UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003 OR [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT For the transition period from __________ to _________ Commission file number 33-24728C CAPITOL BANCORP LTD. (Exact name of registrant as specified in its charter) MICHIGAN 38-2761672 (State or other jurisdiction (I.R.S. Employer of incorporation or Identification organization) Number) 200 WASHINGTON SQUARE NORTH, LANSING, MICHIGAN (Address of principal executive offices) 48933 (Zip Code) (517) 487-6555 (Registrant's telephone number) Not Applicable (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 a check mark whether the registrant is an accelerated filer (as defined in Rule 12b of the Act). Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common stock, No par value: 12,293,820 shares outstanding as of April 22, 2003. Page 1 of 25 INDEX PART I. FINANCIAL INFORMATION FORWARD-LOOKING STATEMENTS Certain of the statements contained in this document, including Capitol's consolidated financial statements, Management's Discussion and Analysis of Financial Condition and Results of Operations and in documents incorporated into this document by reference that are not historical facts, including, without limitation, statements of future expectations, projections of results of operations and financial condition, statements of future economic performance and other forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, are subject to known and unknown risks, uncertainties and other factors which may cause the actual future results, performance or achievements of Capitol and/or its subsidiaries and other operating units to differ materially from those contemplated in such forward-looking statements. The words "intend", "expect", "project", "estimate", "predict", "anticipate", "should", "believe", and similar expressions also are intended to identify forward-looking statements. Important factors which may cause actual results to differ from those contemplated in such forward-looking statements include, but are not limited to: (i) the results of Capitol's efforts to implement its business strategy, (ii) changes in interest rates, (iii) legislation or regulatory requirements adversely impacting Capitol's banking business and/or expansion strategy, (iv) adverse changes in business conditions or inflation, (v) general economic conditions, either nationally or regionally, which are less favorable than expected and that result in, among other things, a deterioration in credit quality and/or loan performance and collectability, (vi) competitive pressures among financial institutions, (vii) changes in securities markets, (viii) actions of competitors of Capitol's banks and Capitol's ability to respond to such actions, (ix) the cost of capital, which may depend in part on Capitol's asset quality, prospects and outlook, (x) changes in governmental regulation, tax rates and similar matters, and (xi) other risks detailed in Capitol's other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated. All subsequent written or oral forward-looking statements attributable to Capitol or persons acting on its behalf are expressly qualified in their entirety by the foregoing factors. Investors and other interested parties are cautioned not to place undue reliance on such statements, which speak as of the date of such statements. Capitol undertakes no obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of unanticipated events. Page ---- Item 1. Financial Statements (unaudited): Consolidated balance sheets - March 31, 2003 and December 31, 2002. 3 Consolidated statements of income - Three months ended March 31, 2003 and 2002. 4 Consolidated statements of changes in stockholders' equity - Three months ended March 31, 2003 and 2002. 5 Consolidated statements of cash flows - Three months ended March 31, 2003 and 2002. 6 Notes to consolidated financial statements. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk. 20 Item 4. Controls and Procedures. 20 PART II. OTHER INFORMATION Item 1. Legal Proceedings. 21 Item 2. Changes in Securities and Use of Proceeds. 21 Item 3. Defaults Upon Senior Securities. 21 Item 4. Submission of Matters to a Vote of Security Holders. 21 Item 5. Other Information. 21 Item 6. Exhibits and Reports on Form 8-K. 21 SIGNATURES 22 CERTIFICATIONS 23 Page 2 of 25 PART I, ITEM I CAPITOL BANCORP LTD. Consolidated Balance Sheets As of March 31, 2003 and December 31, 2002 (Unaudited) March 31 December 31 2003 2002 ----------- ----------- (in thousands) ASSETS Cash and due from banks $ 128,623 $ 125,146 Money market, mutual funds and interest-bearing deposits 54,958 42,301 Federal funds sold 140,364 83,737 ----------- ----------- Cash and cash equivalents 323,945 251,184 Loans held for resale 65,465 75,420 Investment securities: Available for sale, carried at market value 31,693 25,355 Held for long-term investment, carried at amortized cost which approximates market value 8,824 8,784 ----------- ----------- Total investment securities 40,517 34,139 Portfolio loans: Commercial 1,846,601 1,789,036 Real estate mortgage 128,605 127,855 Installment 76,951 74,481 ----------- ----------- Total portfolio loans 2,052,157 1,991,372 Less allowance for loan losses (30,034) (28,953) ----------- ----------- Net portfolio loans 2,022,123 1,962,419 Premises and equipment 20,565 21,737 Accrued interest income 9,342 9,286 Goodwill and other intangibles 24,606 24,739 Other assets 33,726 30,364 ----------- ----------- TOTAL ASSETS $ 2,540,289 $ 2,409,288 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Noninterest-bearing $ 359,916 $ 360,669 Interest-bearing 1,821,524 1,701,403 ----------- ----------- Total deposits 2,181,440 2,062,072 Debt obligations 84,348 93,398 Accrued interest on deposits and other liabilities 16,923 14,182 ----------- ----------- Total liabilities 2,282,711 2,169,652 GUARANTEED PREFERRED BENEFICIAL INTERESTS IN THE CORPORATION'S SUBORDINATED DEBENTURES 61,299 51,583 MINORITY INTERESTS IN CONSOLIDATED SUBSIDIARIES 31,808 28,016 STOCKHOLDERS' EQUITY Common stock, no par value, 25,000,000 shares authorized; issued and outstanding: 2003 - 11,737,860 shares 2002 - 11,663,412 shares 134,211 135,234 Retained earnings 30,228 26,318 Market value adjustment (net of tax effect) for investment securities available for sale (accumulated other comprehensive income) 177 191 ----------- ----------- 164,616 161,743 Less note receivable from exercise of stock options and unallocated ESOP shares (145) (1,706) ----------- ----------- Total stockholders' equity 164,471 160,037 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 2,540,289 $ 2,409,288 =========== =========== Page 3 of 25 CAPITOL BANCORP LTD. Consolidated Statements of Income (Unaudited) For the Three Months Ended March 31, 2003 and 2002 (in thousands, except per share data) Three Months Ended March 31 -------------------- 2003 2002 -------- -------- Interest income: Portfolio loans (including fees) $ 38,385 $ 35,619 Loans held for resale 762 734 Taxable investment securities 199 397 Federal funds sold 284 264 Other 356 241 -------- -------- Total interest income 39,986 37,255 Interest expense: Deposits 11,002 12,193 Debt obligations and other 1,997 2,239 -------- -------- Total interest expense 12,999 14,432 -------- -------- Net interest income 26,987 22,823 Provision for loan losses 1,890 2,090 -------- -------- Net interest income after provision for loan losses 25,097 20,733 Noninterest income: Service charges on deposit accounts 1,071 958 Trust fee income 522 531 Fees from origination of non-portfolio residential mortgage loans 2,237 893 Realized gain (loss) on sale of investment securities available for sale 3 (64) Other 696 480 -------- -------- Total noninterest income 4,529 2,798 Noninterest expense: Salaries and employee benefits 13,427 11,027 Occupancy 1,873 1,520 Equipment rent, depreciation and maintenance 1,165 1,055 Other 4,691 5,191 -------- -------- Total noninterest expense 21,156 18,793 -------- -------- Income before federal income taxes and minority interest 8,470 4,738 Federal income taxes 2,944 1,543 -------- -------- Income before minority interest 5,526 3,195 Minority interest in net income of consolidated subsidiaries (213) (151) -------- -------- NET INCOME $ 5,313 $ 3,044 ======== ======== NET INCOME PER SHARE--Note C Basic $ 0.45 $ 0.39 ======== ======== Diluted $ 0.44 $ 0.38 ======== ======== Page 4 of 25 CAPITOL BANCORP LTD. Consolidated Statements of Changes in Stockholders' Equity (Unaudited) For the Three Months Ended March 31, 2003 and 2002 (in thousands except share data) Note Receivable from Exercise of Stock Accumulated Options and Other Unallocated Common Retained Comprehensive ESOP Stock Earnings Income Shares Total --------- --------- --------- --------- --------- THREE MONTHS ENDED MARCH 31, 2002 Balances at January 1, 2002 $ 67,692 $ 14,173 $ 158 $ (1,851) $ 80,172 Issuance of 2,721,749 shares of common stock to acquire shares of Sun Community Bancorp held by shareholders other than Capitol 43,165 43,165 Issuance of 70,174 shares of common stock upon exercise of stock options 753 753 Issuance of 19,100 shares of common stock upon exercise of warrants 213 213 Cash dividends paid ($.10 per share) (789) (789) Components of comprehensive income: Net income for the period 3,044 3,044 Market value adjustment for investment securities available for sale (net of income tax effect) (194) (194) --------- Comprehensive income for the period 2,850 --------- --------- --------- --------- --------- BALANCES AT MARCH 31, 2002 $ 111,823 $ 16,428 $ (36) $ (1,851) $ 126,364 ========= ========= ========= ========= ========= THREE MONTHS ENDED MARCH 31, 2003 Balances at January 1, 2003 $ 135,234 $ 26,318 $ 191 $ (1,706) $ 160,037 Issuance of 123,850 shares of common stock upon exercise of stock options, net of common stock surrendered to facilitate exercise 279 279 Issuance of 22,512 shares of common stock upon exercise of warrants 259 259 Surrender and cancellation of 71,914 shares of common stock in repayment of note receivable from exercise of stock options (1,561) 1,561 0 Cash dividends paid ($.12 per share) (1,403) (1,403) Components of comprehensive income: Net income for the period 5,313 5,313 Market value adjustment for investment securities available for sale (net of income tax effect) (14) (14) --------- Comprehensive income for the period 5,299 --------- --------- --------- --------- --------- BALANCES AT MARCH 31, 2003 $ 134,211 $ 30,228 $ 177 $ (145) $ 164,471 ========= ========= ========= ========= ========= Page 5 of 25 CAPITOL BANCORP LTD. Consolidated Statements of Cash Flows (Unaudited) For the Three Months Ended March 31, 2003 and 2002 2003 2002 --------- --------- (in thousands) OPERATING ACTIVITIES Net income $ 5,313 $ 3,044 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 1,890 2,090 Depreciation of premises and equipment 958 802 Amortization of intangibles 133 -- Net amortization of investment security premiums 29 1 Loss (gain) on sale of premises and equipment (90) 5 Minority interest in net income of consolidated subsidiaries 213 151 Originations and purchases of loans held for resale (257,718) (203,954) Proceeds from sales of loans held for resale 267,673 216,552 Increase in accrued interest income and other assets (3,393) (2,649) Increase in accrued interest on deposits and other liabilities 2,741 2,066 --------- --------- NET CASH PROVIDED BY OPERATING ACTIVITIES 17,749 18,108 INVESTING ACTIVITIES Proceeds from sale of investment securities available for sale 4,625 -- Proceeds from calls, prepayments & maturities of investment securities 6,626 11,560 Purchases of investment securities (17,681) (12,313) Net increase in portfolio loans (61,594) (60,202) Proceeds from sales of premises and equipment 1,509 -- Purchases of premises and equipment (1,205) (852) --------- --------- NET CASH USED BY INVESTING ACTIVITIES (67,720) (61,807) FINANCING ACTIVITIES Net increase in demand deposits, NOW accounts and savings accounts 34,661 83,333 Net increase in certificates of deposit 84,707 29,625 Net payments on debt obligations (9,050) (550) Net proceeds from issuance of trust-preferred securities 9,700 -- Resources provided by minority interests 3,579 8,383 Net proceeds from issuance of common stock 538 966 Cash dividends paid (1,403) (789) --------- --------- NET CASH PROVIDED BY FINANCING ACTIVITIES 122,732 120,968 --------- --------- INCREASE IN CASH AND CASH EQUIVALENTS 72,761 77,269 Cash and cash equivalents at beginning of period 251,184 163,691 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 323,945 $ 240,960 ========= ========= Page 6 of 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. NOTE A - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Capitol Bancorp Ltd. ("Capitol") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all information and footnotes necessary for a fair presentation of consolidated financial position, results of operations and cash flows in conformity with generally accepted accounting principles. The statements do, however, include all adjustments of a normal recurring nature (in accordance with Rule 10-01(b)(8) of Regulation S-X) which Capitol considers necessary for a fair presentation of the interim periods. The results of operations for the three-month period ended March 31, 2003 are not necessarily indicative of the results to be expected for the year ending December 31, 2003. The consolidated balance sheet as of December 31, 2002 was derived from audited consolidated financial statements as of that date. Certain 2002 amounts have been reclassified to conform to the 2003 presentation. NOTE B - BANK DEVELOPMENT ACTIVITIES Bank development efforts are currently under consideration at March 31, 2003 in several states including pre-development exploratory discussions, lease and employment negotiations and preparation of preliminary regulatory applications for formation and/or acquisition of community banks. NOTE C - NET INCOME PER SHARE The computations of basic and diluted earnings per share were as follows: Three Months Ended March 31 ------------------------- 2003 2002 ----------- ----------- Numerator--net income for the period $ 5,313,000 $ 3,044,000 =========== =========== Denominator: Weighted average number of common shares outstanding (denominator for basic earnings per share) 11,697,756 7,900,928 Effect of dilutive securities--stock options and warrants 438,359 178,937 ----------- ----------- Denominator for dilutive net income per share-- Weighted average number of common shares and potential dilution 12,136,115 8,079,865 =========== =========== Number of antidilutive stock options excluded from diluted earnings per share computation 202,372 119,336 =========== =========== Page 7 of 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. - CONTINUED NOTE D - STOCK OPTIONS Stock option activity for the interim 2003 period is summarized as follows: Weighted Number of Exercise Average Stock Options Price Exercise Outstanding Range Price ------------- ------------------ ------- Outstanding at January 1 2,548,536 $ 4.92 to $ 25.10 $ 15.23 Exercised (335,893) 8.54 to 16.40 15.13 Granted 198,580 20.36 to 23.37 21.32 Cancelled or expired (23,290) -- --------- ------------------ ------- Outstanding at March 31 2,387,933 $ 4.92 to $ 25.10 $ 15.75 As of March 31, 2003, stock options outstanding had a weighted average remaining contractual life of 4.9 years. The following table summarizes stock options outstanding segregated by exercise price range: Weighted Average ------------------------ Remaining Exercise Price Number Exercise Contractual Range Outstanding Price Life ----- ----------- ----- ---- Less than $10.00 95,377 $ 9.14 2.8 years $10.00 to 14.99 908,099 12.49 4.7 years $15.00 to 19.99 977,480 16.62 5.2 years $20.00 to 24.99 306,351 21.60 6.2 years $25.00 or more 100,626 $25.10 1.7 years --------- 2,387,933 Statement of Financial Accounting Standards No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, establishes an alternative fair value method of accounting for stock options whereby compensation expense would be recognized based on the computed fair value of the options on the grant date. By not electing this alternative, certain pro forma disclosures of the expense recognition provisions of Statement No. 123 are required, which are as follows: 2003 2002 ------- ------- Fair value assumptions: Risk-free interest rate 3.5% 4.5% Dividend yield 2.2% 2.5% Stock price volatility .50 .46 Expected option life 7 years 7 years Aggregate estimated fair value of options granted (in thousands) $ 1,890 $ 62 Net income (in thousands): As reported 5,313 3,044 Less pro forma compensation expense regarding fair value of stock option awards, net of related income tax effect (1,229) (41) ------- ------- Pro forma 4,084 3,003 Net income per share: Basic: As reported 0.45 0.39 Pro forma 0.35 0.38 Diluted: As reported 0.44 0.38 Pro forma $ 0.34 $ 0.37 Page 8 of 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CAPITOL BANCORP LTD. -CONTINUED NOTE E - IMPACT OF NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) recently issued Statements No. 146 (ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES) and No. 149 (AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES). These new standards have varying effective dates in 2003 and had no material effect on Capitol's financial statements, upon implementation. Statement No. 148 (ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE) provides alternative methods of transition for a voluntary change to the fair-value based method of accounting for stock-based employee compensation and it amends the prior disclosure requirements of Statement No. 123 to require more prominent and frequent disclosures about the effects of stock-based compensation, including interim disclosures (such interim disclosures appear in Note D). As permitted, Capitol has retained its prior method of accounting for stock-based employee compensation. FASB Interpretation No. 45, GUARANTOR'S ACCOUNTING AND DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES AND INDEBTEDNESS OF OTHERS, expands disclosures about obligations under certain guarantees and, in addition, requires recording a liability for the fair value of the obligations undertaken in issuing the guarantee, applicable to guarantees issued or modified after December 31, 2002. This new guidance had no material effect on Capitol's consolidated financial position or results of operations, upon implementation. FASB Interpretation No. 46, CONSOLIDATION OF VARIABLE INTEREST ENTITIES, clarifies when some entities previously not consolidated under prior accounting guidance, should be. This new guidance, which was effective upon issuance in January 2003, had no material effect upon Capitol's consolidated financial statements upon implementation. A variety of proposed or otherwise potential accounting standards are currently under study by standard-setting organizations and various regulatory agencies. Because of the tentative and preliminary nature of these proposed standards, management has not determined whether implementation of such proposed standards would be material to Capitol's consolidated financial statements. Page 9 of 25 PART I, ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Total assets approximated $2.5 billion at March 31, 2003, an increase of $131 million from the December 31, 2002 level of $2.4 billion. The balance sheet includes Capitol and its consolidated subsidiaries: Total Assets (in $1,000's) --------------------------- March 31 Dec 31 2003 2002 ----------- ----------- Great Lakes Region: Ann Arbor Commerce Bank $ 325,946 $ 309,152 Brighton Commerce Bank 83,323 78,382 Capitol National Bank 211,867 206,130 Detroit Commerce Bank 37,908 30,589 Grand Haven Bank 128,483 123,505 Kent Commerce Bank 73,832 73,801 Macomb Community Bank 88,749 87,050 Muskegon Commerce Bank 86,239 86,465 Oakland Commerce Bank 125,280 115,916 Paragon Bank & Trust 106,754 103,044 Portage Commerce Bank 140,926 139,068 Elkhart Community Bank 48,297 53,210 Goshen Community Bank 39,608 38,115 ----------- ----------- Great Lakes Region Total 1,497,212 1,444,427 Southwest Region: Arrowhead Community Bank 48,427 47,427 Bank of Tucson 141,104 132,094 Camelback Community Bank 87,483 82,387 East Valley Community Bank 37,766 37,640 Mesa Bank 64,585 66,312 Southern Arizona Community Bank 84,444 75,253 Valley First Community Bank 43,379 42,127 Yuma Community Bank 41,589 38,214 Bank of Las Vegas 28,983 26,880 Black Mountain Community Bank 67,626 63,202 Desert Community Bank 59,812 55,170 Red Rock Community Bank 110,276 96,906 Sunrise Bank of Albuquerque 50,267 46,898 Sunrise Bank of Arizona 90,691 82,126 ----------- ----------- Southwest Region Total 956,432 892,636 California Region: Sunrise Bank of San Diego 58,801 50,450 First California Northern Bancorp: Napa Community Bank 39,545 36,042 ----------- ----------- California Region Total 98,346 86,492 Other, net (11,701) (14,267) ----------- ----------- Consolidated $ 2,540,289 $ 2,409,288 =========== =========== Portfolio loans increased during the three-month 2003 period by approximately $61 million. Loan growth was funded primarily by higher levels of time deposits. The majority of portfolio loan growth occurred in commercial loans, consistent with the banks' emphasis on commercial lending activities. Portfolio loan growth in 2003 is net of about $19 million of commercial loans sold to other financial institutions. Page 10 of 25 The allowance for loan losses at March 31, 2003 approximated $30 million or 1.46% of total portfolio loans, an increase from the year-end 2002 ratio of 1.45%. The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses inherent in the loan portfolio at the balance sheet date. Management's determination of the adequacy of the allowance is based on evaluation of the portfolio (including potential impairment of individual loans and concentrations of credit), past loss experience, current economic conditions, volume, amount and composition of the loan portfolio, loan commitments outstanding and other factors. The allowance is increased by provisions charged to operations and reduced by net charge-offs. The table below summarizes portfolio loan balances and activity in the allowance for loan losses for the interim periods (in thousands): 2003 2002 ----------- ----------- Allowance for loan losses at January 1 $ 28,953 $ 23,238 Loans charged-off: Commercial (887) (530) Real estate mortgage (21) (25) Installment (96) (90) ----------- ----------- Total charge-offs (1,004) (645) Recoveries: Commercial 154 38 Real estate mortgage -- 2 Installment 41 21 ----------- ----------- Total recoveries 195 61 ----------- ----------- Net charge-offs (809) (584) Additions to allowance charged to expense 1,890 2,090 ----------- ----------- Allowance for loan losses at March 31 $ 30,034 $ 24,744 =========== =========== Average total portfolio loans for period ended March 31 $ 2,023,830 $ 1,761,605 =========== =========== Ratio of net charge-offs (annualized) to average portfolio loans outstanding 0.16% 0.13% =========== =========== Net charge-offs of loans increased $225,000 in 2003, compared to the three-month period in 2002. The increase, during the quarter ended March 31, 2003, was mainly due to losses associated with loans secured by business equipment and accounts receivable. Page 11 of 25 The amounts of the allowance for loan losses allocated in the following table (in thousands) include all loans for which, based on Capitol's loan rating system, management has concerns, and should not be interpreted as an indication of future charge-offs. March 31, 2003 December 31, 2002 ------------------------- -------------------------- Percentage Percentage of Total of Total Portfolio Portfolio Amount Loans Amount Loans ------ ----- ------ ----- Commercial $ 27,610 1.35% $ 27,226 1.37% Real estate mortgage 1,358 0.06 1,009 0.05 Installment 1,066 0.05 718 0.03 ---------- ----- ----------- ----- Total allowance for loan losses $ 30,034 1.46% $ 28,953 1.45% ========== ===== =========== ===== Total portfolio loans outstanding $2,052,157 $ 1,991,372 ========== =========== Nonperforming loans (i.e., loans which are 90 days or more past due and loans on nonaccrual status) are summarized below (in thousands): March 31 Dec 31 2003 2002 ------- ------- Nonaccrual loans: Commercial $18,414 $15,444 Real estate 657 560 Installment 995 613 ------- ------- Total nonaccrual loans 20,066 16,617 Past due (>=90 days) loans: Commercial 5,045 5,728 Real estate 736 323 Installment 134 222 ------- ------- Total past due loans 5,915 6,273 ------- ------- Total nonperforming loans $25,981 $22,890 ======= ======= Page 12 of 25 Nonperforming loans increased approximately $3.1 million during the three-month period ended March 31, 2003. Of the nonperforming loans at March 31, 2003, about 65% are real estate secured. Those loans, when originated, had appropriate loan-to-value ratios and, accordingly, have loss exposure which is expected to be minimal; however, underlying real estate values depend upon current economic conditions and liquidation strategies. Most other nonperforming loans are generally secured by other business assets. Nonperforming loans at March 31, 2003 are in various stages of resolution for which management believes such loans are adequately collateralized or otherwise appropriately considered in its determination of the adequacy of the allowance for loan losses. In addition to the identification of nonperforming loans involving borrowers with payment performance difficulties (i.e., nonaccrual loans and loans past-due 90 days or more), management utilizes an internal loan review process to identify other potential problem loans which may warrant additional monitoring or other attention. This loan review process is a continuous activity which periodically updates internal loan ratings. At inception, all loans are individually assigned a rating which grades the credits on a risk basis, based on the type and discounted value of collateral, financial strength of the borrower and guarantors and other factors such as nature of the borrower's business climate, local economic conditions and other subjective factors. The loan rating process is fluid and subjective. Potential problem loans include loans which are generally performing as agreed; however, because of loan review's and/or lending staff's risk assessment, increased monitoring is deemed appropriate. In addition, some loans are assigned a more adverse classification, with specific performance issues or other risk factors requiring close management and development of specific remedial action plans. At March 31, 2003, potential problem loans (including the previously mentioned nonperforming loans) approximated $104 million, or about 5% of total consolidated portfolio loans. These potential problem loans do not necessarily have significant loss exposure (nor are they necessarily deemed `impaired'), but rather are classified by management in this manner to aid in loan administration and risk management. Management believes such loans to be adequately considered in its evaluation of the adequacy of the allowance for loan losses. Management believes, however, that current general economic conditions may result in higher levels of future loan losses, in comparison to previous years, as evidenced by higher loan losses in the interim 2003 period. Page 13 of 25 The following comparative analysis summarizes each bank's total portfolio loans, allowance for loan losses, nonperforming loans and ratio of the allowance as a percentage of portfolio loans (dollars in thousands): Allowance as a Percentage Total Allowance for Nonperforming of Total Portfolio Loans Loan Losses Loans Portfolio Loans ----------------------- ----------------------- --------------------- ------------------ March 31 Dec 31 March 31 Dec 31 March Dec 31 March 31 Dec 31 2003 2002 2003 2002 2003 2002 2003 2002 ---------- ---------- ---------- ---------- ---------- ---------- ------- ------- Great Lakes Region: Ann Arbor Commerce Bank $ 281,066 $ 272,604 $ 4,025 $ 3,840 $ 2,829 $ 2,624 1.43% 1.41% Brighton Commerce Bank 69,664 68,239 721 851 170 170 1.03 1.25 Capitol National Bank 162,305 158,651 2,308 2,322 1,764 1,753 1.42 1.46 Detroit Commerce Bank 28,719 26,799 585 627 1,098 751 2.04 2.34 Grand Haven Bank 121,114 114,616 1,744 1,626 2,038 1,605 1.44 1.42 Kent Commerce Bank 69,575 68,848 835 830 86 293 1.20 1.21 Macomb Community Bank 78,890 73,915 1,142 1,136 3,040 3,012 1.45 1.54 Muskegon Commerce Bank 79,544 77,247 1,012 966 2,890 1,806 1.27 1.25 Oakland Commerce Bank 89,857 86,049 1,173 1,119 1,375 1,805 1.31 1.30 Paragon Bank & Trust 91,872 86,571 1,562 1,291 3,035 2,628 1.70 1.49 Portage Commerce Bank 132,111 129,710 1,905 1,815 3,305 3,135 1.44 1.40 Elkhart Community Bank 44,279 43,277 664 658 244 245 1.50 1.52 Goshen Community Bank 36,936 35,408 556 532 -- -- 1.51 1.50 ---------- ---------- ---------- ---------- ---------- ---------- Great Lakes Region Total 1,285,932 1,241,934 18,232 17,613 21,874 19,827 Southwest Region: Arrowhead Community Bank 36,008 36,185 530 543 -- -- 1.47 1.50 Bank of Tucson 90,519 90,176 1,164 1,461 187 187 1.29 1.62 Camelback Community Bank 60,559 63,516 816 960 -- 232 1.35 1.51 East Valley Community Bank 26,748 25,932 405 389 233 17 1.51 1.50 Mesa Bank 59,878 55,588 724 834 -- 242 1.21 1.50 Southern Arizona Community Bank 61,928 60,913 789 914 -- -- 1.27 1.50 Valley First Community Bank 28,490 29,075 641 620 260 261 2.25 2.13 Yuma Community Bank 24,871 25,485 383 383 -- -- 1.54 1.50 Bank of Las Vegas 20,515 19,404 321 292 -- -- 1.56 1.50 Black Mountain Community Bank 50,796 52,240 786 784 327 324 1.55 1.50 Desert Community Bank 43,037 43,351 661 675 1,166 734 1.54 1.56 Red Rock Community Bank 82,025 80,152 1,833 1,203 1,789 861 2.23 1.50 Sunrise Bank of Albuquerque 43,286 38,577 585 521 -- -- 1.35 1.35 Sunrise Bank of Arizona 72,117 65,195 931 881 145 205 1.29 1.35 ---------- ---------- ---------- ---------- ---------- ---------- Southwest Region Total 700,777 685,789 10,569 10,460 4,107 3,063 California Region: Sunrise Bank of San Diego 39,087 39,116 577 577 -- -- 1.48 1.48 First California Northern Bancorp Napa Community Bank 24,697 20,177 392 303 -- -- 1.59 1.50 ---------- ---------- ---------- ---------- ---------- ---------- California Region Total 63,784 59,293 969 880 -- -- -- -- Other, net 1,664 4,356 264 -- -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- ----- ----- Consolidated $2,052,157 $1,991,372 $ 30,034 $ 28,953 $ 25,981 $ 22,890 1.46% 1.45% ========== ========== ========== ========== ========== ========== ===== ===== RESULTS OF OPERATIONS Net income for the three months ended March 31, 2003, was $5.3 million, an increase of $2.3 million or 75% over the same period last year. Diluted earnings per share were $0.44 compared to $0.38 for the prior year period. The percentage increase in net income per share was less than the percentage increase in the amount of net income in 2003 because of the larger share base resulting from Capitol's 2002 share exchanges regarding Sun Community Bancorp, Sunrise Capital Corporation, Indiana Community Bancorp and Nevada Community Bancorp. Net interest income for the first three months of 2003 totaled $27 million, an 18% increase compared to $22.8 million in 2002. This increase is attributable to the expansion in number of banks, the banks' growth and a stable interest rate environment. Page 14 of 25 Noninterest income for the three months ended March 31, 2003 was $4.5 million, an increase of $1.7 million, or 62%, over the same period in 2002. Fees from origination of non-portfolio residential mortgage loans totaled $2.2 million in the interim 2003 period, as compared to $1 million in 2002, due to continuing high volume of loan fees derived from residential mortgage loan refinance activity resulting from sustained low interest rates. Service charges on deposit accounts increased in the first quarter of 2003 by 12%, compared to 2002 due to growth in the number and size of banks. The provision for loan losses for the first quarter of 2003 was $1.9 million as compared to $2.1 million during the corresponding 2002 period. The provision for loan losses is based upon management's analysis of the adequacy of the allowance for loan losses, as previously discussed. Noninterest expense totaled $21.2 million for the interim 2003 period compared to $18.8 million in 2002. The increase in noninterest expense is associated with newly formed banks, growth and increases in general operating costs. Increases in both occupancy and salaries and employee benefits relate primarily to the growth in the number and size of banks within the consolidated group. Other noninterest expense in the 2002 period was higher than in 2003 due to the preopening costs of two start-up banks which commenced operations in the first three months of 2002. Operating results (dollars in thousands) were as follows: Three months ended March 31 ---------------------------------------------------------------------------------------- Return on Return on Total Revenues Net Income Average Equity Average Assets -------------------- -------------------- -------------------- ------------------ 2003 2002 2003 2002 2003 2002 2003 2002 -------- -------- -------- -------- ------- ------- ------- ------- Great Lakes Region: Ann Arbor Commerce Bank $ 5,828 $ 5,415 $ 1,319 $ 1,144 21.91% 21.39% 1.73% 1.69% Brighton Commerce Bank 1,367 1,353 319 188 18.88 12.40 1.60 1.05 Capitol National Bank 3,409 3,120 849 740 22.58 21.94 1.64 1.70 Detroit Commerce Bank 518 601 (21) (26) n/a n/a n/a n/a Grand Haven Bank 2,511 2,141 569 421 22.01 20.39 1.79 1.61 Kent Commerce Bank 1,288 1,408 129 176 13.95 10.64 1.34 .98 Macomb Community Bank 1,371 1,501 (29) 283 n/a 11.61 n/a 1.24 Muskegon Commerce Bank 1,614 1,564 366 331 17.29 17.50 1.74 1.75 Oakland Commerce Bank 1,909 1,870 382 307 16.54 14.24 1.32 1.17 Paragon Bank & Trust 2,164 1,971 166 230 6.41 10.72 .63 .96 Portage Commerce Bank 2,732 2,461 565 418 20.37 15.92 1.61 1.36 Elkhart Community Bank 810 626 118 29 9.64 2.53 .61 .32 Goshen Community Bank 749 493 118 6 10.30 .58 1.19 .09 -------- -------- -------- -------- Great Lakes Region Total 26,270 24,524 4,850 4,247 Southwest Region: Arrowhead Community Bank 917 666 82 (31) 7.52 n/a .71 n/a Bank of Tucson 2,281 2,432 780 573 29.35 22.73 2.33 1.94 Camelback Community Bank 1,447 1,403 306 153 14.98 9.33 1.43 .85 East Valley Community Bank 660 699 (86) (97) n/a n/a n/a n/a Mesa Bank 1,345 1,186 388 167 24.07 12.06 2.31 1.24 Southern Arizona Community Bank 1,282 1,140 305 158 17.61 11.08 1.56 1.00 Valley First Community Bank 689 997 69 63 4.82 4.51 .66 .46 Yuma Community Bank 753 518 82 (14) 8.71 n/a .82 n/a Bank of Las Vegas 382 130 (78) (337) n/a n/a n/a n/a Black Mountain Community Bank 1,105 836 180 55 13.64 4.85 1.13 .45 Desert Community Bank 964 1,152 121 104 9.28 8.51 .86 .69 Red Rock Community Bank 1,760 1,523 (106) 210 n/a 9.65 n/a .99 Sunrise Bank of Albuquerque 963 608 105 (25) 10.85 n/a .88 n/a Sunrise Bank of Arizona 2,312 1,372 91 261 5.85 17.15 .42 1.67 -------- -------- -------- -------- Southwest Region Total 16,860 14,662 2,239 1,240 California Region: Sunrise Bank of San Diego 935 954 43 93 2.30 5.10 .31 .90 First California Northern Bancorp: Napa Community Bank 551 44 (11) (394) n/a n/a n/a n/a -------- -------- -------- -------- California Region Total 1,486 998 32 (301) Other, net (101) (131) (1,808) (2,142) n/a n/a n/a n/a -------- -------- -------- -------- ------- ------- ------- ------- Consolidated $ 44,515 $ 40,053 $ 5,313 $ 3,044 13.09% 14.80% .87% .58% ======== ======== ======== ======== ======= ======= ======= ======= n/a Not applicable Page 15 of 25 LIQUIDITY AND CAPITAL RESOURCES The principal funding source for asset growth and loan origination activities is deposits. Total deposits increased $119 million for the three months ended March 31, 2003, slightly more than the $113 million increase in the corresponding period of 2002. Growth occurred in most interest-bearing deposit categories, with the majority coming from time deposits. The banks generally do not rely on brokered deposits as a key funding source; brokered deposits approximated $233 million as of March 31, 2003, or about 11% of total deposits, an increase of $32 million during the interim 2003 period. Brokered deposits, as a funding source, have increased in recent periods due to competitive environments and selective opportunities to grow deposits at a faster pace and/or lower cost than traditional sources, and may similarly increase in future periods. Noninterest-bearing deposits approximated 16.5% of total deposits at March 31, 2003 and 17.5% at December 31, 2002. Levels of noninterest-bearing deposits can, however, fluctuate based on customers' transaction activity. Interim 2003 deposit growth was deployed primarily into commercial loans, consistent with the banks' emphasis on commercial lending activities. Cash and cash equivalents amounted to $324 million or 13% of total assets at March 31, 2003, compared with $251 million or 10% of total assets at December 31, 2002. As liquidity levels vary continuously based on customer activities, amounts of cash and cash equivalents can vary widely at any given point in time. Management believes the banks' liquidity position at March 31, 2003 is adequate to fund loan demand and meet depositor needs. In addition to cash and cash equivalents, a source of long-term liquidity is the banks' marketable investment securities. Liquidity needs have not historically necessitated the sale of investments in order to meet funding requirements. The banks have not engaged in active trading of their investments. At March 31, 2003, the banks had approximately $32 million of investment securities classified as available for sale which can be utilized to meet various liquidity needs as they arise. Some of the banks have secured lines of credit with a Federal Home Loan Bank. Borrowings thereunder approximated $80 million and additional borrowing capacity approximated $16 million at March 31, 2003. These borrowings increased slightly ($1 million in the interim period of 2003) as a lower-cost funding source versus various rates and maturities of time deposits. At March 31, 2003, Capitol had unused lines of credit from an unrelated financial institution aggregating $21 million. In March 2003, Capitol participated in a pooled trust-preferred securities offering, structured with a 30-year maturity and a variable interest rate, with net proceeds of approximately $9.7 million. These securities augment Capitol's existing capital base and the proceeds have been used to reduce borrowings from an unaffiliated bank. Page 16 of 25 Capitol and its banks are subject to complex regulatory capital requirements, which require maintaining certain minimum capital ratios. These ratio measurements, in addition to certain other requirements, are used by regulatory agencies to determine the level of regulatory intervention and enforcement applied to financial institutions. Management believes Capitol and each of its banks are in compliance with regulatory requirements and are expected to maintain such compliance. Stockholders' equity, as a percentage of total assets, approximated 6.5% at March 31, 2003 a slight decrease from 6.6% at the beginning of the year. Total capital funds (Capitol's stockholders' equity, plus minority interests in consolidated subsidiaries, plus guaranteed preferred beneficial interests in the Corporation's subordinated debentures) aggregated $258 million or 10% of total assets at March 31, 2003. In April 2003, Capitol announced the completion of an $11 million private placement of its common stock to select institutional investors and the issuance of approximately 550,000 shares of previously unissued common stock. Proceeds from the offering have been used to reduce borrowings from an unaffiliated bank and investment in short-term investments. Capitol's operating strategy continues to be focused on the ongoing growth and maturity of its existing banks, coupled with new bank expansion in selected markets as opportunities arise. Accordingly, Capitol may invest in, acquire or otherwise develop additional banks in future periods, subject to economic conditions and other factors, although the timing of such additional banking units, if any, is uncertain. Such future new banks and/or additions of other operating units could be either wholly-owned, majority-owned or otherwise controlled by Capitol. TRENDS AFFECTING OPERATIONS One of the most significant trends which can impact the financial condition and results of operations of financial institutions are changes in market rates of interest. Changes in interest rates, either up or down, have an impact on net interest income (plus or minus), depending on the direction and timing of such changes. At any point in time, there is a difference between interest rate-sensitive assets and interest rate-sensitive liabilities. This means that when interest rates change, the timing and magnitude of the effect of such interest rate changes can alter the relationship between asset yields and the cost of funds. In the first three months of 2003, interest rates have remained relatively stable. The future outlook on interest rates and their impact on Capitol's interest income, interest expense and net interest income is uncertain. Start-up banks generally incur operating losses during their early periods of operations. Recently-formed start-up banks are expected to detract from consolidated earnings performance and start-up banks formed in 2003 and beyond will similarly negatively impact short-term profitability. General economic conditions also have a significant impact on both the results of operations and the financial condition of financial institutions. Page 17 of 25 Media reports raising questions about the health of the domestic economy have continued in 2003. During the first quarter of 2003, nonperforming loans have increased and it is anticipated that levels of nonperforming loans and related loan losses may increase as economic conditions, locally and nationally, evolve. IMPACT OF NEW ACCOUNTING STANDARDS There are several new accounting standards either becoming effective or being issued in 2003. They are listed and discussed in Note E of the accompanying condensed consolidated financial statements. CRITICAL ACCOUNTING POLICIES Capitol's critical accounting policies are described on page 10 of the financial section of its 2002 Annual Report. In the circumstances of Capitol, management believes its "critical accounting policies" are those which encompass the use of estimates (because of inherent subjectivity), allowance for loan losses (due to the inherent subjectivity in estimating loan losses), accounting for income taxes (due to the significant U.S. corporate income tax rate and realization of deferred tax assets) and accounting for goodwill (due to new accounting standards effective at the beginning of 2002). Page 18 of 25 PART I, ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. PART I, ITEM 4 CONTROLS AND PROCEDURES (a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Disclosure controls and procedures were evaluated as of March 31, 2003 ("Evaluation Date"). Such evaluation concluded that Capitol's disclosure controls and procedures are effective to ensure that material information relating to Capitol, including its consolidated subsidiaries, is made known to Capitol's senior management, particularly during the period for which this quarterly report has been prepared. (b) CHANGES IN INTERNAL CONTROL. As of the signature date of this report, there have been no significant changes in Capitol's internal controls or in other factors that could significantly affect internal controls subsequent to the Evaluation Date referred to in (a) above. (c) ASSET-BACKED ISSUERS. Not applicable. [The remainder of this page intentionally left blank] Page 19 of 25 PART II. OTHER INFORMATION Item 1. Legal Proceedings. Capitol and its subsidiaries are parties to certain ordinary, routine litigation incidental to their business. In the opinion of management, liabilities arising from such litigation would not have a material effect on Capitol's consolidated financial position or results of operations. Item 2. Changes in Securities and Use of Proceeds. None. Item 3. Defaults Upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Other Information. None. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits: Exhibit No. Description of Exhibit ----------- ---------------------- 10a Amended and Restated Employment Agreement of Joseph D. Reid dated March 17, 2003 and amendment dated April 17, 2003. 99.1 Certification of Chief Executive Officer, Joseph D. Reid, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification of Chief Financial Officer, Lee W. Hendrickson, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the three months ended March 31, 2003. Page 20 of 25 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. CAPITOL BANCORP LTD. (Registrant) /s/ Joseph D. Reid ------------------------------------------ Joseph D. Reid Chairman and CEO (duly authorized to sign on behalf of the registrant) /s/ Lee W. Hendrickson ------------------------------------------ Lee W. Hendrickson Executive Vice President and Chief Financial Officer Date: May 14, 2003 Page 21 of 25 CERTIFICATIONS I, Joseph D. Reid, Chairman and CEO, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capitol Bancorp Ltd.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and Page 22 of 25 CERTIFICATIONS--CONTINUED 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Joseph D. Reid ----------------------------- Joseph D. Reid Chairman and CEO [The remainder of this page intentionally left blank] Page 23 of 25 CERTIFICATIONS--CONTINUED I, Lee W. Hendrickson, Chief Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capitol Bancorp Ltd.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and Page 24 of 25 CERTIFICATIONS--CONTINUED 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Lee W. Hendrickson ----------------------------- Lee W. Hendrickson Chief Financial Officer [The remainder of this page intentionally left blank] Page 25 of 25