UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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
(State or other jurisdiction of 39-1268055
incorporation or organization) (Identification No.)
217 North Fourth Avenue, Sturgeon Bay, WI 54235
(Address of principal executive offices) (Zip Code)
(920)-743-5551
(Registrant's telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is 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 November 3, 2006: 7,821,141
shares
BAYLAKE CORP. AND SUBSIDIARIES
INDEX
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets (Unaudited) as of
September 30, 2006 and December 31, 2005 3
Consolidated Statements of Income and Comprehensive Income
(Unaudited) for the three and nine months ended
September 30, 2006 and 2005 4
Consolidated Statements of Changes in Stockholders' Equity
(Unaudited) for the nine months ended September 30, 2006
and 2005 5
Consolidated Statements of Cash Flows (Unaudited) for the
nine months ended September 30, 2006 and 2005 6-7
Notes to Consolidated Unaudited Financial Statements 8-13
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 14-38
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 39-40
Item 4. Controls and Procedures 40
PART II - OTHER INFORMATION 40
EXHIBIT INDEX
Signatures 43
Exhibit 31.1 Certification pursuant to Section 302 44
Exhibit 31.2 Certification pursuant to Section 302 46
Exhibit 32.1 Certification pursuant to 18 U.S.C.
Section 1350 48
Exhibit 32.2 Certification pursuant to 18 U.S.C.
Section 1350 49
BAYLAKE CORP.
CONSOLIDATED BALANCE SHEETS (Unaudited)
September 30, 2006 and December 31, 2005
(Dollar amounts in thousands)
September 30, December 31,
2006 2005
------------- ------------
ASSETS
Cash and due from financial institutions $ 21,767 $ 32,855
Federal funds sold 401 199
---------- ----------
Cash and cash equivalents 22,168 33,054
Securities available for sale 188,097 171,638
Loans held for sale 1,043 374
Loans, net of allowance after $8,220 and $9,551 797,557 802,745
Cash value of life insurance 23,968 22,814
Premises held for sale 673 1,167
Premises and equipment, net 27,979 24,703
Federal Home Loan Bank stock 7,266 8,081
Foreclosed assets, net 3,158 3,333
Goodwill 5,723 5,723
Accrued interest receivable 5,941 5,354
Other assets 10,195 10,422
---------- ----------
Total assets $1,093,768 $1,089,408
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest-bearing $ 101,656 $ 110,641
Interest-bearing 766,065 746,070
---------- ----------
Total deposits 867,721 856,711
Federal Home Loan Bank advances 115,180 125,185
Federal funds purchased and repurchase agreements 1,595 1,315
Subordinated debentures 16,100 16,100
Accrued expenses and other liabilities 12,462 10,310
Dividends payable -- 1,243
---------- ----------
Total liabilities 1,013,058 1,010,864
Common stock, $5 par value, authorized 50,000,000; issued-
7,899,197 shares in 2006, 7,805,586 shares in 2005; outstanding-
7,807,184 shares in 2006, 7,782,427 shares in 2005 39,496 39,028
Additional paid-in capital 10,229 9,466
Retained earnings 34,299 32,461
Treasury stock (92,013 shares in 2006 and 23,159 shares in 2005) (1,726) (625)
Accumulated other comprehensive loss (1,588) (1,786)
---------- ----------
Total stockholders' equity 80,710 78,544
---------- ----------
Total liabilities and stockholder equity $1,093,768 $1,089,408
========== ==========
See accompanying notes to Unaudited Consolidated Financial Statements.
3
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three and Nine Months ended September 30, 2006 and 2005
(Dollar amounts in thousands, except per share data)
Three months ended Sept 30 Nine months ended Sept 30
-------------------------- -------------------------
2006 2005 2006 2005
------- ------- ------- -------
Interest and dividend income
Loans, including fees $15,905 $13,576 $45,987 $38,183
Taxable securities 1,648 1,768 4,789 5,226
Tax exempt securities 453 508 1,191 1,400
Federal funds sold and other 88 33 295 66
------- ------- ------- -------
Total interest and dividend income 18,094 15,885 52,262 44,875
------- ------- ------- -------
Interest expense
Deposits 7,395 5,193 20,827 13,514
Federal funds purchased and repurchase agreements 142 215 406 706
Federal Home Loan Bank advances and other debt 1,469 1,224 4,230 2,975
Subordinated debentures 282 461 1,428 1,384
------- ------- ------- -------
Total interest expense 9,288 7,093 26,891 18,579
------- ------- ------- -------
NET INTEREST INCOME 8,806 8,792 25,371 26,296
Provision for loan losses 371 1,547 632 1,668
------- ------- ------- -------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 8,435 7,245 24,739 24,628
------- ------- ------- -------
Other income
Fees from fiduciary activities 206 193 747 556
Fees from loan servicing 295 292 830 863
Fees for other services to customers 1,344 1,260 3,729 3,543
Gains from sales of loans 149 348 559 733
Net gains (loss) from sale and disposal of premises
and equipment 103 (73) 288 (224)
Increase in cash surrender value of life insurance 217 184 641 601
Other income 163 139 402 560
------- ------- ------- -------
Total other income 2,477 2,343 7,196 6,632
------- ------- ------- -------
Non-interest expenses
Salaries and employee benefits 5,066 4,213 14,583 13,070
Occupancy expense 596 717 1,760 1,855
Equipment expense 430 349 1,270 996
Data processing and courier 324 285 939 861
Operation of other real estate 86 87 203 216
Provision for impairment of letter of credit 27 1,846 27 1,846
Other operating expenses 1,797 1,446 5,361 4,235
------- ------- ------- -------
Total non-interest expenses 8,326 8,943 24,143 23,079
------- ------- ------- -------
INCOME BEFORE INCOME TAX EXPENSE 2,586 645 7,792 8,181
Income tax expense (benefit) 703 (62) 2,215 2,330
------- ------- ------- -------
NET INCOME $ 1,883 $ 707 $ 5,577 $ 5,851
------- ------- ------- -------
COMPREHENSIVE INCOME $ 3,717 $ 220 $ 5,775 $ 4,424
------- ------- ------- -------
BASIC EARNINGS PER SHARE $ 0.24 $ 0.09 $ 0.72 $ 0.76
DILUTED EARNINGS PER SHARE $ 0.24 $ 0.09 $ 0.71 $ 0.75
See accompanying notes to Unaudited Consolidated Financial Statements.
4
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited)
Nine months ended September 30,
(Dollar amounts in thousands except for share and per share data)
Accumulated
Common Stock Additional Other
------------------ Paid-in Retained Treasury Comprehensive Total
Shares Amount Capital Earnings Stock Income (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 -- -- -- 5,851 -- -- 5,851
Net changes in unrealized gain (loss) on securities
available for sale, net of $(793) deferred taxes -- -- -- -- -- (1,427) (1,427)
-------
Total comprehensive income 4,424
Stock options exercised 72,950 364 299 -- -- -- 663
Tax benefit from exercise of stock options -- -- 243 -- -- -- 243
Cash dividends declared ($0.45 per share) -- -- -- (3,473) -- -- (3,473)
--------- ------- ------- ------- ------- ------- -------
BALANCE, SEPTEMBER 30, 2005 7,765,727 $38,944 $ 9,348 $30,653 $ (625) $ (258) $78,062
========= ======= ======= ======= ======= ======= =======
BALANCE, JANUARY 1, 2006 7,782,427 $39,028 $ 9,466 $32,461 $ (625) $(1,786) $78,544
Net income for the year -- -- -- 5,577 -- -- 5,577
Net changes in unrealized gain (loss) on securities
available for sale, net of $106 deferred taxes -- -- -- -- -- 198 198
-------
Total comprehensive income 5,775
Stock compensation expense recognized -- -- 39 -- -- -- 39
Stock options exercised 76,587 383 323 -- -- -- 706
Common stock issued under Dividend Reinvestment Plan 17,024 85 183 -- -- -- 268
Treasury stock repurchases (68,854) -- -- -- (1,101) -- (1,101)
Tax benefit from exercise of stock options -- -- 218 -- -- -- 218
Cash dividends declared ($0.48 per share) -- -- -- (3,739) -- -- (3,739)
--------- ------- ------- ------- ------- ------- -------
BALANCE, SEPTEMBER 30, 2006 7,807,184 $39,496 $10,229 $34,299 $(1,726) $(1,588) $80,710
========= ======= ======= ======= ======= ======= =======
See accompanying notes to Unaudited Consolidated Financial Statements.
5
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine months ended September 30, 2006 and 2005
(Dollar amounts in thousands)
2006 2005
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Reconciliation of net income to net cash provided by
operating activities:
Net income $ 5,577 $ 5,851
Adjustments to reconcile net income to net cash
provided to operating activities:
Depreciation and amortization 1,209 1,353
Amortization of debt issuance costs 475 177
Amortization of core deposit intangible 39 39
Provision for losses on loans 632 1,668
Provision for impairment on letter of credit 27 1,846
Net amortization of securities 95 457
Increase in cash surrender value of life insurance (641) (601)
Federal Home Loan Bank stock dividend -- (309)
Net gain on sale of loans (559) (733)
Proceeds from sale of loans held for sale 31,315 38,007
Origination of loans held for sale (31,426) (36,469)
Provision for valuation allowance on other real estate owned 90 54
Net (gain) loss from disposal of other real estate (76) 35
Net (gain) loss from disposal of bank premises and equipment (288) 224
Stock option compensation expense recognized 39 --
Changes in assets and liabilities:
Accrued interest receivable and other assets (947) (956)
Accrued expenses and other liabilities 2,152 873
-------- --------
Net cash provided by operating activities 7,713 11,516
CASH FLOWS FROM INVESTING ACTIVITIES:
Principal payments on securities available-for-sale 15,405 14,143
Purchase of securities available-for-sale (31,653) (30,654)
Proceeds from sale of other real estate owned 2,494 908
Proceeds from sale of premises and equipment 690 316
Loan originations and payments, net 2,231 (35,141)
Proceeds from redemption of FHLB Stock 815 --
Additions to premises and equipment (4,392) (5,415)
Investment in bank-owned life insurance (583) (469)
-------- --------
Net cash used in investing activities (14,993) (56,312)
See accompanying notes to Unaudited Consolidated Financial Statements.
6
BAYLAKE CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30, 2006 and 2005
(Dollar amounts in thousands)
2006 2005
--------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits $ 11,010 $22,083
Net change in federal funds purchased and
repurchase agreements 280 622
Proceeds from Federal Home Loan Bank advances 100,000 25,000
Repayments on Federal Home Loan Bank advances (110,005) (5)
Redemption of subordinated debt (16,100) --
Proceeds from issuance of subordinated debt 16,100 --
Proceeds from exercise of stock options 706 663
Tax benefit from exercises of stock options 218 --
Treasury stock repurchases (1,101) --
Cash dividends paid (4,714) (4,627)
--------- -------
Net cash (used in) provided by financing activities (3,606) 43,736
--------- -------
Net change in cash and cash equivalents (10,886) (1,060)
Beginning cash and cash equivalents 33,054 26,172
--------- -------
ENDING CASH AND CASH EQUIVALENTS $ 22,168 $25,112
========= =======
See accompanying notes to Unaudited Consolidated Financial Statements.
7
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 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 September 30, 2006 and December
31, 2005. The results of operations for the three and nine months ended
September 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 nine months ended September 30 (dollars in
thousands, except per share amounts):
Three months Nine months
ended Sept 30, ended Sept 30,
----------------------- -----------------------
2006 2005 2006 2005
---------- ---------- ---------- ----------
(Net income in thousands)
(NUMERATOR):
Net income $ 1,883 $ 707 $ 5,577 $ 5,851
(DENOMINATOR):
Weighted average number of common
shares outstanding-basic 7,800,998 7,742,346 7,796,443 7,713,177
Dilutive effect of stock options 33,635 86,401 35,990 82,972
Weighted average number of common
shares outstanding-diluted 7,834,633 7,828,747 7,832,433 7,796,149
BASIC EPS $ 0.24 $ 0.09 $ 0.72 $ 0.76
DILUTED EPS $ 0.24 $ 0.09 $ 0.71 $ 0.75
8
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
4. Baylake Corp. paid a cash dividend of $0.16 per share on September 15, 2006
to shareholders of record as of September 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 nine months of 2006, the amount of compensation expense reflected in
the financial statements is $39,000, including $13,000 in the third quarter
of 2006. As a matter of comparing the three and nine months ended September
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 Nine months ended
September 30, 2005 September 30, 2005
------------------ ------------------
(In thousands, except per share amounts)
Net income, as reported $ 707 $5,851
Less: Total stock-based employee compensation
cost determined under the fair value method,
net of income taxes (14) (43)
Pro forma net income 693 5,808
Earnings per share:
Basic - as reported $0.09 $ 0.76
Basic - pro forma $0.09 $ 0.75
Diluted - as reported $0.09 $ 0.75
Diluted - pro forma $0.09 $ 0.74
9
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
The fair value of each option outstanding 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.
A summary of the Company's stock-based compensation activity for the nine
months ended September 30, 2006, is presented below.
Weighted
Weighted average Aggregate
average remaining intrinsic
exercise contractual value
Stock options Shares price term (000's)
- ------------- ------- -------- ----------- ---------
Outstanding at December 31, 2005 486,869 $13.95
Granted -- --
Exercised 76,587 9.21
Forfeited -- --
Outstanding at September 30, 2006 410,282 14.83
Outstanding and in the money options
at September 30, 2006 350,282 13.09 3.4 $966
Options exercisable and in the money
at September 30, 2006 313,901 13.03 3.4 $884
During the first nine months of 2006, $706,000 was received for the
exercise of 76,587 stock options.
6. Effect of Newly Issued But Not Yet Effective Accounting Standards:
In September 2006, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 158, "Accounting
for Defined Benefit Pension and Other Postretirement Plans - amendment of
FASB Statements No. 87, 88, 106, and 132 (R)", ("SFAS 158"). SFAS 158
requires an employer to recognize a plan's overfunded or underfunded status
in its balance sheets and recognize the changes in a plan's funded status
in comprehensive income in the year in which the changes occur. In
addition, SFAS No. 158 requires an employer to measure plan assets and
obligations that determine its funded status as of the end of its fiscal
year. The requirement to recognize the funded status of a benefit plan and
the disclosure requirements are effective as of the end of the fiscal year
ending after December 15, 2006. The requirement to measure plan assets and
benefit obligations as of the employer's fiscal year-end is effective for
fiscal years ending after December 15, 2008. We do not expect the adoption
of SFAS No. 158 will have a significant impact on our financial condition
or results of operations.
10
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
which clarifies the principle that fair value should be based on the
assumptions market participants would use when pricing an asset or
liability and establishes a fair value hierarchy that prioritizes the
information used to develop those assumptions. Under the standard, fair
value measurement would be separately disclosed by level with the fair
value hierarchy. SFAS 157 is effective for financial statements issued for
fiscal years beginning after November 15, 2007 (January 1, 2008 for us),
and interim periods within those fiscal years, with early adoption
permitted. We are currently assessing the impact that SFAS 157 will have on
our financial condition or results of operations.
In September 2006, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements", ("SAB 108"). SAB 108 requires the evaluation of prior-year
misstatements using both the balance sheet approach and the income
statement approach. In the initial year of adoption should either approach
result in quantifying an error that is material in light of quantitative
and qualitative factors, SAB 108 guidance allows for a one-time cumulative
effect adjustment to beginning retained earnings. In years subsequent to
adoption, previously undetected misstatements deemed material shall result
in the restatement of previously issued financial statements in accordance
with FAS 154. SAB 108 is effective for fiscal years ending on or after
November 15, 2006. We do not expect the adoption of this standard will have
a significant impact on our financial condition or results of operations.
Under Emerging Issues Task Force ("EITF") 06-4: Accounting for Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar
Life Insurance Arrangements, the EITF reached a consensus that requires the
recognition of a liability related to the postretirement benefits covered
by an endorsement split-dollar life insurance arrangement. The consensus
highlights that the employer who is the policy holder has a liability for
the benefit it is providing to the employee. The employer has agreed to
maintain the insurance policy in force for the employee's benefit during
his retirement, then the liability recognized during the employee's active
service period should be based on the future cost of insurance to be
incurred during the employee's retirement. Also, if the employer has agreed
to provide the employee with a death benefit, then the liability for the
future death benefit should be recognized under SFAS 106. As of September
30, 2006, this FASB board ratified the above. It is applicable for fiscal
years beginning after December 15, 2006. We do not expect the adoption of
this standard will have a significant impact on our financial condition or
results of operations.
Under EIFT 06-5: Accounting for Purchases of Life Insurance-Determining the
Amount That Could be Realized in Accordance with FASB Technical Bulletin
No. 85-4, "Accounting for Purchases of Life Insurance", the task force
reached a consensus that a policyholder should consider any additional
amounts included in the contractual terms of the policy in determining the
amount that could be realized under the insurance contract. The task forces
agreed that contractual limitations should be considered when determining
the realizable amounts. Those amounts that are recoverable by the
policyholder at the discretion of the insurance company should be excluded
from the amount that could be
11
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
realized. The task force also agreed that fixed amounts that are
recoverable by the policyholder in future periods in excess of one year
from the surrender of the policy should be recognized at their present
value. The task force also reached a consensus that a policyholder should
determine the amount that could be realized under the life insurance
contract assuming the surrender of an individual-life by individual life
policy. The task force also noted that any amount that is ultimately
realized by the policyholder upon the assumed surrender of the final policy
shall be included in the amount that could be realized under the insurance
contract. The issue should be effective for fiscal years beginning after
December 15, 2006, but early adoption is permitted. This was ratified at
the Task Force, September 20, 2006 meeting. We do not expect the adoption
of this standard will have a significant impact on our financial condition
or results of operations.
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes-an interpretation of FASB Statement 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
requires the impact of a tax position to be recognized in the financial
statements if that position is more-likely-than-not of being sustained upon
examination, based on the technical merits of the position. A tax position
meeting the more-likely-than-not threshold is then to be measured at the
largest amount of benefit that is greater than 50 percent likely of being
realized upon settlement. FIN 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. FIN 48 is effective for fiscal years beginning
after December 15, 2006. As discussed in the section titled "Critical
Accounting Policies-Income tax accounting", the Company does have uncertain
tax positions relative to Wisconsin Department of Revenue and income earned
by out of state subsidiaries. For further discussion, please review that
discussion. The Company will adopt FIN 48 in 2007 and is in the process of
assessing the impact on its results of operations, financial position, and
liquidity.
In March 2006, FASB issued Statement of Financial Accounting Standards 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 September
30, 2006, include $505,000 of mortgage servicing rights and
12
BAYLAKE CORP.
NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
$695,000 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.
7. The Bank owns a 49% interest in United Financial Services, Inc. ("UFS") a
data processing service. The Bank's ownership interest totals $3.2 million
and $2.7 million, respectively, at September 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,
UFS entered into an amendment to an earlier agreement for employment 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 shall
be $1,000 per share, less dividends or distributions to owners. Current
book value of UFS is approximately $6,500 per share. Any exercise of the
options will have an effect of reducing the Company's interest in UFS and
decrease other income as those options are exercised.
8. 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.
13
PART 1 - FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Baylake is a full-service financial services company, providing a wide variety
of loan, deposit and other banking products and services to its business,
individual or retail, and municipal customers, as well as a full range of trust,
investment and cash management services. The Company is the bank holding company
of Baylake Bank ("Bank"), chartered as a state bank in Wisconsin and a member
bank of the Federal Reserve and Federal Home Loan Bank.
The following sets forth management's discussion and analysis of the
consolidated financial condition and results of operations of Baylake Corp.
("Baylake" or the "Company") for the three and nine months ended September 30,
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.
14
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
15
formed and contributed assets to subsidiaries located in Nevada; to date, the
Company and its subsidiaries have not been audited on these matters.
The Department sent letters in July 2004 to financial institutions in Wisconsin,
whether or not they are undergoing an audit, reporting on settlements involving
17 banks and their out-of-state investment subsidiaries. The letter provided a
summary of currently available settlement parameters. For periods before 2004,
they include: restrictions on the types of subsidiary income excluded from
Wisconsin taxation; assessment of certain back taxes for a limited period of
time; and interest (but not penalties) on any past-due taxes. For 2004 and going
forward, there are similar provisions plus limits on the amount of subsidiaries'
assets as to which their income will be excluded from Wisconsin tax. Settlement
on the terms outlined would result in the Department's rescission of related
prior letter rulings, and would purport to be binding going forward except for
future legislation or change by mutual agreement. By implication, the Department
appears to accept the general proposition that some out-of-state investment
subsidiary income is not subject to Wisconsin taxes.
The Company continues to believe that it has reported income and paid Wisconsin
taxes correctly in accordance with applicable tax laws and the Department's
prior longstanding interpretations thereof, including interpretations issued
specifically to it. However, in view of the Department's subsequent change in
position (even if that change does not have a basis in law), the aggressive
stance now being taken by the Department, the settlements by some other banks,
and the potential effect that decisions by other similarly situated institutions
may have on the Company's alternatives going forward, the Company has determined
that it would consider a settlement proposal from the Department; however, the
Company has not yet received a specific proposal nor has any assessment been
made against the Company or its subsidiaries. The Department made contact with
the Company's outside counsel in June 2006 with the intention of gathering
various financial data from the Company for the purpose of preparing a formal
settlement proposal for 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 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 nine-month periods ended September 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 Nine months Nine months
ended Sept 30, ended Sept 30, ended Sept 30, ended Sept 30,
2006 2005 2006 2005
-------------- -------------- -------------- --------------
Net income, as reported $1,883 $ 707 $5,577 $5,851
EPS-basic, as reported $ 0.24 $ 0.09 $ 0.72 $ 0.76
16
EPS-diluted, as reported $ 0.24 $ 0.09 $ 0.71 $ 0.75
Cash dividends declared $ 0.16 $ 0.15 $ 0.48 $ 0.45
Return on average assets,
as reported 0.69% 0.26% 0.68% 0.72%
Return on average equity,
as reported 9.54% 3.60% 9.49% 10.09%
Efficiency ratio, as
reported (1) 71.76% 77.97% 72.21% 68.09%
(1) Non-interest expense divided by sum of taxable equivalent net interest
income plus non-interest income, excluding investment securities gains, net
The increase in net income for the three-month period is primarily due to a
decrease in the provision for loan losses and a decrease in non-interest
expense. These were partially offset by an increase in income tax expense. The
decrease in net income for the nine-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.
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 78.7% of total operating income for the three months ended
September 30, 2006, as compared to 79.6% 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 was $9.1 million for the three
months ended September 30, 2006 and 2005. This resulted from an increase in our
net interest margin which occurred partially from an increase in average loans
for the period. Net interest income for the period was offset partially by an
increase in interest foregone on non-accrual loans (due to an increase in the
level of non-performing loans, which do not accrue interest). See "Balance
Sheet-'"Non-Performing Loans, Potential Problem Loans and Other Real Estate"
below. During the nine months ended September 30, 2006, net interest income on a
tax equivalent basis decreased $1.0 million, or 3.8%, to $26.2 million from
$27.3 million for the comparable period in 2005. The decrease resulted from a
decrease in our net interest margin which resulted partially from an increase in
interest foregone on non-accrual loans, offset partially by an increase in
average loans 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 nine months ended September 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
17
funds available without interest cost (demand deposits and equity capital) is an
important component increasing net interest margin.
The net interest margin for the third quarter of 2006 was 3.61%, up 3 basis
points ("bps") from 3.58% for the comparable period in 2005. For the third
quarter of 2006, interest rate spread decreased 3 bps to 3.18% (the net result
of a 93 bps increase in the yield on earning assets more than offset by a 96 bps
increase in the cost of interest-bearing liabilities. During the nine months
ended September 30, 2006, the net interest margin was 3.46% compared to 3.64%
for the comparable period in 2005. Net interest margin decreased as a result of
a decrease in earning assets relative to interest-bearing liabilities and a 26
bps decrease in interest rate spread (the net result of a 88 bps increase in the
yield on earning assets more than offset by a 114 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 September 30, 2006 was at
5.25% compared to 3.75% at September 30, 2005, while the average Federal Funds
rate for the first nine months of 2006 was 191 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
nine 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
nine months of 2006.
For the three months ended September 30, 2006, average-earning assets decreased
$9.9 million, or 1.0%, when compared to the same period last year. The Company
recorded an increase in average loans of $12.8 million, or 1.6%, for the third
quarter of 2006 compared to the same period a year ago. For the nine months
ended September 30, 2006, average-earning assets increased $12.7 million, or
1.3%, when compared to the same period last year. The Company recorded an
increase in average loans of $35.2 million, or 4.5%, for the first nine months
of 2006 compared to the same period a year ago. Loans have typically resulted in
higher rates of interest income to the Company than have investment securities,
which positively affected income in the period.
Interest rate spread is the difference between the tax-equivalent rate earned on
average earning assets and the rate paid on average interest-bearing
liabilities. The interest rate spread decreased for the quarter ended September
30, 2006 when compared to the same period a year ago. The interest rate spread
decreased 3 bps to 3.18% at September 30, 2006 from 3.21% in the same quarter in
2005. While the average yield on earning assets increased 93 bps during the
period, the average rate paid on interest-bearing liabilities increased 96 bps
over the same period. For the nine months ended September 30, 2006, the interest
rate spread decreased 26 bps to 3.06% from 3.32% when compared to the same
period a year earlier. The average yield on earning assets increased 88 bps to
7.00% from 6.12% during the nine-month period, while the average rate paid on
interest-bearing liabilities increased 114 bps. The increase in the rates paid
on interest-bearing liabilities occurred as a result of a higher cost of funding
from deposits and other wholesale funding such as federal funds purchased and
loans from the Federal Home Loan Bank. We would expect that trend to be tempered
in light of the recent Federal Reserve Board interest rate actions to hold
short-term interest rates.
18
TABLE 2
NET INTEREST INCOME ANALYSIS ON A TAX -EQUIVALENT BASIS
($ in thousands)
Three months ended September 30,
2006 2005
---------------------------------------- ----------------------------------------
Average Interest Average Average Interest Average
Balance income/expense yield/Rate Balance income/Expense yield/rate
---------- -------------- ---------- ---------- -------------- ----------
ASSETS
Earning assets:
Loans, net $ 811,119 $15,992 7.89% $ 798,321 $13,653 6.84%
Taxable securities 149,508 1,648 4.41% 172,055 1,768 4.11%
Tax exempt securities 42,544 686 6.45% 45,630 766 6.71%
Federal funds sold and
interest bearing due from
banks 6,682 88 5.27% 3,786 33 3.49%
---------- ------- ---- ---------- ------- ----
Total earning assets 1,009,853 18,414 7.29% 1,019,792 16,220 6.36%
---------- ------- ---- ---------- ------- ----
Non-interest earning
assets 86,984 82,507
Total assets $1,096,837 $1,102,299
---------- ----------
LIABILITIES AND
STOCKHOLDERS' EQUITY
Interest-bearing
liabilities:
Total interest-bearing
deposits 765,970 7,395 3.86% 736,925 5,193 2.82%
Short-term borrowings 8,915 129 5.79% 21,948 204 3.72%
Customer repurchase
agreements 1,303 13 3.99% 1,553 11 2.83%
Federal Home Loan Bank
advances 112,681 1,469 5.21% 122,904 1,224 3.98%
Subordinated debentures 16,100 282 7.01% 16,100 461 11.45%
---------- ------- ---- ---------- ------- -----
Total interest-bearing
liabilities $ 904,969 9,288 4.11% $ 899,430 $ 7,093 3.15%
---------- ------- ---- ---------- ------- ----
Demand deposits 99,928 115,807
Accrued expenses and
other liabilities 12,949 8,573
Stockholders' equity 78,991 78,489
---------- ----------
Total liabilities and
stockholders' equity $1,096,837 $1,102,299
---------- ----------
Interest rate spread $ 9,126 3.18% $ 9,127 3.21%
Net interest margin 3.61% 3.58%
---- ----
19
TABLE 3
NET INTEREST INCOME ANALYSIS ON A TAX -EQUIVALENT BASIS
($ in thousands)
Nine months ended September 30,
2006 2005
---------------------------------------- ----------------------------------------
Average Interest Average Average Interest Average
Balance income/Expense yield/Rate Balance income/expense yield/Rate
---------- -------------- ---------- ---------- -------------- ----------
ASSETS
Earning assets:
Loans, net $ 820,315 $46,241 7.52% $ 785,124 $38,433 6.53%
Taxable securities 147,013 4,789 4.34% 169,714 5,226 4.11%
Tax exempt securities 36,850 1,803 6.52% 41,473 2,117 6.81%
Federal funds sold and
interest bearing due from
banks 8,059 295 4.88% 3,206 66 2.74%
---------- ------- ----- ---------- ------- -----
Total earning assets 1,012,237 53,128 7.00% 999,517 45,842 6.12%
---------- ------- ----- ---------- ------- -----
Non-interest earning
assets 84,591 80,157
---------- ----------
Total assets $1,096,828 $1,079,674
---------- ----------
LIABILITIES AND
STOCKHOLDERS' EQUITY
Interest-bearing
liabilities:
Total interest-bearing
deposits 765,478 20,827 3.63% 727,383 13,514 2.48%
Short-term borrowings 9,449 370 5.22% 27,636 679 3.28%
Customer repurchase
agreements 1,244 36 3.86% 1,421 27 2.53%
Federal Home Loan Bank
advances 118,552 4,230 4.76% 113,449 2,975 3.50%
Subordinated debentures 16,336 1,428 11.66% 16,100 1,384 11.46%
---------- ------- ----- ---------- ------- -----
Total interest-bearing
liabilities $ 911,059 $26,891 3.94% $ 885,989 $18,579 2.80%
---------- ------- ----- ---------- ------- -----
Demand deposits 95,155 107,965
Accrued expenses and
other liabilities 12,270 8,367
Stockholders' equity 78,344 77,353
---------- ----------
20
Total liabilities and
stockholders' equity $1,096,828 $1,079,674
---------- ----------
Interest rate spread $26,237 3.06% $27,263 3.32%
Net interest margin 3.46% 3.64%
===== =====
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 92.3% and 92.6%, respectively, for the first nine 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. 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 nine months of 2006 was
$632,000 as compared to a PFLL of $1.7 million for the first nine months in
2005. The calculation of the amount during the period took into account overall
asset quality in the loan portfolio, including an increase in non-performing
assets. See the discussion below following Table 4. Net loan charge-offs in the
first nine months of 2006 were $2.0 million compared with net charge-offs of
$1.6 million for the same period in 2005. The loans charged-off in the first
nine months of 2006 had a specific reserve in the aggregate of $1.8 million
which approximated the amount charged-off. Net charge-offs as a percentage of
average loans is a key measure of asset quality. Net charge-offs to average
loans were 0.32% for the first nine months of 2006 compared to 0.28% for the
same period in 2005. For the nine months ended September 30, 2006,
non-performing loans increased $15.4 million, although for the three months
ended September 30, 2006 non-performing loans decreased $6.4 million; see below
for further information.
TABLE 4
ALLOWANCE FOR LOAN LOSSES
($ in thousands)
For the nine months For the nine months
ended Sept 30, 2006 ended Sept 30, 2005
------------------- -------------------
Allowance for Loan Losses ("ALL)
Balance at beginning of period $9,551 $10,445
Provision for loan losses 632 1,668
Charge-offs 2,447 1,913
Recoveries 484 292
Balance at end of period $8,220 $10,492
Net charge-offs ("NCOs:) $1,963 $ 1,621
21
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 nine months ended September 30, 2006,
the required allocation of the allowance for these loans only increased $90,000,
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 nine-month period ended September 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.
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 $134,000, or 5.7% to $2.5 million for the
third quarter of 2006 when compared to the third quarter of 2005. For the nine
months ended September 30, 2006, total non-interest income was $7.2 million, an
increase of $564,000, or 8.5%, when compared to the same period in 2005. The
non-interest income to average assets ratio was 0.90% for the three months ended
September 30, 2006 compared to 0.85% for the same period in 2005. For the nine
months ended September 30, 2006, the non-interest income to average assets ratio
was 0.87% compared to 0.82% for the same period in 2005. The increase in
non-interest income for the three-month and nine-month periods is due primarily
to increases in net gains from sales and disposals of premises and equipment.
Table 5 reflects the various components of non-interest income for the
comparable quarters.
22
TABLE 5
NON-INTEREST INCOME
($ in thousands)
Third Third Percent YTD YTD Percent
quarter 2006 quarter 2005 change 2006 2005 change
------------ ------------ ------- ------ ------ -------
Fees from fiduciary
services $ 206 $ 193 6.7% $ 747 $ 556 34.4%
Fees from loan servicing 295 292 1.0% 830 863 (3.8%)
Service charges on
deposit accounts 885 877 0.9% 2,530 2,447 3.4%
Other fee income 200 199 0.5% 530 549 (3.5%)
Financial services
income 259 184 40.8% 669 547 22.3%
Gains from sales of loans 149 348 (57.2%) 559 733 (23.7%)
Net gains (loss) from
sale and disposal of
premises and equipment 103 (73) NM 288 (224) NM
Increase in cash
surrender value of
life insurance 217 184 17.9% 618 601 2.8%
Death benefits realized -- -- NM 23 -- NM
Gain on sale of bank
assets -- -- NM -- 200 NM
Other income 163 139 17.3% 402 360 11.7%
------ ------ ------ ------
Total Other Income $2,477 $2,343 5.7% $7,196 $6,632 8.5%
Service charges on deposit accounts increased $83,000 for the nine-month period
ended September 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 nine months of 2006, gains from sales of loans totaling $559,000
compared to $733,000 in the first nine months of 2005. During the first nine
months of 2006, secondary mortgage loan activity decreased. Additionally gains
from sale of these loans decreased proportionally more as changes in the mix of
commercial/mortgage loans sold, tighter spreads and competitive pressures with
respect to pricing resulted during the period. The Company has seen a decrease
in the number of loan applications, as interest rates have increased over the
nine-month period. Secondary loan production decreased $5.0 million between the
comparable nine-month periods ($31.4 million in the first nine months of 2006
versus $36.5 million in the first nine months of 2005). The decrease 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 nine-month periods ended September 30, 2006, net gains
(loss) from the sale of bank premises and equipment were related to gains of
$188,000 on the sale of bank land located in the Green Bay market area. In
addition, gains totaling $103,000 taken in the third quarter of 2006 for space
related to the Baylake City Center project which was sold by the Company to an
unrelated third party. The net loss on disposal of bank premises of $224,000 for
23
the nine-month period ended September 30, 2005 related to the sale of two
buildings and land formerly used as branch offices in addition to write-downs of
leasehold improvements which occurred in the third quarter of 2005.
For the three-month and nine-month periods ended September 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 decreased $617,000 or 6.9%, to $8.3 million for the three
months ended September 30, 2006 compared to the same period in 2005. For the
nine months ended September 30, 2006, total non-interest expense increased $1.1
million or 4.6%, to $24.1 million compared to the same period in 2005. Impacting
the three-month and nine-month period results for 2005 was a $1.8 million charge
for impairment related to an-off balance sheet letter of credit. The
non-interest expense to average assets ratio was 3.04% for the three months
ended September 30, 2006 compared to 3.25% for the same period in 2005. For the
nine months ended September 30, 2006, the non-interest expense ratio to average
assets was 2.93% compared to 2.85% for the same period in 2005.
Net overhead expense is total non-interest expense less total non-interest
income excluding securities gains. The net overhead expenses to average assets
ratio was 2.13% for the three months ended September 30, 2006 compared to 2.39%
for the same period in 2005. For the nine months ended September 30, 2006, the
net overhead expenses to average assets ratio was 2.06% compared to 2.03% for
the same period in 2005. The efficiency ratio is total non-interest expense as a
percentage of the sum of net-interest income on a fully taxable equivalent basis
and total non-interest income. The efficiency ratio for the three months ended
September 30, 2006 was 71.76% compared to 77.97% for the same period in 2005.
For the nine months ended September 30, 2006, the efficiency ratio was 72.21%
compared to 68.09% for the same period in 2005.
TABLE 6
NON-INTEREST EXPENSE
($ in thousands)
Third Third Percent YTD YTD Percent
quarter 2006 quarter 2005 change 2006 2005 change
------------ ------------ ------- ------- ------- -------
Salaries and employee
benefits $5,066 $4,213 20.2% $14,583 $13,070 11.6%
Occupancy 596 717 (16.9%) 1,760 1,855 (5.1%)
Equipment 430 349 23.2% 1,270 996 27.5%
Data processing and
courier 324 285 13.7% 939 861 9.1%
Operation of other real
estate owned 86 87 (1.1%) 203 216 (6.0%)
Business development and
advertising 253 276 (8.3%) 730 764 (4.5%)
Charitable contributions 52 36 44.4% 158 183 (13.7%)
24
Stationary and supplies 135 139 (2.9%) 397 406 (2.2%)
Director fees 124 134 (7.5%) 395 326 21.2%
FDIC 26 28 (7.1%) 79 84 (6.0%)
Mortgage servicing rights
amortization 86 54 59.3% 182 170 7.1%
Legal and professional 77 115 (33.0%) 327 419 (22.0%)
Loan and collection 308 76 305.3% 615 229 168.6%
Impairment of off-balance
sheet letter of credit 27 1,846 NM 27 1,846 NM
Other operating 736 588 25.2% 2,478 1,654 49.8%
------ ------ ------- -------
Total non-interest
expense $8,326 $8,943 (6.9%) $24,143 $23,079 4.6%
Salaries and employee benefits showed an increase of $853,000, or 20.2%, to $5.1
million for the third quarter of 2006 compared to the same period in 2005. The
number of full-time equivalent employees was 334 as of September 30, 2006
compared to 311 at September 30, 2005, primarily the result of additional
staffing for the remodeled downtown Green Bay branch opened in June 2005 and a
new branch in Suamico that opened for business in August 2006. For the three
months ended September 30, 2006, salary-related expenses increased $520,000, or
17.7%, due principally to merit increases between the years, related staff
increases and additional management personnel added during the period. For the
nine months ended September 30, 2006, salary-related expenses increased $1.3
million or 14.7% 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 $243,000 in
expenses related to the Plan in the third quarter of 2006 compared to $121,000
in the third quarter of 2005 and $623,000 for the nine months ended September
30, 2006 compared to $519,000 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.
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, decreased $40,000, or 3.8%, to
$1.0 million for the third quarter of 2006 compared to the same period in 2005,
primarily the result of a reduction in lease expense for the period. For the
nine months ended September 30, 2006, occupancy and equipment expense,
collectively, increased $179,000, or 6.3%, to $3.0 million compared to the same
period in 2005. The increase for the nine-month period 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.
25
Expenses related to the operation of other real estate owned were flat at
$86,000 for the 2006 three-month period ended September 30 compared to $87,000
for the same period in 2005. For the nine-month period ended September 30, 2006,
other real estate owned expenses decreased $13,000 to $203,000 compared to the
same period in 2005. Included in these results for the nine-month period ended
September 30, 2006 were net gains taken on the sale of other real estate owned
amounting to $75,000 compared to net losses of $35,000 for the same period in
2005. In addition, costs related to the holding of other real estate owned
properties increased $97,000 to $278,000 for the nine months ended September 30,
2006.
Loan and collection expense increased $232,000 to $308,000 for the three months
ended September 30, 2006 compared to the same period in 2005. For the nine
months ended September 30, 2006, loan and collection expense increased $386,000
to $615,000 compared to the same period in 2005. $467,000 of the increase for
the nine months ended September 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 a previously disclosed impaired letter of credit for a commercial
credit in 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 and into at least early 2007.
Other operating expense increased $148,000 for the three months ended September
30, 2006 and $824,000 to $2.5 million for the nine-month period ended September
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. $332,000 (including $105,000 in the
third quarter of 2006) of the increase was related to new product offering costs
and service delivery enhancements, 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 September 30, 2006
was $703,000, an increase of $765,000 compared to the same period in 2005. For
the nine months ended September 30, 2006, income tax expense resulted in a
decrease of $115,000 to $2.2 million compared to an income tax expense of $2.3
million for the same period in 2005. The higher tax expense for the three-month
period ended September 30 reflected the Company's increase in income before
income tax. The lower tax expense for the nine-month period ended September 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 28.4% for the nine months ended September 30, 2006 compared with
28.5% for the same period in 2005. The effective tax rate of 28.4% consisted of
a federal effective tax rate of 23.4% and Wisconsin state effective tax rate of
5.0%. For the nine-month period ended September 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 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
26
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 September 30, 2006, total loans decreased $6.5 million, or 0.8%, to $805.8
million from $812.3 million at December 31, 2005. A decrease of $16.8 million or
3.6% occurred in the commercial real estate loan totals from December 31, 2005
to September 30, 2006 as a result of competitive pricing pressures and principal
paydowns on several large commercial credits during the period. Growth in the
remaining portion of the Company's loan portfolio resulted primarily from an
increase in real estate construction loans to $96.9 million at September 30,
2006 compared to $85.7 million at December 31, 2005.
The following table reflects the composition (mix) of the loan portfolio:
TABLE 7
LOAN PORTFOLIO ANALYSIS
($ in thousands)
September December Percent
30, 2006 31, 2005 change
--------- -------- -------
Amount of loans by type
Real estate-mortgage
Commercial $451,199 $467,956 (3.6%)
1-4 family residential
First liens 91,323 90,946 0.4%
Junior liens 23,778 23,470 1.3%
Home equity 32,095 34,320 (6.5%)
Commercial, financial and agricultural 82,035 80,260 2.2%
Real estate-construction 96,925 85,729 13.1%
Installment
Credit cards and related plans 2,039 2,088 (2.3%)
Other 12,600 12,175 3.5%
Obligations of states and political subdivisions 14,209 15,785 (10.0%)
Less: deferred origination fees, net of costs 426 433 (1.6%)
-------- -------- -----
Total $805,777 $812,296 (0.8%)
Risk Management and the Allowance for Loan Losses
The loan portfolio is the Company's primary asset subject to credit risk. To
reflect this credit risk, the Company sets aside an allowance for probable
incurred credit losses through periodic charges to earnings. These charges are
shown in the Company's consolidated income statement as provision for loan
losses. See "Provision for Loan Losses" above. Credit risk is controlled and
monitored through the use of lending standards, a thorough review of potential
borrowers, and an on-going review of payment performance. Asset quality
administration, including early identification of problem loans and timely
resolution of problems, further enhances management of credit risk and
minimization of loan losses. All specifically identifiable and quantifiable
losses
27
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.
The ALL at September 30, 2006 was $8.2 million compared with $9.6 million at the
end of 2005. This was based on management's analysis of the loan portfolio risk
at September 30, 2006. As such, a provision expense of $632,000 was recorded for
the nine months ended September 30, 2006. The year to date provision has
decreased by $1.0 million 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 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.
28
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. In addition, declines in real estate values
in our market areas may affect collateral values of loans secured by commercial
or residential mortgages, which may require further re-evaluation of allowance
levels.
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
September 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.
29
TABLE 8
NON-PERFORMING ASSETS
($ in thousands)
At or for At or for At or for
the period the period the period
ended ended ended
Sept 30, 2006 Sept 30, 2005 December 31, 2005
------------- ------------- -----------------
Nonperforming Assets:
Nonaccrual loans $22,368 $ 7,299 $ 6,942
Accruing loans past due 90 days or more 0 0 0
------- ------- -------
Total nonperforming loans ("NPLs") $22,368 $ 7,299 $ 6,942
Other real estate owned 3,158 2,629 3,333
------- ------- -------
Total nonperforming assets ("NPAs") $25,526 $ 9,928 $10,275
Ratios:
ALL to NCO's (annualized) 3.14 4.85 2.32
NCO's to average loans (annualized) 0.32% 0.28% 0.52%
ALL to total loans 1.02% 1.33% 1.18%
NPL's to total loans 2.78% 0.92% 0.85%
NPA's to total assets 2.33% 0.90% 0.94%
ALL to NPL's 36.75% 143.75% 137.58%
As indicated in Table 8, non-performing loans at September 30, 2006 were $22.4
million compared to $6.9 million at December 31, 2005. Real estate non-accrual
loans accounted for $21.7 million of the total, of which $2.6 million was
residential real estate, $5.5 million was real estate construction and $13.6
million was commercial real estate. Commercial and industrial non-accrual loans
totaled $487,000.
Non-accrual loans increased during the nine months ended September 30, 2006 by
$15.4 million. The increase is primarily attributable to four commercial loans,
previously disclosed, totaling $15.0 million for businesses that are
experiencing difficulties in sales, cash flow, fiscal operations, and/or general
management issues. Two previously disclosed non-performing loans from the first
quarter of 2006 totaling $6.2 million were brought current during the third
quarter.
Each of these four 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 $13.6 million
and it anticipates protracted litigation of at least twelve months in duration
in each case. Management has allocated $311,000 in the ALL on the basis of a
SFAS 114 analysis for any loss estimated with respect to these loans. One loan
totaling $1.4 million is subject to voluntary liquidation plans that propose to
sell underlying real estate assets in amounts sufficient to repay the
outstanding loan balances.
In spite of an increase in non-performing loans for the nine months ended
September 30, 2006, the balance of impaired loans for which an ALL is allocated
has increased minimally. As indicated the ALL allocated for impaired loans at
September 30, 2006 has decreased $1.1 million compared to December 31, 2005 as
indicated in Table 9.
Information regarding impaired loans is as follows:
30
TABLE 9
IMPAIRED LOANS
($ in thousands)
September 30, December 31,
2006 2005
------------- ------------
Impaired loans with no allocated
allowance for loan loss -- --
Impaired loans with allocated
allowance for loan loss 14,830 14,637
Allowance allocated to impaired
loans 2,175 3,233
As a result the ratio of non-performing loans to total loans at September 30,
2006 was 2.78% compared to 0.85% at end of year 2005. The Company's ALL was
36.8% of total non-performing loans at September 30, 2006 compared to 137.6% at
end of year 2005.
Non-performing assets (non-performing loans plus other real estate owned assets)
at September 30, 2006 were $25.5 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 $3.0 million and two residential real estate
properties totaling $185,000. 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 September 30, 2006, the investment portfolio (which includes investment
securities available for sale) increased $16.5 million, or 9.6%, to $188.1
million from $171.6 million at December 31, 2005. At September 30, 2006, the
investment portfolio represented 17.2% of total assets compared with 15.8% at
December 31, 2005.
Securities available for sale consist of the following:
TABLE 10
INVESTMENT SECURITY ANALYSIS
At September 30, 2006
($ in thousands)
Gross Gross
Unrealized Unrealized
Gains Losses Fair Value
---------- ---------- ----------
Securities available for sale
Obligations of U.S. Treasury &
other U.S. agencies 42 1,311 58,159
31
Mortgage-backed securities 103 1,999 79,462
Obligations of states &
political subdivisions 707 60 46,584
Private placement 17 0 1,015
Other securities 0 0 2,877
---- ------ --------
Total securities available for
sale $869 $3,370 $188,097
At December 31, 2005
($ 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
The decreases 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 September 30, 2006 increased $11.0 million, or 1.3%, to $867.7
million from $856.7 million at December 31, 2005. Non-interest bearing deposits
at September 30, 2006 decreased $9.0 million, or 8.1%, to $101.7 million from
$110.6 million at December 31, 2005. Interest-bearing deposits at September 30,
2006 increased $20.0 million, or 2.7%, to $766.1 million from $746.1 million at
December 31, 2005. Brokered CD's and other brokered deposits totaled $137.8
million at September 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
32
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. Then, in the later half of the year,
deposits tend to increase as a result of receipts during the 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 located in the Green Bay market that opened 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.
Other Funding Sources
Securities under agreements to repurchase at September 30, 2006 increased
$280,000 to $1.6 million from $1.3 million at December 31, 2005. There were no
federal funds purchased at September 30, 2006 and December 31, 2005.
Federal Home Loan Bank Advances totaled $115.2 million at September 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 $498,000 of trust common securities,
and underlying debt securities, that will adjust quarterly at a rate equal to
1.35% over the three month LIBOR. The rate on this financing for the second and
third quarters of 2006, respectively, was 6.31% and 6.85%, respectively,
compared to a fixed rate of 10% for the trust-preferred securities issued under
Baylake Capital Trust I. This lower interest rate has provided interest savings
in the second and third quarters of 2006 and thereafter depending upon the
changes in the interest rate environment. The interest rate for the fourth
quarter of 2006 will be 6.72%. Management believes that this new financing
should provide a better match for the overall interest rate sensitivity position
of the Company going forward.
33
For additional details, please make reference to the Consolidated Financial
Statements and the accompanying footnotes on the Company's Form 10-Q for the
period ended September 30, 2006.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, OFF-BALANCE SHEET RISK, AND CONTINGENT
LIABILITIES
The Company utilizes a variety of financial instruments in the normal course of
business to meet the financial needs of its customers. These financial
instruments include commitments to extend credit, commitments to originate
residential mortgage loans held for sale, commercial letters of credit, standby
letters of credit, and forward commitments to sell residential mortgage loans.
Please refer to the Company's Annual Report on Form 10-K for the year ended
December 31, 2005 for discussion with respect to the Company's quantitative and
qualitative disclosures about its fixed and determinable contractual
obligations. Items disclosed in Form 10-K have not materially changed since that
report was filed.
The following is a summary of our off-balance sheet commitments, all of which
were lending-related commitments:
TABLE 11
LENDING RELATED COMMITMENTS
($ in thousands)
September December
30, 2006 31, 2005
--------- --------
Commitments to fund home equity
line loans $ 49,600 $ 45,435
Commitments to fund residential
real estate construction loans 2,485 3,409
Commitments unused on various other
lines of credit loans 173,050 164,112
-------- --------
Total commitments to extend credit $225,135 $212,956
Financial standby letters of credit $ 21,452 $ 22,160
The following table summarizes the Company's significant contractual obligations
and commitments at September 30, 2006:
TABLE 12
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 $277,509 $101,762 $4,863 $ 0 $384,134
34
Federal funds purchased and
repurchase agreements 1,595 $ 0 $ 0 $ 0 1,595
Federal Home Loan Bank advances 75,000 40,080 100 0 115,180
Subordinated debentures 0 0 0 16,100 16,100
Operating leases 37 0 0 0 37
-------- -------- ------ ------- --------
Total $354,141 $141,842 $4,963 $16,100 $517,046
======== ======== ====== ======= ========
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 and repurchase shares. Dividends
received from Bank totaled $4.2 million for the first nine 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 $4.7 million in the first nine 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 nine months ended September 30, 2006, principal payments totaling $15.4
million were received on investments. The Company purchased $31.7 million in
investments in the first nine months of 2006. This resulted in net cash of $16.3
million used in investing activities for the first nine months of 2006. At
September 30, 2006 the investment portfolio contained $137.6 million of U.S.
Treasury and federal agency backed securities representing 73.2% 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 September 30, 2006 Consolidated Statements of Cash Flows,
deposits increased and resulted in $11.0 million of cash flow during the first
nine months of 2006. The Company's
35
overall deposit base increased 1.3% for the nine months ended September 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 nine-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 $255.8 million, or 31.7%, of loans maturing within one year.
Factors affecting liquidity relative to loans are loan origination volumes, loan
prepayment rates and the maturity structure of existing loans. The Bank's
liquidity position is influenced by changes in interest rates, economic
conditions and competition. Conversely, loan demand as a need for liquidity will
cause the Company to acquire other sources of funding which could be harder to
find; therefore more costly to acquire.
Within the classification of short-term borrowings at September 30, 2006,
federal funds purchased and securities sold under agreements to repurchase
totaled $1.6 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 $115.2 million at September 30, 2006 and $125.2 million at December 31,
2005.
The Bank's liquidity resources were sufficient in the first nine 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 nine 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.
36
Capital Resources
Stockholders' equity at September 30, 2006 and December 31, 2005, respectively,
was $80.7 million and $78.5 million, respectively. In total, stockholders'
equity increased $2.2 million or 2.8%. The increase in stockholders' equity in
2006 was primarily composed of net income; proceeds from the exercise of stock
options and the change in accumulated other comprehensive loss (as a result of
unrealized losses on available for sale securities), offset by the payment of
dividends and repurchase of treasury stock. The change in unrealized losses on
available for sale securities amounted to $198,000 (net of tax) for the first
nine months of 2006; this change resulted from the effects of the increasing
interest rate environment. Total dividends paid increased to $4.7 million in the
nine-month period from $4.6 million in 2005, primarily as a result of an
increase in the per share dividends rate to $0.48 from $0.45. In the three
months ended September 30, 2006, the Company used $1.1 million to repurchase
shares. Stockholders' equity to assets at September 30, 2006 was 7.38% compared
to 7.21% at the end of 2005.
Cash dividends declared in the first nine months of 2006 were $0.48 per share
compared with $0.45 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 $4.7 million in the first nine
months of 2006, as compared to $4.6 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 68,854 of its common shares in the third quarter of 2006
with a cash outlay of $1.1 million, or an average of $16.00 per share.
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 6.85% for the third
quarter. This lower rate has provided 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.
Management regularly reviews the adequacy of the Company's capital 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 believes 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.
37
The Federal Reserve Board has established capital adequacy rules which take into
account risk attributable to balance sheet assets and off-balance sheet
activities. All banks and bank holding companies must meet a minimum total
risk-based capital ratio of 8%. Of the 8% required, at least half must be
comprised of core capital elements defined as Tier 1 capital. The federal
banking agencies also have adopted leverage capital guidelines which banking
organizations must meet. Under these guidelines, the most highly rated banking
organizations must meet a leverage ratio of at least 3% Tier 1 capital to
assets, while lower rated banking organizations must maintain a ratio of at
least 4% to 5%. Failure to meet minimum capital requirements can initiate
certain mandatory -and possible additional discretionary- actions by regulators
that, if undertaken, could have a direct material effect on the consolidated
financial statements.
At September 30, 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.
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
September 30, 2006 and December 31, 2005:
TABLE 13
CAPITAL RATIOS
($ in thousands)
Required To Be Well
Required For Capitalized under
Capital Adequacy Prompt Corrective
Actual Purposes Action Provisions
--------------- ---------------- -------------------
Amount Ratio Amount Ratio Amount Ratio
------- ----- ------ ----- ------ -----
As of September 30, 2006
Total Capital (to Risk Weighted Assets)
Company 100,559 10.88% 73,962 8.00% N/A N/A
Bank 98,378 10.65% 73,924 8.00% 92,405 10.00%
Tier 1 Capital (to Risk Weighted
Assets)
Company 92,339 9.99% 36,981 4.00% N/A N/A
Bank 90,158 9.76% 36,962 4.00% 55,443 6.00%
Tier 1 Capital (to Average Assets)
Company 92,339 8.47% 43,631 4.00% N/A N/A
Bank 90,158 8.27% 43.631 4.00% 54,539 5.00%
As of December 31, 2005
38
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. 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 September 30, 2006, the Company was in compliance with its management
policies with respect to interest rate risk. The Company has not experienced any
material changes to its market risk position since December 31, 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 September 30, 2006.
TABLE 14
39
INTEREST SENSITIVITY
($ in thousands)
Change in Net Interest Income over One Year Horizon
At September 30, 2006 At December 31, 2005
Change in levels of --------------------------------- ---------------------------------
interest rates Dollar change Percentage change Dollar change Percentage change
- ------------------- ------------- ----------------- ------------- -----------------
+200 bp $ 851 2.3% $ 2,572 6.8%
+100 bp 88 0.2% 1,842 4.9%
Base 0 0% 0 0%
- -100 bp (1,684) (4.5%) (2,351) (6.2%)
- -200 bp (3,634) (9.7%) (4,905) (13.0%)
As shown above, at September 30, 2006, the effect of an immediate 200 basis
point increase in interest rates would increase the Company's net interest
income by $851,000 or 2.3%. The effect of an immediate 200 basis point reduction
in rates would decrease the Company's net interest income by $3.6 million or
9.7%.
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
September 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.
40
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
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
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 following table provides the specified information about the repurchases of
shares by the Company during the third quarter of 2006.
Total number of Maximum number of
shares purchased as shares that may be
part of publicly purchased under
Total number of Average price announced plans or the recent plans
Period shares purchased paid per share programs or programs*
- ------ ---------------- -------------- ------------------- ------------------
July 1 to 31, 2006 -- -- -- 300,000
August 1, to 31, 2006 68,854 $16.00 68,854 231,146
September 1 to 30, 2006 -- -- -- 231,146
* At period end.
The "price" used for these purposes is the fair market value of those shares on
the date of purchase.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
41
ITEM 6. EXHIBITS
The following exhibits are furnished herewith:
EXHIBIT NUMBER DESCRIPTION
- -------------- -----------
31.1 Certification under Section 302 of Sarbanes-Oxley by Thomas L.
Herlache, Chief Executive Officer, is attached hereto.
31.2 Certification under Section 302 of Sarbanes-Oxley by Steven D.
Jennerjohn, Chief Financial Officer, is attached hereto.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of
Sarbanes-Oxley is attached hereto.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of
Sarbanes-Oxley is attached hereto.
"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."
42
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
BAYLAKE CORP.
Date: November 3, 2006 /s/ Thomas L. Herlache
----------------------------------------
Thomas L. Herlache
President (CEO)
Date: November 3, 2006 /s/ Steven D. Jennerjohn
----------------------------------------
Steven D. Jennerjohn
Treasurer (CFO)
43