UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006
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
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(State or other jurisdiction of incorporation (Identification No.)
or organization)
217 North Fourth Avenue, Sturgeon Bay, WI 54235
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(Address of principal executive offices) (Zip Code)
(920)-743-5551
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(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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer" and "large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
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 common stock as of August 1, 2006: 7,843,127
shares
BAYLAKE CORP. AND SUBSIDIARIES
INDEX
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets (Unaudited) as of June 30, 2006 and December 31, 2005 3
Consolidated Statements of Income and Comprehensive Income (Unaudited) for the three and six months
ended June 30, 2006 and 2005 4
Consolidated Statements of Changes in Stockholders' Equity (Unaudited) for the six months ended
June 30, 2006 and 2005 5
Consolidated Statements of Cash Flows (Unaudited) for the six months ended June 30, 2006 and 2005 6-7
Notes to Consolidated Unaudited Financial Statements 8-11
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12-37
Item 3. Quantitative and Qualitative Disclosures About Market Risk 37-38
Item 4. Controls and Procedures 38
PART II - OTHER INFORMATION
Signatures 40
EXHIBIT INDEX
Exhibit 10.9 Baylake Bank employment agreement with Robert J. Cera 1-10
Exhibit 31.1 Certification pursuant to Section 302
Exhibit 31.2 Certification pursuant to Section 302
Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350
Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350
BAYLAKE CORP.
CONSOLIDATED BALANCE SHEETS
June 30, 2006 and December 31, 2005
(Amounts in thousands of dollars)
June 30, 2006 December 31,
(Unaudited) 2005
------------- ------------
ASSETS
Cash and due from financial institutions $ 24,530 $ 32,855
Federal funds sold - 199
------------- ------------
Cash and cash equivalents 24,530 33,054
Securities available for sale 183,955 171,638
Loans held for sale 273 374
Loans, net of allowance after $9,425 and $9,551 812,279 802,745
Cash value of life insurance 23,760 22,814
Premises held for sale 1,128 1,167
Premises and equipment, net 27,694 24,703
Federal Home Loan Bank stock 7,266 8,081
Foreclosed assets, net 1,374 3,333
Goodwill 5,723 5,723
Accrued interest receivable 5,690 5,354
Other assets 11,015 10,422
------------- ------------
Total assets $ 1,104,687 $ 1,089,408
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest-bearing $ 102,383 $ 110,641
Interest-bearing 768,659 746,070
------------- ------------
Total deposits 871,042 856,711
Federal Home Loan Bank advances 105,182 125,185
Federal funds purchased and repurchase agreements 22,194 1,315
Subordinated debentures 16,100 16,100
Accrued expenses and other liabilities 11,744 10,310
Dividends payable - 1,243
------------- ------------
Total liabilities 1,026,262 1,010,864
Common stock, $5 par value, authorized 10,000,000; issued- 7,828,286 shares in
2006, 7,805,586 shares in 2005; outstanding- 7,805,127 shares in 2006,
7,782,427 shares in 2005 39,142 39,028
Additional paid-in capital 9,669 9,466
Retained earnings 33,661 32,461
Treasury stock (23,159 shares in 2006 and 2005) (625) (625)
Accumulated other comprehensive income (3,422) (1,786)
------------- ------------
Total stockholders' equity 78,425 78,544
------------- ------------
Total liabilities and stockholder equity $ 1,104,687 $ 1,089,408
============= ============
See accompanying notes to Unaudited Consolidated Financial Statements.
3
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three and Six Months ended June 30, 2006 and 2005
(Amounts in thousands of dollars except per share data)
Three months ended Six months ended
June 30 June 30
2006 2005 2006 2005
Interest and dividend income
Loans, including fees $ 15,418 $ 12,944 $ 30,082 $ 24,607
Taxable securities 1,570 1,729 3,141 3,458
Tax exempt securities 378 489 738 892
Federal funds sold and other 156 16 207 33
-------- -------- -------- --------
Total interest and dividend income 17,522 15,178 34,168 28,990
-------- -------- -------- --------
Interest expense
Deposits 7,090 4,494 13,432 8,321
Federal funds purchased and repurchase agreements 89 318 264 491
Federal Home Loan Bank advances and other debt 1,399 1,014 2,761 1,751
Subordinated debentures 257 462 1,146 923
-------- -------- -------- --------
Total interest expense 8,835 6,288 17,603 11,486
-------- -------- -------- --------
NET INTEREST INCOME 8,687 8,890 16,565 17,504
Provision for loan losses 61 91 261 121
-------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 8,626 8,799 16,304 17,383
-------- -------- -------- --------
Other income
Fees from fiduciary activities 240 184 541 363
Fees from loan servicing 275 288 535 571
Fees for other services to customers 1,246 1,185 2,385 2,283
Gains from sales of loans 209 177 410 385
Net gains (loss) from sale and disposal of premises and
equipment 185 (151) 185 (151)
Increase in cash surrender value of life insurance 175 190 401 417
Other income 151 153 262 421
-------- -------- -------- --------
Total other income 2,481 2,026 4,719 4,289
-------- -------- -------- --------
Non-interest expenses
Salaries and employee benefits 4,525 4,329 9,517 8,857
Occupancy expense 585 602 1,164 1,138
Equipment expense 445 340 840 647
Data processing and courier 315 298 615 576
Operation of other real estate 74 81 117 129
Other operating expenses 1,749 1,441 3,564 2,789
-------- -------- -------- --------
Total non-interest expenses 7,693 7,091 15,817 14,136
-------- -------- -------- --------
INCOME BEFORE INCOME TAX EXPENSE 3,414 3,734 5,206 7,536
Income tax expense 1,044 1,174 1,512 2,392
-------- -------- -------- --------
NET INCOME $ 2,370 $ 2,560 $ 3,694 $ 5,144
-------- -------- -------- --------
COMPREHENSIVE INCOME $ 1,095 $ 3,612 $ 2,059 $ 4,204
-------- -------- -------- --------
BASIC EARNINGS PER SHARE $ 0.30 $ 0.33 $ 0.47 $ 0.67
DILUTED EARNINGS PER SHARE $ 0.30 $ 0.33 $ 0.47 $ 0.66
See accompanying notes to Unaudited Consolidated Financial Statements.
4
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
Six months ended June 30,
(Amounts in thousands of dollars except for per share data)
Accumulated
Other
Common Stock Additional Comprehensive
--------------------- Paid-in Retained Treasury Income Total
Shares Amount Capital Earnings Stock (loss) Equity
--------- ----------- ----------- ----------- -------- ------------- -------
BALANCE, JANUARY 1, 2005 7,692,777 $ 38,580 $ 8,806 $ 28,275 $ (625) $ 1,169 $76,205
Net income for the year - - - 5,144 - - 5,144
Net changes in unrealized
gain (loss) on securities
available for sale, net of
$(526) deferred taxes - - - - - (940) (940)
-------
Total comprehensive income 4,204
Stock options exercised 33,000 165 134 - - - 299
Tax benefit from exercise of
stock options - - 116 - - - 116
Cash dividends declared
($0.30 per share) - - - (2,309) - - (2,309)
--------- ----------- ----------- ----------- -------- ------------- -------
BALANCE, JUNE 30, 2005 7,725,777 $ 38,745 $ 9,056 $ 31,110 $ (625) $ 229 $78,515
========= =========== =========== =========== ======== ============= =======
BALANCE, JANUARY 1, 2006 7,782,427 $ 39,028 $ 9,466 $ 32,461 $ (625) $ (1,786) $78,544
Net income for the year - - - 3,694 - - 3,694
Net changes in unrealized
gain (loss) on securities
available for sale, net of
$(894) deferred taxes - - - - - (1,636) (1,636)
Total comprehensive income 2,058
-------
Stock compensation expense recognized - - 26 - - - 26
Stock options exercised 22,700 114 97 - - - 211
Tax benefit from exercise
of stock options - - 80 - - - 80
Cash dividends declared
($0.32 per share) - - - 2,494) - - (2,494)
--------- ----------- ----------- ----------- -------- ------------- -------
BALANCE, JUNE 30, 2006 7,805,127 $ 39,142 $ 9,669 $ 33,661 $ (625) $ (3,422) $78,425
========= =========== =========== =========== ======== ============= =======
See accompanying notes to Unaudited Consolidated Financial Statements.
5
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Six months ended June 30, 2006 and 2005
(Amounts in thousands of dollars)
2006 2005
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Reconciliation of net income to net cash provided by
operating activities:
Net income $ 3,694 $ 5,144
Adjustments to reconcile net income to net cash
provided to operating activities:
Depreciation and amortization 812 900
Amortization of debt issuance costs 475 118
Amortization of core deposit intangible 26 26
Provision for losses on loans 261 121
Net amortization of securities 85 314
Increase in cash surrender value of life insurance (401) (417)
Federal Home Loan Bank stock dividend - (211)
Net gain on sale of loans (410) (385)
Proceeds from sale of loans held for sale 21,882 8,572
Origination of loans held for sale (21,372) (8,635)
Provision for valuation allowance on other real estate owned 47 20
Net (gain) loss from disposal of other real estate (53) 28
Net (gain) loss from disposal of bank premises and equipment (185) 151
Stock option compensation expense recognized 26 -
Changes in assets and liabilities:
Accrued interest receivable and other assets 497 (871)
Accrued expenses and other liabilities 1,273 623
----------- -----------
Net cash provided by operating activities 6,657 5,498
CASH FLOWS FROM INVESTING ACTIVITIES:
Principal payments on securities available-for-sale 10,291 6,675
Purchase of securities available-for-sale (25,222) (20,886)
Proceeds from sale of other real estate owned 2,356 828
Proceeds from sale of premises and equipment - 290
Loan originations and payments, net (10,205) (39,939)
Additions to premises and equipment (3,579) (4,649)
Investment in bank-owned life insurance (583) (469)
------------ ------------
Net cash used in investing activities (26,942) (58,150)
See accompanying notes to Unaudited Consolidated Financial Statements.
6
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six months ended June 30, 2006 and 2005
(Amounts in thousands of dollars)
2006 2005
--------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits $ 14,331 $ 411
Net change in federal funds purchased and
repurchase agreements 20,879 40,301
Proceeds from Federal Home Loan Bank advances 45,000 15,000
Repayments on Federal Home Loan Bank advances (65,003) (4)
Redemption of subordinated debt (16,100) -
Proceeds from issuance of subordinated debt 16,100 -
Proceeds from exercise of stock options 211 299
Tax benefit from exercises of stock options 80 -
Cash dividends paid (3,737) (3,463)
--------------- ---------------
Net cash provided by financing activities 11,761 52,544
--------------- ---------------
Net change in cash and cash equivalents (8,524) (108)
Beginning cash and cash equivalents 33,054 26,172
--------------- ---------------
ENDING CASH AND CASH EQUIVALENTS $ 24,530 $ 26,064
=============== ===============
See accompanying notes to Unaudited Consolidated Financial Statements.
7
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
JUNE 30, 2006
1. The accompanying consolidated financial statements should be read in
conjunction with Baylake Corp.'s 2005 annual report on Form 10-K. The
accompanying consolidated financial statements are unaudited. These
interim financial statements are prepared in accordance with the
requirements of Form 10-Q, and accordingly do not include all of the
information and footnotes required by U.S. generally accepted accounting
principles for complete financial statements. In the opinion of
management, the unaudited financial information included in this report
reflects all adjustments, consisting of normal recurring accruals, which
are necessary for a fair statement of the financial position as of June
30, 2006 and December 31, 2005. The results of operations for the three
and six months ended June 30, 2006 are not necessarily indicative of
results to be expected for the entire year.
2. To prepare financial statements in conformity with U.S. generally accepted
accounting principles, management makes estimates and assumptions based on
available information. These estimates and assumptions affect the amounts
reported in the financial statements and the disclosures provided, and
actual results could differ. The allowance for loan losses, foreclosed
assets, and fair values of financial instruments are particularly subject
to change.
3. Diluted earnings per share, which reflects the potential dilution that
could occur if outstanding stock options were exercised and stock awards
were fully vested and resulted in the issuance of common stock that then
shared in the earnings of the Company, is computed by dividing net income
by weighted average number of common shares and common stock equivalents.
The following table shows the computation of the basic and diluted
earnings per share for the three and six months ended June 30 (dollars in
thousands, except per share amounts):
Three months ended June 30, Six months ended June 30,
----------------------------------- -----------------------------------
(Net income in thousands)
2006 2005 2006 2005
---------- ------------ ----------- ------------
(NUMERATOR):
Net income $ 2,370 $ 2,560 $ 3,694 $ 5,144
(DENOMINATOR):
Weighted average number of common shares
outstanding-basic 7,803,193 7,700,952 7,794,127 7,698,351
Dilutive effect of stock options 50,450 97,143 51,745 94,323
---------- ------------ ----------- ------------
Weighted average number of common shares
outstanding-diluted 7,853,643 7,798,095 7,845,872 7,792,674
BASIC EPS $ 0.30 $ 0.33 $ 0.47 $ 0.67
DILUTED EPS $ 0.30 $ 0.33 $ 0.47 $ 0.66
8
BAYLAKE CORP.
4. Baylake Corp. declared a cash dividend of $0.16 per share paid on June 15,
2006 to shareholders of record as of June 1, 2006.
5. The Company has a non-qualified stock option plan, which is described more
fully in the Company's December 31, 2005 Annual Report on Form 10-K.
Beginning in 2006, the Company accounts for stock compensation expense
under the provisions of FASB Statement No. 123R, "Accounting for
Stock-Based Compensation" ("FAS 123R") on a modified prospective basis.
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 employment service period, which is normally the
vesting period of the options. This applies to awards granted, modified,
or vesting in fiscal years beginning in 2006. Compensation cost is
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 may no longer issue stock options
under the current plan and thus there will be no further grants
thereunder. Existing options that will vest after the adoption date are
expected to result in an immaterial amount of compensation expense during
2006 through 2008. For the first six months of 2006, the amount of
compensation expense reflected in the financial statements is $26,000,
including $13,000 in the second quarter of 2006. As a matter of comparing
the three and six months ended June 30, 2006 with the same period in 2005,
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 for periods prior to January 1, 2006.
Three months ended June Six months ended June 30,
30, 2005 2005
----------------------- -------------------------
(In thousands, except per share amounts)
------------------------------------------------------------
Net income, as reported $ 2,560 $ 5,144
Less: Total stock-based employee compensation cost determined
under the fair value method, net of income taxes (15) (29)
------- -------
Pro forma net income 2,545 5,115
Earnings per share:
Basic - as reported $ 0.33 $ 0.67
Basic - pro forma $ 0.33 $ 0.66
Diluted - as reported $ 0.33 $ 0.66
Diluted - pro forma $ 0.33 $ 0.66
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.
9
BAYLAKE CORP.
A summary of the Company's stock-based compensation activity for the six
months ended June 30, 2006, is presented below.
Weighted
average
Weighted remaining Aggregate
average contractual intrinsic value
Stock options Shares exercise price term (000's)
- ------------------------------------ -------- -------------- ----------- ---------------
Outstanding at December 31, 2005 486,869 $ 13.95
Granted - -
Exercised 22,700 9.27
Forfeited - -
Outstanding at June 30, 2006 464,169 14.18
Outstanding and in the money options
at June 30, 2006 404,169 12.57 3.1 $ 1,366
Options exercisable and in the money
at June 30, 2006 367,788 12.47 3.1 $ 1,280
During the first six months of 2006, $210,000 was received for the
exercise of 22,700 stock options.
6. The Company redeemed on March 31, 2006 all of its 10.00% Cumulative Trust
Preferred Securities (the "Trust Preferred Securities") and its 10.00%
Common Securities (the "Trust Common Securities") at a redemption price
equal to the $10.00 liquidation amount of each security plus all accrued
and unpaid interest per security to March 31, 2006, the redemption date,
through Baylake Capital Trust I (the "Trust").
The Trust took such action in connection with the concurrent redemption by
Baylake Corp. of all of its $16.6 million 10.00% debentures due March 31,
2031 (the "Debentures") which are held exclusively by the Trust. The
Debentures were redeemed on March 31, 2006 at a redemption price equal to
the principal outstanding of the Debentures plus interest accrued on the
Debentures up to March 31, 2006. In connection with the redemption of the
Debentures, the Company expensed during the first quarter $475,015,
pre-tax, of unamortized origination cost associated with the Debentures.
The Company funded the redemption through the issuance of $16.1 million of
trust preferred securities and $498,000 of trust common securities that
will adjust quarterly at a rate equal to 1.35% over the three-month LIBOR.
The rates for the second and third quarters, respectively, are 6.31% and
6.85%, respectively. There were no debt issuance costs associated with
this most recent issuance.
7. Effect of Newly Issued But Not Yet Effective Accounting Standards: In
March 2006, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting
10
BAYLAKE CORP.
Standards ("SFAS") No. 156, "Accounting for Servicing of Financial Assets,
an amendment of FASB Statement No. 140, " ("SFAS 156"). SFAS 156 requires
an entity to recognize a servicing asset or servicing liability each time
it undertakes an obligation to service a financial asset by entering into
a servicing contract. All separately recognized servicing assets and
servicing liabilities are to be initially measured at fair value, if
practicable. SFAS 156 permits an entity to choose either the Amortization
method or the Fair Value Measurement Method for subsequently measuring
each class of separately recognized servicing assets or servicing
liabilities. Under the amortization method, servicing assets or servicing
liabilities are amortized in proportion to and over the period of
estimated net servicing income or loss and servicing assets or servicing
liabilities are assessed for impairment based on fair value at each
reporting date with the changes in fair value recognized in earnings in
the period in which the changes occur. SFAS 156 is effective for fiscal
years beginning after September 15, 2006, and earlier adoption is
permitted as of the beginning of an entity's fiscal year, provided the
entity has not yet issued financial statements for any period of that
fiscal year. Total servicing rights as of June 30, 2006, include $510,000
of mortgage servicing rights and $749,000 of servicing rights on SBA
loans. The Company will adopt SFAS 156 in 2007 and is in the process of
assessing the impact on its results of operations, financial position, and
liquidity.
In June 2006, the FASB issued Interpretation No. 48 "Accounting for
Uncertainty in Income Taxes" - an interpretation of FASB No. 109" (FIN
48). FIN 48 prescribes a recognition threshold and measurement attribute
for the financial statement recognition and measurement of a tax position
taken or expected to be taken in a tax return. The Interpretation is
effective for fiscal years beginning after December 31, 2006. The Company
is currently evaluating the impact of the adoption of FIN 48, with respect
to its results of operations, financial position and liquidity.
8. The Bank owns a 49% interest in United Financial Services, Inc. ("UFS") a
data processing service. The Bank's ownership interest totals $3.1 million
and $2.7 million, respectively, at June 30, 2006 and 2005, respectively,
and is reflected in the Other Assets in the "Consolidated Balance Sheets".
In addition to the ownership interest, UFS and the Company have a common
member on each respective Board of Directors. The investment in this
entity is carried under the equity method of accounting, and the pro rata
share of its income is included in other income. On June 27, 2006, an
amendment to an earlier agreement dated September 11, 1991 for employment
was entered into with a key employee of UFS allowing that individual the
option to purchase up to 20%, or 240 shares, of the authorized shares of
UFS. The option price is $1,000 per share, less dividends or distributions
to owners. Current book value for UFS is approximately $6,300 per share.
Any exercise of the option will have an effect of reducing the Company's
interest in UFS and decreasing other income as those options are
exercised.
9. In its previous report, the Company indicated that one loan of about $8.1
million might be repaid upon sale of collateral real estate under an
accepted full price offer to purchase, but that closing was subject to
settlement of liens and claims against the property. However, despite
negotiations, the lien claims were not resolved and the offer has been
withdrawn. The Company then filed and has completed a foreclosure on a
portion of the loans in the amount of $4.0 million. Upon withdrawal of the
offer to purchase, the Company is initiating additional foreclosure
proceedings on the remaining loans of about $4.1 million.
11
PART 1 - FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Baylake is a full-service financial services company, providing a wide variety
of loan, deposit and other banking products and services to its business,
individual or retail, and municipal customers, as well as a full range of trust,
investment and cash management services. The Company is the bank holding company
of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member
bank of the Federal Reserve and Federal Home Loan Bank.
The following sets forth management's discussion and analysis of the
consolidated financial condition and results of operations of Baylake Corp.
("Baylake" or the "Company") for the three and six months ended June 30, 2006
and 2005 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.
12
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.
Foreclosed Assets: Foreclosed assets acquired through or instead of loan
foreclosure are initially recorded at fair value when acquired, less estimated
costs to sell, establishing a new cost basis. If fair value declines subsequent
to foreclosure, a valuation allowance is recorded through expense. Costs after
acquisition are expensed.
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. The reserve does not include any specific
reserves relative to any position recently taken by state taxing authorities.
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 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
13
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 did make contact with the Company's outside counsel in June 2006 with
the intention of gathering various financial data from the Company. To this
point, the Department has not provided counsel with any formal request. The
Company will respond to the Department's request once a formal request is
provided.
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.
RESULTS OF OPERATIONS
The following table sets forth the Company's net income and related summary
information for the three and six-months periods ended June 30, 2006 and 2005,
as well as comparisons between the respective periods.
TABLE 1
SUMMARY RESULTS OF OPERATIONS
($ in thousands, except per share data)
Three months Three months Six months Six months
ended June, ended June 30, ended June 30, ended June 30,
2006 2005 2006 2005
------------ -------------- -------------- --------------
Net income, as reported $ 2,370 $ 2,560 $ 3,694 $ 5,144
EPS-basic, as reported $ 0.30 $ 0.33 $ 0.47 $ 0.67
14
EPS-diluted, as reported $ 0.30 $ 0.33 $ 0.47 $ 0.66
Cash dividends declared $ 0.16 $ 0.15 $ 0.32 $ 0.30
Return on average assets, as reported 0.86% 0.94% 0.67% 0.96%
Return on average equity, as reported 12.12% 13.27% 9.47% 13.38%
Efficiency ratio, as reported (1) 67.21% 63.05% 72.46% 63.04%
(1) Non-interest expense divided by sum of taxable equivalent net interest
income plus non-interest income, excluding investment securities gains,
net
The decrease in net income for the three-month period is primarily due to
decreased net interest income and an increase in non-interest expense. These
were partially offset by an increase in other income, a decrease in the
provision for loan losses and a decrease in income tax expense. The decrease in
net income for the six-month period is primarily for the same reasons except
that the provision for loan losses increased for the six-month period.
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 78.3% of total operating income for the three months ended June
30, 2006, as compared to 82.0% for the same period in 2005. Net interest income
represents the difference between interest earned on loans, investments and
other interest earning assets offset by the interest expense attributable to the
deposits and the borrowings that fund such assets. Interest fluctuations
together with changes in the volume and types of earning assets and
interest-bearing liabilities combine to affect total net interest income. This
analysis discusses net interest income on a tax-equivalent basis in order to
provide comparability among the various types of earned interest income.
Tax-exempt interest income is adjusted to a level that reflects such income as
if it were fully taxable.
Net interest income on a tax equivalent basis for the three months ended June
30, 2006 decreased $255,000, or 2.8%, to $9.0 million from $9.2 million over the
comparable period a year ago. The decrease results from a decrease in our net
interest margin which resulted partially from an increase in interest foregone
on non-accrual loans (due to an increase in the level of non-performing loans,
which did not accrue interest), offset partially by an increase in average loans
for the period. See "Balance Sheet-'"Non-Performing Loans, Potential Problem
Loans and Other Real Estate" below. The decrease in net interest income for the
period results from a decrease in net interest margin offset partially by
increased loan levels. During the six months ended June 30, 2006, net interest
income on a tax equivalent basis decreased $1.0 million, or 5.7%, to $17.1
million from $18.1 million for the comparable period in 2005. The decrease
resulted for the same reasons as listed above, including the impact of
approximately $592,000 in non-accrual interest foregone for the period. In
addition, amortization expense of issuance costs related to the redemption of
trust preferred securities (totaling $475,015 in the first quarter) affected
results for the six months ended June 30, 2006. See "Balance Sheet Analysis-Long
Term Debt" below.
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
15
funds available without interest cost (demand deposits and equity capital) is an
important component increasing net interest margin.
The net interest margin for the second quarter of 2006 was 3.53%, down 14 basis
points ("bps") from 3.67% for the comparable period in 2005. This comparable
period decrease was attributable to a 22 bps decrease in interest rate spread
(the net result of a 82 bps increase in the yield on earning assets more than
offset by a 104 bps increase in the cost of interest-bearing liabilities).
During the six months ended June 30, 2006, the net interest margin was 3.38%
compared to 3.67% for the comparable period in 2005. Net interest margin
decreased as a result of an increase in earning assets relative to
interest-bearing liabilities and a 38 bps decrease in interest rate spread (the
net result of a 86 bps increase in the yield on earning assets more than offset
by a 124 bps increase in the cost of interest-bearing liabilities).
As the Federal Reserve Board ("FRB") has steadily increased short-term interest
rates during the latter half of 2004 thru the second quarter of 2006 in an
attempt to keep inflation in control, average interest rates were higher in 2006
than in 2005. Comparatively, the Federal Funds rate at June 30, 2006 was at
5.25% compared to 3.25% at June 30, 2005, while the average Federal Funds rate
for the first six months of 2006 was 197 bps higher than for the same period in
2005. Financial institutions' competition for deposits has driven up the cost of
funds and as a result, net interest margin decreased in the first six months of
2006. Net interest margin was affected by the impact of short-term rate changes
and its affect on wholesale funding costs for the first six months of 2006.
For the three months ended June 30, 2006, average-earning assets increased $12.2
million, or 1.2%, when compared to the same period last year. The Company
recorded an increase in average loans of $33.2 million, or 4.2%, for the second
quarter of 2006 compared to the same period a year ago. For the six months ended
June 30, 2006, average-earning assets increased $24.2 million, or 2.5%, when
compared to the same period last year. The Company recorded an increase in
average loans of $46.6 million, or 6.0%, for the first six months of 2006
compared to the same period a year ago. Loans have typically resulted in higher
rates of interest income to the Company than have investment securities, which
further positively affected income in the period.
Interest rate spread is the difference between the tax-equivalent rate earned on
average earning assets and the rate paid on average interest-bearing
liabilities. The interest rate spread decreased for the quarter ended June 30,
2006 when compared to the same period a year ago. The interest rate spread
decreased 21 bps to 3.15% at June 30, 2006 from 3.36% in the same quarter in
2005. While the average yield on earning assets increased 82 bps during the
period, the average rate paid on interest-bearing liabilities increased 104 bps
over the same period. For the six months ended June 30, 2006, the interest rate
spread decreased 38 bps to 3.00% from 3.38% when compared to the same period a
year earlier. The average yield on earning assets increased 86 bps to 6.85% from
5.99% during the six-month period, while the average rate paid on
interest-bearing liabilities increased 124 bps. The increase in the rates paid
on interest-bearing liabilities occurred as a result of a higher cost of funding
from deposits and other wholesale funding such as federal funds purchased and
loans from the Federal Home Loan Bank. We would expect that trend to continue in
light of the recent Federal Reserve Board interest rate increases.
16
TABLE 2
NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS
($ in thousands)
Three months ended June 30,
2006 2005
----------------------------------- -------------------------------
Interest Average Interest Average
Average income/ yield/ Average income/ yield/
Balance expense Rate Balance expense rate
----------- -------- ------- ----------- -------- -------
ASSETS
Earning assets:
Loans, net $ 823,936 $ 15,501 7.53% $ 790,764 $ 13,024 6.59%
Taxable securities 145,043 1,570 4.33% 167,638 1,730 4.13%
Tax exempt securities 35,104 574 6.54% 43,477 739 6.80%
Federal funds sold and interest bearing due from banks 12,569 156 4.96% 2,541 16 2.52%
----------- -------- ------ ----------- -------- ------
Total earning assets 1,016,652 17,801 7.00% 1,004,420 15,509 6.18%
----------- -------- ------ ----------- -------- ------
Non-interest earning assets 84,408 81,328
----------- -----------
Total assets $ 1,101,060 $ 1,085,748
----------- -----------
LIABILITIES AND STOCKHOLDERS'EQUITY
Interest-bearing liabilities:
Total interest-bearing deposits 775,806 7,090 3.66% 723,435 4,494 2.48%
Short-term borrowings 6,394 78 4.88% 37,798 310 3.28%
Customer repurchase agreements 1,086 11 4.05% 1,170 8 2.74%
Federal Home Loan Bank advances 118,534 1,399 4.72% 115,262 1,014 3.52%
Subordinated debentures 16,100 257 6.39% 16,100 462 11.48%
----------- -------- ------ ----------- -------- ------
Total interest-bearing liabilities $ 917,920 8,835 3.85% $ 893,765 $ 6,288 2.81%
----------- -------- ------ ----------- -------- ------
Demand deposits 92,205 105,922
Accrued expenses and other liabilities 12,696 8,891
Stockholders' equity 78,239 77,170
----------- -----------
Total liabilities and stockholders' equity $ 1,101,060 $ 1,085,748
----------- -----------
Interest rate spread $ 8,966 3.15% $ 9,221 3.36%
Net interest margin 3.53% 3.67%
------ ------
17
TABLE 3
NET INTEREST INCOME ANALYSIS ON A TAX - EQUIVALENT BASIS
($ in thousands)
Six months ended June 30,
2006 2005
-------------------------------- -------------------------------
Interest Average Interest Average
Average income/ yield/ Average income/ yield/
Balance Expense Rate Balance expense Rate
----------- -------- ------- ----------- -------- -------
ASSETS
Earning assets:
Loans, net $ 824,989 $ 30,249 7.33% $ 778,416 $ 24,780 6.37%
Taxable securities 145,745 3,141 4.31% 168,524 3,458 4.10%
Tax exempt securities 33,955 1,117 6.58% 39,360 1,351 6.86%
Federal funds sold and interest bearing
due from banks 8,760 207 4.73% 2,911 33 2.27%
----------- -------- ------ ----------- -------- ------
Total earning assets 1,013,449 34,714 6.85% 989,211 29,622 5.99%
----------- -------- ------ ----------- -------- ------
Non-interest earning assets 83,374 78,963
----------- -----------
Total assets $ 1,096,823 $ 1,068,174
----------- -----------
LIABILITIES AND STOCKHOLDERS'EQUITY
Interest-bearing liabilities:
Total interest-bearing deposits 765,228 13,432 3.51% 722,533 8,321 2.30%
Short-term borrowings 9,720 241 4.96% 30,527 475 3.11%
Customer repurchase agreements 1,214 23 3.79% 1,354 16 2.36%
18
Federal Home Loan Bank advances 121,537 2,761 4.54% 108,643 1,751 3.22%
Subordinated debentures 16,456 1,146 13.93% 16,100 923 11.47%
----------- -------- ------ ----------- -------- ------
Total interest-bearing liabilities $ 914,155 $ 17,603 3.85% $ 879,157 $ 11,486 2.61%
----------- -------- ------ ----------- -------- ------
Demand deposits 92,730 103,979
Accrued expenses and other liabilities 11,922 8,132
Stockholders' equity 78,016 76,906
----------- -----------
Total liabilities and stockholders' equity $ 1,096,823 $ 1,068,174
Interest rate spread $ 17,111 3.00% $ 18,136 3.38%
Net interest margin 3.38% 3.67%
------ ------
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 92.4% and 92.6%, respectively, for the first six months
of 2006 and 2005, respectively.
Provision for Loan Losses
The provision for loan losses ("PFLL") is the cost of providing an allowance for
probable incurred losses. As previously discussed, the allowance consists of
specific and general components. The Company's internal risk system is used to
identify loans that meet the criteria as being "impaired" under the definition
of SFAS 114. The specific component relates to loans that are individually
classified as impaired or loans otherwise classified as substandard or doubtful.
These identified loans for potential impairment are assigned a loss allocation
based upon that analysis. The general component covers non-classified and is
based on historical loss experience adjusted for current factors. These current
factors include loan growth, net charge-offs, changes in the composition of the
loan portfolio, delinquencies, management's evaluation of loan quality, general
economic factors and collateral values.
As a result of this process, the PFLL for the first six months of 2006 was
$261,000 as compared to a PFLL of $121,000 for the first six months in 2005. The
calculation of the amount took into account overall asset quality in the loan
portfolio during the period, including the substantial increase in
non-performing assets. Net loan charge-offs in the first six months of 2006 were
$387,000 compared with net charge-offs of $1.0 million for the same period in
2005. Net charge-offs as a percentage of average loans is a key measure of asset
quality. Net charge-offs to average loans were 0.09% for the first six months of
2006 compared to 0.26% for the same period in 2005. For the six months ended
June 30, 2006, non-performing loans increased $21.7 million; see below for
further information.
19
TABLE 4
ALLOWANCE FOR LOAN LOSSES
($ in thousands)
For the six For the six
months ended months ended
June 30, 2006 June 30, 2005
------------- -------------
Allowance for Loan Losses ("ALL)
Balance at beginning of period $ 9,551 $ 10,445
Provision for loan losses 261 121
Charge-offs 782 1,235
Recoveries 395 233
Balance at end of period $ 9,425 $ 9,564
Net charge-offs ("NCOs:) $ 387 $ 1,002
As described more fully in Table 8 below, non-accrual loans increased
significantly during the period from December 31, 2005. However, despite the
increase in non-accrual loans during the six months ended June 30, 2006, the
required allocation of the allowance for these loans only increased $102,000, as
these loans had previously been assessed for impairment under the requirements
of SFAS 114. The amount of non-performing loans increased substantially during
the six-month period ended June 2006. The provision did not increase as
significantly because of management's belief and expectations that collateral
values on these loans and other factors will likely ultimately minimize any
related loss (although there can be no assurances).
See "Balance Sheet Analysis - Non-Performing Loans, Potential Problem Loans and
Other Real Estate" below. In addition, the reduction in net charge-offs for the
six months ended June 30, 2006 were factors in the determination of a provision
of $261,000 for the first six months of 2006.
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. Also, negative developments relating to our non-performing
loans, including diminution of value of the collateral or increased costs of
collection, 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 which would
negatively affect our earnings taken. 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 $455,000, or 22.5% to $2.5 million for the
second quarter of 2006 when compared to the second quarter of 2005. For the six
months ended June 30, 2006, total non-interest income was $4.7 million, an
increase of $430,000, or 10.0%, when compared to the same period in 2005. The
non-interest income to average assets ratio was 0.90% for the three months ended
June 30, 2006 compared to 0.75% for the same period in 2005. For the six months
ended June 30, 2006, the non-interest income to average assets ratio was 0.86%
compared to
20
0.80% for the same period in 2005. The increase in non-interest income for the
three-month and six-month periods is due primarily to increases in net gains
from sales and disposals of premises and equipment of $185,000 in 2006 compared
to net losses of $151,000 for the same period in 2005.
Table 5 reflects the various components of non-interest income for the
comparable quarters.
TABLE 5
NON-INTEREST INCOME
($ in thousands)
Second Second
quarter quarter Percent YTD YTD Percent
2006 2005 change 2006 2005 change
------- ------- -------- ------ ------ --------
Fees from fiduciary services $ 240 $ 184 30.4% $ 541 $ 363 49.0%
Fees from loan servicing 275 288 (4.5%) 535 571 (6.1%)
Service charges on deposit accounts 851 845 0.7% 1,645 1,570 4.8%
Other fee income 165 163 1.2% 330 350 (5.7%)
Financial services income 230 177 29.9% 410 363 12.9%
Gains from sales of loans 209 177 18.1% 410 385 6.5%
Net gains (loss) from sale and disposal of
premises and equipment 185 (151) NM 185 (151) NM
Increase in cash surrender value of
life insurance 175 190 (7.9%) 401 417 (3.8%)
Death benefits realized 23 - NM 23 - NM
Gain on sale of bank assets - 21 NM - 200 NM
Other income 128 132 (3.0%) 239 221 8.1%
------- ------- ------ ------ ------ ------
Total Other Income $ 2,481 $ 2,026 22.5% $4,719 $4,289 10.0%
Service charges on deposit accounts increased $75,000 for the six-month period
ended June 30, 2006 due in part to the implementation of new product offerings
such as High Performance Checking ("HPC") and other price increases implemented
during the latter part of 2005.
In the first six months of 2006, gains from sales of loans totaling $410,000
were similar to the $385,000 recorded in the first six months of 2005. During
the first six months of 2006, secondary mortgage loan activity increased
although gains from sale of these loans did not increase in the
21
same proportion as a result of a change in the mix of commercial/mortgage loans
sold, tighter spreads and competitive pressures with respect to pricing.
Although interest rates have increased over the six-month period, the Company
has not seen a decrease in the number of loan applications. Secondary loan
production increased $12.7 million between the comparable six-month periods
($21.3 million in the first six months of 2006 versus $8.6 million in the first
six months of 2005). The increase in loan production was driven primarily by
secondary mortgage and commercial loan production (loan production to be sold to
the secondary market) and resulting sales.
For the three-month and six-month periods ended June 30, 2006, net gains (loss)
from the sale of bank premises and equipment were related to non-recurring gains
of $188,000 on the sale of bank land located in the Green Bay market area. The
net loss on disposal of bank premises of $151,000 for the same time period in
2005 related to the sale of two buildings and land formerly used as branch
offices.
For the three-month and six-month periods ended June 30, 2006 compared to the
same period in 2005, the decrease in gain on sale of bank assets was related to
a gain on sale of stock of $200,000 ($21,000 recognized in the second quarter of
2005) in connection with a third party acquisition of Pulse (an ATM
operator/provider) in which the Bank held an ownership interest.
Non-Interest Expense
Non-interest expense increased $602,000 or 8.5%, to $7.7 million for the three
months ended June 30, 2006 compared to the same period in 2005. For the six
months ended June 30, 2006, total non-interest expense increased $1.7 million or
11.9%, to $15.8 million compared to the same period in 2005. The non-interest
expense to average assets ratio was 2.79% for the three months ended June 30,
2006 compared to 2.61% for the same period in 2005. For the six months ended
June 30, 2006, the non-interest expense ratio to average assets was 2.88%
compared to 2.65% for the same period in 2005.
Net overhead expense is total non-interest expense less total non-interest
income excluding securities gains. The net overhead expenses to average assets
ratio was 1.89% for the three months ended June 30, 2006 compared to 1.87% for
the same period in 2005. For the six months ended June 30, 2006, the net
overhead expenses to average assets ratio was 2.02% compared to 1.84% for the
same period in 2005. The efficiency ratio is total non-interest expense as a
percentage of the sum of net-interest income on a fully taxable equivalent basis
and total non-interest income. The efficiency ratio for the three months ended
June 30, 2006 was 67.21% compared to 63.05% for the same period in 2005. For the
six months ended June 30, 2006, the efficiency ratio was 72.46% compared to
63.04% for the same period in 2005.
TABLE 6
NON-INTEREST EXPENSE
($ in thousands)
Second Second
quarter quarter Percent YTD YTD Percent
2006 2005 change 2006 2005 change
-------- -------- -------- -------- -------- --------
Salaries and employee benefits $ 4,525 $ 4,329 4.5% $ 9,517 $ 8,857 7.5%
Occupancy 585 602 (2.8%) 1,164 1,138 2.3%
Equipment 445 340 30.9% 840 647 29.8%
22
Data processing and courier 315 298 5.7% 615 576 6.8%
Operation of other real estate owned 74 81 (8.6%) 117 129 (9.3%)
Business development and advertising 243 284 (14.4%) 477 488 (2.3%)
Charitable contributions 30 55 (45.5%) 106 147 (27.9%)
Stationary and supplies 158 155 1.9% 262 267 (1.9%)
Director fees 152 110 38.2% 271 192 41.1%
FDIC 26 29 (10.3%) 53 56 (5.4%)
Mortgage servicing rights amortization 41 54 (24.1%) 96 116 (17.2%)
Legal and professional 45 128 (64.8%) 250 304 (17.8%)
Loan and collection 263 101 160.4% 307 154 99.4%
Other operating 791 525 50.7% 1,742 1,065 63.6%
-------- -------- ------- -------- -------- -------
Total non-interest expense $ 7,693 $ 7,091 8.5% $ 15,817 $ 14,136 11.9%
Salaries and employee benefits showed an increase of $196,000, or 4.5%, to $4.5
million for the second quarter of 2006 compared to the same period in 2005. The
number of full-time equivalent employees was 326 as of June 30, 2006 compared to
308 at June 30, 2005, primarily the result of additional staffing for the
remodeled downtown Green Bay branch opened in June 2005. For the three months
ended June 30, 2006, salary-related expenses increased $386,000, or 13.3%, due
principally to merit increases between the years and related staff increases.
For the six months ended June 30, 2006, salary-related expenses increased
$755,000, or 13.2% compared to the same period in 2005 for the reasons listed
previously. In the first quarter of 2005, the Company implemented the Baylake
Bank Supplemental Executive Retirement Plan ("Plan"), which is intended to
provide certain management and highly compensated employees of the Bank who have
contributed, and are expected to continue to contribute, to the Bank's success
by providing for deferred compensation in addition to that available under the
Bank's other retirement programs. It amounted to approximately $45,000 in
expenses related to the Plan in the second quarter of 2006 compared to $94,000
in the second quarter of 2005 and $380,000 for the six months ended June 30,
2006 compared to $398,000 for the same period a year earlier. The fluctuation in
Plan expenses are driven from the timing of determining the discretionary
contribution in addition to the change in market prices on a periodic basis.
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 2006. Bonus expense decreased
$92,000 to $166,000 for the second quarter of 2006 ($167,000 decrease to
$317,000 for the first six months of 2006), as various income-related goals were
not met during the period. Management will continue its efforts to control
salaries and employee benefits expense, although increases in these expenses are
likely to continue in future years.
Occupancy and equipment expense, collectively, increased $88,000, or 9.3%, to
$1.0 million for the second quarter of 2006 compared to the same period in 2005.
For the six months ended June 30, 2006, occupancy and equipment expense,
collectively, increased $219,000, or 12.3%, to $2.0
23
million compared to the same period in 2005. The increase for both the
three-month and six-month periods for 2006 were attributable to additional
depreciation resulting from the downtown Green Bay branch as mentioned
previously, costs related to various equipment upgrades and increased utility
costs.
Expenses related to the operation of other real estate owned decreased $7,000 to
$74,000 for the 2006 three-month period ended June 30 compared to the same
period in 2005. For the six -- month period ended June 30, 2006, other real
estate owned expenses decreased $12,000 to $117,000 compared to the same period
in 2005. Included in these results for the six - month period ended June 30,
2006 were net gains taken on the sale of other real estate owned amounting to
$53,000 compared to net losses of $29,000 for the same period in 2005. In
addition, costs related to the holding of other real estate owned properties
increased $70,000 to $170,000 for the six months ended June 30, 2006.
Loan and collection expense increased $162,000 to $263,000 for the three months
ended June 30, 2006 compared to the same period in 2005. For the six months
ended June 30, 2006, loan and collection expense increased $153,000 to $307,000
compared to the same period in 2005. $220,000 of the expense totaling $307,000
for the six months ended June 30, 2006 relates to legal and operating costs on
two commercial loan credits, one of which is a non-performing loan and the other
related to an impaired letter of credit for a commercial credit previously
mentioned in filings from the third quarter of 2005. Both properties are listed
for sale through an independent third party. Costs on these properties are
expected to continue through the balance of 2006.
Other operating expense increased $266,000 for the three months ended June 30,
2006 and $677,000 to $1.7 million for the six-month period ended June 30, 2006
compared to the same periods in 2005. The increase was due in part to costs of
$216,000 related to various employee recruitment and search expenses, including
those costs related to the searches for a new bank president/chief operating
officer and a market president. $184,000 of the increase was related to new
product offering costs, including those for the HPC product introduced in the
fourth quarter of 2005.
Income Taxes
Income tax expense for the Company for the three months ended June 30, 2006 was
$1.0 million, a decrease of $130,000, or 11.1%, compared to the same period in
2005. For the six months ended June 30, 2006, income tax expense resulted in a
decrease of $880,000 to $1.5 million compared to an income tax expense of $2.4
million for the same period in 2005. The lower tax expense for the three-month
and six-month periods ended June 30 reflected the Company's decrease in income
before income tax resulting in an increased proportion of non-taxable income to
total income before income taxes.
The Company's effective tax rate (income tax expense divided by income before
taxes) was 29.0% for the six months ended June 30, 2006 compared with 31.7% for
the same period in 2005. The effective tax rate of 29.0% consisted of a federal
effective tax rate of 23.7% and Wisconsin state effective tax rate of 5.3%. For
the three and six-month periods ended June 30, 2006, taxable income decreased
while tax-exempt interest income from municipal investments and income from BOLI
increased proportionately, which caused the change in the effective tax rate.
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
24
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 in future periods.
BALANCE SHEET ANALYSIS
Loans
At June 30, 2006, total loans (including loans held for sale) increased $9.4
million, or 1.2%, to $821.7 million from $812.3 million at December 31, 2005.
Growth in the Company's loan portfolio resulted primarily from an increase in
real estate construction loans to $97.9 million at June 30, 2006 compared to
$85.7 million at December 31, 2005. A decrease of $5.2 million or 1.1% occurred
in the commercial real estate loan totals from December 31, 2005 to June 30,
2006 as a result of competitive pricing pressures and principal paydowns on
several large commercial credits during the period. Growth in commercial real
estate mortgages and commercial loans will continue to be the focus for the
Company although the higher interest rate environment along with competitive
pricing pressures will continue for the balance of 2006.
The following table reflects the composition (mix) of the loan portfolio:
TABLE 7
LOAN PORTFOLIO ANALYSIS
($ in thousands)
June 30, December Percent
2006 31, 2005 change
-------- -------- -------
Amount of loans by type
Real estate-mortgage
Commercial $462,726 $467,956 (1.1%)
1-4 family residential
First liens 92,173 90,946 1.3%
Junior liens 25,088 23,470 6.9%
Home equity 32,074 34,320 (6.5%)
Commercial, financial and agricultural 82,854 80,260 3.2%
Real estate-construction 97,872 85,729 14.2%
Installment
Credit cards and related plans 2,079 2,088 (0.4%)
Other 13,372 12,175 9.8%
Obligations of states and political subdivisions 13,918 15,785 (11.8%)
Less: deferred origination fees, net of costs 452 433 4.4%
Total $821,704 $812,296 1.2%
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
25
an on-going review of payment performance. Asset quality administration,
including early identification of problem loans and timely resolution of
problems, further enhances management of credit risk and minimization of loan
losses. All specifically identifiable and quantifiable losses are charged off
against the allowance. Charged-off loans are subject to periodic review, and
specific efforts are taken to achieve maximum recovery of principal and
interest.
As indicated in Table 4 above, the ALL at June 30, 2006 was $9.4 million
compared with $9.6 million at the end of 2005. This was based on management's
analysis of the loan portfolio risk at June 30, 2006. As such a provision
expense of $261,000 was recorded for the six months ended June 30, 2006. The
quarter to date provision has increased by $140,000 compared to the same period
in 2005, 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
26
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 2005.
Management remains watchful of credit quality issues and believes that issues
within the portfolio are reflective of the challenging economic environment
experienced over the past few years. Should the economic climate deteriorate
from current levels, borrowers may experience difficulty, and the level of
non-performing loans, charge-offs and delinquencies could rise and require
further increases in the provision.
Consideration for making such allocations is consistent with the factors
discussed above, and all of the factors are subject to change; thus, the
allocation is not necessarily indicative of the loan categories in which future
loan losses will occur. It would also be expected that the amount allocated for
any particular type of loan will increase or decrease proportionately to both
the changes in the loan balances and to increases or decreases in the estimated
loss in loans of that type. In other words, changes in the risk profile of the
various parts of the loan portfolio should be reflected in the allowance
allocated.
While there exists probable asset quality problems in the loan portfolio, in
view of collateral values, management believes sufficient reserves have been
provided in the ALL to absorb probable incurred losses in the loan portfolio at
June 30, 2006. 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.
27
TABLE 8
NON-PERFORMING ASSETS
($ in thousands)
At or for the At or for the At or for the
period ended June period ended June period ended
30, 2006 30, 2005 December 31, 2005
----------------- ----------------- -----------------
Nonperforming Assets:
Nonaccrual loans $ 28,677 $ 7,907 $ 6,942
Accruing loans past due 90 days or more 0 0 0
---------- ---------- ----------
Total nonperforming loans ("NPLs") $ 28,677 $ 7,907 $ 6,942
Other real estate owned 1,374 2,096 3,333
---------- ---------- ----------
Total nonperforming assets ("NPAs") $ 30,051 $ 10,003 $ 10,275
Ratios:
ALL to NCO's (annualized) 12.18 4.77 2.32
NCO's to average loans (annualized) 0.09% 0.26% 0.52%
ALL to total loans 1.15% 1.20% 1.18%
NPL's to total loans 3.49% 0.99% 0.85%
NPA's to total assets 2.72% 0.91% 0.94%
ALL to NPL's 32.87% 120.96% 137.58%
As indicated in Table 8, non-performing loans at June 30, 2006 were $28.7
million compared to $6.9 million at December 31, 2005. Real estate non-accrual
loans accounted for $28.1 million of the total, of which $2.6 million was
residential real estate, $5.3 million was real estate construction and $20.2
million was commercial real estate. Commercial and industrial non-accrual loans
totaled $479,000.
Non-accrual loans increased during the six months ended June 30, 2006 by $21.7
million. The increase is primarily attributable to six commercial loans totaling
$21.3 million for businesses that are experiencing difficulties in sales, cash
flow, fiscal operations, and/or general management issues. Of these, two loans
totaling $2.7 million are commercial real estate development loans, two loans
totaling $11.4 million are recreational real estate golf properties; one loan
totaling $2.9 million is a hotel facility and one loan totaling $4.3 million is
a retail shopping mall.
Each of these six non-performing loans is secured primarily by commercial or
residential real estate, and secondarily, by personal guarantees from principals
of the respective borrowers. The Company has initiated or is in the process of
initiating foreclosure actions on three of these loans involving $8.3 million
and it anticipates protracted litigation of at least twelve months in duration
in each case. Management has allocated $911,000 in the ALL on the basis of a
SFAS 114 analysis for any loss estimated with respect to these loans. One loan,
totaling $8.1 million has been partially foreclosed for an amount of $4.0
million and an additional foreclosure is being initiated on the remaining $4.1
million. Two loans totaling $4.9 million are subject to voluntary liquidation
plans that propose to sell underlying real estate assets in amounts sufficient
to repay the outstanding loan balances.
Current impairments have been established for each of these credits and the
Company does not anticipate any further loss at this time, in part due to
expected collateral values.
28
As a result the ratio of non-performing loans to total loans at June 30, 2006
was 3.49% compared to 0.85% at end of year 2005. The Company's ALL was 32.9% of
total non-performing loans at June 30, 2006 compared to 137.6% at end of year
2005.
Non-performing assets (non-performing loans plus other real estate owned assets)
at June 30, 2006 were $30.1 million compared to $10.3 million at December 31,
2005. Other real estate owned, which represents property that the Company
acquired through foreclosure or in satisfaction of debt, consisted of ten
commercial properties totaling $1.4 million. Other real estate owned at December
31, 2005 totaled $3.3 million and consisted of seventeen properties.
Investment Portfolio
The investment portfolio is intended to provide the Company with adequate
liquidity, flexibility in asset/liability management and, lastly, an increase in
its earning potential.
At June 30, 2006, the investment portfolio (which includes investment securities
available for sale) increased $12.3 million, or 7.2%, to $184.0 million from
$171.6 million at December 31, 2005. At June 30, 2006, the investment portfolio
represented 16.7% of total assets compared with 15.8% at December 31, 2005.
Securities available for sale consist of the following:
TABLE 9
INVESTMENT SECURITY ANALYSIS
At June 30, 2006
($ in thousands)
Gross Gross
Unrealized Unrealized
Gains Losses Fair Value
---------- ---------- ----------
Securities available for sale
Obligations of U.S. Treasury & other U.S. agencies 24 2,144 60,170
Mortgage-backed securities 0 2,813 80,059
Obligations of states & political subdivisions 239 659 39,552
Private placement 18 0 1,015
Other securities 0 0 3,159
-------- -------- --------
Total securities available for sale $ 281 $ 5,616 $183,955
At December 31, 2005
($ in thousands)
Gross Gross
Unrealized Unrealized
Gains Losses Fair Value
---------- ---------- ----------
Securities available for sale
Obligations of U.S. Treasury & other U.S. Agencies $ 179 $ 1,153 $ 59,819
Mortgage-backed securities 2 2,015 72,531
Obligations of states & political subdivisions 407 269 33,827
Private placement 44 0 1,040
Other securities 0 0 4,421
-------- -------- --------
Total investment securities $ 632 $ 3,437 $171,638
29
The increases in unrealized losses are related principally to changes in
interest rates. As the Company has the ability to hold these securities for the
foreseeable future, no declines were deemed to be other than temporary.
Deposits
Total deposits at June 30, 2006 increased $14.3 million, or 1.7%, to $871.0
million from $856.7 million at December 31, 2005. Non-interest bearing deposits
at June 30, 2006 decreased $8.3 million, or 7.5%, to $102.4 million from $110.6
million at December 31, 2005. Interest-bearing deposits at June 30, 2006
increased $22.6 million, or 3.0%, to $768.7 million from $746.1 million at
December 31, 2005. Brokered CD's and other brokered deposits totaled $155.7
million at June 30, 2006 compared to $155.1 million at December 31, 2005. 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 first half of the year in anticipation of the summer
tourist season.
Emphasis has been, and will continue to be, placed on generating additional core
deposits in the remainder of 2006 and 2007 through competitive pricing of
deposit products and through the branch delivery systems that have already been
established and a new branch in Green Bay that is planned to open in the third
quarter of 2006. 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 2006 and in 2007 as an additional source of funds to provide for loan
growth in the event that core deposit growth goals would not be accomplished.
Under that scenario, the Company will continue to look at other wholesale
sources of funds, if the brokered CD market became illiquid or more costly in
terms of interest rate.
30
Other Funding Sources
Federal funds purchased and securities under agreements to repurchase at June
30, 2006 increased $20.9 million to $22.2 million from $1.3 million at December
31, 2005. Federal funds purchased increased from no federal funds purchased at
December 31, 2005 to $21.2 million at June 30, 2006, accounting for the majority
of the increase. They have increased to fund the growth in the investment and
loan portfolios which was coupled with slower growth in core deposits and a
reduction in Federal Home Loan Bank Advances during the six-month period ended
June 30, 2006.
Federal Home Loan Bank Advances totaled $105.2 million at June 30, 2006 compared
to $125.2 million at December 31, 2005. 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.
Long-term Debt
In connection with the issuance of Trust Preferred Securities in 2001 (see
"Capital Resources"), the Company issued long-term subordinated debentures to
Baylake Capital Trust I, a Delaware Business Trust, formed by the Company. The
aggregate principal amount of the debentures due 2031, to the trust is
$16,597,940. These securities were redeemed on March 31, 2006.
The redemption of these securities were funded through the issuance of $16.1
million of trust preferred securities and $498,000 of trust common securities,
and underlying debt securities, that will adjust quarterly at a rate equal to
1.35% over the three month LIBOR. The rate on this financing for the second
quarter was 6.31% and will be 6.85% for the third quarter of 2006 compared to a
fixed rate of 10% for the trust preferred securities issued under Baylake
Capital Trust I. This lower interest rate has provided interest savings in the
second quarter of 2006 and thereafter depending upon the changes in the interest
rate environment. Management believes that this new financing should provide a
better match for the overall interest rate sensitivity position of the Company
going forward.
For additional details, please make reference to the Consolidated Financial
Statements and the accompanying footnotes on the Company's Form 10-Q for the
period ended June 30, 2006.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT
LIABILITIES
The Company utilizes a variety of financial instruments in the normal course of
business to meet the financial needs of its customers. These financial
instruments include commitments to extend credit, commitments to originate
residential mortgage loans held for sale, commercial letters of credit, standby
letters of credit, and forward commitments to sell residential mortgage loans.
Please refer to the Company's Annual Report on Form 10-K for the year ended
December 31, 2005 for discussion with respect to the Company's quantitative and
qualitative disclosures about its fixed and determinable contractual
obligations. Items disclosed in Form 10-K have not materially changed since that
report was filed.
31
The following is a summary of our off-balance sheet commitments, all of which
were lending-related commitments:
TABLE 10
LENDING RELATED COMMITMENTS
($ in thousands)
June 30, 2006 December 31, 2005
------------- -----------------
Commitments to fund home equity line loans $ 48,370 $ 45,435
Commitments to fund residential real estate construction loans 2,917 3,409
Commitments unused on various other lines of credit loans 154,899 164,112
--------- -----------
Total commitments to extend credit $ 206,186 $ 212,956
Financial standby letters of credit $ 21,713 $ 22,160
The following table summarizes the Company's significant contractual obligations
and commitments at June 30, 2006:
TABLE 11
CONTRACTUAL OBLIGATIONS
($ in thousands)
WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS AFTER 5 YEARS TOTAL
------------- --------- --------- ------------- ---------
Certificates of deposit and other time deposit
obligations $ 255,649 $ 140,947 $ 4,437 $ 61 $ 401,094
Federal funds purchased and repurchase agreements 22,194 $ 0 $ 0 $ 0 22,194
Federal Home Loan Bank advances 70,000 10,081 101 25,000 105,182
Construction of branch facility 288 0 0 0 288
Subordinated debentures 0 0 0 16,100 16,100
Operating leases 41 7 0 0 48
---------- --------- --------- ---------- ---------
Total $ 348,172 $ 151,035 $ 4,538 $ 41,161 $ 544,906
32
LIQUIDITY
Liquidity management refers to the ability of the Company to ensure that cash is
available in a timely manner to meet loan demand and depositors' needs, and to
service other liabilities as they become due, without undue cost or risk, and
without causing a disruption to normal operating activities. The Company and the
Bank have different liquidity considerations.
The Company's primary sources of funds are dividends from the Bank, investment
income, and net proceeds from borrowings and the offerings of junior
subordinated obligations, in addition to the issuance of its common stock
securities. The Company manages its liquidity position in order to provide funds
necessary to pay dividends to its shareholders. Dividends received from Bank
totaled $2.5 million for the first six months of 2006 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 $3.7 million in the first six months of 2006.
The Bank meets its cash flow needs by having funding sources available to it to
satisfy the credit needs of customers as well as having available funds to
satisfy deposit withdrawal requests. Liquidity at the Bank is derived from
deposit growth, maturing loans, the maturity of the investment portfolio, access
to other funding sources, marketability of certain of its assets; the ability to
use its loan and investment portfolios as collateral for secured borrowings and
strong capital positions.
Maturing investments have been a primary source of liquidity at the Bank. For
the six months ended June 30, 2006, principal payments totaling $10.3 million
were received on investments. The Company purchased $25.2 million in investments
in the first six months of 2006. This resulted in net cash of $14.9 million used
in investing activities for the first six months of 2006. At June 30, 2006 the
investment portfolio contained $140.3 million of U.S. Treasury and federal
agency backed securities representing 76.2% 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. The seasonal pattern results from the
tourism-oriented businesses in our market area. As a financing activity
reflected in the June 30, 2006 Consolidated Statements of Cash Flows, deposits
increased and resulted in $14.3 million of cash flow during the first six months
of 2006. The Company's overall deposit base increased 1.7% for the six months
ended June 30, 2006. Deposit growth is generally the most stable source of
liquidity for the Bank, although brokered deposits, which are inherently less
stable than locally generated core deposits, are sometimes used. The Company's
reliance on these deposits remained constant during the six-month period.
Affecting liquidity are core deposit growth levels, certificate of deposit
maturity structure and retention, and characteristics and diversification of
wholesale funding sources affecting the channels by which brokered deposits are
acquired. Conversely, deposit outflow will cause the Bank to develop alternative
sources of funds which may not be as liquid and potentially a more costly
alternative.
The scheduled maturity of loans can provide a source of additional liquidity.
The Bank has $245.2 million, or 29.8%, of loans maturing within one year.
Factors affecting liquidity relative to loans are loan origination volumes, loan
prepayment rates and the maturity structure of existing
33
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 June 30, 2006, federal
funds purchased and securities sold under agreements to repurchase totaled $22.2
million compared to $1.3 million at the end of 2005. 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 $105.2
million at June 30, 2006 and $125.2 million at December 31, 2005.
The Bank's liquidity resources were sufficient in the first six months of 2006
to fund the growth in loans and investments, increase the volume of interest
earning assets and meet other cash needs when necessary.
Management expects that deposit growth will continue to be the primary funding
source of the Bank's liquidity on a long-term basis, along with a stable
earnings base, the resulting cash generated by operating activities, and a
strong capital position. Although federal funds purchased and borrowings from
the FHLB provided funds in the first six months of 2006, management expects
deposit growth to be a reliable funding source in the future as a result of
branch expansion efforts and marketing efforts to attract and retain core
deposits. In addition, the Bank may acquire additional brokered deposits as
funding for short-term liquidity needs. Shorter-term liquidity needs will mainly
be derived from growth in short-term borrowings, maturing federal funds sold and
portfolio investments, loan maturities and access to other funding sources.
In assessing liquidity, historical information such as seasonality (loan
demand's affect on liquidity which starts before and during the tourist season
and deposit draw down which affects liquidity shortly before and during the
early part of the tourist season), local economic cycles and the economy in
general are considered along with the current ratios, management goals and the
unique characteristics of the Company. Management believes that, in the current
economic environment, the Company's and the Bank's liquidity position is
adequate. To management's knowledge, there are no known trends nor any known
demands, commitments, events or uncertainties that will result or are reasonably
likely to result in a material increase or decrease in the Bank's or the
Company's liquidity.
Capital Resources
Stockholders' equity at June 30, 2006 and December 31, 2005, respectively, was
$78.4 million and $78.5 million, respectively. In total, stockholders' equity
decreased $119,000 or 0.2%. The decrease in stockholders' equity in 2006 was
primarily composed of the change in accumulated other comprehensive loss (as a
result of unrealized losses on available for sale securities) and the payment of
dividends, almost completely offset by net income and proceeds from the exercise
of stock options. The change in unrealized losses on available for sale
securities amounted to $1.6 million (net of tax) for the first six months of
2006; this change resulted from the effects of the increasing interest rate
environment. Total dividends paid increased to $3.7 million in the six-month
period from $3.5 million in 2005, primarily as a result of an increase in the
per share dividends rate to $0.32 from $0.30. Stockholders' equity to assets at
June 30, 2006 was 7.10% compared to 7.21% at the end of 2005.
34
On March 31, 2006, the Company redeemed its outstanding junior subordinated
indentures and trust preferred securities for a total of $16.6 million which
constitutes the $16.1 million stated principal values of those amounts plus
$510,389 in accrued interest. See "Management's Discussion of Analysis of
Financial Condition and Results of Operations - Balance Sheet Analysis - Long
Term Debt" above.
The redemption of these securities were funded through the issuance of $16.1
million of trust preferred securities and $498,000 of trust common securities
issued under the name Baylake Capital Trust II ("Trust II") that will adjust
quarterly at a rate equal to 1.35% over the three month LIBOR. The initial rate
on this financing for the second quarter was 6.31% and will be 6.85% for the
third quarter. This lower rate will provide savings beginning in the second
quarter of 2006 and management believes that the new financing should provide a
better match for the overall interest rate sensitivity position of the Company
going forward. For banking regulatory purposes, these securities are considered
Tier 1 capital.
Cash dividends declared in the first six months of 2006 were $0.32 per share
compared with $0.30 in 2005. The Company provided a 6.7% increase in normal
dividends per share in 2006 over 2005 as a result of earnings for 2006. Total
funds utilized in the payment of dividends were $3.7 million in the first six
months of 2006, as compared to $3.5 million in the corresponding period of 2005.
On June 5, 2006, the Company's Board of Directors authorized management, in its
discretion, to repurchase up to 300,000 shares, representing approximately 3.8%
of the Company's common stock in a timeframe not to exceed June 30, 2007.
Although the Company may not repurchase all 300,000 within the allotted time
period, the program will allow the Company to repurchase its shares as
opportunities arise at prevailing market prices in open market or privately
negotiated transactions. Shares repurchased are held as treasury stock and
accordingly, are accounted for as a reduction of stockholders' equity. The
Company repurchased none of its common shares in the first six months of 2006.
The adequacy of the Company's capital is regularly reviewed to ensure that
sufficient capital is available for current and future needs and is in
compliance with regulatory guidelines. The assessment of overall capital
adequacy depends upon a variety of factors, including asset quality, liquidity,
stability of earnings, changing competitive forces, economic conditions in
markets served and strength of management. Management is confident that because
of current capital levels and projected earnings levels, capital levels are more
than adequate to meet the ongoing and future concerns of the Company.
The Federal Reserve Board has established capital adequacy rules which take into
account risk attributable to balance sheet assets and off-balance sheet
activities. All banks and bank holding companies must meet a minimum total
risk-based capital ratio of 8%. Of the 8% required, at least half must be
comprised of core capital elements defined as Tier 1 capital. The federal
banking agencies also have adopted leverage capital guidelines which banking
organizations must meet. Under these guidelines, the most highly rated banking
organizations must meet a leverage ratio of at least 3% Tier 1 capital to
assets, while lower rated banking organizations must maintain a ratio of at
least 4% to 5%. Failure to meet minimum capital requirements can initiate
certain mandatory -and possible additional discretionary- actions by regulators
that, if undertaken, could have a direct material effect on the consolidated
financial statements.
At June 30, 2006 and December 31, 2005, 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.
35
To be "well capitalized" under the regulatory framework, the Tier 1 capital
ratio must meet or exceed 6%, the total capital ratio must meet or exceed 10%
and the leverage ratio must meet or exceed 5%.
The following table presents the Company's and the Bank's capital ratios as of
June 30, 2006 and December 31, 2005:
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 June 30, 2006
Total Capital (to
Risk Weighted Assets)
Company 101,295 10.82% 74,872 8.00% N/A N/A
Bank 99,190 10.60% 74,836 8.00% 93,545 10.00%
Tier 1 Capital (to
Risk Weighted Assets)
Company 91,870 9.82% 37,436 4.00% N/A N/A
Bank 89,765 9.60% 37,418 4.00% 56,127 6.00%
Tier 1 Capital (to
Average Assets)
Company 91,870 8.39% 43,799 4.00% N/A N/A
Bank 89,765 8.20% 43.799 4.00% 54,749 5.00%
As of December 31, 2005
Total Capital (to
Risk Weighted Assets)
Company 99,882 10.73% 74,472 8.00% N/A N/A
Bank 97,327 10.51% 74,404 8.00% 93,005 10.00%
Tier 1 Capital (to
Risk Weighted Assets)
Company 90,332 9.70% 37,236 4.00% N/A N/A
Bank 87,778 9.44% 37,202 4.00% 55,803 6.00%
Tier 1 Capital (to
Average Assets)
Company 90,332 8.27% 43,692 4.00% N/A N/A
Bank 87,778 8.11% 43,590 4.00% 54,488 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.
36
Management actively reviews capital strategies for the Company to ensure that
capital levels are appropriate based on the perceived business risks, further
growth opportunities, industry standards, and regulatory requirements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
The Company's primary market risk exposure is interest rate risk. Interest rate
risk is the risk that the Company's earnings and capital will be adversely
affected by changes in interest rates. The Company does not use derivatives to
mitigate its interest rate risk.
The Company's earnings are derived from the operations of its direct and
indirect subsidiaries with particular reliance on net interest income,
calculated as the difference between interest earned on loans and investments
and the interest expense paid on deposits and other interest bearing
liabilities, including advances from FHLB and other borrowings. Like other
financial institutions, the Company's interest income and interest expense are
affected by general economic conditions and by the policies of regulatory
authorities, including the monetary policies of the Board of Governors of the
Federal Reserve System. Changes in the economic environment may influence, among
other matters, the growth rate of loans and deposits, the quality of the loan
portfolio and loan and deposit pricing. Fluctuations in interest rates are not
predictable or controllable.
As of June 30, 2006, 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 in net
interest income exceeds the Company's internal limits by $440,000 for the
period. The Company has noted the issue and the Company feels that other
mitigating factors minimize that potential effect given the current rate
environment. The Company has not experienced any material changes to its market
risk position since December 31, 2005, as described in the Company's 2005 Form
10-K Annual Report.
The Company's overall interest rate sensitivity is demonstrated by net interest
income analysis. Net interest income analysis measures the change in net
interest income in the event of hypothetical changes in interest rates. This
analysis assesses the risk of change in net interest income in the event of
sudden and sustained 1.0% to 2.0% increases and decreases in market interest
rates. The table below presents the Company's projected changes in net interest
income for the various rate shock levels at June 30, 2006.
TABLE 13
INTEREST SENSITIVITY
($ in thousands)
Change in Net Interest Income over One Year Horizon
- ---------------------------------------------------------------------------------
At June 30, 2006 At December 31, 2005
--------------------------- ---------------------------
Change in levels of Percentage Percentage
interest rates Dollar change change Dollar change change
- ------------------- ------------- ---------- ------------- ----------
+200 bp $ 1,644 4.2% $ 2,572 6.8%
+100 bp 438 1.1% 1,842 4.9%
Base 0 0% 0 0%
- -100 bp (2,021) (5.2%) (2,351) (6.2%)
- -200 bp (4,310) (11.1%) (4,905) (13.0%)
As shown above, at June 30, 2006, the effect of an immediate 200 basis point
increase in interest rates would increase the Company`s net interest income by
$1.6 million or 4.2%. The effect of an immediate 200 basis point reduction in
rates would decrease the Company's net interest income by $4.3 million or 11.1%.
37
Changes in the mix of earning assets and interest - bearing liabilities
decreased the Company's asset sensitivity during the past twelve months.
Computations of the prospective effects of hypothetical interest rate changes
are based on numerous assumptions, including the relative levels of market
interest rates and loan prepayments, and should not be relied upon as indicative
of actual results. Actual values may differ from those projections set forth
above, should market conditions vary from the assumptions used in preparing the
analyses. Further, the computations do not contemplate any actions the Company
may undertake in response to changes in interest rates.
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURES CONTROLS AND PROCEDURES: The Company's management, with the
participation of the Company's Chief Executive Officer and Chief Financial
Officer, has evaluated the effectiveness of the Company's disclosure controls
and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the "Exchange Act") as of June
30, 2006. 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 six-month period ended June 30, 2006 to the calculation of the
allowance for loan loss reserve. Such enhancement is explained in Item 2,
Management's Discussion and Analysis found in the sections entitled "Provision
for Loan Losses" and "Balance Sheet Analysis-Risk Management and the Allowance
for Loan Losses" which discussions are incorporated by reference in this item.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Baylake and its subsidiaries may be involved from time to time in various
routine legal proceedings incidental to its business. Neither Baylake nor any of
its subsidiaries is currently engaged in any legal proceedings that are expected
to have a material adverse effect on the results of operations or financial
position of Baylake.
ITEM 1A. RISK FACTORS
38
See "Risk Factors" in Item 1A of the Company's annual report on Form 10-K for
the year ended December 31, 2005.
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
a) The Company's Annual Meeting of Shareholders was held on June 5,
2006. b) Not applicable
c) The only matter voted upon was the election of two directors for
terms expiring in 2009. The results are as follows:
Election of directors For Against or withheld
- --------------------- --------- -------------------
Richard A. Braun 6,376,707 239,643
William C. Parsons 6,005,681 610,669
As a consequence of the Company's staggered board of directors, other directors
remained in office. Directors continuing in office for terms expiring in 2007
are John W. Bunda, Roger G. Ferris, Thomas L. Herlache and Paul Jay Sturm.
Directors continuing in office for terms expiring in 2008 are Robert W. Agnew,
George Delveaux, Jr., Dee Geurts-Bengtson and Joseph Morgan. As previously
disclosed on June 30, 2006, it was announced that Robert Cera would become a
director effective August 21, 2006. His term will expire in 2009.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS
The following exhibits are furnished herewith:
EXHIBIT NUMBER DESCRIPTION
- -------------- -----------------------------------------------------------
10.9 Baylake Bank Employment Agreement with Robert J. Cera
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.
"Management agrees to furnish to the Securities and Exchange Commission, upon
request, a copy of any other agreements or instruments of Baylake Corp. and its
subsidiaries defining the rights of holders of any long-term debt whose
authorization does not exceed 10% of total assets."
39
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
BAYLAKE CORP.
---------------------------------
Date: August 3, 2006 /s/ Thomas L. Herlache
----------------------------------------
Thomas L. Herlache
President (CEO)
Date: August 3, 2006 /s/ Steven D. Jennerjohn
----------------------------------------
Steven D. Jennerjohn
Treasurer (CFO)
40