied is 25,000 square feet. Approximately 91,000 square feet of the
project will be sold for office and condominium use. This portion of the
property has been listed for sale with a commercial
9
BAYLAKE CORP. AND SUBSIDIARIES
real estate brokerage firm. The estimated costs allocated to this portion
of the project amounts to $3.5 million.
8. Effect of Newly Issued But Not Yet Effective Accounting Standards: FAS 123R
requires all public companies to record compensation cost for stock options
provided to employees in return for employee service. The cost is measured
at the fair value of the options when granted, and this cost is expensed
over the employee service period, which is normally the vesting period of
the options. This will apply to awards granted or modified after the first
year beginning after June 15, 2005. Compensation cost will also be recorded
for prior option grants that vest after the date of adoption. The effect on
results of operations will depend on the level of future option grants and
the calculation of the fair value of the options granted at such future
date, as well as the vesting periods provided, and so cannot currently be
predicted. The Company has ceased issuing stock options under the current
plan and thus expects no further grants. However, the plan is still in
existence and the Company has reserved the right to grant additional
options. Existing options that will vest after the adoption date are
expected to result in an immaterial amount of compensation expense during
2005 though 2008.
SOP 03-3 requires that a valuation allowance for loans acquired in a
transfer, including in a business combination, reflect only losses incurred
after acquisition and should not be recorded at acquisition. It applies to
any loan acquired in a transfer that showed evidence of credit quality
deterioration since it was made.
The effect of these new standards on the Company's financial position and
results of operations is not expected to be material upon adoption.
10
PART 1 - FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Baylake is a full-service financial services company, providing a wide variety
of loan, deposit and other banking products and services to its business,
individual or retail, and municipal customers, as well as a full range of trust,
investment and cash management services. The Company is the bank holding company
of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member
bank of the Federal Reserve and Federal Home Loan Bank.
The following sets forth management's discussion and analysis of the
consolidated financial condition and results of operations of Baylake Corp.
("Baylake" or the "Company") for the three and six months ended June 30, 2005
and 2004 which may not be otherwise apparent from the consolidated financial
statements included in this report. Unless otherwise stated, the "Company" or
"Baylake" refers to this entity and to its subsidiaries on a consolidated basis
when the context indicates. For a more complete understanding, this discussion
and analysis should be read in conjunction with the financial statements,
related notes, the selected financial data and the statistical information
presented elsewhere in this report.
FORWARD-LOOKING INFORMATION
This discussion and analysis of financial condition and results of operations,
and other sections of this report, may contain forward-looking statements that
are based on the current expectations of management. Such expressions of
expectations are not historical in nature and are forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
Words such as "anticipates," "believes," "estimates," "expects," "forecasts,"
"intends," "is likely," "plans," "projects," and other such words are intended
to identify in such forward-looking statements. The statements contained herein
and in such forward-looking statements involve or may involve certain
assumptions, risks and uncertainties, many of which are beyond the control of
the Company, that may cause actual future results to differ materially from what
may be expressed or forecasted in such forward-looking statements. Readers
should not place undue expectations on any forward-looking statements. In
addition to the assumptions and other factors referenced specifically in
connection with such statements, the following factors could impact the business
and financial prospects of the relationships; demand for financial products and
financial services; the degree of competition by traditional and non-traditional
financial services competitors; changes in banking legislation or regulations;
changes in tax laws and the results of recent Wisconsin state tax developments;
changes in interest rates; changes in prices; the impact of technological
advances; governmental and regulatory policy changes; trends in customer
behavior as well as their ability to repay loans; and changes in the general
economic conditions, nationally or in the State of Wisconsin.
11
CRITICAL ACCOUNTING POLICIES
In the course of the Company's normal business activity, management must select
and apply many accounting policies and methodologies that lead to the financial
results presented in the consolidated financial statements of the Company. Some
of these policies are more critical than others.
Allowance for Loan Losses: The allowance for loan losses ("ALL") is a valuation
allowance for probable incurred credit losses. Loan losses are charged against
the allowance when management believes the uncollectibility of a loan balance is
confirmed. Subsequent recoveries, if any, are credited to the allowance.
Management estimates the allowance balance required using past loan loss
experience, the nature and volume of the portfolio, information about specific
borrower situations and the estimated collateral values, economic conditions,
and other factors. Allocations of the allowance may be made for specific loans,
but the entire allowance is available for any loan that, in management's
judgment, should be charged-off.
The allowance consists of specific and general components. The specific
component relates to loans that are individually classified as impaired or loans
otherwise classified as substandard or doubtful. The general component covers
non-classified loans and is based on historical loss experience adjusted for
current factors.
A loan is impaired when full payment under the loan terms is not expected.
Commercial and commercial real estate loans are individually evaluated for
impairment. If a loan is impaired, a portion of the allowance is allocated so
that the loan is reported, net, at the present value of estimated future cash
flows using the loan's existing rate or at the fair value of collateral, if
repayment is expected solely from the collateral. Large groups of smaller
balance homogeneous loans, such as consumer and residential real estate loans,
are collectively evaluated for impairment, and accordingly, they are not
separately identified for impairment disclosures.
Goodwill: Goodwill results from business acquisitions and represents the excess
of the purchase price over the fair value of the acquired tangible assets and
liabilities and identifiable intangible assets. Goodwill is assessed at least
annually for impairment, and any such impairment will be recognized in the
period identified.
Income tax accounting: The assessment of tax assets and liabilities involves the
use of estimates, assumptions, interpretations, and judgments concerning certain
accounting pronouncements and federal and state tax codes. There can be no
assurance that future events, such as court decisions or positions of federal
and state taxing authorities, will not differ from management's current
assessment, the impact of which could be significant to the consolidated results
of the Company's operations and reported earnings. The Company believes that the
tax assets and liabilities are adequate and properly recorded in the
consolidated financial statements.
Income tax expense may be affected by developments in the state of Wisconsin.
Like many financial institutions that are located in Wisconsin, a subsidiary of
the Bank located in the state of Nevada holds and manages various investment
securities. Due to that fact that these subsidiaries are out of state, income
from their operations has not been subject to Wisconsin state taxation. Although
the Wisconsin Department of Revenue issued favorable tax rulings regarding
Nevada subsidiaries of Wisconsin financial institutions, the Department
representatives have recently stated that the Department intends to revoke those
rulings and tax some or all these subsidiaries' income, even though there has
been no intervening change in the law. The Department also implemented a program
in 2003 for the audit of Wisconsin financial institutions who have
12
formed and contributed assets to subsidiaries located in Nevada; to date, the
Company and its subsidiaries have not been audited on these matters.
The Department sent letters in July 2004 to financial institutions in Wisconsin,
whether or not they are undergoing an audit, reporting on settlements involving
17 banks and their out-of-state investment subsidiaries. The letter provided a
summary of currently available settlement parameters. For periods before 2004,
they include: restrictions on the types of subsidiary income excluded from
Wisconsin taxation; assessment of certain back taxes for a limited period of
time; and interest (but not penalties) on any past-due taxes. For 2004 and going
forward, there are similar provisions plus limits on the amount of subsidiaries'
assets as to which their income will be excluded from Wisconsin tax. Settlement
on the terms outlined would result in the Department's rescission of related
prior letter rulings, and would purport to be binding going forward except for
future legislation or change by mutual agreement. By implication, the Department
appears to accept the general proposition that some out-of-state investment
subsidiary income is not subject to Wisconsin taxes.
The Company continues to believe that it has reported income and paid Wisconsin
taxes correctly in accordance with applicable tax laws and the Department's
prior longstanding interpretations thereof, including interpretations issued
specifically to it. However, in view of the Department's subsequent change in
position (even if that change does not have a basis in law), the aggressive
stance now being taken by the Department, the settlements by some other banks,
and the potential effect that decisions by other similarly situated institutions
may have on the Company's alternatives going forward, the Company has determined
that it would be prudent to obtain and consider a settlement proposal from the
Department; however, the Company has not yet received a specific proposal nor
has any assessment been made against the Company or its subsidiaries. The
Company will need to review any settlement proposal in more specific detail to
quantify in any definitive way the Department's view of its exposure and to
evaluate alternatives. Although there will likely be challenges to the
Department's actions and interpretations, the Bank's net income would be reduced
if the Department succeeds in its actions and interpretations. The Bank could
also incur costs in the future to address any action taken against it by the
Department.
RESULTS OF OPERATIONS
The following table sets forth the Company's net income and related summary
information for the three and six-months periods ended June 30, 2005 and 2004,
as well as comparisons between the respective periods.
TABLE 1
SUMMARY RESULTS OF OPERATIONS
($ in thousands, except per share data)
Three months Three months Six months Six months
ended June 30, ended June 30, ended June 30, ended June 30,
2005 2004 2005 2004
-------------- -------------- -------------- --------------
Net income, as reported $2,560 $2,593 $5,144 $4,489
EPS-basic, as reported $ 0.33 $ 0.34 $ 0.67 $ 0.59
EPS-diluted, as reported $ 0.33 $ 0.34 $ 0.66 $ 0.58
Cash dividends declared $ 0.15 $ 0.14 $ 0.30 $ 0.28
Return on average assets, as reported 0.95% 1.04% 0.97% 0.91%
Return on average equity, as reported 13.31% 14.54% 13.49% 12.69%
Efficiency ratio, as reported (1) 65.76% 57.96% 65.27% 60.39%
13
(1) Non-interest expense divided by sum of taxable equivalent net interest
income plus non-interest income, excluding investment securities gains, net
The decrease in net income for the three-month period is primarily due to an
increase in non-interest expense and a decrease in other income. These were
partially offset by an increase in net interest income and a reduction in the
provision for loan losses. The increase in net income for the six-month period
is primarily due to increased net interest income and a reduction in the
provision for loan losses. These increases were partially offset by a decrease
in other income and an increase in non-interest expense and income tax expense.
Net Interest Income
Net interest income is the largest component of the Company's operating income
(net interest income on a tax-equivalent basis plus other non-interest income),
accounting for 80.2% of total operating income for the three months ended June
30, 2005, as compared to 75.6% for the same period in 2004. Net interest income
represents the difference between interest earned on loans, investments and
other interest earning assets offset by the interest expense attributable to the
deposits and the borrowings that fund such assets. Interest fluctuations
together with changes in the volume and types of earning assets and
interest-bearing liabilities combine to affect total net interest income. This
analysis discusses net interest income on a tax-equivalent basis in order to
provide comparability among the various types of earned interest income.
Tax-exempt interest income is adjusted to a level that reflects such income as
if it were fully taxable.
Net interest income on a tax equivalent basis for the three months ended June
30, 2005 increased $609,000, or 7.1%, to $9.2 million from $8.6 million over the
comparable period a year ago. The increase results from increased loan levels
offset partially by a decrease in net interest margin. During the six months
ended June 30, 2005, net interest income increased $1.4 million, or 8.4%, to
$18.1 million from $16.7 million for the comparable period in 2004. The increase
results from improvement in net interest margin and increased loan levels.
Net interest margin is tax-equivalent net interest income expressed as a
percentage of average earning assets. The net interest margin exceeds the
interest rate spread because of the use of non-interest bearing sources of funds
to fund a portion of earning assets. As a result, the level of funds available
without interest cost (demand deposits and equity capital) is an important
component increasing net interest margin.
The net interest margin for the second quarter of 2005 was 3.67%, down 3 basis
points ("bps") from 3.70% for the comparable period in 2004. This comparable
period decrease was attributable to a 12 bps decrease in interest rate spread
(the net result of a 80 bps increase in the yield on earning assets offset by a
92 bps increase in the cost of interest-bearing liabilities). During the six
months ended June 30, 2005, the net interest margin was 3.67% compared to 3.63%
for the comparable period in 2004. Net interest margin improved as a result of
an increase in earning assets relative to interest-bearing liabilities offset
partially by a 4 bps decrease in interest rate
14
spread (the net result of a 64 bps increase in the yield on earning assets
offset by a 68 bps increase in the cost of interest-bearing liabilities).
As the Federal Reserve Board ("FRB") has steadily increased interest rates
during the latter half of 2004 and the first half of 2005, average interest
rates were higher in 2005 than in 2004. Interest rates rose steadily during the
period with four rate increases totaling 100 bps between the comparable first
six month periods. The Company had positioned the balance sheet to be slightly
asset sensitive (which means that assets will re-price faster than liabilities);
thus, the rate increases impacted net interest income positively. The Company
expects that in a gradually increasing interest rate environment, we would
continue to anticipate that our income statement would benefit from asset
sensitivity over the long term, although changes in the portfolio or the pace of
increases could affect that trend. For instance, net interest margin decreased
in the second quarter as a result of deposit mix which caused short-term
deposits to re-price slightly higher relative to the changes occurring in the
re-pricing within the loan portfolio.
For the three months ended June 30, 2005, average-earning assets increased $72.5
million, or 7.8%, when compared to the same period last year. The Company
recorded an increase in average loans of $50.5 million, or 6.8%, for the second
quarter of 2005 compared to the same period a year ago. For the six months ended
June 30, 2005, average-earning assets increased $67.0 million, or 7.3%, when
compared to the same period last year. The Company recorded an increase in
average loans of $45.4 million, or 6.2%, for the first six months of 2005
compared to the same period a year ago. Although they tend to have more risk,
loans have typically resulted in higher rates of interest income to the Company
than have investment securities, which further positively affected income in the
quarter.
Interest rate spread is the difference between the tax-equivalent rate earned on
average earning assets and the rate paid on average interest-bearing
liabilities. The interest rate spread decreased for the quarter ended June 30,
2005 when compared to the same period a year ago. The interest rate spread
decreased 11 bps to 3.37% at June 30, 2005 from 3.48% in the same quarter in
2004. While the average yield on earning assets increased 80 bps during the
period, the average rate paid on interest-bearing liabilities increased 92 bps
over the same period. For the six months ended June 30, 2005, the interest rate
spread decreased 3 bps to 3.38% from 3.41% when compared to the same period a
year earlier. The average yield on earning assets increased 64 bps to 5.98% from
5.34% during the six-month period, while the average rate paid on
interest-bearing liabilities increased 68 bps. The increase in the rates paid on
interest-bearing liabilities occurred as a result of a higher cost of funding
from deposits and other wholesale funding such as federal funds purchased and
loans from the Federal Home Loan Bank. We would expect that trend to continue in
light of the recent Federal Reserve Board interest rate increases.
15
TABLE 2
NET INTEREST INCOME ANALYSIS ON A TAX -EQUIVALENT BASIS
($ in thousands)
Three months ended June 30,
2005 2004
------------------------------- -------------------------------
Interest Average Interest Average
Average income/ yield/ Average income/ yield/
Balance expense Rate Balance expense rate
---------- -------- ------- ---------- -------- -------
ASSETS
Earning assets:
Loans, net $ 790,764 $13,024 6.59% $ 740,244 $10,303 5.57%
Taxable securities 167,638 1,730 4.13% 157,458 1,638 4.16%
Tax exempt securities 43,477 739 6.80% 31,796 566 7.12%
Federal funds sold and
interest bearing due from banks 2,541 16 2.52% 2,421 4 0.66%
---------- ------- ----- ---------- ------- -----
Total earning assets 1,004,420 15,509 6.18% 931,919 12,511 5.37%
---------- ------- ----- ---------- ------- -----
Non-interest earning assets 81,328 72,498
---------- ----------
Total assets $1,085,748 $1,004,417
---------- ----------
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
Total interest-bearing deposits 723,435 4,494 2.48% 678,704 2,810 1.66%
Short-term borrowings 37,798 310 3.28% 31,514 107 1.36%
Customer repurchase agreements 1,170 8 2.74% 1,100 3 1.09%
Federal Home Loan Bank advances 115,262 1,014 3.52% 97,888 544 2.22%
Subordinated debentures 16,100 462 11.48% 16,100 435 10.81%
---------- ------- ----- ---------- ------- -----
Total interest-bearing liabilities $ 893,765 $ 6,288 2.81% $ 825,306 $ 3,899 1.89%
---------- ------- ----- ---------- ------- -----
Demand deposits 105,922 99,773
Accrued expenses and other liabilities 8,891 7,618
Stockholders' equity 77,170 71,720
---------- ----------
Total liabilities and stockholders' equity $1,085,748 $1,004,417
---------- ----------
Interest rate spread $ 9,221 3.37% $ 8,612 3.48%
Net interest margin 3.67% 3.70%
----- -----
16
TABLE 3
NET INTEREST INCOME ANALYSIS ON A TAX -EQUIVALENT BASIS
($ in thousands)
Six months ended June 30,
2005 2004
------------------------------- -------------------------------
Interest Average Interest Average
Average income/ yield/ Average income/ yield/
Balance expense Rate Balance expense rate
---------- -------- ------- ---------- -------- -------
ASSETS
Earning assets:
Loans, net $ 778,416 $24,780 6.37% $733,015 $20,274 5.53%
Taxable securities 168,524 3,458 4.10% 154,553 3,214 4.16%
Tax exempt securities 39,360 1,351 6.86% 32,757 1,160 7.08%
Federal funds sold and interest
bearing due from banks 2,911 33 2.27% 1,929 7 0.73%
---------- ------- ----- -------- ------- -----
Total earning assets 989,211 29,622 5.99% 922,254 24,655 5.35%
---------- ------- ----- -------- ------- -----
Non-interest earning assets 78,963 71,507
---------- --------
Total assets $1,068,174 $993,761
---------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
Total interest-bearing deposits 722,533 8,321 2.30% 678,447 5,828 1.72%
Short-term borrowings 30,527 475 3.11% 32,343 217 1.34%
Customer repurchase agreements 1,354 16 2.36% 1,062 5 0.94%
Federal Home Loan Bank advances 108,643 1,751 3.22% 90,336 1,023 2.26%
Subordinated debentures 16,100 923 11.47% 16,100 847 10.52%
---------- ------- ----- -------- ------- -----
17
Total interest-bearing liabilities $ 879,157 $11,486 2.61% $818,288 $ 7,920 1.94%
---------- ------- ----- -------- ------- -----
Demand deposits 103,979 97,199
Accrued expenses and other liabilities 8,132 7,110
Stockholders' equity 76,906 71,164
---------- --------
Total liabilities and stockholders' equity $1,068,174 $993,761
---------- --------
Interest rate spread $18,136 3.38% $16,735 3.41%
Net interest margin 3.67% 3.63%
----- -----
The ratio of average earning assets to average total assets measures
management's ability to employ overall assets for the production of interest
income. This ratio was 92.6% and 92.8%, respectively, for the first six months
of 2005 and 2004, respectively.
Provision for Loan Losses
The provision for loan losses ("PFLL") is the cost of providing an allowance for
probable incurred losses. Prior to the third quarter of 2004, the Company
determined the allowance by risk rating loans that were classified as
substandard or doubtful thru a grading process that was predicated on various
risk rating matrices and the assignment of potential loss based on those
ratings. In addition, the remaining loans in the portfolio were assigned risk
weightings based on their various classifications. During the third quarter of
2004, the Company further enhanced its methodologies to individually review
substandard and doubtful loans for impairment and bring other factors into the
process to evaluate the ALL. The Company made these enhancements to more
accurately reflect the risk inherent in the loan portfolio.
As previously discussed, the allowance consists of specific and general
components. The specific component relates to loans that are individually
classified as impaired or loans otherwise classified as substandard or doubtful.
The general component covers non-classified loans and is based on historical
loss experience adjusted for current factors. These current factors, include
loan growth, net charge-offs, changes in the composition of the loan portfolio,
delinquencies, management's evaluation of loan quality, general economic factors
and collateral values.
As a result of this process, the PFLL for the first six months of 2005 was
$121,000 as compared to a PFLL of $1.5 million for the first six months in 2004.
Net improvements in the loan portfolio, including a decrease in identified
potential problem loans were factors in the level of provision for the first six
months of 2005. Net loan charge-offs in the first six months of 2005 were $1.0
million compared with net charge-offs of $578,000 for the same period in 2004.
The loans charged-off in the first six months of 2005 had a specific reserve in
the aggregate of $910,000 which approximated the amount charged-off. Net
charge-offs to average loans were 0.26% for the first six months of 2005
compared to 0.16% for the same period in 2004. For the six months ended June 30,
2005, non-accrual loans increased $2.0 million, in part as the result of a
transfer to
18
non-accrual of a $1.9 million commercial real estate credit which already was on
our watch list. There was not a material change in the amount of reserve
allocated to this credit, as a result of this transfer. At the end of July 2005,
this credit was current.
TABLE 3
ALLOWANCE FOR LOAN LOSSES
($ in thousands)
For the six months For the six months
ended June 30, 2005 ended June 30, 2004
------------------- -------------------
Allowance for Loan Losses ("ALL)
Balance at beginning of period $10,445 $12,159
Provision for loan losses 121 1,499
Charge-offs 1,235 1,129
Recoveries 233 551
Balance at end of period $ 9,564 $13,080
Net charge-offs ("NCOs:) $ 1,002 $ 578
As described more fully in Table 7 below, non-accrual loans increased during the
period from December 31, 2004, however, the total amount of non-performing loans
decreased by $3.5 million and non-performing assets decreased by $4.0 million.
Furthermore, despite the increase in non-accrual loans during the six months
ended June 30, 2005, the required allocation of the allowance for such loans
increased only minimally, primarily due to improvement in the loan portfolio as
measured by the level of non-performing loans, resulting in a provision of
$121,000 for the first half of 2005.
Management believes that the current provision conforms to the Company's loan
loss reserve policy and is adequate in view of the present condition of the
Company's loan portfolio. However, a decline in the quality of our loan
portfolio, as a result of general economic conditions, factors affecting
particular borrowers or our market area, or otherwise, could affect the adequacy
of the allowance. If there are significant charge-offs against the allowance, or
we otherwise determine that the allowance is inadequate, we will need to make
higher provisions in the future. See "Risk Management and the Allowance for Loan
Losses" and "Non-Performing Loans, Potential Problem Loans and Other Real
Estate" below for more information related to non-performing loans.
Non-Interest Income
Total non-interest income decreased $496,000, or 17.9% to $2.3 million for the
second quarter of 2005 when compared to the second quarter of 2004. For the six
months ended June 30, 2005, total non-interest income was $4.5 million, a
decrease of $203,000, or 4.3%, when compared to the same period in 2004. The
non-interest income to average assets ratio was 0.84% for the three months ended
June 30, 2005 compared to 1.11% for the same period in 2004. For the six months
ended June 30, 2005, the non-interest income to average assets ratio was 0.85%
compared to 0.96% for the same period in 2004. The decrease in non-interest
income for the three-month and six-month periods is mainly due to decreases,
both in gains on sale of bank premises and in gains from sale of loans offset by
an increase in other services to customers.
19
Table 4 reflects the various components of non-interest income for the
comparable quarters.
TABLE 4
NON-INTEREST INCOME
($ in thousands)
Second Second
quarter quarter Percent YTD YTD Percent
2005 2004 change 2005 2004 change
------- ------- ------- ------ ------ -------
Fees from fiduciary services $ 184 $ 188 (2.1%) $ 363 $ 362 0.3%
Fees from loan servicing 288 234 23.1% 571 477 19.7%
Service charges on deposit
accounts 845 798 5.9% 1,570 1,453 8.1%
Other fee income 163 155 5.2% 350 322 8.7%
Financial services income 177 241 (26.6%) 363 389 (6.7%)
Gains from sales of loans 177 317 (44.2%) 385 625 (38.4%)
Increase in cash surrender
value of life insurance 190 194 (2.1%) 417 392 6.4%
Gain on sale of bank
assets 124 482 (74.3%) 303 482 (37.1%)
Other income 132 167 (21.0%) 221 244 (9.4%)
------ ------ ------ ------
Total Other Income $2,280 $2,776 (17.9%) $4,543 $4,746 (4.3%)
Service charges on deposit accounts increased $47,000 for the three-month period
and $117,000 for the six-month period ended June 30, 2005 due in part to the
implementation of an overdraft privilege program started in the third quarter of
2004 and other price increases implemented during the latter part of 2004.
In the first half of 2005, gains from sales of loans were affected by a slowdown
in refinancing activity throughout the industry due to higher mortgage rates. In
comparison, the same period in 2004 saw slightly higher levels of loan
refinancing as a result of the historically low interest rate environment. Gains
from sales of loans decreased $240,000 between the comparable periods of 2005
and 2004. The decrease was driven primarily by secondary mortgage and commercial
loan production (loan production to be sold to the secondary market) and
resulting sales. As interest rates have increased over the six months, the
Company has seen a decrease in the number of loan applications. Secondary loan
production declined 41.7% between the comparable first six-month periods ($18.5
million in the first six months of 2005 versus $31.7 million in the first six
months of 2004).
20
For both the three and six month periods ended June 30, 2005, the reduction in
gain on sale of bank assets was related to gains taken in 2004 on the sale of
bank land located in the Green Bay market area totaling $482,000. Gains totaling
$103,000 were realized in the second quarter of 2005 on the sale of various bank
premises and equipment. Partially offsetting the decrease were gains realized on
the sale of stock of Pulse in 2005. Gains related to a gain on sale of stock of
$200,000 ($21,000 recognized in the second quarter) in connection with a third
party acquisition of Pulse (an ATM operator/provider) in which the Bank held
shares resulted from that transaction.
Financial service income decreased $64,000, or 26.6%, in the second quarter of
2005 as a result of slowdown in business activity. For the six months ended June
30, 2005, financial services income has decreased $28,000, or 6.7%, when
compared to the same period in 2004.
Non-Interest Expense
Non-interest expense increased $744,000 or 11.3%, to $7.3 million for the three
months ended June 30, 2005 compared to the same period in 2004. For the six
months ended June 30, 2005, total non-interest expense increased $1.4 million,
or 10.9%, to $14.4 million compared to the same period in 2004. The non-interest
expense to average assets ratio was 2.71% for the three months ended June 30,
2005 compared to 2.63% for the same period in 2004. For the six months ended
June 30, 2005, non-interest expense ratio to average assets was 2.69% compared
to 2.61% for the same period in 2004.
Net overhead expense is total non-interest expense less total non-interest
income excluding securities gains. The net overhead expenses to average assets
ratio was 1.87% for the three months ended June 30, 2005 compared to 1.52% for
the same period in 2004. For the six months ended June 30, 2005, the net
overhead expenses to average assets ratio was 1.84% compared to 1.66% for the
same period in 2004. The efficiency ratio is total non-interest expense as a
percentage of the sum of net-interest income on a fully taxable equivalent basis
and total non-interest income. The efficiency ratio for the three months ended
June 30, 2005 was 63.86% compared to 57.97% for the same period in 2004. For the
six months ended June 30, 2005, the efficiency ratio was 63.45% compared to
60.39% for the same period in 2004.
TABLE 5
NON-INTEREST EXPENSE
($ in thousands)
Second Second Percent YTD YTD Percent
quarter 2005 quarter 2004 change 2005 2004 change
------------ ------------ ------- ------- ------- -------
Salaries and employee
benefits $4,329 $3,944 9.8% $ 8,857 $ 7,809 13.4%
Occupancy 602 529 13.8% 1,138 1,051 8.3%
Equipment 340 299 13.7% 647 668 (3.1%)
Data processing and
courier 298 272 9.6% 576 555 3.8%
Operation of other real
estate owned 81 146 (44.5%) 129 271 (52.4%)
Business development
and advertising 284 267 6.4% 488 394 23.9%
21
Charitable contributions 55 59 (6.8%) 147 161 (8.7%)
Stationary and supplies 155 132 17.4% 267 241 10.8%
Director fees 110 112 (1.8%) 192 210 (8.6%)
FDIC 29 28 3.6% 56 57 (1.8%)
Mortgage servicing
rights amortization 54 66 (18.2%) 116 132 (12.1%)
Legal and professional 128 102 25.5% 304 194 56.7%
Loss on disposal of
fixed assets 254 0 NM 254 0 NM
Other operating 626 645 (2.9%) 1,219 1,230 (0.9%)
------ ------ ------- -------
Total non-interest
expense $7,345 $6,601 11.3% $14,390 $12,973 10.9%
Salaries and employee benefits showed an increase of $385,000, or 9.8%, to $4.3
million for the second quarter of 2005 compared to the same period in 2004. The
number of full-time equivalent employees was 308 as of June 30, 2005 and 2004.
For the three months ended June 30, 2005, salary-related expenses increased
$131,000, or 4.7%, due principally to merit increases between the years. For the
six months ended June 30, 2005, salary-related expenses increased $211,000, or
3.8%, compared to the same period in 2004 for the reasons listed previously. In
the first quarter, the Company implemented the Baylake Bank Supplemental
Executive Retirement Plan ("Plan"), which is intended to provide certain
management and highly compensated employees of the Bank who have contributed,
and are expected to continue to contribute, to the Bank's success by providing
for deferred compensation in addition to that available under the Bank's other
retirement programs. It amounted to approximately $94,000 in expenses related to
the vested portion of the Plan contributions in the second quarter of 2005 and
$398,000 for the six months ended June 30, 2005. Accrued bonus expense and
benefit costs, principally for health insurance and pension costs, represent the
remaining increase in personnel-related costs. The increase in health insurance
costs is expected to continue for the balance of 2005 and for 2006. Management
will continue its efforts to control salaries and employee benefits expense,
although increases in these expenses are likely to continue in future years.
Expenses related to the operation of other real estate owned decreased $65,000
to $81,000 for the 2005 three-month period ended June 30 compared to the same
period in 2004. For the six-month period ended June 30, 2005, other real estate
owned expenses decreased $142,000 to $129,000 compared to the same period in
2004. These expenses decreased primarily as a result of the disposal of several
properties in early 2005. Included in these expenses were net losses taken on
the sale of other real estate owned amounting to $29,000 for the six months
ended June 30, 2005 compared to net gains taken on sale of $11,000 for the same
period in 2004. In addition, costs related to the holding of other real estate
owned properties decreased $182,000 to $100,000 for the first six months of
2005.
Legal and professional expense for the first six months in 2005 increased
substantially, by $110,000, to $304,000. The increase was the result of
increased costs relative to SEC compliance primarily as a result of enhanced
requirements imposed by the Sarbanes-Oxley Act of 2002 and related SEC actions.
22
The loss on disposal of fixed assets relates primarily to the sale of two
buildings and land formerly used as branch offices. In addition, the bank closed
one leased facility during the period, for which leasehold improvements were
written off during the period. In each case, the branches had been replaced with
newer facilities and had been unoccupied at date of sale or closing.
Income Taxes
Income tax expense for the Company for the six months ended June 30, 2005 was
$2.4 million, an increase of $427,000, or 21.7%, compared to the same period in
2004. The higher tax expense in 2005 reflected the Company's increase in before
tax earnings.
The Company's effective tax rate (income tax expense divided by income before
taxes) was 31.7% for the six months ended June 30, 2005 compared with 30.4% for
the same period in 2004. The effective tax rate of 31.7% consisted of a federal
effective tax rate of 25.9% and Wisconsin State effective tax rate of 5.8%.
Taxable income increased while tax-exempt interest income from municipal
investments and income from BOLI did not increase in a like manner.
Income tax expense recorded in the consolidated statements of income involves
interpretation and application of certain accounting pronouncements and federal
and state tax codes, and is, therefore, considered a critical accounting policy.
The Company undergoes examination by various taxing authorities. Such taxing
authorities may require that changes in the amount of tax expense or valuation
allowance be recognized when their interpretations differ from those of
management, based on their judgments about information available to them at the
time of their examinations. See "Critical Accounting Policies-Income Tax
Accounting" above regarding Wisconsin tax matters which may affect our income
tax expense.
BALANCE SHEET ANALYSIS
Loans
At June 30, 2005, total loans increased $38.6 million, or 5.1%, to $795.8
million from $757.2 million at December 31, 2004. Growth in the Company's loan
portfolio resulted primarily from an increase in real estate commercial loans to
$458.5 million at June 30, 2005 compared to $424.7 million at December 31, 2004.
In addition, growth in real estate construction loans increased to $86.0 million
at June 30, 2005 compared to $80.4 million at December 31, 2004. Growth in
commercial real estate mortgages and commercial loans occurred principally as a
result of the Company's expansion efforts (primarily in the Green Bay market)
and the strong economic growth in that market.
The following table reflects the composition (mix) of the loan portfolio
(dollars in thousands):
23
TABLE 6
LOAN PORTFOLIO ANALYSIS
($ in thousands)
June 30, December 31, Percent
2005 2004 change
-------- ------------ -------
Amount of loans by type
Real estate-mortgage
Commercial $458,501 $424,712 8.0%
1-4 family residential
First liens 82,158 78,321 4.9%
Junior liens 21,038 20,244 3.9%
Home equity 34,014 35,785 (5.0%)
Commercial, financial and agricultural 85,720 83,787 2.3%
Real estate-construction 85,960 80,384 6.9%
Installment
Credit cards and related plans 2,118 2,152 (1.6%)
Other 12,778 11,784 8.4%
Obligations of states and political subdivisions 13,924 20,457 (32.0%)
Less: deferred origination fees, net of costs 426 398 7.0%
-------- -------- -----
Total $795,785 $757,228 5.1%
Risk Management and the Allowance for Loan Losses
The loan portfolio is the Company's primary asset subject to credit risk. To
reflect this credit risk, the Company sets aside an allowance for probable
incurred credit losses through periodic charges to earnings. These charges are
shown in the Company's consolidated income statement as provision for loan
losses. See "Provision for Loan Losses" above. Credit risk is controlled and
monitored through the use of lending standards, a thorough review of potential
borrowers, and an on-going review of payment performance. Asset quality
administration, including early identification of problem loans and timely
resolution of problems, further enhances management of credit risk and
minimization of loan losses. All specifically identifiable and quantifiable
losses are charged off against the allowance. Charged-off loans are subject to
periodic review, and specific efforts are taken to achieve maximum recovery of
principal and interest.
As indicated in Table 3 above, the ALL at June 30, 2005 was $9.6 million
compared with $10.4 million at the end of 2004. This was based on management's
analysis of the loan portfolio risk at June 30, 2005. As such a provision
expense of $121,000 was recorded for the six months ended June 30, 2005. The
quarter to date provision has decreased by $1.4 million compared to the same
period in 2004, as discussed previously.
The provision for loan losses is predominately a function of management's
evaluation of the loan portfolio, with particular emphasis directed toward
non-performing and other potential problem loans. During these evaluations,
consideration is also given to such factors as management's evaluation of
specific loans, the level and composition of impaired loans, other
non-performing loans, historical loan experience, results of examinations by
regulatory agencies and various other factors.
On a quarterly basis, management reviews the adequacy of the ALL. Commercial
credits are graded by the loan officers and the loan review function validates
the officers' grades. In the event that the loan review function downgrades the
loan, it is included in the allowance analysis at the lower grade. The grading
system is in compliance with the regulatory classifications and the allowance is
allocated to the loans based on the regulatory grading, except in instances
where there are known differences (i.e., collateral value is nominal, etc.). To
establish the appropriate level of the allowance, a sample of loans (including
impaired and non-performing loans) are reviewed and classified as to potential
loss exposure.
Based on an estimation computed pursuant to the requirements of Financial
Accounting Standards Board ("FASB") Statement No. 5, "Accounting for
Contingencies," and FASB
24
Statements No. 114 and 118, "Accounting by Creditors for Impairment of a Loan,"
the analysis of the ALL consists of two components: (i) specific credit
allocation established for expected losses resulting from analysis developed
through specific credit allocations on individual loans for which the recorded
investment in the loan exceeds its fair value; (ii) general portfolio allocation
based on historical loan loss experience for each loan category and adjusted for
economic conditions as well as specific and other factors in the markets in
which the Company operates.
In prior years, the Company did not consistently use subjective reserves based
on general economic conditions and specific economic factors as a component of
the ALL analysis, but rather used the unallocated portion of the ALL to
recognize this inherent factor. During the third quarter of 2004, as part of its
review of internal control over financial reporting and efforts to improve that
control, the Company refined the process to calculate the ALL to use the
subjective factors and thus the previously unallocated portion was allocated to
the various loan categories. Management believes that there would be no material
change in the balance of the ALL if this approach was used in all of the periods
presented.
The specific credit allocation of the ALL is based on a regular analysis of
loans over a fixed-dollar amount where the internal credit rating is at or below
a predetermined classification. The fair value of the loan is determined based
on either the present value of expected future cash flows discounted at the
loan's effective interest rate, the market price of the loan, or, if the loan is
collateral dependent, the fair value of the underlying collateral less cost of
sale.
The general portfolio allocation component of the ALL is determined
statistically using a loss migration analysis that examines historical loan loss
experience. The loss migration analysis is performed quarterly and loss factors
are updated regularly based on actual experience. The general portfolio
allocation element of the ALL also includes consideration of the amounts
necessary for concentrations and changes in portfolio mix and volume.
The ALL is based on estimates, and ultimate losses will vary from current
estimates. These estimates are reviewed monthly, and as adjustments, either
positive or negative, become necessary, a corresponding increase or decrease is
made in the provision for loan losses. The composition of the loan portfolio has
not significantly changed since year-end 2004.
Management remains watchful of credit quality issues and believes that issues
within the portfolio are reflective of the challenging economic environment
experienced over the past few years. Should the economic climate deteriorate
from current levels, borrowers may experience difficulty, and the level of
non-performing loans, charge-offs and delinquencies could rise and require
further increases in the provision.
Consideration for making such allocations is consistent with the factors
discussed above, and all of the factors are subject to change; thus, the
allocation is not necessarily indicative of the loan categories in which future
loan losses will occur. It would also be expected that the amount allocated for
any particular type of loan will increase or decrease proportionately to both
the changes in the loan balances and to increases or decreases in the estimated
loss in loans of that type. In other words, changes in the risk profile of the
various parts of the loan portfolio should be reflected in the allowance
allocated.
While there exists probable asset quality problems in the loan portfolio,
management believes sufficient reserves have been provided in the ALL to absorb
probable incurred losses in the loan portfolio at June 30, 2005. Ongoing efforts
are being made to collect these loans, and the Company involves the legal
process when necessary to minimize the risk of further deterioration of these
loans for full collection.
25
While management uses available information to recognize losses on loans, future
adjustments to the ALL may be necessary based on changes in economic conditions
and the impact of such change on the Company's borrowers. As an integral part of
their examination process, various regulatory agencies also review the Company's
ALL. Such agencies may require that changes in the ALL be recognized when their
credit evaluations differ from those of management, based on their judgments
about information available to them at the time of their examination.
Non-Performing Loans, Potential Problem Loans and Other Real Estate
Management encourages early identification of non-accrual and problem loans in
order to minimize the risk of loss. This is accomplished by monitoring and
reviewing credit policies and procedures on a regular basis.
Non-performing loans are a leading indicator of future loan loss potential.
Non-performing loans are defined as non-accrual loans, guaranteed loans 90 days
or more past due but still accruing, and restructured loans. Additionally,
whenever management becomes aware of facts or circumstances that may adversely
impact on the collection of principal or interest on loans, it is the practice
of management to place such loans on non-accrual status immediately rather than
waiting until the loans become 90 days past due. The accrual of interest income
is discontinued when a loan becomes 90 days past due as to principal or
interest. When interest accruals are discontinued, interest credited to income
is reversed. If collection is in doubt, cash receipts on non-accrual loans are
used to reduce principal rather than recorded as interest income.
TABLE 7
NON-PERFORMING ASSETS
($ in thousands)
At or for the At or for the At or for the
period ended period ended period ended
June 30, 2005 June 30, 2004 December 31, 2004
------------- ------------- -----------------
Nonperforming Assets:
Nonaccrual loans $ 7,907 $11,104 $ 5,920
Accruing loans past due 90 days or more 0 0 0
------- ------- -------
Total nonperforming loans ("NPLs") $ 7,907 $11,104 $ 5,920
Other real estate owned 2,096 2,614 2,572
------- ------- -------
Total nonperforming assets ("NPAs") $ 7,907 $13,718 $ 8,492
Ratios:
ALL to NCO's (annualized) 4.73 11.25 3.15
NCO's to average loans (annualized) 0.26% 0.16% 0.45%
ALL to total loans 1.20% 1.76% 1.38%
NPL's to total loans 0.99% 1.50% 0.78%
NPA's to total assets 0.91% 1.36% 0.81%
ALL to NPL's 120.96% 117.80% 176.44%
26
As indicated in Table 7, non-performing loans at June 30, 2005 were $7.9 million
compared to $5.9 million at December 31, 2004. This increase is due, in part to
the transfer to non-accrual of a $1.9 million commercial real estate credit
which already was on our watch list. There was not a material change in the
amount of reserve allocated to this credit, as a result of this transfer.
Non-accrual loans represented $7.9 million of the total non-performing loans.
Real estate non-accrual loans accounted for $7.4 million of the total, of which
$920,000 was residential real estate, $2.0 million was real estate construction
and $4.5 million was commercial real estate, while commercial and industrial
non-accrual loans total $479,000. As a result the ratio of non-performing loans
to total loans at June 30, 2005 was 0.99% compared to 0.78% at end of year 2004.
The Company's ALL was 121.0% of total non-performing loans at June 30, 2005
compared to 176.4% at end of year 2004.
Non-performing assets (non-performing loans plus other real estate owned assets)
at June 30, 2005 were $10.0 million compared to $8.5 million at December 31,
2004. Other real estate owned, which represents property that the Company
acquired through foreclosure or in satisfaction of debt, consisted of two
residential and twelve commercial properties totaling $2.1 million. Other real
estate owned at December 31, 2004 totaled $2.6 million and consisted of sixteen
properties.
Potential problem loans are currently performing loans that management believes
may incur difficulties in complying with loan repayment terms. Management's
decision to place loans in this category does not necessarily mean that the
Company expects to take losses on such loans, but that management needs to be
more vigilant in its efforts to oversee the loans and recognize that a higher
degree of risk is associated with these potential problem loans. At June 30,
2005, potential problem loans amounted to $4.1 million compared to a total of
$9.3 million at December 31, 2004.
Investment Portfolio
The investment portfolio is intended to provide the Company with adequate
liquidity, flexibility in asset/liability management and, lastly, an increase in
its earning potential.
At June 30, 2005, the investment portfolio (which includes investment securities
available for sale) increased $12.4 million, or 6.3%, to $209.8 million from
$197.4 million at December 31, 2004. At June 30, 2005, the investment portfolio
represented 19.0% of total assets compared with 18.8% at December 31, 2004.
Securities available for sale consist of the following:
27
TABLE 8
INVESTMENT SECURITY ANALYSIS
At June 30, 2005
($ in thousands)
Gross Gross
Unrealized Unrealized
Gains Losses Fair Value
---------- ---------- ----------
Securities available for sale
Obligations of U.S. Treasury & other U.S.
agencies 545 502 63,236
Mortgage-backed securities 51 1,155 93,808
Obligations of states & political
subdivisions 1,379 50 47,114
Private placement 45 0 1,040
Other securities 0 0 4,626
------ ------ --------
Total securities available for sale $2,020 $1,707 $209,824
At December 31, 2004
($ in thousands)
Gross Gross
Unrealized Unrealized
Gains Losses Fair Value
---------- ---------- ----------
Securities available for sale
Obligations of U.S. Treasury & other U.S.
Agencies $ 965 $ 214 $ 59,547
Mortgage-backed securities 190 794 99,360
Obligations of states & political
subdivisions 1,556 0 33,973
Private placement 76 0 1,070
Other securities 0 0 3,442
------ ------ --------
Total investment securities $2,787 $1,008 $197,392
Deposits
Total deposits at June 30, 2005 increased $411,000, or 0.5%, to $845.0 million
from $844.5 million at December 31, 2004. Non-interest bearing deposits at June
30, 2005 decreased $9.5 million, or 7.9%, to $111.0 million from $120.5 million
at December 31, 2004. Interest-bearing deposits at June 30, 2005 increased $9.9
million, or 1.4%, to $734.0 million from $724.0 million at December 31, 2004.
Brokered CD's totaled $190.2 million at June 30, 2005 compared to $175.4 million
at December 31, 2004. Time deposits greater than $100,000 and brokered time
deposits were priced within the framework of the Company's rate structure and
did not materially increase the average rates on deposit liabilities. If
liquidity concerns arose, the Company has alternative
28
sources of funds such as lines with correspondent banks and borrowing
arrangements with FHLB should the need present itself. Increased competition for
consumer deposits and customer awareness of interest rates continues to limit
the Company's core deposit growth in these types of deposits. Typically, overall
deposits for the first six months tend to decline slightly as a result of the
seasonality of the Company's customer base as customers draw down deposits
during the early first half of the year in anticipation of the summer tourist
season.
Emphasis has been, and will continue to be, placed on generating additional core
deposits in 2005 through competitive pricing of deposit products and through the
branch delivery systems that have already been established. The Company will
also attempt to attract and retain core deposit accounts through new product
offerings and quality customer service. The Company also may increase brokered
time deposits during the remainder of the year 2005 and in 2006 as an additional
source of funds to provide for loan growth in the event that core deposit growth
goals would not be accomplished. Brokered deposits tend to be by their nature to
be less stable than core deposits, and may also bear a higher cost structure.
Under a scenario of increased brokered deposits, the Company will continue to
look at other wholesale sources of funds, if the brokered CD market became
illiquid or more costly in terms of interest rate.
Borrowings
Federal funds purchased and securities under agreements to repurchase at June
30, 2005 increased $40.3 million to $41.6 million from $1.3 million at December
31, 2004. Federal funds purchased increased from no funds purchased at December
31, 2004 to $40.4 million at June 30, 2005 accounting for the majority of the
increase. These have increased to fund the growth in the loan portfolio which
was coupled with a decrease in core deposits during the quarter ended June 30,
2005.
Federal Home Loan Bank Advances totaled $115.2 million at June 30, 2005 compared
to $100.2 million at December 31, 2004. Typically, borrowings increase in order
to fund growth in the loan portfolio in periods when borrowings increase more
rapidly than deposits. The Company will borrow monies if borrowing is a less
costly form of funding loans compared to the cost of acquiring deposits or if
deposit growth is not sufficient. Additionally, the availability of deposits
also determines the amount of funds the Company needs to borrow in order to fund
loan demand. The Company anticipates it will continue to use wholesale funding
sources of this nature, if these borrowings add incrementally to overall
profitability.
In connection with the issuance of Trust Preferred Securities in 2001 (see
"Capital Resources"), the Company issued long-term subordinated debentures to
Baylake Capital Trust I, a Delaware Business Trust, formed by the Company. The
aggregate principal amount of the debentures due 2031, to the trust is
$16,597,940. For additional details, please make reference to the Consolidated
Financial Statements and the accompanying footnotes on the Company's Form 10-K
for the year 2004.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT
LIABILITIES
The Company utilizes a variety of financial instruments in the normal course of
business to meet the financial needs of its customers. These financial
instruments include commitments to extend credit, commitments to originate
residential mortgage loans held for sale, commercial letters of credit, standby
letters of credit, and forward commitments to sell residential mortgage loans.
Please refer to the Company's Annual Report on Form 10-K for the year ended
December 31,
29
2004 for discussion with respect to the Company's quantitative and qualitative
disclosures about its fixed and determinable contractual obligations. Items
disclosed in Form 10-K have not materially changed since that report was filed.
The following is a summary of our off-balance sheet commitments, all of which
were lending-related commitments:
TABLE 9
LENDING RELATED COMMITMENTS
($ in thousands)
June 30, 2005 December 31, 2004
------------- -----------------
Commitments to fund home equity
line loans $ 47,967 $ 45,101
Commitments to fund commercial real
estate loans 5,843 5,314
Commitments unused on various other
lines of credit loans 164,999 135,889
-------- --------
Total commitments to extend credit $218,809 $186,304
Financial standby letters of credit $ 24,203 $ 23,428
The following table summarizes the Company's significant contractual obligations
and commitments at June 30, 2005:
TABLE 10
CONTRACTUAL OBLIGATIONS
($ in thousands)
(IN THOUSANDS) WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS AFTER 5 YEARS TOTAL
-------------- ------------- --------- --------- ------------- --------
Federal funds purchased
and repurchase agreements $ 41,585 $ 0 $ 0 $ 0 $ 41,585
Federal Home Loan Bank
advances 75,000 15,000 188 25,000 115,188
Subordinated debentures 0 0 0 16,100 16,100
Operating leases 101 238 160 0 499
-------- ------- ---- ------- --------
Total $116,686 $15,238 $348 $41,100 $173,372
30
LIQUIDITY
Liquidity management refers to the ability of the Company to ensure that cash is
available in a timely manner to meet loan demand and depositors' needs, and to
service other liabilities as they become due, without undue cost or risk, and
without causing a disruption to normal operating activities. The Company and the
Bank have different liquidity considerations.
The Company's primary sources of funds are dividends from the Bank, investment
income, and net proceeds from borrowings and the offerings of junior
subordinated obligations, in addition to the issuance of its common stock
securities. The Company manages its liquidity position in order to provide funds
necessary to pay dividends to its shareholders. Dividends received from Bank
totaled $2.4 million for the first six months of 2005 and will continue to be
the Company's main source of long-term liquidity. The dividends from the Bank
along with existing cash were sufficient to pay cash dividends to the Company's
shareholders of $2.3 million in the first six months of 2005.
The Bank meets its cash flow needs by having funding sources available to it to
satisfy the credit needs of customers as well as having available funds to
satisfy deposit withdrawal requests. Liquidity at the Bank is derived from
deposit growth (including brokered deposits), maturing loans, the maturity of
the investment portfolio, access to other funding sources (such as federal funds
purchased), marketability of certain of its assets; the ability to use its loan
and investment portfolios as collateral for secured borrowings and strong
capital positions.
Maturing investments have been a primary source of liquidity at the Bank. For
the six months ended June 30, 2005, principal payments totaling $6.7 million
were received on investments. $20.9 million in investments were purchased in the
first six months of 2005. This resulted in net cash of $14.2 million used in
investing activities for the first six months of 2005. At June 30, 2005 the
investment portfolio contained $157.0 million of U.S. Treasury and federal
agency backed securities representing 74.8% of the total investment portfolio.
These securities tend to be highly marketable.
Deposit growth is typically another source of liquidity for the Bank in the
latter half of each year, although deposits typically shrink in the first half
resulting in a use of cash. As a financing activity reflected in the June 30,
2005 Consolidated Statements of Cash Flows, deposits increased and resulted in
$411,000 of cash flow during the first six months of 2005. The Company's overall
deposit base increased 0.5% for the six months ended June 30, 2005. Deposit
growth is generally the most stable source of liquidity for the Bank. Although
brokered deposits are inherently less stable than locally generated core
deposits, we use them when we believe it is appropriate as a result of market
conditions in our markets as compared to the brokered markets and/or when we
need to supplement local deposit generation to fund loans. Affecting liquidity
are core deposit growth levels, certificate of deposit maturity structure and
retention, and characteristics and diversification of wholesale funding sources
affecting the channels by which brokered deposits are acquired. Conversely,
deposit outflow will cause the Bank to develop alternative sources of funds
which may not be as liquid and potentially a more costly alternative.
The scheduled maturity of loans can provide a source of additional liquidity.
Factors affecting liquidity relative to loans are loan origination volumes, loan
prepayment rates and the maturity structure of existing loans. The Bank's
liquidity position is influenced by changes in interest rates, economic
conditions and competition. Conversely, loan demand as a need for liquidity will
cause the Company to acquire other sources of funding which could be harder to
find; therefore more costly to acquire.
31
Within the classification of short-term borrowings at June 30, 2005, federal
funds purchased and securities sold under agreements to repurchase totaled $41.6
million compared to $1.3 million at the end of 2004. Federal funds are purchased
from various upstream correspondent banks while securities sold under agreements
to repurchase are obtained from a base of business customers. Borrowings from
FHLB, short-term or long-term, are another source of funds. They total $115.2
million at June 30, 2005 and $100.2 million at December 31, 2004.
The Bank's liquidity resources were sufficient in the first six months of 2005
to fund the growth in loans and investments, increase the volume of interest
earning assets and meet other cash needs when necessary.
Management expects that deposit growth will continue to be the primary funding
source of the Bank's liquidity on a long-term basis, along with a stable
earnings base, the resulting cash generated by operating activities, and a
strong capital position. Although federal funds purchased and borrowings from
the FHLB provided funds in the first six months of 2005, management expects
deposit growth to be a reliable funding source in the future as a result of
branch expansion efforts and marketing efforts to attract and retain core
deposits. In addition, the Bank may acquire additional brokered deposits as
funding for short-term liquidity needs. Shorter-term liquidity needs will mainly
be derived from growth in short-term borrowings, maturing federal funds sold and
portfolio investments, loan maturities and access to other funding sources.
In assessing liquidity, historical information such as seasonality (loan
demand's affect on liquidity which starts before and during the tourist season
and deposit draw down which affects liquidity shortly before and during the
early part of the tourist season), local economic cycles and the economy in
general are considered along with the current ratios, management goals and the
unique characteristics of the Company. Management believes that, in the current
economic environment, the Company's and the Bank's liquidity position is
adequate. To management's knowledge, there are no known trends nor any known
demands, commitments, events or uncertainties that will result or are reasonably
likely to result in a material increase or decrease in the Bank's or the
Company's liquidity.
Capital Resources
Stockholders' equity at June 30, 2005 increased $2.3 million or 3.0% to $78.5
million, compared with $76.2 million at end of year 2004. The increase in
stockholders' equity in 2005 was primarily composed of the growth in retained
earnings and proceeds from the exercise of stock options, partially offset by
the change in unrealized losses on available for sale securities and the payment
of dividends. The change in unrealized losses on available for sale securities
amounted to $940,000 for the first six months of 2005; this change resulted from
the effects of the increasing interest rate environment. Total dividends paid
increased to $2.3 million in the six months ended June 30, 2005 from $2.0
million for the same period in 2004, primarily as a result of an increase in the
per share dividends rate to $0.30 from $0.28. Stockholders' equity to assets at
June 30, 2005 was 7.10% compared to 7.27% at the end of 2004.
In 2001, the Company formed Baylake Capital Trust I ("the Trust") as a statutory
business trust organized for the sole purpose of issuing trust preferred
securities and investing the proceeds thereof in junior subordinated debentures
of the Company, the sole asset of the Trust. The trust preferred securities
enhanced regulatory capital and added liquidity. The common securities of the
Trust are wholly-owned by the Company. The trust preferred securities and common
securities of the trust represent preferred undivided beneficial interests in
the assets of Baylake
32
Capital Trust I, and the holder of the preferred securities will be entitled to
a preference over the common securities of the Trust upon an event of default
with respect to distributions and amounts payable on redemption or liquidation.
These trust preferred securities are tax-advantaged issues for the Company that
qualify for Tier 1 capital treatment to the Company. Distributions on these
securities are included in interest expense on guaranteed preferred beneficial
interest.
The Company had $16.6 million of junior subordinated debentures outstanding to
the Trust and the Trust had $16.1 million of trust preferred securities
outstanding at June 30, 2005 and December 31, 2004, respectively. Under
applicable regulatory guidelines, the Trust Preferred Securities qualify as Tier
1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion of
Trust Preferred Securities would qualify as Tier 2 capital. As of June 30, 2005,
all $16.1 million of the Trust Preferred Securities qualify as Tier 1 Capital.
The Company's capital base (before SFAS 115 change) increased primarily due to
the retention of earnings. The Company's dividend reinvestment plan typically
provides capital improvement, as the holders of approximately 23% of Company's
Common Stock participate in the plan.
Cash dividends paid in the first six months of 2005 were $0.30 per share
compared with $0.28 in 2004. The Company provided a 7.2% increase in normal
dividends per share in 2005 over 2004 as a result of earnings for 2005. Total
funds utilized in the payment of dividends were $2.3 million in the first six
months of 2005, as compared to $2.0 million in the corresponding period of 2004.
In 1997, the Company's Board of Directors authorized management, in its
discretion, to repurchase up to 7,000 shares of the Company's common stock each
calendar quarter in the market. The shares repurchased would be used to fill its
needs for the dividend reinvestment program, any future benefit plans, and the
Company's stock purchase plan. Shares repurchased are held as treasury stock and
accordingly, are accounted for as a reduction of stockholders' equity. The
Company repurchased none of its common shares in the first six months of 2005.
The adequacy of the Company's capital is regularly reviewed to ensure that
sufficient capital is available for current and future needs and is in
compliance with regulatory guidelines. The assessment of overall capital
adequacy depends upon a variety of factors, including asset quality, liquidity,
stability of earnings, changing competitive forces, economic conditions in
markets served and strength of management. Management is confident that because
of current capital levels and projected earnings levels, capital levels are more
than adequate to meet the ongoing and future concerns of the Company.
The Federal Reserve Board has established capital adequacy rules which take into
account risk attributable to balance sheet assets and off-balance sheet
activities. All banks and bank holding companies must meet a minimum total
risk-based capital ratio of 8%. Of the 8% required, at least half must be
comprised of core capital elements defined as Tier 1 capital. The federal
banking agencies also have adopted leverage capital guidelines which banking
organizations must meet. Under these guidelines, the most highly rated banking
organizations must meet a leverage ratio of at least 3% Tier 1 capital to
assets, while lower rated banking organizations must maintain a ratio of at
least 4% to 5%. Failure to meet minimum capital requirements can initiate
certain mandatory -and possible additional discretionary- actions by regulators
that, if undertaken, could have a direct material effect on the consolidated
financial statements.
At June 30, 2005 and December 31, 2004, the Company was categorized as "well
capitalized" under the regulatory framework for prompt corrective action. There
are no conditions or events since that notification that management believes
have changed the Company's category.
33
To be "well capitalized" under the regulatory framework, the Tier 1 capital
ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10%
and the leverage ratio must meet or exceed 5%.
The following table presents the Company's and the Bank's capital ratios as of
June 30, 2005 and December 31, 2004:
TABLE 11
CAPITAL RATIOS
($ in thousands)
Required For Required To Be
Capital Well Capitalized
Adequacy under Prompt Corrective
Actual Purposes Action Provisions
-------------- -------------- -----------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
As of June 30, 2005
Total Capital (to Risk
Weighted Assets)
Company 97,831 10.60% 73,843 8.00% N/A N/A
Bank 94,065 10.20% 73,749 8.00% 92,186 10.00%
Tier 1 Capital (to Risk
Weighted Assets)
Company 88,268 9.56% 36,922 4.00% N/A N/A
Bank 84,502 9.17% 36,874 4.00% 55,312 6.00%
Tier 1 Capital (to
Average Assets)
Company 88,268 8.18% 43,179 4.00% N/A N/A
Bank 84,502 7.83% 43,179 4.00% 53,973 5.00%
As of December 31, 2004
Total Capital (to Risk
Weighted Assets)
Company 95,433 10.95% 69,791 8.00% N/A N/A
Bank 91,521 10.53% 69,580 8.00% 86,975 10.00%
Tier 1 Capital (to Risk
Weighted Assets)
Company 84,988 9.75% 34,895 4.00% N/A N/A
Bank 81,076 9.33% 34,790 4.00% 52,185 6.00%
Tier 1 Capital (to
Average Assets)
Company 84,988 8.27% 41,129 4.00% N/A N/A
Bank 81,076 7.91% 41,025 4.00% 51,282 5.00%
Management believes that a strong capital position is necessary to take
advantage of opportunities for profitable expansion of product and market share,
and to provide depositor and investor confidence. The Company's capital level is
strong, but also must be maintained at an appropriate level to provide the
opportunity for an adequate return on the capital employed.
34
Management actively reviews capital strategies for the Company to ensure that
capital levels are appropriate based on the perceived business risks, further
growth opportunities, industry standards, and regulatory requirements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The Company's primary market risk exposure is interest rate risk. Interest rate
risk is the risk that the Company's earnings and capital will be adversely
affected by changes in interest rates. The Company does not use derivatives to
mitigate its interest rate risk.
The Company's earnings are derived from the operations of its direct and
indirect subsidiaries with particular reliance on net interest income,
calculated as the difference between interest earned on loans and investments
and the interest expense paid on deposits and other interest bearing
liabilities, including advances from FHLB and other borrowings. Like other
financial institutions, the Company's interest income and interest expense are
affected by general economic conditions and by the policies of regulatory
authorities, including the monetary policies of the Board of Governors of the
Federal Reserve System. Changes in the economic environment may influence, among
other matters, the growth rate of loans and deposits, the quality of the loan
portfolio and loan and deposit pricing. Fluctuations in interest rates are not
predictable or controllable.
As of June 30, 2005, the Company was in compliance with its management policies
with respect to interest rate risk. The Company has not experienced any material
changes to its market risk position since December 31, 2004, as described in the
Company's 2004 Form 10-K Annual Report.
The Company's overall interest rate sensitivity is demonstrated by net interest
income analysis. Net interest income analysis measures the change in net
interest income in the event of hypothetical changes in interest rates. This
analysis assesses the risk of change in net interest income in the event of
sudden and sustained 1.0% to 2.0% increases and decreases in market interest
rates. The table below presents the Company's projected changes in net interest
income for the various rate shock levels at June 30, 2005.
TABLE 12
INTEREST SENSITIVITY
($ in thousands)
Change in Net Interest Income over One Year Horizon
---------------------------------------------------
At June 30, 2005 At December 31, 2004
-------------------- --------------------
Change in levels Dollar Percentage Dollar Percentage
of interest rates change change change change
- ----------------- ------- ---------- ------- ----------
+200 bp $ 1,576 4.4% $ 2,357 6.3%
+100 bp 704 1.9% 1,092 2.9%
Base 0 0% 0 0%
- -100 bp (1,203) (3.3%) (1,756) (4.7%)
- -200 bp (2,610) (7.2%) (3,656) (9.7%)
As shown above, at June 30, 2005, the effect of an immediate 200 basis point
increase in interest rates would increase the Company's net interest income by
$1.6 million or 4.4%. The effect of an immediate 200 basis point reduction in
rates would decrease the Company's net interest income by $2.6 million or 7.2%.
35
Changes in the mix of earning assets and interest-bearing liabilities increased
the Company's asset sensitivity during the past twelve months.
Computations of the prospective effects of hypothetical interest rate changes
are based on numerous assumptions, including the relative levels of market
interest rates and loan prepayments, and should not be relied upon as indicative
of actual results. Actual values may differ from those projections set forth
above, should market conditions vary from the assumptions used in preparing the
analyses. Further, the computations do not contemplate any actions the Company
may undertake in response to changes in interest rates.
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the
participation of the Company's Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Company's disclosure controls
and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of June
30, 2005. Based on such evaluation, the Company's Chief Executive Officer and
Chief Financial Officer have concluded that, as of the end of such period, the
Company's disclosure controls and procedures are effective in timely alerting
them to material information relating to the Company's disclosure controls and
procedures to the Company required to be included in this quarterly report on
Form 10-Q.
INTERNAL CONTROL OVER FINANCIAL REPORTING: There have not been any changes in
the Company's internal control over financial reporting (as such term is defined
in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal
quarter to which this report relates that have materially affected, or are
reasonably likely to materially affect, the Company's internal controls
subsequent to the date of such evaluation with the exception of enhancements
made during the quarter to the calculation of the allowance for loan loss
reserve. Such enhancement is explained in Item 2, Management's Discussion and
Analysis found in the sections entitled "Provision for Loan Losses" and "Balance
Sheet Analysis-Risk Management and the Allowance for Loan Losses" which
discussions are incorporated by reference in this item.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Baylake and its subsidiaries may be involved from time to time in various
routine legal proceedings incidental to its business. Neither Baylake nor any of
its subsidiaries is currently engaged in any legal proceedings that are expected
to have a material adverse effect on the results of operations or financial
position of Baylake.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
36
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a) The Company's Annual Meeting of Shareholders was held on June 6, 2005.
b) Not applicable
c) The only matter voted upon was the election of four directors for
terms expiring in 2008. The results are as follows:
Election of directors For Against or withheld
- --------------------- --------- -------------------
Robert W. Agnew 6,491,023 29,876
George Delveaux, Jr. 6,071,673 449,226
Dee Geurts-Bengtson 6,485,221 35,678
Joseph Morgan 6,482,796 38,103
As a consequence of the Company's staggered board of directors, other directors
remained in office. Directors continuing in office for terms expiring in 2006
are Ronald D. Berg, Richard A. Braun and William C. Parsons. Directors
continuing in office for terms expiring in 2007 are John W. Bunda, Roger G.
Ferris, Thomas L. Herlache, and Paul Jay Sturm.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS
The following exhibits are furnished herewith:
EXHIBIT NUMBER DESCRIPTION
- -------------- -----------
31.1 Certification under Section 302 of Sarbanes-Oxley by Thomas L.
Herlache, Chief Executive Officer, is attached hereto.
31.2 Certification under Section 302 of Sarbanes-Oxley by Steven D.
Jennerjohn, Chief Financial Officer, is attached hereto.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of
Sarbanes-Oxley is attached hereto.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of
Sarbanes-Oxley is attached hereto.
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
BAYLAKE CORP.
Date: August 8, 2005 /s/ Thomas L. Herlache
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Thomas L. Herlache
President (CEO)
Date: August 8, 2005 /s/ Steven D. Jennerjohn
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Steven D. Jennerjohn
Treasurer (CFO)
38