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 SEPTEMBER 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 incorporation (Identification No.)
or organization)
217 North Fourth Avenue, Sturgeon Bay, WI 54235
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(920)-743-5551
- --------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
None
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes {X} No { }
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes {X} No { }
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes { } No {X}
Applicable Only to Corporate Issuers:
Number of outstanding shares of each of common stock, par value $5.00 per share,
as of November 1, 2005: 7,765,727 shares
BAYLAKE CORP. AND SUBSIDIARIES
INDEX
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets (Unaudited) as of September 30, 2005 and
December 31, 2004 3
Consolidated Statements of Income and Comprehensive Income
(Unaudited) for the three and nine months ended September 30, 2005 and 2004 4 -5
Consolidated Statements of Changes in Stockholders' Equity (Unaudited)
for the nine months ended September 30, 2005 and 2004 6
Consolidated Statements of Cash Flows (Unaudited) for the nine months
ended September 30, 2005 and 2004 7-8
Notes to Consolidated Unaudited Financial Statements 9-11
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12-36
Item 3. Quantitative and Qualitative Disclosures About Market Risk 36-38
Item 4. Controls and Procedures 38
PART II - OTHER INFORMATION
Signatures 39
EXHIBIT INDEX
Exhibit 31.1 Certification pursuant to Section 302 40
Exhibit 31.2 Certification pursuant to Section 302 42
Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 44
Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 45
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, 2005 and December 31, 2004
(Amounts in thousands of dollars)
Sept 30, 2005 December 31,
(Unaudited) 2004
------------- ------------
ASSETS
Cash and due from financial institutions $ 21,980 $ 20,727
Federal funds sold 3,132 5,445
----------- ------------
Cash and cash equivalents 25,112 26,172
Securities available for sale 211,227 197,392
Loans held for sale 544 1,349
Loans, net of allowance after $10,492 and $10,445 779,256 746,783
Cash value of life insurance 22,632 21,561
Premises and equipment, net 28,508 24,777
Federal Home Loan Bank stock 8,006 7,697
Foreclosed assets, net 2,629 2,572
Goodwill 5,723 5,723
Accrued interest receivable 5,202 4,330
Other assets 10,799 9,392
----------- ------------
Total assets $ 1,099,638 $ 1,047,748
=========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest-bearing $ 119,609 $ 120,511
Interest-bearing 747,015 724,030
----------- ------------
Total deposits 866,624 844,541
Federal Home Loan Bank advances 125,187 100,192
Federal funds purchased and repurchase agreements 1,906 1,284
Subordinated debentures 16,100 16,100
Accrued expenses and other liabilities 11,759 8,272
Dividends payable - 1,154
----------- ------------
Total liabilities 1,021,576 971,543
Common stock, $5 par value, authorized 50,000,000; issued-
7,788,886 shares in 2005, 7,715,936 shares in 2004; outstanding-
7,765,727 shares in 2005, 7,692,777 shares in 2004 38,944 38,580
Additional paid-in capital 9,348 8,806
Retained earnings 30,653 28,275
Treasury stock (23,159 shares in 2005 and 2004) (625) (625)
Accumulated other comprehensive income (loss) (258) 1,169
----------- ------------
Total stockholders' equity 78,062 76,205
----------- ------------
Total liabilities and stockholder equity $ 1,099,638 $ 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 Nine Months ended September 30, 2005 and 2004
(Amounts in thousands of dollars except per share data)
Three months ended Sept 30 Nine months ended Sept 30
2005 2004 2005 2004
Interest and dividend income
Loans, including fees $ 13,576 $ 10,722 $ 38,183 $ 30,835
Taxable securities 1,768 1,664 5,226 4,878
Tax exempt securities 508 362 1,400 1,128
Federal funds sold and other 33 4 66 11
--------- --------- --------- --------
Total interest and dividend income 15,885 12,752 44,875 36,852
--------- --------- --------- --------
Interest expense
Deposits 5,193 2,890 13,514 8,718
Federal funds purchased and repurchase agreements 215 67 706 289
Federal Home Loan Bank advances and other debt 1,224 610 2,975 1,633
Subordinated debentures 461 424 1,384 1,271
--------- --------- --------- --------
Total interest expense 7,093 3,991 18,579 11,911
--------- --------- --------- --------
NET INTEREST INCOME 8,792 8,761 26,296 24,941
Provision for loan losses 1,547 70 1,668 1,569
--------- --------- --------- --------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 7,245 8,691 24,628 23,372
--------- --------- --------- --------
Other income
Fees from fiduciary activities 193 167 556 529
Fees from loan servicing 292 286 863 763
Fees for other services to customers 1,260 1,100 3,543 3,264
Gains from sales of loans 348 420 733 1,045
Increase in cash surrender value of life insurance 184 190 601 582
Other income 142 164 666 890
--------- --------- --------- --------
Total other income 2,419 2,327 6,962 7,073
--------- --------- --------- --------
Noninterest expenses
Salaries and employee benefits 4,213 3,860 13,070 11,669
Occupancy expense 717 517 1,855 1,568
Equipment expense 349 332 996 1,000
Data processing and courier 285 280 861 835
Operation of other real estate 87 65 216 336
Provision for impairment of letter of credit 1,846 -- 1,846 --
Other operating expenses 1,522 1,432 4,565 4,051
--------- --------- --------- --------
Total other expenses 9,019 6,486 23,409 19,459
--------- --------- --------- --------
INCOME BEFORE INCOME TAX EXPENSE 645 4,532 8,181 10,986
Income tax expense (benefit) (62) 1,458 2,330 3,423
--------- --------- --------- --------
NET INCOME $ 707 $ 3,074 $ 5,851 $ 7,563
--------- --------- --------- --------
COMPREHENSIVE INCOME $ 220 $ 5,245 $ 4,424 $ 7,419
--------- --------- --------- --------
BASIC EARNINGS PER SHARE $ 0.09 $ 0.40 $ 0.76 $ 0.99
DILUTED EARNINGS PER SHARE $ 0.09 $ 0.40 $ 0.75 $ 0.98
See accompanying notes to Unaudited Consolidated Financial Statements.
4
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
Nine months ended September 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 - - - 7,563 - - 7,563
Net changes in unrealized gain (loss)
on securities available for sale, net
of $72 deferred taxes - - - - - (144) (144)
-------
Total comprehensive income 7,419
Stock options exercised 67,306 336 375 - - - 711
Tax benefit from exercise of stock options - - 107 - - - 107
Cash dividends declared ($0.42 per share) - - - (3,207) - - (3,207)
--------- -------- ---------- -------- -------- ------------- -------
BALANCE, SEPTEMBER 30, 2004 7,672,283 $ 38,477 $ 8,645 $ 26,220 $ (625) $ 1,941 $74,658
========= ======== ========== ======== ======== ============= =======
BALANCE, JANUARY 1, 2005 7,692,777 $ 38,580 $ 8,806 $ 28,275 $ (625) $ 1,169 $76,205
Net income for the year - - - 5,851 - - 5,851
Net changes in unrealized gain (loss)
on securities available for sale,
net of $(793) deferred taxes - - - - - (1,427) (1,427)
-------
Total comprehensive income 4,424
Stock options exercised 72,950 364 299 - - - 663
Tax benefit from exercise of stock options - - 243 - - - 243
Cash dividends declared ($0.45 per share) - - - (3,473) - - (3,473)
--------- -------- ---------- -------- -------- ------------- -------
BALANCE, SEPTEMBER 30, 2005 7,765,727 $ 38,944 $ 9,348 $ 30,653 $ (625) $ (258) $78,062
========= ======== ========== ======== ======== ============= =======
See accompanying notes to Unaudited Consolidated Financial Statements.
5
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine months ended September 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 $ 5,851 $ 7,563
Adjustments to reconcile net income to net cash
provided to operating activities:
Depreciation and amortization 1,353 1,267
Provision for losses on loans 1,668 1,569
Provision for impairment on letter of credit 1,846 -
Net amortization of securities 457 398
Increase in cash surrender value of life insurance (601) (582)
Federal Home Loan Bank stock dividend (309) (337)
Net gain on sale of loans (733) (1,045)
Proceeds from sale of loans held for sale 38,007 49,070
Origination of loans held for sale (36,469) (48,190)
Net (gain) loss from disposal of other real estate 35 (178)
Net (gain) loss from disposal of bank premises and equipment 224 (482)
Changes in assets and liabilities:
Accrued interest receivable and other assets (685) (1,496)
Accrued expenses and other liabilities 873 2,123
-------- --------
Net cash provided by operating activities 11,517 9,680
CASH FLOWS FROM INVESTING ACTIVITIES:
Principal payments on securities available-for-sale 14,143 15,019
Purchase of securities available-for-sale (30,654) (30,832)
Proceeds from sale of other real estate owned 908 2,242
Proceeds from sale of premises and equipment 316 767
Cash paid in completion of acquisition - (754)
Loan originations and payments, net (35,141) (41,907)
Additions to premises and equipment (5,415) (2,691)
Investment in bank-owned life insurance (470) -
-------- --------
Net cash used in investing activities (56,313) (58,156)
See accompanying notes to Unaudited Consolidated Financial Statements.
6
BAYLAKE CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30, 2005 and 2004
(Amounts in thousands of dollars)
2005 2004
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits $ 22,083 $ 19,588
Net change in federal funds purchased and
repurchase agreements 622 5,008
Proceeds from Federal Home Loan Bank advances 25,000 25,101
Repayments on Federal Home Loan Bank advances (5) -
Payments on other borrowings and long-term debt - (53)
Proceeds from exercise of stock options 663 711
Cash dividends paid (4,627) (4,268)
-------- --------
Net cash provided by financing activities 43,736 46,087
-------- --------
Net change in cash and cash equivalents (1,060) (2,389)
Beginning cash and cash equivalents 26,172 24,226
-------- --------
ENDING CASH AND CASH EQUIVALENTS $ 25,112 $ 21,837
======== ========
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 17,349 $ 11,997
Income taxes $ 3,099 $ 2,093
See accompanying notes to Unaudited Consolidated Financial Statements.
7
BAYLAKE CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 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
September 30, 2005 and December 31, 2004. The results of operations for
the three and nine months ended September 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 nine months ended September 30
(dollars in thousands, except per share amounts):
Three months ended Nine months ended
September 30, September 30,
(Net income in thousands)
2005 2004 2005 2004
----------- ------------ ----------- -----------
(NUMERATOR):
Net income $ 707 $ 3,074 $ 5,851 $ 7,563
(DENOMINATOR):
Weighted average number of common
shares outstanding-basic 7,742,346 7,654,549 7,713,177 7,633,253
Dilutive effect of stock options 86,401 76,477 82,972 72,323
----------- ------------ ----------- ------
Weighted average number of common
shares outstanding-diluted 7,828,747 7,731,026 7,796,149 7,705,576
BASIC EPS $ 0.09 $ 0.40 $ 0.76 $ 0.99
DILUTED EPS $ 0.09 $ 0.40 $ 0.75 $ 0.98
8
BAYLAKE CORP. AND SUBSIDIARIES
4. Baylake Corp. declared a cash dividend of $0.15 per share paid on
September 15, 2005 to shareholders of record as of September 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 Nine months ended
September 30, September 30,
(In thousands, except per share amounts)
2005 2004 2005 2004
------- --------- --------- ---------
Net income, as reported $ 707 $ 3,074 $ 5,851 $ 7,563
Less: Total stock-based
compensation cost determined
under the fair value based
method, net of income taxes (14) (27) (43) (82)
------- --------- --------- ---------
Pro forma net income 693 3,047 5,808 7,481
Basic-as reported $ 0.09 $ 0.40 $ 0.76 $ 0.99
Basic-pro forma $ 0.09 $ 0.40 $ 0.75 $ 0.98
Diluted-as reported $ 0.09 $ 0.40 $ 0.75 $ 0.98
Diluted-pro forma $ 0.09 $ 0.39 $ 0.74 $ 0.97
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 September 30, 2004 Form 10-Q have been
reclassified to conform to the September 30, 2005 presentation.
7. Included in the totals for Premises and Equipment is $6.1 million related
to the construction project for Baylake City Center LLC. The $6.1 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 opened for
business. Costs for this project have amounted to $2.1 million. The space
occupied is 25,000 square feet. Approximately 91,000 square feet of the
project are expected to be sold for office and
9
BAYLAKE CORP. AND SUBSIDIARIES
condominium use. This portion of the property has been listed for sale
with a commercial real estate brokerage firm. The estimated costs
allocated to this portion of the project amount to $4.0 million.
8. In the process of completing loan and asset quality reviews for the third
quarter ended September 30, 2005, a matter came to management's attention
of potential cash flow problems for one of the Company's borrowers. As the
information became available, the Company completed an impairment analysis
to determine their exposure on loans to this borrower as well as a letter
of credit outstanding for this borrower. This resulted in the Company
allocating a reserve of 100%, or $500,000, to this borrower's loans at
September 30, 2005. In addition to this, included in other operating
expenses for the three-month and nine-month periods ended September 30,
2005 is a provision for impairment losses totaling $1.8 million reflecting
a liability established by the Company for their exposure related to the
value of a letter of credit to this borrower to its currently estimated
realizable value at September 30, 2005.
9. On October 17, 2005, the banking regulators commenced a regularly
scheduled examination of the Bank. There can be no assurance that the
regulators will not identify items which may have an impact on the
financial statements of the Company.
10. 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 2006 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 nine months ended September 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 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.
13
RESULTS OF OPERATIONS
The following table sets forth the Company's net income and related summary
information for the three and nine-months periods ended September 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 Nine months Nine months
ended Sept 30, ended Sept 30, ended Sept 30, ended Sept 30,
2005 2004 2005 2004
Net income, as reported $ 707 $3,074 $5,851 $7,563
EPS-basic, as reported $ 0.09 $ 0.40 $ 0.76 $ 0.99
EPS-diluted, as reported $ 0.09 $ 0.40 $ 0.75 $ 0.98
Cash dividends declared $ 0.15 $ 0.14 $ 0.45 $ 0.42
Return on average assets, as
reported 0.26% 1.21% 0.72% 1.01%
Return on average equity, as
reported 3.60% 17.04% 10.09% 14.14%
Efficiency ratio, as reported (1) 78.11% 57.11% 68.40% 59.26%
(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 and nine-month periods is
primarily due to an increase in non-interest expense and an increase in the
provision for loan losses. Both of these items were impacted by negative
developments relating to one borrower, which resulted in a $1.8 million
provision for impairment on the letter of credit, as well as a $650,000
provision for the borrower's related loans. These were partially offset by an
increase in net interest income and a decrease in 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 79.1% of total operating income for the three months ended
September 30, 2005, as compared to 79.5% 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
September 30, 2005 increased $96,000, or 1.1%, to $9.1 million from $9.0 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 nine
months ended September 30, 2005, net interest income increased $1.5 million, or
5.8%, to $27.3 million from $25.8 million for the comparable period in 2004. The
increase results for the same reasons as listed above.
14
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 third quarter of 2005 was 3.58%, down 27 basis
points ("bps") from 3.85% for the comparable period in 2004. This comparable
period decrease was attributable to a 39 bps decrease in interest rate spread
(the net result of a 81 bps increase in the yield on earning assets offset by a
120 bps increase in the cost of interest-bearing liabilities). During the nine
months ended September 30, 2005, the net interest margin was 3.64% compared to
3.70% for the comparable period in 2004. Net interest margin decreased as a
result of an increase in earning assets relative to interest-bearing liabilities
offset partially by a 16 bps decrease in interest rate spread (the net result of
a 70 bps increase in the yield on earning assets offset by a 86 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 nine months of 2005, average
interest rates were higher in 2005 than in 2004. Interest rates rose steadily
during the period with six rate increases totaling 150 bps between the
comparable first nine 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 third 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 September 30, 2005, average-earning assets increased
$81.5 million, or 8.7%, when compared to the same period last year. The Company
recorded an increase in average loans of $53.6 million, or 7.2%, for the third
quarter of 2005 compared to the same period a year ago. For the nine months
ended September 30, 2005, average-earning assets increased $71.9 million, or
7.7%, when compared to the same period last year. The Company recorded an
increase in average loans of $48.2 million, or 6.5%, for the first nine months
of 2005 compared to the same period a year ago. Although they tend to have more
risk, loans have typically resulted in higher rates of interest income to the
Company than have investment securities, which further positively affected
income in the quarter.
Interest rate spread is the difference between the tax-equivalent rate earned on
average earning assets and the rate paid on average interest-bearing
liabilities. The interest rate spread decreased for the quarter ended September
30, 2005 when compared to the same period a year ago. The interest rate spread
decreased 39 bps to 3.21% at September 30, 2005 from 3.60% in the same quarter
in 2004. While the average yield on earning assets increased 81 bps during the
period, the average rate paid on interest-bearing liabilities increased 120 bps
over the same period. For the nine months ended September 30, 2005, the interest
rate spread decreased 16 bps to 3.32% from 3.48% when compared to the same
period a year earlier. The average yield on earning assets increased 70 bps to
6.12% from 5.42% during the nine-month period, while the average rate paid on
interest-bearing liabilities increased 86 bps. The increase in the rates paid on
interest-bearing liabilities occurred as a result of a higher cost of funding
from deposits and other wholesale funding such as federal funds purchased and
loans from the Federal Home Loan Bank. We would expect that trend to continue in
light of the recent Federal Reserve Board interest rate increases.
15
TABLE 2
NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS
($ in thousands)
Three months ended September 30,
2005 2004
-------------------------------- --------------------------------
Interest Average Interest Average
Average income/ yield/ Average income/ yield/
Balance expense Rate Balance expense rate
ASSETS
Earning assets:
Loans, net $ 798,321 $ 13,653 6.84% $ 744,714 $ 10,803 5.80%
Taxable securities 172,055 1,768 4.11% 161,135 1,664 4.13%
Tax exempt securities 45,630 766 6.71% 30,802 551 7.16%
Federal funds sold and
interest bearing due
from banks 3,786 33 3.49% 1,608 4 1.00%
----------- -------- ----- ----------- -------- -----
Total earning assets 1,019,792 16,220 6.36% 938,259 13,022 5.56%
----------- -------- ----- ----------- -------- -----
Non-interest earning
assets 82,507 74,860
----------- -----------
Total assets $ 1,102,299 $ 1,013,119
----------- -----------
LIABILITIES AND
STOCKHOLDERS'EQUITY
Interest-bearing
liabilities:
Total interest-bearing
deposits 736,925 5,193 2.82% 686,697 2,890 1.68%
Short-term borrowings 21,948 204 3.72% 14,658 64 1.75%
Customer repurchase
agreements 1,553 11 2.83% 1,196 3 1.00%
Federal Home Loan Bank
advances 122,904 1,224 3.98% 100,195 610 2.44%
Subordinated debentures 16,100 461 11.45% 16,100 424 10.53%
----------- -------- ----- ----------- -------- -----
Total interest-bearing
liabilities $ 899,430 $ 7,093 3.15% $ 818,846 $ 3,991 1.95%
----------- -------- ----- ----------- -------- -----
Demand deposits 115,807 114,181
Accrued expenses and
other liabilities 8,573 7,932
Stockholders' equity 78,489 72,160
----------- ------
Total liabilities and
stockholders' equity $ 1,102,299 $ 1,013,119
----------- -----------
Interest rate spread $ 9,127 3.21% $ 9,031 3.60%
Net interest margin 3.58% 3.85%
----- -----
16
TABLE 3
NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS
($ in thousands)
Nine months ended September 30,
2005 2004
-------------------------------- --------------------------------
Interest Average Interest Average
Average income/ yield/ Average income/ yield/
Balance Expense Rate Balance Expense Rate
ASSETS
Earning assets:
Loans, net $ 785,124 $ 38,433 6.53% $ 736,943 $ 31,077 5.62%
Taxable securities 169,714 5,226 4.11% 156,763 4,878 4.15%
Tax exempt securities 41,473 2,117 6.81% 32,123 1,711 7.10%
Federal funds sold and
interest bearing due
from banks 3,206 66 2.74% 1,821 11 0.81%
----------- -------- ----- ----------- -------- -----
Total earning assets 999,517 45,842 6.12% 927,650 37,677 5.42%
----------- -------- ----- ----------- -------- -----
Non-interest earning
assets 80,157 73,016
----------- -----------
Total assets $ 1,079,674 $ 1,000,666
----------- -----------
LIABILITIES AND
STOCKHOLDERS'EQUITY
Interest-bearing
liabilities:
Total interest-bearing
deposits 727,383 13,514 2.48% 681,217 8,718 1.71%
Short-term borrowings 27,636 679 3.28% 26,405 281 1.42%
Customer repurchase
agreements 1,421 27 2.53% 1,107 8 0.96%
Federal Home Loan Bank 113,449 2,975 3.50% 93,646 1,633 2.33%
advances
Subordinated debentures 16,100 1,384 11.46% 16,100 1,271 10.53%
----------- -------- ----- ----------- -------- -----
Total interest-bearing
liabilities $ 885,989 $ 18,579 2.80% $ 818,475 $ 11,911 1.94%
----------- -------- ----- ----------- -------- -----
Demand deposits 107,965 102,901
Accrued expenses and
other liabilities 8,367 7,976
17
Stockholders' equity 77,353 71,314
----------- -----------
Total liabilities and
stockholders' equity $ 1,079,674 $ 1,000,666
----------- -----------
Interest rate spread $ 27,263 3.32% $ 25,766 3.48%
Net interest margin 3.64% 3.70%
---- ----
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 92.7%, respectively, for the first nine 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 nine months of 2005 was $1.7
million as compared to a PFLL of $1.6 million for the first nine months in 2004.
Net declines in asset quality in the loan portfolio were a factor in the level
of provision for the first nine months of 2005. This was offset partially by a
decrease in identified potential problem loans for the period. Net loan
charge-offs in the first nine months of 2005 were $1.6 million compared with net
charge-offs of $771,000 for the same period in 2004. The loans charged-off in
the first nine months of 2005 had a specific reserve in the aggregate of $1.3
million which approximated the amount charged-off. Net charge-offs to average
loans on an annualized basis were 0.28% for the first nine months of 2005
compared to 0.14% for the same period in 2004. For the nine months ended
September 30, 2005, non-accrual loans increased $1.4 million, in part as the
result of a transfer to non-accrual of a $1.0 million commercial real estate
credit which already was on our watch list. There was not a material change in
the amount of reserve allocated to this credit, as a result of this transfer. At
the end of October 2005, this credit was still in non-accrual status.
18
TABLE 4
ALLOWANCE FOR LOAN LOSSES
($ in thousands)
For the nine For the nine
months ended months ended
Sept 30, 2005 Sept 30, 2004
Allowance for Loan Losses ("ALL)
Balance at beginning of period $ 10,445 $ 12,159
Provision for loan losses 1,668 1,569
Charge-offs 1,913 1,689
Recoveries 292 918
Balance at end of period $ 10,492 $ 12,957
Net charge-offs ("NCOs:) $ 1,621 $ 771
As described more fully in Table 8 below, non-accrual loans increased during the
period from December 31, 2004. The required allocation of the allowance for such
loans increased $1.2 million. Included in this increase was the potential
problem loan of $500,000 that was determined to be impaired and allocated a
specific provision of $500,000 at September 30, 2005. Additional financing
approved in October 2005 in the form of a line of credit for $200,000 has been
afforded this borrower to meet various funding needs and Management has included
this additional financing in its impairment analysis. These facts in addition to
the net charge-offs for the nine months ended September were factors in the
determination of a provision of $1.7 million for the nine-month period ended
September 30, 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 increased $92,000, or 4.0% to $2.4 million for the
third quarter of 2005 when compared to the third quarter of 2004. For the nine
months ended September 30, 2005, total non-interest income was $7.0 million, a
decrease of $111,000, or 1.6%, when compared to the same period in 2004. The
non-interest income to average assets ratio was 0.88% for the three months ended
September 30, 2005 compared to 0.92% for the same period in 2004. For the nine
months ended September 30, 2005, the non-interest income to average assets ratio
was 0.86% compared to 0.94% for the same period in 2004. The decrease in
non-interest income for the nine-month periods is mainly due to decreases in
gains on sale of bank premises. Additionally the decrease for the three-month
and nine-month periods is due to decreases in gains from sales of loans offset
by an increase in other services to customers.
19
Table 5 reflects the various components of non-interest income for the
comparable quarters.
TABLE 5
NON-INTEREST INCOME
($ in thousands)
Third Third
quarter quarter Percent YTD YTD Percent
2005 2004 change 2005 2004 change
Fees from fiduciary
services $ 193 $ 167 15.6% $ 556 $ 529 5.1%
Fees from loan servicing 292 286 2.1% 863 763 13.1%
Service charges on
deposit accounts 877 753 16.5% 2,447 2,206 10.9%
Other fee income 199 161 23.6% 549 483 13.7%
Financial services
income 184 186 (1.1%) 547 575 (4.9%)
Gains from sales of
loans 348 420 (17.1%) 733 1,045 (29.9%)
Increase in cash
surrender value of life
insurance 184 190 (3.2%) 601 582 3.3%
Gain on sale of bank
assets 3 - NM 306 482 (36.5%)
Other income 139 164 (15.2%) 360 408 (11.8%)
------- ------- ------- -------
Total Other Income $ 2,419 $ 2,327 4.0% $ 6,962 $ 7,073 (1.6%)
Service charges on deposit accounts increased $124,000 for the three-month
period and $241,000 for the nine-month period ended September 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 nine months 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 $312,000 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 nine months, the
Company has seen a decrease in the number of loan applications. Secondary loan
production declined 24.3% between the comparable first nine-month periods ($36.5
million in the first nine months of 2005 versus $48.2 million in the first nine
months of 2004).
20
For the nine month period ended September 30, 2005, the reduction in gain on
sale of bank assets was related to non-recurring gains taken in 2004 on the sale
of bank land located in the Green Bay market area totaling $482,000. Gains
totaling $106,000 were realized in the first nine months 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. Pulse was an ATM
operator/provider in which the Bank held shares.
Financial service income was flat for the third quarter of 2005 with a decrease
of $2,000, or 1.1%. For the nine months ended September 30, 2005, financial
services income has decreased $28,000, or 4.9%, when compared to the same period
in 2004 as a result of slowdown in business activity.
Non-Interest Expense
Impacting the three and nine-month periods ended September 30, 2005 was a $1.8
million charge for impairment related to an off-balance sheet letter of credit,
as mentioned in note 8 to our consolidated financial statements. As a result,
non-interest expense increased $2.5 million or 39.1%, to $9.0 million for the
three months ended September 30, 2005 compared to the same period in 2004. For
the nine months ended September 30, 2005, total non-interest expense increased
$4.0 million, or 20.3%, to $23.4 million compared to the same period in 2004.
The non-interest expense to average assets ratio was 3.27% for the three months
ended September 30, 2005 compared to 2.56% for the same period in 2004. For the
nine months ended September 30, 2005, non-interest expense ratio to average
assets was 2.89% compared to 2.59% for the same period in 2004.
Net overhead expense is total non-interest expense less total non-interest
income excluding securities gains. The net overhead expenses to average assets
ratio was 2.39% for the three months ended September 30, 2005 compared to 1.64%
for the same period in 2004. For the nine months ended September 30, 2005, the
net overhead expenses to average assets ratio was 2.03% compared to 1.65% for
the same period in 2004. The efficiency ratio is total non-interest expense as a
percentage of the sum of net-interest income on a fully taxable equivalent basis
and total non-interest income. The efficiency ratio for the three months ended
September 30, 2005 was 78.11% compared to 57.11% for the same period in 2004.
For the nine months ended September 30, 2005, the efficiency ratio was 68.40%
compared to 59.26% for the same period in 2004.
21
TABLE 6
NON-INTEREST EXPENSE
($ in thousands)
Third Third
quarter quarter Percent YTD YTD Percent
2005 2004 change 2005 2004 change
Salaries and employee
benefits $ 4,213 $ 3,860 9.1% $13,070 $11,669 12.0%
Occupancy 717 517 38.7% 1,855 1,568 18.3%
Equipment 349 332 5.1% 996 1,000 (0.4%)
Data processing and
courier 285 280 1.8% 861 835 3.1%
Operation of other real
estate owned 87 65 33.8% 216 336 (35.7%)
Business development
and advertising 276 171 61.4% 764 565 35.2%
Charitable contributions 36 33 9.1% 183 194 (5.7%)
Stationary and supplies 139 141 (1.4%) 406 382 6.3%
Director fees 134 104 28.8% 326 314 3.8%
FDIC 28 28 0.0% 84 85 (1.2%)
Mortgage servicing
rights amortization 54 57 (5.3%) 170 189 (10.1%)
Legal and professional 115 152 (24.3%) 419 346 21.1%
Loss on disposal of
fixed assets 76 0 NM 330 0 NM
Provision for
impairment of letter of
credit 1,846 0 NM 1,846 0 NM
Other operating 664 746 (11.0%) 1,883 1,976 (4.7%)
------- ------- ------- -------
Total non-interest
expense $ 9,019 $ 6,486 39.1% $23,409 $19,459 20.3%
Salaries and employee benefits showed an increase of $353,000, or 9.2%, to $4.2
million for the third quarter of 2005 compared to the same period in 2004. The
number of full-time equivalent employees was 311 as of September 30, 2005
compared to 308 at September 30, 2004. For the three months ended September 30,
2005, salary-related expenses increased $288,000, or 10.9%, due principally to
merit increases between the years and related staff increases. For the nine
months ended September 30, 2005, salary-related expenses increased $499,000, or
6.1%, compared to the same period in 2004 for the reasons listed previously.
Contributing to the increase in salary and employee benefits were expenses
related to the Baylake Bank Supplemental Executive Retirement Plan ("Plan"). In
the first quarter, the Company implemented the 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. Costs amounted to approximately $121,000 in
expenses related to the vested portion of the Plan contributions in the third
quarter of 2005 and $519,000 for the nine months ended September 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.
22
Expenses related to the operation of other real estate owned increased $22,000
to $87,000 for the 2005 three-month period ended September 30 compared to the
same period in 2004. For the nine -- month period ended September 30, 2005,
other real estate owned expenses decreased $120,000 to $216,000 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 $35,000 for
the nine months ended September 30, 2005 compared to net gains taken on sale of
$178,000 for the same period in 2004. In addition, costs related to the holding
of other real estate owned properties decreased $333,000 to $181,000 for the
first nine months of 2005.
Legal and professional expense for the first nine months in 2005 increased
substantially, by $73,000, to $419,000. 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.
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.
The provision for impairment loss on the letter of credit relates to the
establishment of a liability for the Company's exposure on a letter of credit.
Subsequent to the end of the third quarter, a matter relating to potential cash
flow problems affecting one of the Company's borrowers came to management's
attention. This customer has a letter of credit arrangement with the Company
totaling $8.8 million; the letter of credit supports secondary market financing
on behalf of the borrower. The Company has completed an analysis of this
off-balance sheet commitment and provided $1.8 million to establish a liability
for the potential exposure. The Company now believes that the letter of credit
will be drawn upon, and as such, the collateral and cash flows will not be
sufficient to support the outstanding debt. The Company is monitoring the
financial condition of the borrower on an ongoing basis and if it continues to
deteriorate, may need to provide additional reserves with respect to the
off-balance sheet commitment.
Income Taxes
Income tax expense for the Company for the nine months ended September 30, 2005
was $2.3 million, a decrease of $1.1 million, or 31.9%, compared to the same
period in 2004. For the three months ended September 30, 2005, income tax
expense resulted in a $62,000 income tax benefit compared to an income tax
expense of $1.5 million for the same period in 2004. The tax benefit for the
three months, and the lower tax expense reflected for the three and nine-months
periods ended September 30 reflected the Company's decrease in before tax
earnings.
The Company's effective tax rate (income tax expense divided by income before
taxes) was 28.5% for the nine months ended September 30, 2005 compared with
31.2% for the same period in 2004. The effective tax rate of 28.5% consisted of
a federal effective tax rate of 23.6% and Wisconsin state effective tax rate of
4.9%. For the three and nine-month periods ended September 30, the decrease in
income tax expense was primarily due to a decrease in taxable income in addition
to an increase in tax-exempt interest income from municipal investments.
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.
23
BALANCE SHEET ANALYSIS
Loans
At September 30, 2005, total loans increased $32.5 million, or 4.3%, to $789.7
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
$454.6 million at September 30, 2005 compared to $424.7 million at December 31,
2004. In addition, growth in real estate construction loans increased to $89.6
million at September 30, 2005 compared to $80.4 million at December 31, 2004.
Growth in commercial real estate mortgages and commercial loans occurred
principally as a result of the Company's expansion efforts (primarily in the
Green Bay market) and the strong economic growth in that market.
The following table reflects the composition (mix) of the loan portfolio:
TABLE 7
LOAN PORTFOLIO ANALYSIS
($ in thousands)
September December 31, Percent
30, 2005 2004 change
Amount of loans by type
Real estate-mortgage
Commercial $ 454,575 $424,712 7.0%
1-4 family residential
First liens 85,361 78,321 9.0%
Junior liens 22,167 20,244 9.5%
Home equity 34,290 35,785 (4.2%)
Commercial, financial and agricultural 75,461 83,787 (9.9%)
Real estate-construction 89,620 80,384 11.5%
Installment
Credit cards and related plans 2,073 2,152 (3.7%)
Other 12,281 11,784 4.2%
Obligations of states and political subdivisions 14,338 20,457 (29.9%)
Less: deferred origination fees, net of costs 418 398 5.0%
--------- -------- -----
Total $ 789,748 $757,228 4.3%
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.
24
As indicated in Table 4 above, the ALL at September 30, 2005 was $10.5 million
compared with $10.4 million at the end of 2004. This was based on management's
analysis of the loan portfolio risk at September 30, 2005. A provision expense
of $1.7 million relating to a letter of credit impairment was recorded for the
nine months ended September 30, 2005. See discussion above in "Results of
Operations-Provision for Loan Losses." The quarter to date provision has
increased by $1.5 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 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.
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
25
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 September 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.
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.
26
TABLE 8
NON-PERFORMING ASSETS
($ in thousands)
At or for the At or for the At or for the
period ended period ended period ended
Sept 30, 2005 Sept 30, 2004 December 31, 2004
Nonperforming Assets:
Nonaccrual loans $ 7,299 $ 13,239 $ 5,920
Accruing loans past due 90 days or more 0 0 0
-------- --------- --------
Total nonperforming loans ("NPLs") $ 7,299 $ 13,239 $ 5,920
Other real estate owned 2,629 2,520 2,572
-------- --------- --------
Total nonperforming assets ("NPAs") $ 9,928 $ 15,759 $ 8,492
Ratios:
ALL to NCO's (annualized) 4.85 12.60 3.15
NCO's to average loans (annualized) 0.28% 0.14% 0.45%
ALL to total loans 1.33% 1.72% 1.38%
NPL's to total loans 0.92% 1.76% 0.78%
NPA's to total assets 0.90% 1.53% 0.81%
ALL to NPL's 143.75% 97.87% 176.44%
As indicated in Table 8, non-performing loans at September 30, 2005 were $7.3
million compared to $5.9 million at December 31, 2004. This increase is due, in
part to the transfer to non-accrual of a $1.0 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 $7.3 million of the total non-performing loans.
Real estate non-accrual loans accounted for $6.5 million of the total, of which
$893,000 was residential real estate and $5.4 million was commercial real
estate, while commercial and industrial non-accrual loans total $746,000. As a
result the ratio of non-performing loans to total loans at September 30, 2005
was 0.92% compared to 0.78% at end of year 2004. The Company's ALL was 143.8% of
total non-performing loans at September 30, 2005 compared to 176.4% at end of
year 2004.
Non-performing assets (non-performing loans plus other real estate owned assets)
at September 30, 2005 were $9.9 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 fifteen commercial properties totaling $2.6 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 September
30, 2005, potential problem loans amounted to $3.8 million compared to a total
of $9.3 million at December 31, 2004. As a result of impairment analysis, $6.0
million of potential problem loans were specifically allocated a portion of the
loan loss provision and transferred from potential problem loans since end of
year 2004.
27
As mentioned previously, an impairment loss has been provided in the amount of
$1.8 million to establish a liability for potential exposure for a customer's
letter of credit arrangement with the Company totaling $8.8 million. The letter
of credit supports secondary market financing on behalf of the borrower. The
Company is monitoring the financial condition of the borrower (in the hotel
industry) on an ongoing basis, and if it continues to deteriorate, may need to
provide additional reserves with respect to the off-balance sheet commitment.
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 September 30, 2005, the investment portfolio (which includes investment
securities available for sale) increased $13.8 million, or 7.0%, to $211.2
million from $197.4 million at December 31, 2004. At September 30, 2005, the
investment portfolio represented 19.2% of total assets compared with 18.8% at
December 31, 2004.
Securities available for sale consist of the following:
TABLE 9
INVESTMENT SECURITY ANALYSIS
At September 30, 2005
($ in thousands)
Gross Gross
Unrealized Unrealized
Gains Losses Fair Value
---------- ---------- ----------
Securities available for sale
Obligations of U.S. Treasury &
other U.S. agencies 399 742 70,429
Mortgage-backed securities 12 1,277 91,229
Obligations of states &
political subdivisions 1,192 70 46,806
Private placement 45 0 1,040
Other securities 0 0 1,723
------ ------ ----------
Total securities available for
sale $1,648 $2,089 $ 211,227
28
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
Federal Home Loan Bank Stock
At September 30, 2005, the Company has $8 million of Federal Home Loan Bank
stock. Of this amount, $1.8 million is in excess of the amount that the Company
is required to hold. In late October the FHLB issued a statement that they would
suspend redeeming excess or voluntary capital stock. The FHLB indicated that it
would resume the voluntary redemptions as soon as possible. While the Company
does believe that this will not have a financial statement impact, we are
continuing to monitor the situation.
Deposits
Total deposits at September 30, 2005 increased $22.1 million, or 2.6%, to $866.6
million from $844.5 million at December 31, 2004. Non-interest bearing deposits
at September 30, 2005 decreased $902,000, or 0.7%, to $119.6 million from $120.5
million at December 31, 2004. Interest-bearing deposits at September 30, 2005
increased $23.0 million, or 3.2%, to $747.0 million from $724.0 million at
December 31, 2004. Brokered CD's totaled $179.3 million at September 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
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.
29
Emphasis has been, and will continue to be, placed on generating additional core
deposits in the remainder of 2005 and 2006 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 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
September 30, 2005 increased $622,000 to $1.9 million from $1.3 million at
December 31, 2004. Securities under repurchase provided the increase between
periods. There were no federal funds purchased at September 30, 2005 and
December 31, 2004.
Federal Home Loan Bank Advances totaled $125.2 million at September 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
$16,597,940. For additional details, please make reference to the Consolidated
Financial Statements and the accompanying footnotes on the Company's Form 10-K
for the year 2004.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT
LIABILITIES
The Company utilizes a variety of financial instruments in the normal course of
business to meet the financial needs of its customers. These financial
instruments include commitments to extend credit, commitments to originate
residential mortgage loans held for sale, commercial letters of credit, standby
letters of credit, and forward commitments to sell residential mortgage loans.
Please refer to the Company's Annual Report on Form 10-K for the year ended
December 31, 2004 for discussion with respect to the Company's quantitative and
qualitative disclosures about its fixed and determinable contractual
obligations. Items disclosed in Form 10-K have not materially changed since that
report was filed.
30
The following is a summary of our off-balance sheet commitments, all of which
were lending-related commitments:
TABLE 10
LENDING RELATED COMMITMENTS
($ in thousands)
September 30, 2005 December 31, 2004
Commitments to fund home equity
line loans $ 55,161 $ 45,101
Commitments to fund commercial real
estate loans 4,726 5,314
Commitments unused on various other
lines of credit loans 173,633 135,889
---------- ----------
Total commitments to extend credit $ 233,520 $ 186,304
Financial standby letters of credit $ 24,412 $ 23,428
See "Balance Sheet Analysis - Non-Performing Loans, Potential Problem Loans and
Other Real Estate" for a discussion of potential exposure relating to a $8.8
million letter of credit arrangement with a customer.
The following table summarizes the Company's significant contractual obligations
and commitments at September 30, 2005:
TABLE 11
CONTRACTUAL OBLIGATIONS
($ in thousands)
WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS AFTER 5 YEARS TOTAL
------------- --------- --------- ------------- --------
Federal funds
purchased and
repurchase
agreements $ 1,906 $ 0 $ 0 $ 0 $ 1,906
Federal Home Loan
Bank advances 85,000 15,000 187 25,000 125,187
Subordinated
debentures 0 0 0 16,100 16,100
Operating leases 128 220 112 0 460
------- --------- ----- --------- --------
Total $87,034 $ 15,220 $ 299 $ 41,100 $143,653
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 $3.6 million for the first nine 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 $4.6 million in the first nine months of 2005.
31
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 nine months ended September 30, 2005, principal payments totaling $14.1
million were received on investments. The Company purchased $30.7 million in
investments in the first nine months of 2005. This resulted in net cash of $16.6
million used in investing activities for the first nine months of 2005. At
September 30, 2005 the investment portfolio contained $161.7 million of U.S.
Treasury and federal agency backed securities representing 76.5% 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 September
30, 2005 Consolidated Statements of Cash Flows, deposits increased and resulted
in $22.1 million of cash flow during the first nine months of 2005. The
Company's overall deposit base increased 2.6% for the nine months ended
September 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.
Within the classification of short-term borrowings at September 30, 2005,
federal funds purchased and securities sold under agreements to repurchase
totaled $1.9 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 $125.2 million at September 30, 2005 and $100.2 million at December 31,
2004.
The Bank's liquidity resources were sufficient in the first nine 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 nine 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.
32
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 September 30, 2005 increased $1.9 million or 2.4% to
$78.1 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 $1.4 million for the first nine months of 2005; this change resulted
from the effects of the increasing interest rate environment. Total dividends
paid increased to $3.5 million in the nine months ended September 30, 2005 from
$3.2 million for the same period in 2004, primarily as a result of an increase
in the per share dividends rate to $0.45 from $0.42. Stockholders' equity to
assets at September 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 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 September 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 September 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 19% of Company's
Common Stock participate in the plan.
33
Cash dividends paid in the first nine months of 2005 were $0.45 per share
compared with $0.42 in 2004. The Company provided a 7.1% increase in normal
dividends per share in 2005 over 2004. Total funds utilized in the payment of
dividends were $4.6 million in the first nine months of 2005, as compared to
$4.3 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 nine 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 September 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.
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%.
34
The following table presents the Company's and the Bank's capital ratios as of
September 30, 2005 and December 31, 2004:
TABLE 12
CAPITAL RATIOS
($ in thousands)
Required To Be
Well Capitalized
Required For under Prompt
Capital Adequacy Corrective Action
Actual Purposes Provisions
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
As of September 30, 2005
Total Capital (to
Risk Weighted Assets)
Company 98,802 10.69% 73,958 8.00% N/A N/A
Bank 94,794 10.27% 73,857 8.00% 92,321 10.00%
Tier 1 Capital (to
Risk Weighted Assets)
Company 88,310 9.55% 36,979 4.00% N/A N/A
Bank 84,302 9.13% 36,929 4.00% 55,393 6.00%
Tier 1 Capital (to
Average Assets)
Company 88,310 8.06% 43,848 4.00% N/A N/A
Bank 84,302 7.69% 43,848 4.00% 54,809 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. 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.
35
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 September 30, 2005, the Company was in compliance with its management
policies with respect to interest rate risk with the exception that the effect
of an immediate 200 basis point decrease in the prime rate over a one-year
horizon would impact negatively net interest income by 11.1%. The Company's
guidelines have internal limits of not more than a 10% change. The dollar change
would equate to a $379,000 decrease in net interest income for that period
exceeding the Company's internal limits. The Company has noted the issue and the
Company feels that other mitigating factors minimize that potential effect given
the current rate environment. The Company has not experienced any material
changes to its market risk position since December 31, 2004, as described in the
Company's 2004 Form 10-K Annual Report.
The Company's overall interest rate sensitivity is demonstrated by net interest
income analysis. Net interest income analysis measures the change in net
interest income in the event of hypothetical changes in interest rates. This
analysis assesses the risk of change in net interest income in the event of
sudden and sustained 1.0% to 2.0% increases and decreases in market interest
rates. The table below presents the Company's projected changes in net interest
income for the various rate shock levels at September 30, 2005.
36
TABLE 13
INTEREST SENSITIVITY
($ in thousands)
Change in Net Interest Income over One Year Horizon
At September 30, 2005 At December 31, 2004
--------------------------- -------------------------
Change in levels of Percentage Percentage
interest rates Dollar change change Dollar change change
- ------------------- ------------- ---------- ------------- ----------
+200 bp $ 2,324 6.7% $ 2,357 6.3%
+100 bp 1,027 3.0% 1,092 2.9%
Base 0 0% 0 0%
- -100 bp (1,826) (5.3%) (1,756) (4.7%)
- -200 bp (3,821) (11.1%) (3,656) (9.7%)
As shown above, at September 30, 2005, the effect of an immediate 200 basis
point increase in interest rates would increase the Company`s net interest
income by $2.3 million or 6.7%. The effect of an immediate 200 basis point
reduction in rates would decrease the Company's net interest income by $3.8
million or 11.1%.
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
September 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.
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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
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
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.
38
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: November 9, 2005 /s/ Thomas L. Herlache
------------------------
Thomas L. Herlache
President (CEO)
Date: November 9, 2005 /s/ Steven D. Jennerjohn
--------------------------
Steven D. Jennerjohn
Treasurer (CFO)
39