Exhibit 13
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[D&N LOGO]
1998 Annual Report
GENERAL
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D&N Financial Corporation ("D&N" or "the Company") is a savings bank holding
company whose sole subsidiary is D&N Bank ("the Bank"). D&N's primary focus is
the delivery of retail financial services through its community banking offices
in Michigan and loan origination network in the Upper Midwest. This discussion
highlights important trends and events that have shaped the Company's financial
performance in 1998.
In 1998, D&N reported net income of $16.1 million, or $1.69 per diluted share.
Earnings in 1997 were $14.3 million or $1.53 per diluted share. In 1996, before
one-time regulatory charges and the tax benefit of a previous year's net
operating loss, earnings were $10.1 million or $1.14 per diluted share.
On December 31, 1998, the Company's balance sheet included total assets of $2.02
billion, compared to $1.82 billion at the end of 1997. This 11% growth reflected
primarily the Bank's loan origination success, with $1.02 billion of new loans
funded in 1998. Outstanding loan balances totaled $1.34 billion at December 31,
1998, an increase of 2% during the year. Mortgage-backed securities also
increased by 38% to $494 million as the Bank securitized $83 million of its
residential mortgage loan production with the Federal National Mortgage
Association ("Fannie Mae").
In 1998, the Company made provisions for loan losses of $2.5 million, after
making provisions of $1.35 million and $1.1 million in 1997 and 1996,
respectively. At December 31, 1998, the allowance for loan losses was $11.0
million, or 0.82% of outstanding loans.
Noninterest income increased by 54.9% in 1998 after increasing by 23.5% in 1997.
The 1998 increase includes an 8% improvement in deposit-related fees and an
increase of $4.08 million in gains from the sale of loans and mortgage-backed
securities.
RESULTS OF OPERATIONS
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NET INTEREST INCOME
The Company's primary source of earnings is its net interest income, defined as
the difference between the interest earned on its loans and investments and the
interest paid on its deposits and other liabilities. Interest income and
interest expense each increased in 1998 as the average size of the Company's
earning assets grew 16.1% during the year. Interest income increased by $14.3
million, or 11.4%, in 1998. The average yield on earning assets decreased by 32
basis points to 7.59% in 1998, from 7.91% in 1997. In 1996, earning assets
yielded 7.95%. Driving the interest income gains in 1998 was D&N's 16.1%
increase in the average balance of earning assets, which followed an increase of
21.1% in 1997 and 14.7% in 1996.
Interest expense increased by $10.5 million, or 13.7%, in 1998 as the average
balance of interest-bearing liabilities increased by 15.0%, which more than
offset the 6 basis point decrease paid on those liabilities. In 1998, interest-
bearing liabilities had an average cost of 5.06%, compared to 5.12% in 1997 and
4.93% in 1996. The decrease of the average yield on interest-earning assets
combined with the 16% increase in their average balance resulted in a decrease
of the interest rate spread from 2.79% in 1997 to 2.53% in 1998. In 1996 the
spread was 3.02%. Similarly, the Bank's net interest margin, or ratio of net
interest income to average interest-earning assets, decreased from 3.08% in 1997
to 2.86% in 1998. In 1996 the net interest margin was 3.26%. Average interest-
earning assets exceeded average interest-bearing liabilities by $119.4 million
in 1998 compared to $88.7 million in 1997 and $64.5 million in 1996.
Average balances of loans outstanding were higher in 1998 than 1997, as the
Company's loan originations increased significantly. Average balances of
mortgage-backed securities were also higher reflecting loan securitization
efforts, while the investment securities category decreased. Loans increased by
$130 million, or 11%; mortgage-backed securities increased by $151 million, or
56%; and investment securities decreased by $25.1 million, or 20%. Average
earning rates on loans and mortgage-backed securities were lower in 1998 than
1997, while the average earning rate on investment securities increased. In
1998, loans earned an average yield of 7.99% compared to 8.25% in 1997.
Mortgage-backed securities earned an average of 6.60% in 1998, versus an average
rate of 7.15% in 1997. Investment securities earned 6.44% in 1998, an increase
from 6.28% in 1997.
The average balances of all interest-earning asset categories increased from
1996 to 1997.
Average deposit balances increased 10.0% to $1.11 billion in 1998, from $1.01
billion in 1997. Approximately 81% of this growth was from the Bank's continuing
operations, with the remainder attributable to the purchase, in September, 1998,
of $72 million in deposits. The average cost of deposits decreased 14 basis
points, to 4.60%, in 1998. From 1996 to 1997, average deposit balances
increased by $74 million, or 7.9%. In 1996, the average cost of deposits was
4.67%.
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The average balance of borrowed funds increased by 25.1%, to $611 million in
1998, from $488 million in 1997. In 1996, the average balance of borrowed funds
was $310 million.
The following tables set forth the extent to which the Company's net interest
income has been affected by changes in average interest rates and average
balances of interest-earning assets and interest-bearing liabilities.
Years Ended December 31, 1998 and 1997
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Average balance (1) Average rate Interest Variance due to:(2)
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Increase
1998 1997 1998 1997 1998 1997 (Decrease) Volume Rate
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(Dollars in thousands)
Interest-earning assets:
Loans (3)................... $1,323,767 $1,194,090 7.99% 8.25% $105,777 $ 98,560 $ 7,217 $10,452 $(3,235)
Mortgage-backed securities(4) 417,508 267,010 6.60 7.15 27,568 19,085 8,483 10,035 (1,552)
Investments and deposits (4) 102,933 128,071 6.44 6.28 6,629 8,048 (1,419) (1,615) 196
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1,844,208 1,589,171 7.59 7.91 139,974 125,693 14,281 18,872 (4,591)
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Interest-bearing liabilities:
Deposits..................... 1,113,999 1,012,237 4.60 4.74 51,206 47,961 3,245 4,711 (1,466)
Borrowings................... 610,856 488,251 5.91 5.90 36,079 28,793 7,286 7,228 58
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1,724,855 1,500,488 5.06 5.12 87,285 76,754 10,531 11,939 (1,408)
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Interest rate spread........... 2.53 2.79
Excess average earning assets $119,353 $88,683 7.59% 7.91%
============================================
Net interest margin............ 2.86% 3.08% $52,689 $48,939 $3,750 $6,933 $(3,183)
========================================================================
Years Ended December 31, 1997 and 1996
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Average balance (1) Average rate Interest Variance due to:(2)
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Increase
1997 1996 1997 1996 1997 1996 (Decrease) Volume Rate
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(Dollars in thousands)
Interest-earning assets:
Loans (3) $1,194,090 $1,062,108 8.25% 8.11% $98,560 $86,151 12,409 $10,917 $1,492
Mortgage-backed securities(4) 267,010 146,560 7.15 7.46 19,085 10,930 8,155 8,627 (472)
Investments and deposits (4) 128,071 103,848 6.28 6.96 8,048 7,228 820 1,562 (742)
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1,589,171 1,312,516 7.91 7.95 125,693 104,309 21,384 21,106 278
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Interest-bearing liabilities:
Deposits..................... 1,012,237 938,484 4.74 4.67 47,961 43,859 4,102 3,469 633
Borrowings................... 488,251 309,516 5.90 5.71 28,793 17,687 11,106 10,294 812
-----------------------------------------------------------------------------------------------------
1,500,488 1,248,000 5.12 4.93 76,754 61,546 15,208 13,763 1,445
-----------------------------------------------------------------------------------------------------
Interest rate spread........... 2.79 3.02
Excess average earning assets $88,683 $64,516 7.91% 7.95%
===================================================
Net interest margin............ 3.08% 3.26% $48,939 $42,763 $6,176 $7,343 $(1,167)
========================================================================
(1) Based on average daily balances.
(2) Changes to interest income and interest expense attributable to changes in
both rate and volume have been proportionately to the change due to rate
and the change due to volume.
(3) Loans on nonaccrual are included in the average balances shown above. The
variance due to rate includes the of such loans because no interest is
earned on such loans.
(4) Average rates on mortgage-backed and investment securities available for
sale are based on historical cost balances.
NONINTEREST INCOME
D&N's noninterest income includes recurring fees from loan and deposit-related
activities, recurring income from the marketing of assets that are originated
for sale, and nonrecurring gains and losses from events such as sales of non-
earning and depreciated assets. D&N's loan and deposit-related fee income
totaled $6.2 million in 1998, up $243,000 or 4.1% from 1997, reflecting
primarily the Bank's
2
growing core deposit base and the initiation of fees for non-customer usage of
the Bank's automatic teller machine network. In 1998, net loan servicing and
administrative fees decreased slightly from 1997 to $1.9 million. Deposit-
related fees increased by 7.6% to $4.4 million in 1998.
Gains on sales of loans and mortgage-backed securities totaled $6.4 million in
1998, up from $2.3 million in 1997. In 1998, $227 million of D&N's residential
mortgages were sold to secondary market investors, compared to $103 million in
1997. Other income increased from $657,000 in 1997 to $1.23 million in 1998
mainly due to D&N Bank's subsidiary, Quincy Insurance Agency, offering
annuities and investment products, and one-time income from the sale of
purchased mortgage servicing rights and the recovery of a previously written-off
investment.
NONINTEREST EXPENSE
General and administrative expenses totaled $36.4 million in 1998, an increase
of $3.7 million compared to 1997. The increase reflects the costs of D&N's
expanding retail delivery network, and the variable-based compensation
consequences of higher loan production levels.
Operating costs of other real estate owned ("OREO") exceeded net recoveries on
sales for such properties by $167,000 in 1998. In 1997, net recoveries on sales
of OREO exceeded operating costs for such properties by $81,000. In 1996,
noninterest expense included $71,000 of net operating costs related to OREO.
In 1998, D&N's Federal Deposit Insurance Corporation insurance premium was
$794,000, compared to $658,000 in 1997. The premium was $2.4 million in 1996,
excluding that year's Savings Association Insurance Fund recapitalization
assessment of $5.5 million.
INCOME TAXES
The Company's effective income tax rates were 32.97% in 1998, 35.09% in 1997 and
3.74% in 1996. The tax rate in 1996 was effected by reductions in a portion of
the valuation allowance for deferred tax assets provided in prior years, when
the Company incurred substantial net operating losses.
FINANCIAL CONDITION
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BALANCE SHEET TRENDS
At December 31, 1998, D&N's assets totaled $2.02 billion, an increase of $203
million, or 11%, from the previous year end. The Company's balance sheet growth
has been fueled by substantial loan production.
At year end 1998, net loans receivable were $1.33 billion, a modest increase
from December 31, 1997. The Company sold $227 million of residential mortgage
loans during 1998. Balances of mortgage-backed securities increased $136
million, or 38%, as a consequence of the securitization of $83 million of the
Bank's residential mortgage loan production and purchases of collateralized
mortgage obligations ("CMOS"). The balance of loans serviced for others
increased from $519 million to $576 million during 1998.
The Company's liabilities increased by 11%, or $185 million, to $1.87 billion at
December 31, 1998, compared to $1.69 billion at the end of 1997. Overall deposit
balances increased by 21%, or $221 million, while core deposits experienced a
36% increase from $375 million at December 31, 1997, to $508 million at year-end
1998. in September, 1998, the Company purchased approximately $72 million in
deposits. Excluding those balances, total and core deposits increased 14% and
24%, respectively, during 1998. Borrowed funds decreased by 6.7%, or $41
million, in 1998, while advance payments by borrowers and investors held in
escrow increased from $17.6 million to $25.4 million.
In 1998, D&N's common stockholders' equity rose from $98.1 million to $115.5
million. Profitable operations contributed $16.1 million to the Company's
retained earnings while the proceeds from the exercise of options and
accompanying tax benefits added $3.3 million to the equity accounts. Cash
dividends and purchases of treasury stock through an oddlot repurchase program
returned $2.2 million to shareholders in 1998. An additional source of equity in
1998 was $1.7 million of market-value in excess of book-value attributable to
investment and mortgage-backed securities held for sale. In accordance with the
provisions of the Statement of Financial Accounting Standards ("SFAS") 115,
"Accounting for Certain Investments in Debt and Equity Securities", unrealized
gains such as these are recorded in the stockholders' equity section of the
Company's Statement of Financial Condition, but are not recognized through the
Statement of Operations.
Under its federal charter, the Bank must maintain adequate levels of capital to
assure the safety and soundness of its operations. At December 31, 1998, the
Bank had a tangible capital ratio of 6.40%, a core capital ratio of 6.40%, and a
risk-based capital ratio of 10.94%. D&N Bank's ratios continue to exceed the
levels specified in the Financial Institutions Reform, Recovery and Enforcement
Act
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("FIRREA" or "the Act") as minimally acceptable standards. at the close of
1998, those minimum standards were tangible capital of 1.50%, core capital of
3.0% (with a proposed regulation which would raise the core capital requirement
to between 4.00% and 5.00%), and risk-based capital of 8.00%.
The Bank's primary regulator, the Office of Thrift Supervision ("OTS"), prompt
corrective action regulations establish five capital categories for thrift
institutions: well capitalized, adequately capitalized, undercapitalized,
severely undercapitalized and critically undercapitalized. These categories are
determined for the supervisory purposes of Section 38 of the Federal Deposit
Insurance Act (which establishes a system of mandatory and discretionary
supervisory actions which generally become more severe as capital levels
decline) and may not necessarily constitute an accurate measure of the Bank's
current overall financial condition or its future prospects. A thrift generally
will be considered "well capitalized" if it has a core capital (or leverage)
ratio of at least 5.0%, a Tier 1 risk-based capital ratio of at least 6.0% and a
total risk-based capital ratio of at least 10.0%. A thrift generally will be
considered "adequately capitalized" if it has a core capital (or leverage) ratio
of at least 4.0%, a Tier 1 risk-based capital ratio of at least 4.0%, and a
total risk-based capital ratio of at least 8.0%. The Bank's core (or leverage),
Tier 1 risk-based and total risk-based capital ratios at December 31, 1998 of
6.40%, 10.17% and 10.94%, respectively, exceeded the minimum capital ratios
established for "well capitalized" institutions.
The OTS issued rules adding an interest rate risk component to the total capital
that certain rate-sensitive institutions must maintain. The rule requires the
OTS to measure an institution's interest rate risk as the percentage change in
market value of its portfolio resulting from a hypothetical 200 basis point
shift in interest rates. At December 31, 1998, D&N's level of interest rate risk
was such that no additional capital was required.
LIQUIDITY AND CAPITAL RESOURCES
The OTS also requires that institutions maintain liquid assets in the form of
cash, U.S. Government securities, mortgage-backed securities and other
qualifying assets, in amounts equal to at least 4% of net withdrawable accounts
and borrowed funds payable in one year or less. For the month of December 1998,
the Bank's average liquidity ratio was 36.1%, up from the December 1997 ratio of
13.9%.
Borrowing capacity can be viewed as a supplemental source of liquidity for the
Bank. D&N's government bond and mortgage-backed securities portfolios include
high quality investment securities which are readily acceptable as collateral
for additional borrowed funds, obtainable from either the FHLB system or from
other financial institutions. Also, much of the Bank's residential mortgage loan
portfolio would be acceptable as collateral to support new advances from the
FHLB. In the aggregate, by virtue of its inventory of unpledged security and
mortgage loan collateral, D&N had approximately $344 million of unused borrowing
capacity at December 31, 1998.
LOAN PORTFOLIO
The following table categorizes the Bank's loans receivable for the past five
years.
DECEMBER 31
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1998 1997 1996 1995 1994
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(Dollars in thousands)
Residential mortgages.......................... $ 650,502 $ 703,580 $ 600,923 $597,892 $526,572
Mortgages on income-producing property......... 94,552 81,830 85,619 89,176 115,162
Construction loans............................. 55,322 56,446 39,673 41,056 19,900
Consumer loans................................. 504,069 449,551 339,268 239,459 170,939
Commercial loans............................... 51,319 38,435 12,345 7,769 4,748
Allowance for losses........................... (10,995) (10,549) (11,042) (10,081) (8,349)
Discounts, deferrals and other................. (15,621) (18,334) (10,910) (12,912) (7,097)
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$1,329,148 $1,300,959 $1,055,876 $952,359 $821,875
=============================================================
D&N's investment in loans increased by $28 million, or 2%, in 1998. Consumer and
commercial loans increased, while investment in residential mortgages declined
by 8%. The decline in the residential mortgage portfolio reflects the sale and
securitization of residential mortgages as one component of the Bank's strategy
to manage interest rate risk. Consumer loans increased by $55 million, or 12% in
1998. Commercial loans increased by $13 million. Mortgages on income-producing
properties increased by $13 million, or 16%, while construction loan balances
decreased by $1.1 million, or 2%. At the end of 1998, 52% of the Company's loan
balances were in consumer or business-related loans, compared to a 47%
weighting at the end of 1997. D&N originated $825 million of loans in 1998, up
$203 million, or 32.6% from $622 million originated in 1997. Consumer loan
production totaled $344 million in 1998, up by $20.4 million, or 6.3%, from
1997. Aggregate mortgage production in 1998 was $373 million, an increase of
$112 million, or 42.9%, from 1997. Construction lending accounted for $49.6
million, down slightly from $54.0 million in 1997. Supplementing the Company's
mortgage production was $192 million of purchased loans in 1998, down from $235
million in 1997.
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CREDIT RISK MANAGEMENT AND PROVISION FOR LOSSES ON LOANS AND OTHER ASSETS
At December 31, 1998, the Company's nonperforming assets totaled $9.2 million,
up from $5.3 million at the end of the previous year and $8.1 million at the end
of 1996. The 1998 balance was comprised of $7.9 million of nonperforming loans
and $1.4 million of other real estate owned ("OREO"). At the end of 1998,
nonperforming loans comprised 0.59% of the loan portfolio, and the allowance
for loan losses stood at 140% of the total balances of nonperforming loans.
The following table traces the Company's nonperforming asset experience for the
last five years.
DECEMBER 31
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1998 1997 1996 1995 1994
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(Dollars in thousands)
Nonaccruing loans....................................... $ 7,867 $ 3,162 $ 6,429 $ 8,133 $17,949
Accruing loans delinquent more than 90 days............. -- 274 -- 24 5
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Total nonperforming loans.......................... 7,867 3,436 6,429 8,157 17,954
Other real estate owned (OREO) and other repossessed
assets................................................... 1,372 1,864 1,662 1,544 6,566
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Total nonperforming assets......................... $ 9,239 $ 5,300 $ 8,091 $ 9,701 $24,520
======================================================
Nonperforming loans as a percentage of total loans...... 0.59% 0.26% 0.60% 0.85% 2.16%
Nonperforming assets as a percentage of total assets.... 0.46% 0.29% 0.55% 0.79% 2.17%
Allowance for loan losses as a percentage of
nonperforming loans..................................... 139.76% 307.01% 171.75% 123.59% 46.50%
Allowances for loan and OREO losses as a percentage of
nonperforming assets.................................... 119.01% 199.04% 136.47% 105.29% 35.40%
Provision and Allowance for Loan Losses
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The allowance for loan losses represents the Company's estimate of probable
credit losses related to specifically identified loans as well as probable
credit losses inherent in the remainder of the Company's loan portfolio that
have been incurred as of the balance sheet date. The allowance for loan losses
is maintained at an adequate level through additions to the provision for loan
losses. An appropriate level of the general allowance is determined based on
the application of projected risk percentages to graded loans by categories. In
addition, specific reserves are established for individual loans when deemed
necessary by management. Management also considers other factors when
determining the unallocated allowance, including loan quality, changes in the
size and character of the loan portfolio, consultation with regulatory
authorities, amount of nonperforming loans, delinquency trends , economic
conditions and industry trends.
SFAS No. 114, Accounting By Creditors for Impairment of a Loan, as amended by
SFAS No. 118, considers a loan impaired when it is probable that payment of
principal and interest will not be collected in accordance with the contractual
terms of the original loan agreement. Consistent with this definition, all non-
accrual and restructured loans (with the exception of residential mortgage and
consumer installment loans) are impaired. An impaired loan for which it is
deemed necessary to record a specific allowance is, typically, written down to
the fair value of the underlying collateral at the time it is placed on non-
accrual status via a direct charge-off against the allowance for loan losses.
Consequently, those impaired loans not requiring a specific allowance represent
loans for which the fair value of the underlying collateral equaled or exceeded
the recorded investment in the loan. All impaired loans were evaluated using
the fair value of the underlying collateral as the measurement method.
It must be understood, however, that inherent risks and uncertainties related to
the operation of a financial institution require management to depend on
estimates, appraisals and evaluations of loans to prepare the Company's
financial statements. Changes in economic conditions and the financial
prospects of borrowers may result in abrupt changes to the estimates, appraisals
or evaluations used. In addition, if actual circumstances and losses differ
substantially from management's assumptions and estimates, the allowance for
loan losses may not be sufficient to absorb all future losses, and net income
could be significantly impacted.
Gross loan charge-offs increased $218,000 to $2.4 million in 1998, compared to
$2.2 million in 1997 and $1.5 million in 1996. The ratio of net loan charge-
offs to average loans, including loans held for sale, was 0.15% for 1998 and
1997, compared to 0.01% for 1996. Commercial loan net charge-offs as a
percentage of average commercial loans was 0.03% for 1998, compared to 0% for
1997 and 1996. Residential real estate mortgage loan net charge-offs as a
percentage of average residential mortgage loans, including loans held for sale,
was 0.03% for 1998, 0.04% for 1997 and 0.05% for 1996. Mortgages on income
producing property net charge-offs as a percentage of average mortgages on
income producing property was 0.03% for 1998, compared to 0.24% for 1997 and,
due to recoveries on properties
5
previously written down, was (1.00)% for 1996. Consumer loan net charge-offs as
a percentage of average consumer loans was 0.37% for 1998 and 1997 compared to
0.33% for 1996.
Allowances for losses on the loan portfolio totaled $11.0 million at December
31, 1998. Losses of $2.4 million were charged off and $347,000 was recovered, as
new provisions for loan losses of $2.5 million were recorded during the year. At
year-end, the allowance for loan losses represented .82% of the total
outstanding loan portfolio balance.
The following table details the changes in the Company's allowance for loan
losses for the last five years.
Year Ended December 31
-------------------------------------------------
1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------
(Dollars in thousands)
Balance at beginning of period......................... $10,549 $11,042 $10,081 $ 8,349 $11,570
Charge-offs:
Residential mortgages................................ 226 290 314 169 110
Mortgages on income-producing property............... 38 277 -- 1,019 3,109
Commercial loans..................................... 14 -- -- -- --
Consumer loans....................................... 2,123 1,616 1,216 999 773
-------------------------------------------------
2,401 2,183 1,530 2,187 3,992
Recoveries:
Residential mortgages................................ -- -- 3 917 9
Mortgages on income-producing property............... -- -- 1,098 245 300
Commercial loans..................................... -- -- -- -- --
Consumer loans....................................... 347 340 290 357 362
-------------------------------------------------
347 340 1,391 1,519 671
Net Charge-offs........................................ 2,054 1,843 139 668 3,321
Provision charged to operations........................ 2,500 1,350 1,100 2,400 100
-------------------------------------------------
Balance at end of period............................... $10,995 $10,549 $11,042 $10,081 $ 8,349
=================================================
Net charge-offs as a percentage of average loans....... 0.15% 0.15% 0.01% 0.07% 0.43%
Allowance for loan losses as a percentage of total
loans................................................. 0.82% 0.80% 1.03% 1.05% 1.01%
The Company's policy for charging off loans varies with respect to the category
of and specific circumstances surrounding each loan under consideration.
Installment loans are generally charged off when deemed to be uncollectible or
180 days past due, whichever comes first. Charge-offs of commercial loans and
residential real estate mortgage loans are made on the basis of management's
ongoing evaluation of non-performing loans.
The following table summarizes the allocation of the allowance for loan losses
for general, specific and unallocated allowances by loan type and the percentage
of each loan type of total portfolio loans. The entire allowance, however, is
available for use against any type of loan loss deemed necessary.
December 31
----------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
----------------------------------------------------------------------------------------------
% of % of % of % of % of
Amount loans Amount loans Amount loans Amount loans Amount loans
to total to total to total to total to total
----------------------------------------------------------------------------------------------
(Dollars in thousands)
- ---------------------------------------------------------------------------------------------------------------------------------
General allowances:
Residential mortgages.............. $ -- 49% $ -- 54% $ 11 57% $ 642 63% $ 634 63%
Mortgages on income-producing 2,680
property........................... -- 10 767 9 1,275 10 11 4,332 17
Commercial loans................... -- 4 -- 3 -- 1 -- 1 -- --
Consumer loans..................... 4,065 37 3,303 34 2,681 32 1,616 25 810 20
----------------------------------------------------------------------------------------------
Total general allowances........... 4,065 100% 4,070 100% 3,967 100% 4,938 100% 5,776 100%
6
December 31
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1998 1997 1996 1995 1994
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% of % of % of % of % of
Amount loans Amount loans Amount loans Amount loans Amount loans
to total to total to total to total to total
--------------------------------------------------------------------------------------------------
(Dollars in thousands)
- ------------------------------------------------------------------------------------------------------------------------------------
Specific allowances:
Residential mortgages.............. -- -- -- -- -- -- -- -- -- --
Mortgages on income-producing
property........................... 1,145 -- 145 -- 385 -- -- -- 860 --
Commercial loans................... -- -- -- -- -- -- -- -- -- --
Consumer loans..................... -- -- -- -- -- -- -- -- -- --
--------------------------------------------------------------------------------------------------
Total specific allowances......... 1,145 145 385 -- 860
Unallocated allowances............. 5,785 6,334 6,690 5,143 1,713
--------------------------------------------------------------------------------------------------
Total allowance for loans....... $10,995 100% $10,549 100% $11,042 100% $10,081 100% $8,349 100%
==================================================================================================
The following table summarizes the graded loan categories used in the allocation
of the allowance for loan losses among the Company's loans in each of the past
three years.
DECEMBER 31
----------------------------------------------------
1998 1997 1996
- ---------------------------------------------------------------------------------------------------
(Dollars in thousands)
Graded loan categories:........................
Pass (Superior, High and Satisfactory)......... $1,322,513 $1,292,006 $1,042,541
Special mention................................ 4,579 10,812 13,303
Substandard.................................... 11,906 8,545 10,652
Doubtful....................................... -- -- 37
Loss........................................... 1,145 145 385
----------------------------------------------------
Total loans.................................. $1,340,143 $1,311,508 $1,066,918
====================================================
Each element of the general allowance for December 31, 1998 was determined as
adequate by applying the following risk percentages to each grade: Pass -
residential: 0%, commercial: 0%, consumer: 0.80%; Special mention - residential:
0%, commercial: 0%, consumer 0.83%; Substandard - residential: 0%, commercial:
0%, consumer: 1.66%; Doubtful - 50%; and loss - 100%. The risk percentages are
developed by the Company in consultation with regulatory authorities, actual
loss experience and peer group loss experience, and are adjusted for current
economic conditions. The risk percentages are considered a prudent measurement
of the risk of the Company's loan portfolio.
The Company periodically reviews each commercial loan and assigns a grade based
on loan type, collateral value, financial condition of the borrower and payment
history. Delinquent residential mortgage and installment loans are reviewed and
assigned a rating based on their payment history, financial condition of the
borrower and collateral values. Specific mortgage and installment loans are
also reviewed in conjunction with the previously described review of any related
commercial loan.
Based upon these reviews, the Company determines the grades for its loan
portfolio on a quarterly basis and reviews the adequacy of the allowance for
loan losses. Management believes this periodic review provides a mechanism that
results in loans being graded in the proper category and accordingly, assigned
the proper risk loss percentage in computing the general and specific reserve.
The provision for loan losses increased to $2.5 million during 1998 from $1.4
million in 1997. Additional provision was necessary as a result of the growth
of $79 million, or 13%, in consumer and business-related loans. In recognition
of this dynamic, the Company increased its loan loss provision for the higher
potential of losses typically associated with these types of loans. In 1997,
the provision for loan losses increased to $1.4 million from $1.1 million, with
the increased volume of consumer and commercial loans being the relevant factor
for the change.
There have been no changes in the Company's adequacy reviews or estimation
methods since 1996.
7
ANALYSIS OF CASH FLOWS
The Company's balances of cash and cash equivalents decreased from $20.5 million
to $16.0 million in 1998. During the year, $188 million of cash was provided
from financing activities, primarily from expanded borrowings and increases in
customers' deposit balances. Investing activities utilized $320 million of
available cash and cash equivalents as loan purchases, mortgage-backed security
purchases, and purchases of investment securities exceeded repayments in these
categories. Operating activities provided $128 million of net cash in 1998.
ASSET/LIABILITY MANAGEMENT
The Company's objectives for the management of assets and liabilities include
achieving and maintaining adequate and stable levels of both net interest income
and market value for the Company's net assets. The level of net interest income
that can be attained is enhanced by assuming credit, liquidity and interest rate
risks and by striving to keep nonearning asset balances to a minimum. Net
interest income and market value of portfolio equity ("MVPE") stability is
enhanced across various interest rate scenarios by properly matching maturity
structures of assets and liabilities.
Interest Rate Risk Management
- -----------------------------
The Company's Asset/Liability Committee ("ALCO"), which meets monthly, is
responsible for reviewing the interest rate sensitivity position of the Company
and establishing policies to monitor and limit exposure to interest rate risk.
Senior management at the Bank is responsible for ensuring that the Bank's asset
and liability management procedures adhere to corporate policies.
During 1998, short-term and long-term interest rates decreased fairly
significantly. The three-month treasury bill decreased 88 basis points from
December 31, 1997 to December 31, 1998, while the 30-year treasury bond
decreased 83 basis points and the prime lending rate decreased 75 basis points
during 1998. As a result of these rate decreases, the demand for residential
loans increased significantly during 1998. Commercial lending was also
positively affected by the decrease in interest rates.
The Company employs various tools, including static gap analysis, interest rate
sensitivity analysis and simulation analysis, to assess the sensitivity of its
net interest income and MVPE to changes in interest rates.
Static Gap Analysis
- -------------------
D&N's cumulative gap analysis for December 31, 1998 is found in the table below.
MATURITY
--------------------------------------------------------------------------
0 to 3 4 to 12 1 to 5 Over 5
Months Months Years Years Total
- ------------------------------------------------------------------------------------------------------------------
(Dollars in thousands)
Assets:
Cash and due from banks/others..... $ 15,979 -- -- -- $ 15,979
Investment securities.............. 101,254 5 15 28,798 130,072
Mortgage-backed certificates....... 39,601 102,238 267,017 85,356 494,212
Net loans receivable............... 269,097 363,534 566,425 130,092 1,329,148
Other assets....................... 10,649 2,273 13,238 22,583 48,743
-----------------------------------------------------------------------
TOTAL ASSETS $436,580 $468,050 $846,695 $266,829 $2,018,154
=======================================================================
Liabilities:
Deposits........................... $233,468 $536,149 $310,581 $183,942 $1,264,140
FHLB advances and other borrowed
money.............................. 204,673 88,704 283,755 1,003 578,135
Escrow funds....................... -- -- -- 25,416 25,416
Other liabilities.................. -- -- -- 6,284 6,284
-----------------------------------------------------------------------
TOTAL LIABILITIES $438,141 $624,853 $594,336 $216,645 $1,873,975
=======================================================================
Preferred Stock of Subsidiary........... -- -- -- 28,719 28,719
Stockholders Equity:
Common stock....................... -- -- -- 93 93
Additional paid-in capital......... -- -- -- 78,375 78,375
Retained earnings and other........ -- -- -- 36,992 36,992
Treasury stock..................... -- -- -- -- --
-----------------------------------------------------------------------
TOTAL LIABILITIES AND EQUITY $438,141 $624,853 $594,336 $360,824 $2,018,154
=======================================================================
8
Maturity
--------------------------------------------------------------------------
0 to 3 4 to 12 1 to 5 Over 5
Months Months Years Years Total
- -------------------------------------------------------------------------------------------------------------------
(Dollars in thousands)
Reprice difference................. $(1,561) $(156,803) $252,359 $(93,995)
Cumulative gap..................... $(1,561) $(158,364) $ 93,995 --
Percent of total assets............ (0.08)% (7.85)% 4.66% --
For each maturity category in the table above, the difference between interest-
earning assets and interest-bearing liabilities reflects an imbalance between
repricing opportunities for the two sides of the balance sheet. The consequence
of a negative cumulative gap at the end of one year suggests that, if interest
rates were to fall, the Company's earnings stream would be enhanced as more
liability balances would reprice to lower rates than would asset balances.
Similarly, the negative cumulative gap suggests that if interest rates were to
rise, liability costs would increase more quickly than asset yields, placing
negative pressure on earnings.
With a cumulative one-year gap of (7.85)%, D&N's balance sheet is liability
sensitive. At year-end, however, 32.9% of the Bank's loan portfolio carried
variable or adjustable interest rates, and a growing proportion of the fixed-
rate loan portfolio was comprised of relatively shorter-term consumer
installment loans.
The balances presented in the table above reflect contractual repricings for
certificates of deposit. Certain demand deposit accounts and regular savings
accounts, however, have been classified as repricing beyond one year. While
these accounts are subject to immediate withdrawal, experience has shown them to
be relatively rate insensitive. If these accounts were included in the 0-3 month
category, the gap in that time frame would be negative $306 million and the
cumulative gap at twelve months would be negative $427 million.
Analysis of Interest Sensitive Assets and Liabilities
- -----------------------------------------------------
The following table shows the Company's financial instruments that are sensitive
to changes in interest rates, categorized by expected maturity, and the
instruments' fair values at December 31, 1998.
Maturity
--------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 Thereafter Fair Value
--------------------------------------------------------------------------------
(Dollars in thousands)
Interest sensitive assets:
Loans receivable:
Real estate mortgages.... $216,111 $149,553 $108,606 $ 83,773 $ 61,384 $181,335 $ 800,762
Average interest rate.... 7.91% 7.77% 7.65% 7.69% 7.52% 7.34% 7.66%
Non-real estate
commercial............... 30,593 10,158 5,161 3,357 913 637 50,819
Average interest rate.... 8.66% 8.78% 8.77% 9.03% 8.01% 7.68% 8.69%
Consumer................. 192,625 130,600 86,951 49,972 25,287 15,773 501,208
Average interest rate.... 8.94% 8.89% 8.81% 8.79% 8.55% 8.50% 8.84%
Mortgage-backed securities......... 137,263 106,311 72,781 50,206 34,797 90,655 492,013
Average interest rate.... 6.62% 6.52% 6.45% 6.41% 6.30% 6.28% 6.47%
Investment securities
and interest bearing
deposits................. 99,959 5 5 -- -- 29,895 129,864
Average interest rate.... 6.16% 4.80% 4.90% -- -- 7.81% 6.54%
Mortgage servicing assets 735 624 531 451 383 2,173 4,897
--------------------------------------------------------------------------------
Total interest sensitive assets $677,286 $397,251 $274,035 $187,759 $122,764 $320,468 $1,979,563
================================================================================
9
Maturity
--------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 Thereafter Fair Value
--------------------------------------------------------------------------------------------------
(Dollars in thousands)
Interest sensitive liabilities:
Deposits:
NOW accounts.............. $ 32,333 $ 17,477 $ 10,486 $ 5,243 $ 4,369 $ 17,479 $ 87,387
Average interest rate..... 1.66% 1.66% 1.66% 1.66% 1.66% 1.66% 1.66%
Savings deposits.......... 40,339 33,234 23,746 17,813 11,880 110,588 237,600
Average interest rate..... 2.91% 2.98% 3.03% 3.07% 3.15% 3.31% 3.14%
Money-market accounts..... 82,064 7,271 4,155 3,116 2,078 5,194 103,878
Average interest rate..... 3.27% 3.27% 3.27% 3.27% 3.27% 3.27% 3.27%
Certificates of deposit... 612,856 92,759 25,239 10,021 4,411 19,298 764,584
Average interst rate...... 5.52% 5.63% 5.68% 6.06% 5.47% 5.83% 5.55%
Borrowings:
Securities sold under
agreements to repurchase.. 18,153 -- -- -- -- -- 18,153
Average interest rate...... 5.50% -- -- -- -- -- 5.50%
FHLB Advances and
Other borrowed money...... 205,815 147,235 208,370 464 399 3,374 565,657
Average interest rate..... 5.93% 5.80% 5.65% 9.95% 9.95% 8.32% 5.81%
------------------------------------------------------------------------------------------------
Total interest sensitive
liabilities.................... $991,560 $297,976 $271,996 $ 36,657 $ 23,137 $155,933 $1,777,259
================================================================================================
Expected maturities are contractual maturities adjusted for prepayments of
principal. The Company uses certain assumptions to estimate fair values and
expected maturities. For assets, expected maturities are based upon contractual
maturity, projected repayments and prepayments of principal. The prepayment
assumptions are based on the Company's own historical experience. The
assumptions used to present deposit balances are essentially the same as those
used in the gap analysis. The actual maturities of these instruments could vary
substantially if future prepayments differ from the Company's historical
experience.
Earnings Simulation
- -------------------
On a monthly basis, the earnings simulation model is used to quantify the
effects of various hypothetical changes in interest rates on the Company's
projected net interest income over the ensuing twelve-month period. The model
permits management to evaluate the effects of various parallel shifts of the
U.S. Treasury yield curve, upward and downward, on net interest income expected
in a stable interest rate environment (i.e. base net interest income).
As of December 31, 1998, the earnings simulation model projects net interest
income would decrease by 7.9% of base net interest income for 1999, assuming an
immediate parallel shift upward in market interest rates by 300 basis points.
If market interest rates fall by 300 basis points, the model projects net
interest income would decrease by 7.0%. These projected levels are well within
the Company's policy limits. The earnings simulation model assumes that current
balance sheet totals remain constant and all maturities and prepayments of
interest-earning assets and interest-bearing liabilities are reinvested at
current market rates.
Impact of Interest Rate Fluctuations and Inflation on Earnings
- --------------------------------------------------------------
Unlike most industrial companies, substantially all the assets and liabilities
of a financial institution are monetary in nature. As a result, interest rate
fluctuations generally have a more significant and direct impact on a financial
institution's performance than do the effects of inflation. To the extent
inflation affects interest rates, real estate values and other costs, the
Company's lending activities may be adversely impacted. Significant increases
in interest rates make it more difficult for potential borrowers to purchase
residential property and to qualify for mortgage loans. As a result, the
Company's volume of loans originated may be reduced and the potential reduction
in the related interest income may be much larger than would be implied by a
simple linear extrapolation of the results generated by the earnings simulation
model. Significant decreases in interest rates typically result in higher loan
prepayment activity, which reduces interest income and causes the Company's
mortgage servicing rights to decrease in value. However, a lower interest rate
environment
10
would enable more potential borrowers to reduce their mortgage interest rate and
qualify for relatively higher mortgage loan balances, therefore resulting in
higher mortgage loan production activity as well as interest income.
Significant Litigation
In 1989, the Financial Institutions Reform, Recovery and Enforcement Act
("FIRREA" or "the Act") was passed, significantly altering the regulatory
environment in which depository institutions in general, and the Company in
particular, would subsequently operate. A provision of the act provided for the
elimination, over time, of one form of regulatory capital that many
institutions, including D&N Bank, had utilized in their capital structures. The
phased elimination of supervisory goodwill, an intangible asset previously
created when companies such as D&N acquired weaker institutions, resulted in
many of the affected companies experiencing capital shortfalls. In D&N's case,
$42 million of unamortized supervisory goodwill was permitted to be counted as
regulatory capital in 1989 at the time of the act's passage, while $37 million
remained in 1993 when its phase-out as qualifying capital was complete. The loss
of this significant portion of D&N's regulatory capital base precipitated
drastic changes in the Company's strategic plans, including the 56% shrinkage of
the balance sheet from $2.3 billion in 1988 to $1.0 billion in 1993, the closure
of the Company's national network of mortgage origination offices, the
elimination of many jobs, and the cessation of stockholder dividends.
A number of institutions, including D&N Bank, that were adversely affected by
the FIRREA legislation subsequently initiated legal actions against the United
States Government. The institutions have claimed that the inducements offered by
federal regulatory agencies to acquire weakened or insolvent thrifts constituted
contractual agreements that the goodwill created through the acquisition
transactions would qualify as regulatory capital. FIRREA's mandated phase-out of
regulatory capital treatment for supervisory goodwill, then, has been alleged to
be a breach of a contract right. The United States Court of Federal Claims has
registered approximately 120 similar cases, including D&N's, which seek damages
for such breach.
Early cases were bifurcated into questions of liability and damages, with the
trial courts reasoning that, until the question of the government's liability
was unequivocally established, efforts to determine damages or to develop damage
theories were potentially irrelevant. Three early cases have proceeded through
the Court of Claims, and after consolidation, through the Federal Circuit of the
United States Court of Appeals, and the United States Supreme Court. In July of
1996, the Supreme Court found generally that the United States was liable for
damages under a theory of contractual breach, and that claims of governmental
immunity were not applicable in these cases. The cases were remanded to the
Court of Claims where arguments concerning the extent of damages began in 1997.
In consideration of the complexities of the pending litigation, the similarity
of issues in the various cases, and the potential magnitude of the damage
amounts that might ultimately be awarded, the Court of Claims has issued a case
management order on the remaining cases, in essence creating an orderly
procedure for these lawsuits, including D&N's suit, to proceed. Estimation of
potential liability or damages from this action is speculative at this time.
NEW ACCOUNTING PRONOUNCEMENTS
In October 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
134, "Accounting for Mortgage-Backed Securities Retained after the
Securitization of Mortgage Loans Held for Sale by a Mortgage Banking
Enterprise". When SFAS 134 is initially applied, an enterprise may reclassify
mortgage-backed securities and other beneficial interests retained after the
securitization of mortgage loans held for sale from the trading category, except
for those with sales commitments in place. Those securities and other interests
shall be classified based on the entity's ability and intent to hold those
investments. This standard will be adopted effective January 1, 1999 and is not
expected to have any material effect on the Company's financial statements.
YEAR 2000
D&N utilizes various electronic computer systems for the delivery of its
financial services products such as deposit accounts and loans, for the
maintenance of its financial and other business records, and for general
management purposes. Some of these systems include legacy procedures that may
have been designed and historic data that may have been stored in such a manner
that inconsistencies or failures might occur when dates from the new millennium
are considered. Commonly known as the Year 2000 problem, a myriad of related
potential computing difficulties face entities that rely extensively upon
computer systems. D&N's major computer systems include deposit accounts,
commercial lending, consumer lending, financial control, and sales platform
support applications provided by M&I Data Services, Inc.; mortgage lending
applications provided by ALLTEL Information Services, Inc. and FiTech, Inc.; and
internally maintained micro-computer and network systems which support
management functions and communications.
D&N's Year 2000 project is progressing on schedule. The project is addressing
computer hardware, software, procedures, large borrowers and facilities. This
project began in October 1996 and is scheduled for completion by June 1999.
To date all at-risk computer hardware has been tested and confirmed Year 2000
compliant.
11
The four primary business applications (deposit account processing, installment
loan account processing, general ledger and mortgage loan processing) have been
certified Year 2000 compliant. The remaining application systems are being
tested and contingency plans have been developed to mitigate business
operational risk.
D&N's internally maintained systems, consisting primarily of a Lotus Notes
server array and various workstation-based business suite software, are Year
2000 compliant as currently installed.
All newly acquired software is being tested for Year 2000 compliance before
acceptance. Software testing has been done to verify date changes from 1999 to
2000, the identification and correct processing of leap years, along with
numerous date projections from 1999 through the next millennium using day, month
and year increments.
Manual procedures have been reviewed and scheduled for change where date
specific actions occur. Necessary changes to supporting forms to properly
record dates in the new millennium have been identified and are being made.
Large commercial borrowers have been reviewed for their Year 2000 readiness and,
where necessary, their progress is being monitored for corrective action, their
business continuation and ability to repay their loans. New loan customers are
also being assessed for Year 2000 risk.
The building facilities owned and leased by the Bank have been reviewed for Year
2000 associated issues such as device controllers used for HVAC, elevators,
alarms and vaults. Where necessary, corrective actions have been taken.
Costs associated with addressing the Year 2000 issue as it affects D&N's third
party applications is implicitly included in the contractual arrangements for
those applications. D&N's total Year 2000 estimated project cost, which is
based upon currently available information, includes expenses for the review and
testing of third parties including governmental applications. However, there
can be no guarantee that the hardware, software and systems of such third
parties will be without unfavorable Year 2000 issues and therefore not present a
material adverse impact upon the Bank.
Year 2000 compliance costs incurred during fiscal 1998 totaled approximately
$26,000. This figure does not include the implicit costs associated with the
reallocation of internal staff hours to Year 2000 project related efforts. At
this time, management currently estimates Year 2000 compliance costs will not
exceed $100,000. This estimate does not include normal ongoing costs for
computer hardware, software, terminals and related devices that would be
replaced with the Company's ongoing programs for updating its delivery
infrastructure without the presence of the Year 2000 issue. The aforementioned
Year 2000 project cost estimate may change as the Bank progresses in its Year
2000 programs and obtains additional information associated with, and conducts
further testing concerning third parties. At this time no significant projects
have been delayed as a result of D&N's Year 2000 effort.
Management of the Company believes it has an effective program in place to
resolve the Year 2000 issue in a timely manner. As noted above, the Company has
not yet completed all necessary phases of the Year 2000 program. In the event
that the Company does not complete any additional phases, under the most
reasonably likely worst case scenario, the Company would be required to process
certain transactions manually, which may effect customer service. In
addition, disruptions in the economy generally resulting from Year 2000 issues
could also materially adversely affect the Company. The Company could be
subject to litigation for equipment shutdown or failure to properly date
customer records. The amount of potential liability and lost revenue cannot be
reasonably estimated at this time.
OTHER ITEMS
On December 1, 1998, the Company announced that it had entered into a definitive
agreement to merge with Republic Bancorp Inc. (Nasdaq:RBNC), whereby Republic
Bancorp will be the surviving corporation. The combined company will create the
fourth largest bank holding company with headquarters in Michigan with over $4
billion in assets. The merger is subject to shareholder and regulatory
approvals, and is expected to be completed in the second quarter 1999.
The operations of D&N Financial Corporation, and the financial services industry
generally, are influenced by many factors, including the interest rate
environment, competition, legislative and regulatory developments and general
economic conditions.
Except for the historical information contained in this report, certain
statements made herein are forward-looking statements that involve risks and
uncertainties and are subject to various factors that could cause actual results
to differ materially from these statements. Factors that might cause such a
difference include, but are not limited to: regional and national economic
conditions, substantial changes in levels of market interest rates, credit and
other risks of lending and investment activities and competitive and regulatory
factors.
12
SELECTED FINANCIAL HIGHLIGHTS
D&N FINANCIAL CORPORATION
1998 1997 1996 1995 1994
- -----------------------------------------------------------------------------------------------------------------------------------
(Dollars in thousands, except per share data)
FOR THE YEAR:
Net interest income $ 52,689 $ 48,939 $ 42,763 $ 34,750 $ 23,786
Provision for loan losses 2,500 1,350 1,100 2,400 100
Noninterest income 13,820 8,920 7,224 6,912 7,488
Net income 16,062 14,325 8,995 10,417 3,383
Earnings per share
Basic 1.75 1.58 1.08 1.27 0.41
Diluted 1.69 1.53 1.01 1.24 0.41
Shares outstanding:
Basic 9,157,923 9,093,682 8,336,517 8,172,292 8,161,600
Diluted 9,507,130 9,364,874 8,906,109 8,403,028 8,185,146
Stock price range 15 1/4 - 29 3/4 14 57/64 - 26 3/4 10 29/32 - 16 9/64 6 19/32 - 12 17/64 6 1/64 - 9 3/32
Cash dividends declared,
per common share $ 0.20 $ 0.10 -- -- --
AT YEAR END:
Total assets 2,018,154 1,815,315 1,473,054 1,228,497 1,128,732
Net loans receivable 1,329,148 1,300,959 1,055,876 952,359 821,875
Nonperforming assets 9,238 5,300 8,091 9,701 24,520
Mortgage-backed securities 494,212 358,296 251,256 127,709 151,293
Excess of cost over net assets of
association acquired -- -- -- -- 384
Capitalized mortgage servicing rights 4,822 2,136 1,443 1,113 968
Deposits 1,264,140 1, 043,167 964,133 922,932 817,674
Borrowings 578,135 619,523 404,037 216,295 226,956
Stockholders' equity 115,460 98,082 86,121 71,979 58,325
Per share 12.39 10.78 9.38 8.75 7.15
Tangible stockholders' equity 107,771 97,184 85,110 70,855 58,264
Per share 11.57 10.68 9.27 8.62 7.14
Number of offices 53 48 48 46 41
SELECTED RATIOS:
Return on average assets 0.85% 0.88% 0.67% 0.89% 0.31%
Return on average equity 15.11 15.75 11.58 16.01 5.97
Average equity to average assets 5.61 5.59 5.77 5.53 5.26
Net interest margin 2.87 3.08 3.26 3.04 2.31
General & administrative expenses to
average assets 1.92 2.01 2.34 2.44 2.48
Nonperforming assets to total assets 0.46 0.29 0.55 0.79 2.17
Allowance for loan losses to
nonperforming loans 139.78 275.72 166.77 122.21 46.38
Allowance for loan losses to total
loans 0.82 0.80 1.03 1.05 1.01
Net loan charge-offs to average loans 0.15 0.15 0.01 0.07 0.43
Tangible capital ratio 6.40 6.55 5.11 5.41 5.05
Core capital ratio 6.40 6.55 5.11 5.41 5.09
Risk-based capital ratio 10.94 11.98 9.94 10.45 10.08
All per share amounts have been restated to include the effects of a 10% stock
dividend and adoption of SFAS 128, in 1997.
13
[PRICEWATERHOUSECOOPERS LETTERHEAD]
Report of Independent Auditors
To the Board of Directors and Stockholders of
D&N Financial Corporation:
In our opinion, the accompanying Consolidated Statements of Condition and the
related Consolidated Statements of Operations, Stockholders' Equity and of Cash
Flows present fairly, in all material respects, the financial position of D&N
Financial Corporation and its Subsidiary at December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
January 21, 1999
14
CONSOLIDATED STATEMENTS OF CONDITION
D&N FINANCIAL CORPORATION
December 31
-------------------------
1998 1997
----------- ------------
(Dollars in thousands)
ASSETS
Cash and due from banks $ 15,945 $ 16,239
Federal funds sold -- 300
Interest-bearing deposits in other banks 34 3,958
---------- ----------
Total cash and cash equivalents 15,979 20,497
Investment securities
(market value of $28,678,000 in 1998 and $56,594,000 in 1997) 28,678 56,524
Investment securities available for sale (at market value) 101,394 46,112
Mortgage-backed securities
(market value of $42,025,000 in 1998 and $199,525,000 in 1997) 41,446 198,050
Mortgage-backed securities available for sale (at market value) 452,766 160,246
Loans receivable (including loans held for sale of $8,801,000 in 1998
and $5,275,000 in 1997) 1,340,143 1,311,508
Allowance for loan losses (10,995) (10,549)
---------- ----------
Net loans receivable 1,329,148 1,300,959
Other real estate owned, net 857 1,474
Federal income taxes 2,721 1,129
Office properties and equipment, net 19,005 16,621
Other assets 26,160 13,703
---------- ----------
$2,018,154 $1,815,315
========== ==========
LIABILITIES
Checking and NOW accounts $ 166,802 $ 119,412
Money market accounts 103,878 92,314
Savings deposits 237,600 163,119
Time deposits 754,317 667,204
Accrued interest 1,543 1,118
---------- ----------
Total deposits 1,264,140 1,043,167
Securities sold under agreements to repurchase 18,153 149,092
FHLB advances and other borrowed money 559,982 470,431
Advance payments by borrowers and investors held in escrow 25,416 17,585
Other liabilities 6,284 8,239
---------- ----------
Total liabilities 1,873,975 1,688,514
PREFERRED STOCK OF SUBSIDIARY 28,719 28,719
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value per share (1,000,000 shares authorized;
none issued) -- --
Common stock, $.01 par value per share (shares authorized - 25,000,000;
shares outstanding - 9,318,089 in 1998 and 9,197,224 in 1997) 93 92
Additional paid-in capital 78,375 77,025
---------- ----------
Total paid-in capital 78,468 77,117
Retained earnings - substantially restricted 35,265 21,042
Less: Cost of treasury stock (none in 1998 and 98,129 in 1997) -- (1,581)
Accumulated other comprehensive income 1,727 1,504
---------- ----------
Total stockholders' equity 115,460 98,082
---------- ----------
$2,018,154 $1,815,315
========== ==========
See Notes to Consolidated Financial Statements.
15
CONSOLIDATED STATEMENTS OF INCOME
D&N Financial Corporation
Year Ended December 31
1998 1997 1996
-------------------------------------------------
(Dollars in thousands, except earnings per share)
INTEREST INCOME
Loans $ 105,777 $ 98,560 $ 86,151
Mortgage-backed securities 27,568 19,085 10,930
Investments and deposits 6,629 8,048 7,228
-------- -------- --------
Total interest income 139,974 125,693 104,309
INTEREST EXPENSE
Deposits 51,206 47,961 43,859
Securities sold under agreements to repurchase 4,521 5,571 2,193
FHLB advances and other borrowed money 31,558 23,222 15,494
-------- -------- --------
Total interest expense 87,285 76,754 61,546
-------- -------- --------
Net interest income 52,689 48,939 42,763
Provision for loan losses 2,500 1,350 1,100
-------- -------- --------
Net interest income after provision for loan
losses 50,189 47,589 41,663
NONINTEREST INCOME
Loan administrative fees 1,850 1,916 1,914
Deposit related fees 4,389 4,080 3,621
Gain on sale of loans held for sale 3,521 1,728 1,031
Gain on sale of securities available for sale 2,830 539 188
Other income 1,230 657 470
-------- -------- --------
Total noninterest income 13,820 8,920 7,224
NONINTEREST EXPENSE
Compensation and benefits 19,643 17,881 16,881
Occupancy 3,362 3,110 2,834
Other expense 13,357 11,655 11,863
-------- -------- --------
General and administrative expense 36,362 32,646 31,578
Other real estate owned, net 167 (81) 71
FDIC insurance 794 658 7,894
-------- -------- --------
Total noninterest expense 37,323 33,223 39,543
-------- -------- --------
Income before income tax expense 26,686 23,286 9,344
Federal income tax expense 7,901 7,743 349
-------- -------- --------
Income before preferred stock dividends 18,785 15,543 8,995
Preferred stock dividend of subsidiary 2,723 1,218 --
-------- -------- --------
NET INCOME $ 16,062 $ 14,325 $ 8,995
======== ======== ========
Earnings per share:
Basic $ 1.75 $ 1.58 $ 1.08
======== ======== ========
Diluted $ 1.69 $ 1.53 $ 1.01
======== ======== ========
See Notes to Consolidated Financial Statements.
16
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
D&N Financial Corporation
Treasury Accumulated
Additional Stock & Leveraged Other Total
Common Paid-in Retained Treasury ESOP Comprehensive Stockholders'
Stock Capital Earnings Warrants Debt Income Equity
---------- --------- ---------- --------- -------- -------------- --------------
(Dollars in thousands)
Balance December 31, 1995 $ 75 $ 49,936 $ 20,573 $ (257) $ (63) $ 1,715 $ 71,979
Comprehensive Income:
Net income -- -- 8,995 -- -- -- 8,995
Change in value of securities
available for sale -- -- -- -- -- (472) (472)
------
Total comprehensive income 8,523
Issuance of common stock
upon exercise of stock options
and warrants - 960,508 shares 9 9,046 -- -- -- -- 9,055
Purchase of treasury stock
and warrants -- -- -- (3,499) -- -- (3,499)
Reissuance of 256,251 treasury shares -- (3,530) -- 3,350 -- -- --
Reduction of leveraged ESOP debt -- -- -- -- 63 -- 63
---------- ------- --------- -------- ----- ------------- --------
Balance December 31, 1996 $ 84 $ 55,452 $ 29,568 $ (226) $ -- $ 1,243 $ 86,121
Comprehensive Income:
Net income -- -- 14,325 -- -- -- 14,325
Change in value of securities
available for sale -- -- -- -- -- 261 261
--------
Total comprehensive income 14,586
Cash dividends, common stock
($0.10 per share) -- -- (826) -- -- -- (826)
10% common stock dividend, at
fair market value 8 22,017 (22,025) -- -- -- --
Issuance of common stock upon
exercise of stock options -
98,681 shares -- 1,196 -- -- -- -- 1,196
Purchase of treasury stock -- -- -- (2,995) -- -- (2,995)
Reissuance of 96,681 treasury shares -- (1,640) -- 1,640 -- -- --
---------- ------- --------- -------- ----- ------------- --------
Balance December 31, 1997 $ 92 $ 77,025 $ 21,042 $ (1,581) $ -- $ 1,504 $ 98,082
Comprehensive Income:
Net income -- -- 16,062 -- -- -- 16,062
SFAS 133 transition adjustment -- -- -- -- -- 2,432 2,432
Change in value of securities
available for sale -- -- -- -- -- (2,209) (2,209)
--------
Total comprehensive income 16,285
Cash dividends, common stock
($0.20 per share) -- -- (1,839) -- -- -- (1,839)
Issuance of common stock upon
exercise of stock options -
235,224 shares 1 3,314 -- -- -- -- 3,315
Purchase of treasury stock -- -- -- (383) -- -- (383)
Reissuance of 114,359 treasury shares -- (1,964) -- 1,964 -- -- --
---------- ------- --------- -------- ----- ------------- ------------
Balance December 31, 1998 $ 93 $ 78,375 $ 35,265 $ -- $ -- $ 1,727 $115,460
========== ========= ========= ======== ===== ============= ============
See Notes to Consolidated Financial Statements.
17
CONSOLIDATED STATEMENTS OF CASH FLOWS
D&N FINANCIAL CORPORATION
Year Ended December 31
1998 1997 1996
---------- ---------- ----------
(Dollars in thousands)
OPERATING ACTIVITIES
Net income $ 16,062 $ 14,325 $ 8,995
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses 2,500 1,350 1,100
Depreciation and amortization of office properties and equipment 2,323 1,987 1,954
Amortization of net premiums (discounts) on purchased
loans and securities (520) (925) (73)
Originations and purchases of loans held for sale (106,167) (47,928) (56,132)
Proceeds from sales of loans held for sale 231,097 89,889 73,658
Gain on securities available for sale (2,830) (539) (188)
Gain on sale of loan servicing rights (207) -- --
Amortization and writedowns of mortgage servicing rights 1,866 543 300
Increase in originated mortgage servicing rights (4,554) (1,236) (543)
(Increase) decrease in income taxes deferred (1,367) 5,357 (662)
Increase in prepaid dealer reserves (2,635) (3,223) (1,918)
(Increase) decrease in core deposit intangible (6,791) 113 113
Other (1,026) (37) 635
--------- --------- ---------
Net cash provided by operating activities 127,751 59,676 27,239
INVESTING ACTIVITIES
Proceeds from sales of investment securities available for sale -- 20 298
Proceeds from maturities of investment securities 231,353 202,066 83,970
Purchases of investment securities to be held to maturity (259,044) (184,903) (107,012)
Proceeds from sales of mortgage-backed securities available for sale 112,168 24,094 --
Principal collected on mortgage-backed securities 175,549 64,150 54,951
Purchases of mortgage-backed securities (337,029) (107,400) (58,661)
Loans purchased (193,778) (234,886) (148,405)
Net change in loans receivable (45,029) (137,882) (94,006)
(Increase) decrease in other real estate owned 617 (4) (151)
Sales of loan servicing rights 207 -- --
Purchases of office properties and equipment (5,229) (3,279) (3,128)
--------- --------- ---------
Net cash used by investing activities (320,215) (378,024) (272,144)
FINANCING ACTIVITIES
Increase in time deposits 87,113 50,102 23,058
Increase in other deposits 133,435 28,748 18,666
Proceeds from notes payable, securities sold under agreements
to repurchase and other borrowed money 340,285 513,052 309,040
Payments on maturity of notes payable, securities sold under
agreements to repurchase and other borrowed money (381,811) (297,717) (121,482)
Net change in advance payments by borrowers and investors
held in escrow 7,831 5,777 479
Common stock cash dividend (1,839) (826) --
Net proceeds from issuance of stock 3,315 1,196 9,055
Purchases of treasury stock/warrants (383) (2,995) (3,499)
Proceeds from issuance of subsidiary preferred stock -- 28,719 --
Reduction of leveraged ESOP debt -- -- (63)
--------- --------- ---------
Net cash used by investing activities 187,946 326,056 235,254
Increase (Decrease) in cash and cash equivalents (4,518) 7,708 (9,651)
Cash and cash equivalents at beginning of year 20,497 12,789 22,440
--------- --------- ---------
Cash and cash equivalents at end of year $ 15,979 $ 20,497 $ 12,789
========= ========= =========
Supplemental disclosures of cash flow information:
Interest paid $ 87,487 $ 75,416 $ 61,689
Income taxes paid $ 8,740 $ 2,027 $ 299
Noncash investing activities:
Transfer of loans to other real estate owned $ 359 $ 961 $ 3,373
Securitization of loans into mortgage-backed securities $ 82,856 $ 86,066 $ 119,717
See Notes to Consolidated Financial Statements.
18
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
D&N FINANCIAL CORPORATION, DECEMBER 31, 1998
NOTE A: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
D&N Financial Corporation ("the Company") is a financial services holding
company whose sole subsidiary is D&N Bank ("the Bank"), a federally-chartered
stock savings bank. D&N Financial Corporation's primary business is the
delivery of financial services to consumers and businesses through its network
of 53 community banking and financial services offices in Michigan.
Principles of Consolidation: The consolidated financial statements include
the accounts and transactions of the Company and the Bank and the Bank's
wholly-owned subsidiaries. Significant intercompany accounts and transactions
have been eliminated in consolidation.
Use of Estimates in the Preparation of Financial Statements: The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates and assumptions.
Cash and Cash Equivalents: Cash and cash equivalents represent short-term
highly liquid investments with original maturities of three months or less and
include cash, demand deposits in other banks and interest-bearing deposits in
other banks.
Investment Classifications: Securities are classified as either held to
maturity (amortized cost), trading (fair value, with unrealized gains and losses
reported in income), or available for sale (fair value, with unrealized gains
and losses reported directly in equity, net of taxes).
Investment and Mortgage-Backed Securities: Investment and mortgage-backed
securities which the Company has the ability and the intent to hold until
maturity are stated at amortized cost. Investment and mortgage-backed
securities available for sale are carried at fair value. Fair value adjustments
are included in stockholders' equity, net of tax. Gains or losses realized on
the sale of investment and mortgage-backed securities are determined by the
specific identification method and are included in securities gains (losses).
Interest income is adjusted using the level-yield method for amortization of
premiums and accretion of discounts.
Allowance for Loan Losses: The allowance for loan losses represents the
Company's estimate of probable credit losses related to specifically identified
loans as well as probable credit losses inherent in the remainder of the
Company's loan portfolio that have been incurred as of the balance sheet date.
The allowance for loan loss is maintained at an adequate level through additions
to the provision for loan losses. An appropriate level of the general allowance
is determined based on the application of projected risk percentages to graded
loans by categories. In addition, specific reserves are established for
individual loans when deemed necessary by management. Management also considers
other factors when determining the unallocated allowance, including loan
quality, changes in the size and character of the loan portfolio, consultation
with regulatory authorities, amount of nonperforming loans, delinquency trends,
economic conditions and industry trends.
SFAS No. 114, Accounting By Creditors for Impairment of a Loan, as
amended by SFAS No. 118, considers a loan impaired when it is probable that
payment of principal and interest will not be collected in accordance with the
contractual terms of the original loan agreement. Consistent with this
definition, all non-accrual and restructured loans (with the exception of
residential mortgage and consumer installment loans) are impaired. An impaired
loan for which it is deemed necessary to record a specific allowance is,
typically, written down to the fair value of the underlying collateral at the
time it is placed on non-accrual status via a direct charge-off against the
allowance for loan losses. Consequently, those impaired loans not requiring a
specific allowance represent loans for which the fair value of the underlying
collateral equaled or exceeded the recorded investment in the loan. All impaired
loans were evaluated using the fair value of the underlying collateral as the
measurement method.
It must be understood, however, that inherent risks and uncertainties
related to the operation of a financial institution require management to depend
on estimates, appraisals and evaluations of loans to prepare the Company's
financial statements. Changes in economic conditions and the financial
prospects of borrowers may result in abrupt changes to the estimates, appraisals
or evaluations used. In addition, if actual circumstances and losses differ
substantially from management's assumptions and estimates, the allowance for
loan losses may not be sufficient to absorb all future losses, and net income
could be significantly impacted.
Each element of the general allowance for December 31, 1998 was determined
as adequate by applying the following risk percentages to each grade: Pass -
residential: 0%, commercial: 0%, consumer: 0.80%; Special mention - residential:
0%, commercial:
19
0%, consumer: 0.83%; Substandard - residential: 0%, commercial: 0%, consumer:
1.66%; Doubtful - 50%; and Loss - 100%. The risk percentages are developed by
the Company in consultation with regulatory authorities, actual loss experience
and peer group loss experience, and are adjusted for current economic
conditions. The risk percentages are considered a prudent measurement of the
risk of the Company's loan portfolio. The general allowances for December 31,
1997 and December 31, 1996 were determined as adequate based on this same rating
system, using different risk percentages.
The Company periodically reviews each commercial loan and assigns a grade
based on loan type, collateral value, financial condition of the borrower and
payment history. Delinquent residential mortgage and installment loans are
reviewed and assigned a rating based on their payment history, financial
condition of the borrower and collateral values. Specific mortgage and
installment loans are also reviewed in conjunction with the previously described
review of any related commercial loan.
Based upon these reviews, the Company determines the grades for its loan
portfolio on a quarterly basis and computes the allowance for loan losses.
Management believes this periodic review provides a mechanism that results in
loans being graded in the proper category and accordingly, assigned the proper
risk loss percentage in computing the general or specific reserve.
Mortgage Loans Held for Sale: The Bank enters into commitments to
originate and does originate mortgage loans for sale to investors and in the
secondary market.
Loans held for sale are carried at the lower of cost or market value,
determined on an aggregate basis. Commitment fees are amortized either over the
commitment period or the combined commitment and loan period depending upon the
probability of performance under the commitment.
Interest on Loans: Interest on loans is credited to income when earned.
An allowance for interest on loans is provided when management considers the
collection of these loans doubtful and the accrual of interest is usually
suspended when a loan becomes more than 90 days past due.
Loan Fees: Loan origination and commitment fees and certain direct loan
origination costs are deferred and recognized over the lives of the related
loans as an adjustment of the yields using the level-yield method.
Other Real Estate Owned: Real estate acquired through foreclosure and
similar proceedings is recorded at estimated fair value of the property, less
cost to dispose of, at the acquisition date. Operating expenses of such
properties, net of any income, are charged to expense.
Depreciation: Provisions for depreciation are computed using the straight-
line method over the estimated useful lives of office properties and equipment,
as follows: buildings - 40 years; leasehold improvements - life of lease;
furniture and fixtures - 15 years; and computers - 3 years.
Securities Sold Under Agreements to Repurchase: The Company enters into
sales of investment and mortgage-backed securities under agreements to
repurchase the same or essentially identical securities. The agreements are
short-term and are accounted for as secured borrowings. The obligations to
repurchase securities sold are reflected as a liability and the securities which
collateralize the agreements are reflected as an asset in the Consolidated
Statements of Condition.
Capitalized Mortgage Servicing Rights: The Company services mortgage loans
for investors. Fees earned for and in connection with this activity are
recognized as income when the related mortgage payments are received. Mortgage
servicing costs are charged to expense as incurred.
As the Company acquires mortgage servicing rights through either the
purchase or origination of mortgage loans and sells or securitizes those loans
with servicing rights retained, it must allocate the total cost of the mortgage
loans to the mortgage servicing rights and the loans (without the mortgage
servicing rights) based on their relative fair values. Capitalized mortgage
servicing rights are reported in Other Assets. The capitalized cost of mortgage
servicing rights is amortized in proportion to, and over the period of,
estimated net servicing income (servicing revenue in excess of servicing costs),
into noninterest income.
Capitalized mortgage servicing rights are periodically assessed for
impairment based on the fair value of those rights on a disaggregate basis,
stratified by mortgage type, term and rate. Identified impairments are
recognized through a valuation allowance.
20
Income Taxes: The Company uses the liability method in accounting for
income taxes. Under this method, deferred income taxes result from temporary
differences between the tax bases of assets and liabilities and the bases
reported in the consolidated financial statements. The deferred taxes are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.
Per Share Data: The Company adopted SFAS 128 "Earnings per Share", for the
year ended December 31, 1997. The earnings per share for the year 1996 has been
restated to comply with this standard.
Basic earnings per share is calculated by dividing net income by the
average number of shares outstanding during the applicable period.
The Company has issued stock options and warrants which are considered to
be potentially dilutive to common stock. Diluted earnings per share is
calculated by dividing net income by the average number of shares outstanding
during the applicable period adjusted for these potentially dilutive options and
warrants.
The following table sets forth the computation of per share earnings as
provided in SFAS 128, and illustrates the dilutive effect of options and
warrants outstanding:
Year Ending December 31
---------------------------------------------------------------
1998 1997 1996
---------------------------------------------------------------
Earnings Earnings Earnings
Shares per share Shares per share Shares per share
-------- ---------- -------- ----------- ------ ----------
(In thousands, except per share earnings)
Basic EPS: 9,158 $ 1.75 9,094 $ 1.58 8,337 $ 1.08
Net dilutive effect of:
Stock options outstanding 349 (0.06) 271 (0.05) 167 (0.02)
Warrants outstanding -- -- -- -- 402 (0.05)
----- ------ ----- ------ ----- ------
Diluted EPS: 9,507 $ 1.69 9,365 $ 1.53 8,906 $ 1.01
===== ====== ===== ====== ===== ======
Options to purchase 170,234 shares of common stock at $24.38 to $25.50 per
share were outstanding at December 31, 1998. Options to purchase 107,800
shares of common stock at $19.26 to $24.37 per share were outstanding at
December 31, 1997. These options were not included in the computation of
diluted earnings per share because the exercise prices were greater than the
average annual market price of the common stock in 1998 and 1997, respectively.
Reclassifications: Certain amounts in previously issued consolidated
financial statements have been reclassified to conform with the current year
presentation.
Comprehensive Income: The Bank adopted Statement of Financial Accounting
Standards ("SFAS") No. 130, Reporting Comprehensive Income, as of January 1,
1998. SFAS No. 130 established standards for reporting and display of
comprehensive income and its components. The Company displays comprehensive
income in the statement of stockholders' equity and has reclassified all prior
periods as required.
Segment Reporting: In 1998, the Company adopted SFAS 131, Disclosure about
Segments of an Enterprise and Related Information. SFAS 131 supersedes SFAS 14,
Financial Reporting for Segments of a Business Enterprise, replacing the
"industry segment" approach with the "management" approach which designates the
internal organization that is used by management for making operating decisions
and assessing performance as the source of the Company's reportable segments.
SFAS 131 also requires disclosure about products and services, geographic areas,
and major customers. The adoption of SFAS 131 did not affect results of
operations or financial position but did affect the disclosure of segment
information (see "Segment Information" Note W).
Accounting for Derivative Instruments and Hedging Activities: The Company
elected to adopt Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities, on July 1, 1998, which
constituted early adoption. In accordance with the transition provision of SFAS
133, the Company reclassified $163.4 million of "held-to-maturity" securities as
"available-for-sale". This reclassification resulted in a net-of-tax cumulative-
effect-type adjustment of approximately $2.4 million in other comprehensive
income. Under the provision of SFAS 133, such reclassification does not call
into question the Company's intent to hold current or future debt securities to
their maturity.
21
NOTE B: BUSINESS COMBINATION
On April 10, 1996, Macomb Federal Savings Bank ("Macomb") was merged into
the Company. The Company issued 716,497 shares of common stock and cash in lieu
of fractional shares for all of the outstanding shares of Macomb. At the time
of the merger, Macomb had assets and stockholders' equity (unaudited) of
$41,932,000 and $6,268,000, respectively. The merger was accounted for as a
pooling-of-interests and accordingly, the financial statements have been
restated to include the results of Macomb.
A reconciliation of previously reported net interest income and net income
is as follows:
Three Months Ended
March 31, 1996
-----------------------
(Dollars in thousands)
Net interest income (as previously reported) $9,465
Macomb Federal Savings Bank - net interest income 217
------
Total net interest income $9,682
======
Net income (as previously reported) $3,497
Macomb Federal Savings Bank - net income (9)
------
Total net income $3,488
======
A reconciliation of per share income is as follows:
Three Months Ended
March 31, 1996
----------------------
Basic earnings per share
Net income (as previously reported) $ 0.47
Macomb Federal Savings Bank (0.05)
------
Basic earnings per share $ 0.42
======
Diluted earnings per share
Net income (as previously reported) $ 0.44
Macomb Federal Savings Bank (0.04)
------
Diluted earnings per share $ 0.40
======
NOTE C: REAL ESTATE INVESTMENT TRUST
D&N Capital Corporation ("D&N Capital") is a Delaware corporation
incorporated on March 18, 1997 for the purpose of acquiring and holding real
estate assets and is a Real Estate Investment Trust ("REIT"). All shares of
common stock of D&N Capital are owned by D&N Bank.
On July 17, 1997, D&N Capital sold 1.21 million shares of its 9.0%
noncumulative preferred stock, Series A with a liquidation preference of $25.00
per share (totaling $30,250,000). As part of this transaction, D&N Capital
received $28,719,000 in net proceeds, after offering costs of $1,531,000. The
Series A Preferred Shares are generally not redeemable prior to July 21, 2002.
On or after July 21, 2002, the Series A Preferred Shares may be redeemed for
cash at the option of the Bank, in whole or in part, at a redemption price of
$25.00 per share.
The preferred shares are treated as Tier-1 Capital by the Bank, and are
traded on Nasdaq as DNFCP. During 1998 and 1997, D&N Capital declared and paid
preferred dividends totaling $2,722,500 and $1,217,563, respectively.
NOTE D: RESTRICTIONS ON CASH AND NONINTEREST-BEARING BALANCES
The Company is required to maintain reserve balances with the Federal
Reserve Bank. The average amounts of those reserve balances for the years ended
December 31, 1998 and December 31, 1997 were $1,235,000 and $452,000,
respectively.
22
NOTE E: INVESTMENT SECURITIES
Investment securities consisted of the following:
1998 1997
-----------------------------------------------
Book Market Book Market
Value Value Value Value
---------- ---------- ---------- -----------
(Dollars in thousands)
U.S. Treasury securities $ -- $ -- $ 33,299 $ 33,369
Investment in Federal Home Loan Bank stock 28,651 28,651 23,200 23,200
Other equity securities 27 27 25 25
-------- -------- -------- --------
Held to maturity 28,678 28,678 56,524 56,594
U.S. Treasury securities 10,237 10,246 44,764 44,860
Commercial paper 89,851 89,851 -- --
Municipal bonds 141 141 148 148
Other securities 1,141 1,156 1,088 1,104
Valuation allowances 24 -- 112 --
-------- -------- -------- --------
Available for sale 101,394 101,394 46,112 46,112
-------- -------- -------- --------
$130,072 $130,072 $102,636 $102,706
======== ======== ======== ========
An analysis of gross unrealized gains and losses is as follows:
1998 1997
-----------------------------------------------
Gross Gross Gross Gross
Unrealized Unrealized Unrealized Unrealized
Gains Losses Gains Losses
---------- ---------- ---------- ----------
(Dollars in thousands)
Held to maturity $ -- $ -- $ 70 $ --
-------- -------- -------- --------
U.S. Treasury securities -- -- 70 --
Available for sale 9 -- 97 (1)
U.S. Treasury securities 15 -- 16 --
-------- -------- -------- --------
Other securities 24 -- 113 (1)
-------- -------- -------- --------
$ 24 $ -- $ 183 $ (1)
======== ======== ======== ========
There were no sales of investment securities during 1998 or 1997. Proceeds
from sales of investment securities available for sale during 1996 were
$298,000. Gross gains of $188,000 were realized on those sales.
The book value, market value and average yield of U. S. Treasury securities
available for sale with contractual maturities under one year available for sale
at December 31, 1998 were $10,237,000, $10,246,000 and 6.03% respectively.
23
NOTE F: MORTGAGE-BACKED SECURITIES
Mortgage-backed securities consisted of the following:
December 31
--------------------------------------------
1998 1997
--------------------- ---------------------
Book Market Book Market
Value Value Value Value
---------- --------- ---------- ---------
(Dollars in thousands)
Government agency securities $ 5,528 $ 5,694 $112,156 $113,253
Collateralized mortgage obligations 35,824 35,992 84,788 84,987
Accrued interest receivable 339 339 1,285 1,285
Net discounts (245) -- (179) --
-------- -------- -------- --------
Held to maturity 41,446 42,025 198,050 199,525
December 31
-------------------------------------------
1998 1997
--------------------- ---------------------
Book Market Book Market
Value Value Value Value
---------- --------- ---------- ---------
(Dollars in thousands)
Government agency securities 95,590 96,652 86,658 88,145
Collateralized mortgage obligations 350,213 353,055 69,104 69,715
Interest-only certificates 153 620 378 1,422
Accrued interest receivable 2,439 2,439 964 964
Net premiums 1,738 -- 940 --
Valuation allowances 2,633 -- 2,202 --
-------- -------- -------- --------
Available for sale 452,766 452,766 160,246 160,246
-------- -------- -------- --------
$494,212 $494,791 $358,296 $359,771
======== ======== ======== ========
Mortgage-backed securities with a carrying value of $109,125,000 are
specifically pledged as collateral for advances from the Federal Home Loan Bank
of Indianapolis and other borrowings.
An analysis of gross unrealized gains and losses is as follows:
December 31
------------------------------------------------
1998 1997
---------- ----------
Gross Gross Gross Gross
Unrealized Unrealized Unrealized Unrealized
Gains Losses Gains Losses
---------- ----------- ---------- -----------
(Dollars in thousands)
Government agency securities $ 167 $ -- $1,238 $(368)
Collateralized mortgage obligations 422 (8) 675 (70)
------ ----- ------ -----
Held to maturity 589 (8) 1,913 (438)
Government agency securities 1,027 -- 743 (1)
Collateralized mortgage obligations 1,342 (203) 424 (8)
Interest only certificates 467 -- 1,044 --
------ ----- ------
Available for sale 2,836 (203) 2,211 (9)
------ ----- ------ -----
$3,425 $(211) $4,124 $(447)
====== ===== ====== =====
Proceeds from sales of mortgage-backed securities available for sale
during 1998 were $112,557,000. Gross gains of $2,830,000 were realized on
those sales. Proceeds from sales of mortgage-backed securities available for
sale during 1997 were $30,154,000. Gross gains of $543,000 and gross losses of
$4,000 were realized on those sales. There were no sales of mortgage-backed
securities during 1996.
24
The book value and market value of mortgage-backed securities at December 31,
1998, by contractual maturity, were as follows:
Held to Maturity Available for Sale
------------------ -----------------------------
Book Market Average Book Market Average
Value Value Yield Value Value Yield
-------- -------- -------- -------- -------- ---------
(Dollars in thousands)
Government agency securities
Less than one year $ -- $ -- --% $ -- $ -- --%
One to five years 835 843 6.76 -- -- --
Five to ten years 679 695 7.55 -- -- --
After ten years 4,014 4,156 7.54 95,625 96,652 6.40
------- ------- ----- -------- -------- --------
5,528 5,694 7.42 95,625 96,652 6.40
Collateralized mortgage obligations
Less than one year -- -- -- -- -- --
One to five years -- -- -- -- -- --
Five to ten years 3,996 4,039 6.82 -- -- --
After ten years 31,583 31,953 7.00 351,916 353,055 6.33
------- ------- ----- -------- -------- --------
35,579 35,992 6.98 351,916 353,055 6.33
Interest-only certificates
Less than one year -- -- -- -- -- --
One to five years -- -- -- -- -- --
Five to ten years -- -- -- 2 10 1411.67
After ten years -- -- -- 151 610 143.30
------- ------- ----- -------- -------- --------
-- -- -- 153 620 168.18
------- ------- ----- -------- -------- --------
$41,107 $41,686 7.04% $447,694 $450,327 6.40%
======= ======= ===== ======== ======== ========
Mortgage-backed securities will mature according to the repayment
characteristics of the underlying mortgage loans which collateralize the
securities. Expected maturities for mortgage-backed securities will differ from
contractual maturities because borrowers have the right to prepay.
The aggregate book value and aggregate market value of the securities of
any one issuer, other than U.S. Government agencies, did not exceed 10% of
stockholders' equity at December 31, 1998 or 1997.
NOTE G: LOANS RECEIVABLE
The carrying amounts and fair values of loans receivable consisted of the
following:
December 31
------------------------------------------------
1998 1997
---------- ----------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ---------- ----------- ----------
(Dollars in thousands)
Residential mortgages $ 638,725 $ 643,103 $ 694,902 $ 706,459
Residential mortgages held for sale 8,801 8,804 5,275 5,275
Mortgages on income producing property 94,009 93,869 81,304 79,007
Construction loans 55,122 54,986 56,176 55,901
Consumer loans 501,062 501,208 446,710 449,276
Commercial loans 51,022 50,819 38,164 37,706
Accrued interest receivable 7,023 7,023 7,311 7,311
---------- ---------- ---------- ----------
1,355,764 1,359,812 1,329,842 1,340,935
Less:
Discounts on purchased loans (2,312) -- (2,356) --
Allowance for loan losses 10,995 -- 10,549 --
Undisbursed portion of loan proceeds 17,679 -- 20,315 --
Deferred income 254 -- 375 --
---------- ---------- ---------- ----------
$1,329,148 $1,359,812 $1,300,959 $1,340,935
========== ========== ========== ==========
25
Credit is extended based on evaluation of the borrower's financial
condition, the value of the collateral and, in the case of income producing
property, the sufficiency of net cash flows from the property's operation to
service the debt. When loans are made to businesses, personal guarantees may
also be required of owners or partners.
Loans collateralized by income producing property are categorized as
follows:
December 31
-------------------------------
1998 1997
------------------------------
(Dollars in thousands)
Shopping centers $24,020 $22,185
Offices 18,355 6,905
Multi-family apartments 12,238 19,913
Motels/hotels 11,270 11,491
Nursing Homes 9,498 5,291
Condominium Development 6,945 4,240
Industrial 6,830 4,774
Mobile home parks 4,262 2,118
Other 591 4,387
----------------------------
$94,009 $81,304
============================
Loans collateralized by income producing property categorized by state are
as follows:
December 31
------------------------
1998 1997
-------------------------
(Dollars in thousands)
Michigan $85,017 $65,697
California 6,261 11,008
New York -- 805
Pennsylvania 241 405
Other 2,490 3,389
-------------------------
$94,009 $81,304
=========================
Changes in the allowance for loan losses are summarized as follows:
1998 1997 1996
-----------------------------
(Dollars in thousands)
Balance at beginning of year $10,549 $11,042 $10,081
Provisions for loan losses 2,500 1,350 1,100
Net charge-offs (2,054) (1,843) (139)
-----------------------------
Balance at end of year $10,995 $10,549 $11,042
=============================
At December 31, 1998 and 1997, the total recorded investment in impaired
loans, as defined by SFAS 114 "Accounting by Creditors for Impairment of a
Loan", was $9,667,000 and $4,779,000, respectively. In 1998 and 1997 the amount
of the recorded investment for which there is a related allowance for loan
losses is $1,145,000 and $145,000, respectively, and the amount of the recorded
investment for which there is no related allowance for loan losses is $8,522,000
and $4,634,000, respectively. Interest income on impaired loans is recognized
primarily on a cash basis. During 1998 and 1997, the amount of interest income
recognized on impaired loans was insignificant.
Changes in capitalized mortgage servicing rights, included in other assets
in the Consolidated Statements of Condition, are summarized as follows:
1998 1997 1996
----------------------------
(Dollars in thousands)
Balance at beginning of year $ 2,136 $1,443 $1,113
Originations and acquisitions 4,552 1,236 630
Amortizations, sales, and writedowns (1,866) (543) (300)
---------------------------
Balance at end of year $ 4,822 $2,136 $1,443
===========================
26
Changes in the valuation allowance for mortgage servicing rights are
summarized as follows:
1998 1997 1996
---------------------------
(Dollars in thousands)
Balance at beginning of year $ 321 $ 221 $ 291
Additions:
Purchased mortgage servicing right -- 38 151
Originated mortgage servicing rights 464 154 55
---------------------------
Total additions 464 192 206
Reductions:
Purchased mortgage servicing rights 177 69 158
Originated mortgage servicing rights 99 23 118
---------------------------
Total reductions 276 92 276
---------------------------
Balance at end of year $ 509 $ 321 $ 221
===========================
At December 31, 1998 and 1997, the fair value of capitalized mortgage
servicing rights was $4,897,000 and $2,389,000, respectively.
Loans serviced for others amounted to $575,818,000, $518,877,000, and
$415,156,000 at December 31, 1998, 1997 and 1996, respectively.
NOTE H: OTHER REAL ESTATE OWNED
Other real estate owned ("OREO") consisted of the following:
December 31
--------------------
1998 1997
--------------------
(Dollars in thousands)
Real estate acquired through foreclosure $ 680 $ 742
Real estate in judgment 177 732
---------------
$ 857 $1,474
===============
Changes in the allowance for possible losses on OREO are summarized as
follows:
1998 1997 1996
-------------------------
(Dollars in thousands)
Balance at beginning of year $ -- $ -- $ 133
Provision for losses -- -- --
Net charge-offs -- -- --
-------------------------
Balance at end of year $ -- $ -- $ 133
=========================
The Company recorded writedowns of other real estate owned amounting to
$61,000 during 1998 and $75,000 during 1996. The Company did not record any
writedowns of other real estate owned in 1997.
The Company recognized net gains on sale of OREO amounting to $68,000,
$132,000 and $164,000 during 1998, 1997 and 1996, respectively.
27
NOTE I: OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment are summarized as follows:
December 31
----------------------
1998 1997
----------------------
(Dollars in thousands)
Cost:
Land $ 2,651 $ 2,565
Buildings and improvements 19,348 17,653
Furniture and equipment 17,214 18,749
-------------------
39,213 38,967
Less accumulated depreciation 20,208 22,346
-------------------
$19,005 $16,621
===================
Depreciation and amortization expense was $2,323,000, $1,987,000 and
$1,954,000 in 1998, 1997 and 1996, respectively.
Rental expense for leased properties and equipment was $1,424,000,
$1,150,000 and $938,000 in 1998, 1997 and 1996, respectively. The aggregate
minimum annual rental commitments under these leases are approximately
$1,323,000 in 1999, $1,208,000 in 2000, $1,082,000 in 2001, $837,000 in 2002,
$539,000 in 2003 and $2,422,000 thereafter.
NOTE J: DEPOSITS
The carrying amounts and fair values of deposits and the nominal rates of
interest paid were as follows:
December 31
--------------------------------------------------------------------------
1998 1997
--------------------------------------------------------------------------
Weighted Weighted
Carrying Fair Average Carrying Fair Average
Amount Value Rate Amount Value Rate
- ---------------------------------------------------------------------------------------------------
(Dollars in thousands)
Checking accounts $ 79,415 $ 79,415 --% $ 56,473 $ 56,473 --
NOW accounts 87,387 87,387 1.66 62,939 62,939 1.51
Money market accounts 103,878 103,878 3.27 92,314 92,314 4.02
Savings deposits 237,600 237,600 3.14 163,119 163,119 3.16
Certificates of deposit 754,317 764,584 5.55 667,204 673,314 5.93
Accrued interest 1,543 1,543 -- 1,118 1,118 --
---------------------------------------------------------------------
$1,264,140 $1,274,407 4.29% $1,043,167 $1,049,277 4.74%
=====================================================================
Included in deposits are $228,468,000 and $144,426,000 of deposit accounts
with balances in excess of $100,000 as of December 31, 1998 and 1997,
respectively.
Certificates of deposit had the following maturities at December 31, 1998:
Weighted
Amount Average Rate
---------------------------
(Dollars in thousands)
1999 $605,344 5.52%
2000 91,464 5.63
2001 24,801 5.68
2002 9,737 6.06
2003 and beyond 22,971 5.76
----------------------
$754,317 5.55%
======================
28
The average balance, interest expense and average rate on deposits were as
follows:
1998 1997 1996
---------------------------------------------------------------------------------------------------------
Average Interest Average Average Interest Average Average Interest Average
Balance Expense Rate Balance Expense Rate Balance Expense Rate
---------------------------------------------------------------------------------------------------------
(Dollars in thousands)
Checking accounts $ 62,935 $ -- -- % $ 47,680 $ -- -- % $ 40,349 $ -- $ --
NOW and money
market accounts 168,545 4,841 2.87 152,615 4,547 2.98 146,863 4,490 3.06
Savings deposits 196,502 6,581 3.35 154,541 4,623 2.99 153,701 4,446 2.89
Certificates of deposit 686,017 39,784 5.80 657,401 38,791 5.90 597,571 34,923 5.84
------------------------------------------------------------------------------------------------------
$1,113,999 $ 51,206 4.60% $1,012,237 $ 47,961 4.74% $ 938,484 $ 43,859 4.67%
======================================================================================================
NOTE K: SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase, in which the Company
will repurchase identical securities, consisted of the following:
December 31
-------------------------------------
1998 1997
-------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-------------------------------------
(Dollars in thousands)
Collateral pledged:
Mortgage-backed securities and Treasury
notes with a book value including accrued
interest of $18,715,000 and a market value
of $18,997,000 in 1998, and a book value
including accrued interest of $151,761,000
and a market value of $152,766,000 in 1997. $18,153 $18,153 $149,092 $149,092
=====================================
Securities sold under agreements to repurchase averaged $80,106,000 and
$98,471,000 during 1998 and 1997, respectively, and the maximum amounts
outstanding at any month-end during 1998 and 1997 were $148,639,000 and
$181,055,000, respectively.
The securities underlying the agreements were delivered to the dealers who
arranged the transactions. The dealers may have sold, loaned or otherwise
disposed of such securities to other parties in the normal course of their
operations, and have agreed to resell to the Company essentially identical
securities at the maturities of the agreements.
As of December 31, 1998, the only agreement to repurchase was with Bear
Stearns in the amount of $18,153,000 at an interest rate of 5.50%, with a
maturity date of January 8, 1999.
29
NOTE L: FHLB ADVANCES AND OTHER BORROWED MONEY
The carrying amounts and fair values of Federal Home Loan Bank of
Indianapolis ("FHLB") advances and other borrowed money consisted of the
following:
December 31
--------------------------------------------------------------------
1998 1997 1998 1997
---- ---- ----------------- -------------------
Year of Weighted Carrying Fair Carrying Fair
Maturity Average Rate Amount Value Amount Value
- ---------------------------------------------------------------------------------------------------------------
(Dollars in thousands)
Advances from FHLB:
Variable rate of interest:
5.69 - 5.88% 1998 --% 5.76% $ -- $ -- $ 61,000 $ 61,001
Fixed rate of interest:
5.47 - 5.98% 1998 -- 5.88 -- -- 153,000 153,190
5.81 - 6.20 1999 5.99 5.99 179,000 179,801 179,000 179,927
5.35 - 5.97 2000 5.78 5.92 145,000 146,608 70,000 70,509
5.21 - 5.94 2001 5.64 -- 205,000 207,831 -- --
4.00 2005 4.00 4.00 1,003 925 1,003 888
-------------------------------------------------------------------
530,003 535,165 464,003 465,515
Other borrowed money:
Overnight funds 5.36 -- 25,285 25,285 -- --
Collateralized mortgage obligation. 10.60 10.04 4,694 5,207 6,428 6,974
--------------------------------------------------------
$559,982 $565,657 $470,431 $472,489
======================================
The Company is required to maintain qualifying loans, investments and
mortgage-backed securities as collateral for the FHLB advances.
The collateralized mortgage obligation ("CMO") was issued through a special
purpose finance subsidiary established in 1986. The CMO is secured by mortgage-
backed securities with unpaid principal balances of $5,241,000 and $7,154,000 at
December 31, 1998 and December 31, 1997, respectively. The note underlying the
obligations bears interest, payable quarterly, at a rate of 7.27%, with a
contractual maturity date of 2010.
NOTE M: FEDERAL INCOME TAXES
Federal income tax expense (credit) consisted of the following:
1998 1997 1996
------------------------
(Dollars in thousands)
Current $7,138 $4,634 $ --
Deferred 763 3,109 3,228
Change in valuation allowance
for deferred tax assets -- -- (2,879)
------------------------
$7,901 $7,743 $ 349
========================
Deferred income tax expense (credit) included in stockholders' equity
related to the change in unrealized holding gains (losses) on securities
available for sale for 1998, 1997 and 1996 amounted to $262,000, $141,000, and
$(181,000), respectively.
30
A reconciliation of the statutory federal income tax rate to the effective
income tax rate follows:
1998 1997 1996
--------------------
Statutory tax rate 35.0% 35.0% 35.0%
Effect of:
Change in valuation allowance
for deferred tax assets -- -- (30.8)
Other, net (2.0) 0.1 (0.5)
--------------------
Effective tax rate 33.0% 35.1% 3.7%
====================
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of the Company's deferred and other tax assets and liabilities are as follows:
December 31
----------------------
1998 1997
----------------------
(Dollars in thousands)
Deferred tax assets:
Allowance for loan losses $3,031 $3,086
Net deferral required by SFAS 91 17 79
Pension and other benefit obligations 676 700
Other, net 281 398
------------------
Total deferred tax assets 4,005 4,263
Deferred tax liabilities:
Securities marked to market for tax purposes* 147 (13)
Fixed assets 644 588
FHLB stock 1,075 1,075
Valuation adjustment on CMO residuals 1,459 1,431
Other, net 52 53
------------------
Total deferred tax liabilities 3,377 3,134
------------------
Total net deferred tax assets 628 1,129
Current income tax receivable due to overpayments 2,093 --
------------------
Total net federal income tax assets $2,721 $1,129
==================
* The amount shown is net of the $930,000 and $810,000 tax effect of SFAS 115
unrealized holding gains at December 31, 1998 and December 31, 1997,
respectively.
NOTE N: STOCKHOLDERS' EQUITY AND REGULATORY MATTERS
OTS regulations governing the payment of dividends by savings institutions
provide that an institution may only pay dividends with regulatory approval.
Unlike the Bank, the Company is not subject to these regulatory restrictions on
the payment of dividends to its stockholders. However, the source of future
dividends may depend upon the payment of dividends from the Bank to the Company.
In December 1993, the Company issued 1,003,219 units in a shareholder
rights offering. Each unit consisted of three shares of common stock and one
warrant. Each warrant entitled the holder thereof to purchase one share of
common stock at an exercise price of $8.25 at any time no later than December
31, 1996. During 1996, 1995 and 1994, 996,369, 2,553 and 390 warrants were
exercised, respectively. The warrant period ended with 3,907 warrants
unexercised.
During 1996, the Company paid a one-time charge of $5.5 million pretax,
($3.6 million after tax) as the mandated contribution of D&N Bank, to replenish
the Federal Deposit Insurance Corporation's depleted Savings Association
Insurance Fund ("SAIF"). This charge is the result of federal legislation
passed and signed into law on September 30, 1996, which required all thrifts to
pay a one-time assessment to restore the SAIF fund to its statutory reserve
level. The assessment was 65.7 basis points (b.p.) of the institution's
deposits as of March 31, 1995.
31
Macomb had a leveraged Employee Stock Ownership Plan ("ESOP") which was
terminated subsequent to the merger with the Company. The related ESOP debt was
paid in full in 1996.
In December, 1996, D&N Financial Corporation's Board of Directors
authorized a program to acquire up to 440,000 shares of D&N Financial
Corporation common stock for the Company's treasury. In 1996, 257,222 shares
were acquired and 256,251 were reissued as holders of D&N Financial Corporation
warrants (issued in 1993) presented their maturing warrants for conversion to
common stock. In 1997, the authorized program was completed when an additional
182,050 shares were acquired for general corporate purposes, including the
satisfaction of its obligation to issue shares upon the exercise of employees'
and directors' stock options. By December 31, 1998, 100% of these shares had
been reissued upon the exercise of stock options.
On December 10, 1997, the Company declared a $.05 per share cash dividend
and a 10% stock dividend. Both were paid on January 13, 1998, to holders of
record on December 23, 1997. The liability for the cash dividend is shown in
Other Liabilities on the accompanying financial statements. All per share data
have been adjusted to include the effect of the stock dividend.
During 1998, the Company declared and paid a $0.05 per share cash dividend,
quarterly. The fourth quarter's dividend was paid on January 12, 1999, to
holders of record December 23, 1998. The liability for the cash dividend is
shown in Other Liabilities on the accompanying financial statements.
Regulatory standards, as dictated by the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 ("FIRREA") impose the following capital
requirements: a risk-based capital standard expressed as a percent of risk-
adjusted assets, a leverage ratio of core capital to total adjusted assets, and
a tangible capital ratio expressed as a percent of total adjusted assets. As of
December 31, 1998, the Bank exceeded all regulatory capital standards.
The table below summarizes as of December 31, 1998, the Bank's capital
requirements under FIRREA and its actual capital ratios at that date:
Regulatory Bank Actual
Requirements Capital
---------------------------------------------
Amount Percent Amount Percent
---------------------------------------------
(Dollars in thousands)
Risk-based capital $101,933 8.00% $139,380 10.94%
Tier 1 risk-based capital 76,450 6.00 129,530 10.17
Core capital 60,720 3.00 129,530 6.40
Tangible capital 30,360 1.50 129,530 6.40
The FDIC Improvement Act of 1992 ("FDICIA") requires each federal banking
agency to implement prompt corrective actions for institutions that it
regulates. The OTS has adopted rules, based upon FDICIA's five capital tiers:
well capitalized, adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized. Under FDICIA, the OTS is
required to take supervisory action against institutions that are not deemed
either well capitalized or adequately capitalized.
The rules generally provide that a savings institution is well capitalized
if its risk-based capital ratio is 10% or greater, its ratio of core capital to
risk-based assets ("tier 1 risk-based capital") is 6% or greater, its core
capital ("leverage") ratio is 5% or greater, and the institution is not subject
to a capital directive. At December 31, 1998, the Bank was considered well
capitalized.
NOTE O: EMPLOYEE BENEFIT PLANS
The Company sponsors an employee savings and investment plan in which all
employees may participate after completing a minimum of 1,000 hours in an
eligibility period. The plan allows participants to make contributions by
salary deductions equal to 19% or less of their salary pursuant to Section
401(k) of the Internal Revenue Code. Employee contributions are matched by the
Company at the rate of 100 cents per dollar, up to 6% of the employee's salary.
Employees vest immediately in their own contributions and over a five-year
period in the Company's contributions. Employee contributions may be invested
in a variety of instruments, including the
32
Company's common stock and preferred stock of D&N Capital Corporation. The
Company's matching contribution is invested at the direction of the participant.
The Company's contributions to the plan were $688,000, $653,000 and $621,000 in
1998, 1997, and 1996, respectively.
The Company terminated its noncontributory defined benefit retirement plan
during 1996, with all assets being distributed to participants. No gain or loss
was recorded on this transaction.
NOTE P: POSTRETIREMENT BENEFITS
The Company has a contributory unfunded benefit plan which provides
postretirement medical benefits to certain employees who have retired prior to
September 30, 1995. The Company is recognizing its accumulated postretirement
benefit obligation over a prospective 20-year period.
The following table sets forth the change in accumulated postretirement
benefit obligation for the years ended 1998 and 1997.
1998 1997
-----------------------
(Dollars in thousands)
Accumulated postretirement benefit obligation,
beginning of year $1,187 $1,241
Interest cost 95 84
Employee contribution 27 20
Benefits paid (183) (180)
Actuarial loss 303 22
-------------------
Accumulated postretirement benefit obligation,
end of year $1,429 $1,187
===================
The following table sets forth the plan's status and amounts recognized in
the Company's Consolidated Statements of Condition:
December 31
1998 1997
------------------------
(Dollars in thousands)
Accumulated postretirement benefit obligation $1,429 - $1,187
Unrecognized net loss (418) (141)
Unrecognized transition obligation (732) (780)
-----------------------
Accrued postretirement benefit cost $ 279 $ 266
=======================
Postretirement benefit expense included the following components:
1998 1997 1996
-------------------
(Dollars in thousands)
Service cost $ -- $ -- $ --
Interest cost 95 84 97
Amortization of transition obligation 48 48 48
-------------------
$ 143 $ 132 $ 145
===================
A weighted average discount rate of 6.50% in 1998 and 7.25% in 1997 was
used in determining the accumulated post retirement benefit obligation. The
1998 health care trend rate was projected to be 8.5% for participants under the
age of 65, and this rate is assumed to trend downward until it reaches 5.5% and
remains at that level thereafter. This trend rate assumption does not have a
significant effect on the plan; therefore, a one percent change in the trend
rate is not material in the determination of the accumulated postretirement
benefit obligation or the ongoing expense.
33
NOTE Q: STOCK OPTION PLAN
The Company has stock option plans in which 1,214,000 shares of common
stock have been reserved for issuance as of December 31, 1998. Under the plans,
the exercise price of any option will not be less than the fair market value of
the common stock on the date of grant. The dates on which the options are first
exercisable is determined by the Stock Option Committee of the Board of
Directors and have generally vested over a two year period from the date of
grant. The term on any option may not exceed ten years from the date of grant.
The Company has elected to continue to measure compensation cost using the
intrinsic value method, in accordance with Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, since
all options are granted at a fixed price not less than the fair market value of
the Company's common stock on the date of grant, no compensation cost has been
recognized for its stock option plans. Had stock option costs of these plans
been determined based on the fair value at the 1998, 1997 and 1996 grant dates
for awards under those plans consistent with the methodology of Statement of
Financial Accounting Standards No. 123 ("SFAS 123"), "Accounting for Stock Based
Compensation", the pro forma effects on the Company's net income and earnings
per share would be as follows:
1998 1997 1996
--------------------------------------------------
(Dollars in thousands, except earnings per share)
Net income (as reported) $16,062 $14,325 $8,995
Stock option compensation cost (994) (761) (396)
------------------------------------------
Pro forma net income $15,068 $13,564 $8,599
==========================================
Basic earnings per share (as reported) $ 1.75 $ 1.58 $ 1.08
Stock option compensation cost (0.10) (0.08) (0.05)
------------------------------------------
Pro forma basic earnings per share $ 1.65 $ 1.50 $ 1.03
==========================================
Diluted earnings per share (as reported) $ 1.69 $ 1.53 $ 1.01
Stock option compensation cost (0.10) (0.08) (0.04)
------------------------------------------
Pro forma diluted earnings per share $ 1.59 $ 1.45 $ 0.97
==========================================
The fair value of each option grant in 1998, 1997 and 1996 was estimated
using the Black-Scholes option pricing model with the following assumptions
used:
1998 1997 1996
------------------------------
Estimated weighted average fair value
per share of options granted $11.19 $ 7.63 $ 4.61
Assumptions:
Annualized dividend yield .9% .8% --
Common-stock price volatility 37.4% 32.5% 25.1%
Weighted average risk
free rate of return 5.7% 6.5% 5.9%
Weighted average
expected option term (in years) 7 5 5
The following table sets forth changes in options outstanding:
1998 1997 1996
-----------------------------------------------------------------------------
Weighted Weighted Weighted
Amount Avg. Price Amount Avg. Price Amount Avg. Price
-----------------------------------------------------------------------------
Shares under option:
Outstanding at beginning
of year 949,346 $12.07 820,943 $ 9.31 653,956 $ 7.56
Granted 77,834 25.41 261,087 19.55 315,929 12.26
Forfeited (8,253) 21.90 (34,003) 12.27 (21,836) 9.45
Canceled -- -- -- -- (6,353) 14.60
Exercised (227,852) 9.15 (98,681) 9.05 (120,753) 7.22
----------------------------------------------------------------------------
Outstanding at end of
year 791,075 14.14 949,346 12.07 820,943 9.31
----------------------------------------------------------------------------
Exercisable at end of
year 661,620 $12.61 738,092 $11.25 590,858 $ 8.40
----------------------------------------------------------------------------
34
The following table sets forth details of options outstanding at December 31, 1998:
Options Outstanding Options Exercisable
- -----------------------------------------------------------------------------------------------------
Weighted Weighted Weighted
Range of Average Average Average
Exercise Number Remaining Exercise Number Exercise
Prices Outstanding Contractual life Price Exercisable Price
- -----------------------------------------------------------------------------------------------------
$ 5.45 - 7.62 226,212 4.9 Years $ 6.98 226,212 $ 6.98
10.17 - 12.05 199,147 6.4 Years 11.47 199,147 11.47
12.95 - 14.04 55,186 7.9 Years 14.03 55,186 14.03
16.36 - 25.50 310,530 8.7 Years 21.08 181,075 20.46
- -----------------------------------------------------------------------------------------------------
$ 5.45 - 25.50 791,075 7.0 Years $14.14 661,620 $12.61
======================================================================================================
NOTE R: LITIGATION
The Company is a defendant in a number of matters of litigation,
substantially all of which have arisen in the ordinary course of business. It
is the opinion of management that the resulting liabilities, if any, from these
actions will not materially affect the Consolidated Financial Statements.
D&N Bank is a plaintiff, like approximately 120 other institutions, in a
currently pending claim in the United States Court of Federal Claims seeking
substantial damages as a result of the 1989 Financial Institutions Reform,
Recovery and Enforcement Act's mandatory phase-out of the regulatory capital
treatment of supervisory goodwill. The ultimate outcome of this matter as it
relates to D&N, cannot be determined at this time.
NOTE S: FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is party to financial instruments with off-balance sheet risk
(in the normal course of its business) to meet the financial needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These financial instruments may include commitments to originate or purchase
loans, standby letters of credit, recourse arrangements on sold assets, and
forward commitments. The instruments involve, to varying degrees, elements of
credit and interest rate risk in addition to the amounts recognized in the
Consolidated Statements of Condition. The contract amounts of those instruments
reflect the extent of the Company's involvement in particular classes of
financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for loan commitments, standby letters of
credit and recourse arrangements is represented by the contractual amount of
those instruments. The Company uses the same credit policies in making
commitments and conditional obligations as for on-balance sheet instruments.
For forward commitments, the contract amounts do not represent exposure to
credit loss. The Company controls the credit risk of those instruments through
credit approvals, limits and monitoring procedures.
35
The following table sets forth financial instruments with off-balance sheet
risk and their contract amounts and fair values:
December 31
---------------------------------------
1998 1997
---------------------------------------
Contract Fair Contract Fair
Amount Value Amount Value
---------------------------------------
(Dollars in thousands)
Financial instruments whose contract amounts
represent credit risk:
Commitments to originate and purchase loans $ 82,029 $ (820) $78,710 $(787)
Unused lines of credit 107,087 (1,071) 93,709 (937)
Standby letters of credit 4,922 (49) 3,907 (39)
Loans sold with recourse 921 (46) 2,155 (108)
Financial instruments whose contract amounts
exceed the amount of credit risk:
Forward commitments to sell loans 14,200 (71) 6,400 (64)
Commitments to originate loans are agreements to lend to a customer
provided there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Since some of the commitments are expected to
expire without being drawn on, the total commitment amounts do not necessarily
represent future cash requirements. The Company evaluates each customer's
creditworthiness on a case-by-case basis. The amount of collateral obtained, if
deemed necessary by the Company upon extension of credit, is based on
management's evaluation of the borrower's creditworthiness.
Standby letters of credit are conditional commitments issued by the Company
to guarantee the performance by a customer to a third party. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers. Additionally, the Company has
retained credit risk on certain residential and commercial mortgage loans sold
with recourse with outstanding balances at December 31, 1998 of $921,000 and
none, respectively. These balances as of December 31, 1997 were $1,310,000 and
$845,000, respectively. The maximum amount of loss to which the Company is
subject, under the recourse provisions, is $921,000 at December 31, 1998.
Management does not believe the recourse provisions subject the Company to any
material risk of loss. This credit risk is considered to be no more onerous than
that existing on similar loans in the Company's loan portfolio.
Forward commitments to sell loans are contracts the Company negotiates for
the purpose of reducing the market risk associated with rate lock agreements
with customers for new loan applications that have not yet been closed. In order
to fulfill a forward commitment, the Company typically exchanges through FNMA,
FHLMC or GNMA, its current production of loans for mortgage-backed securities
which are then delivered to a national securities firm at a future date at
prices or yields specified by the contracts. Risks may arise from the possible
inability of the Company to originate loans to fulfill the contracts, in which
case the Company would normally purchase securities in the open market to
deliver against the contracts.
NOTE T: FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and fair values of
financial instruments at the dates indicated. SFAS 107, "Disclosures about Fair
Value of Financial Instruments", defines the fair value of a financial
instrument as the amount at which the instrument could be exchanged in a current
transaction between willing parties, other than in a forced or liquidation sale.
36
December 31
------------------------------------------------------
1998 1997
------------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------------------------------------------------------
(Dollars in thousands)
Cash and cash equivalents $ 15,979 $ 15,979 $ 20,497 $ 20,497
Investment securities (Note E) 130,072 130,072 102,636 102,706
Mortgage-backed securities (Note F) 494,212 494,791 358,296 359,771
Loans receivable (Note G) 1,329,148 1,359,812 1,300,959 1,340,935
Deposits (Note J) (1,264,140) (1,274,407) (1,043,167) (1,049,277)
Securities sold under agreement
to repurchase (Note K) (18,153) (18,153) (149,092) (149,092)
Debt (Note L) (559,982) (565,657) (470,431) (472,489)
Commitments to originate and
purchase loans (Note S) -- (820) -- (787)
Unused lines of credit (Note S) -- (1,071) -- (937)
Standby letters of credit (Note S) -- (49) -- (39)
Loans sold with recourse (Note S) -- (46) -- (108)
Forward commitments to sell loans (Note S) -- (71) -- (64)
Estimation of Fair Values
SFAS 107 requires disclosure of fair value information about financial
instruments, whether or not recognized in the Statement of Condition, for which
it is practicable to estimate that value. In cases where quoted market prices
are not available, fair values are based on estimates using present value or
other valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. In that regard, the derived fair value estimates cannot be substantiated
by comparison to independent markets and, in many cases, could not be realized
in immediate settlement of the instrument. SFAS 107 excludes certain financial
instruments and all nonfinancial instruments from its disclosure requirements.
Accordingly, the aggregate fair value amounts presented do not represent the
underlying value of the Company.
The carrying amounts reported in the Statement of Condition for cash and
cash equivalents approximate those assets' fair value. Fair values for
investment securities and mortgage-backed securities are based on quoted market
prices, where available. If quoted market prices are not available, fair values
are based on quoted market prices of comparable instruments. Fair values for the
Company's loans are estimated using discounted cash flow analyses, using
interest rates currently being offered for loans with similar terms to borrowers
of similar credit quality. The carrying amount of accrued interest approximates
its fair value.
The fair values of checking and NOW accounts, money market accounts and
savings deposits are the amounts payable on demand at the reporting date. The
fair value for fixed-maturity time deposits is estimated using a discounted cash
flow analyses using the rates currently offered for deposits with similar
remaining maturities. The fair values of securities sold under agreement to
repurchase and the Company's debt are estimated using discounted cash flow
analyses, based on the Company's current incremental borrowing rates for debt
with similar terms and remaining maturities. Fair values for the Company's off-
balance sheet instruments (guarantees and credit commitments) are based on
current settlement or termination values and on fees currently charged to enter
into similar agreements, given the remaining terms of the agreements and the
counterparties' credit standing.
NOTE U: SEGMENT INFORMATION
D&N Financial Corporation's two reportable segments are Community Banking
and Wholesale Banking. Community Banking includes our network of full service
banking offices and provides a full range of deposit products and residential,
commercial and consumer loans. Wholesale Banking includes residential and
consumer loan servicing and underwriting operations, mortgage lending through
correspondents, and D&N Mortgage Corporation, and the origination of consumer
installment loans through automobile and other durable goods dealers. All
Other includes the Bank's insurance subsidiary, a seasoned portfolio of out-of-
market purchased
37
commercial real estate loans, and the treasury which facilitates inter-segment
funds transfers and manages the corporation's external borrowing and
interest-rate-risk management activities.
The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. D&N Financial Corporation
evaluates performance based on average balances and net profit or loss including
income taxes. The performance evaluation is completed on a full allocation
basis and therefore corresponds to the Corporation's consolidated net income.
Inter-segment income and expense items are charged at either the current market
rate or an estimate of actual expense incurred to provide a service to other
business lines.
The measurement of the performance of the business segments is based on
the management structure of the Corporation and is not necessarily comparable
with similar information for any other financial institution. The information
presented is also not necessarily indicative of the segments' financial
condition and results of operations if they were independent entities.
The following table sets forth the reportable segments for the years ending
December 31, 1998, 1997 and 1996.
Community Banking Wholesale Banking
1998 1997 1996 1998 1997 1996
----------------------------------------------------------------------------
(Dollars in thousands)
Net interest
income 37,709 34,994 30,675 14,076 10.578 7,893
Provision for
loan losses 994 1,056 1,579 1,506 348 563
Noninterest income:
From external
customers 10,176 6,618 5,377 2,491 1,539 1,272
Inter-segment 5 4 172 0 0 0
Inter-segment
noninterest expense 2,407 2,887 1,877 (1,598) (1,936) (1,878)
Depreciation and
amortization 2,060 1,627 1,590 2,150 914 558
Federal income tax 6,275 4,909 1,642 2,297 2,149 833
Segment profit
(loss) 12,676 8,918 6,627 4,579 3,903 3,358
============================================================================
Segment average
assets 1,182,677 997,991 794,567 665,809 539,307 452,951
============================================================================
Capital
expenditures 4,449 2,279 2,465 701 888 468
============================================================================
All Other Total
1998 1997 1996 1998 1997 1996
----------------------------------------------------------------------------
Net interest
income 904 3,367 4,195 52,689 48,939 42,763
Provision for
loan losses 0 (54) (1,042) 2,500 1,350 1,100
Noninterest income:
From external
customers 1,221 895 787 13,888 9,052 7,436
Inter-segment (5) (4) (172) 0 0 0
Inter-segment
noninterest expense (809) (951) 1 0 0 0
Depreciation and
amortization 96 90 198 4,306 2,631 2,346
Federal income tax (671) 685 (2,126) 7,901 7,743 349
Segment profit
(loss) (1,193) 1,504 (990) 16,062 14.325 8,995
============================================================================
Segment average
assets 57,547 88,924 86,718 1,906,033 1,626,222 1,334,236
============================================================================
Capital
expenditures 79 112 194 5,229 3,279 3,128
============================================================================
38
NOTE V: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Income
Before
Net Provision Income Income
Interest Interest Interest For Loan Gain on Tax Tax Net Earnings Per Share
Income Expense Income Losses Securities Expense Expense Income Basic Diluted
--------------------------------------------------------------------------------------------------------------------
(Dollars in thousands, except earnings per share and stock price)
1st
Quarter
1998 $ 34,547 $ 21,342 $ 13,205 $ 525 $ -- $ 6,786 $ 2,208 $ 3,897 $ 0.43 $ 0.41
1997 28,335 17,000 11,335 300 -- 5,075 1,781 3,294 0.36 0.35
2nd
Quarter
1998 34,368 21,049 13,319 550 -- 6,325 1,663 3,982 0.44 0.42
1997 30,293 18,484 11,809 300 539 5,505 1,926 3,579 0.39 0.38
3rd
Quarter
1998 35,588 22,416 13,172 650 1,360 6,889 2,160 4,048 0.44 0.43
1997 32,142 19,626 12,516 300 -- 6,262 2,003 3,722 0.41 0.40
4th
Quarter
1998 35,471 22,478 12,993 775 1,470 6,686 1,870 4,135 0.45 0.43
1997 34,923 21,644 13,279 450 -- 6,444 2,033 3,730 0.41 0.40
Year
1998 139,974 87,285 52,689 2,500 2,830 26,686 7,901 16,062 1.75 1.69
1997 125,693 76,754 48,939 1,350 539 23,286 7,743 14,325 1.58 1.53
Stock Price
Range
High Low
--------------------
1st
Quarter
1998 $ 28 1/2 23 1/2
1997 16 15/16 14 57/64
2nd
Quarter
1998 29 3/4 25 1/4
1997 17 1/2 15 33/64
3rd
Quarter
1998 27 1/4 15 1/4
1997 19 49/64 16 13/16
4th
Quarter
1998 29 16
1997 26 3/4 19 13/64
Year
1998 29 3/4 15 1/4
1997 26 3/4 14 57/64
39
NOTE W: D&N FINANCIAL CORPORATION - PARENT COMPANY ONLY
FINANCIAL INFORMATION CONDENSED STATEMENTS OF CONDITION
December 31
------------------------------
1998 1997
------------------------------
(Dollars in thousands)
ASSETS
Cash and cash equivalents $ 2 $ 2
Amounts receivable from subsidiary 3,289 3,523
Investments in subsidiary 112,654 94,994
---------------------------
$115,945 $98,519
===========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Dividends payable $ 466 $ 414
Other liabilities 19 23
Stockholders' equity 115,460 98,082
---------------------------
$115,945 $98,519
===========================
CONDENSED STATEMENTS OF INCOME
Year Ended December 31
-----------------------------------
1998 1997 1996
-----------------------------------
(Dollars in thousands)
Interest income from subsidiary $ 135 $ 228 $ 64
Equity in undistributed net income of subsidiary 16,272 14,388 9,378
Noninterest expense:
Compensation and benefits 12 10 13
Other 333 281 434
-------------------------------
Total noninterest expense 345 291 447
-------------------------------
Income before income tax expense 16,062 14,325 8,995
Federal income tax expense -- -- --
-------------------------------
Net income $ 16,062 $ 14,325 $ 8,995
===============================
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31
-------------------------------
1998 1997 1996
-------------------------------
(Dollars in thousands)
Operating activities
Net income $ 16,062 $ 14,325 $ 8,995
Items not affecting cash:
Equity in undistributed net income of subsidiary (16,272) (14,388) (9,378)
Other 47 438 115
-------------------------------
Net cash provided (used) by operating activities (163) 375 (268)
Investing activities
Change in intercompany receivable 234 2,581 (5,225)
Financing activities
Proceeds from exercise of stock options 2,151 865 9,055
Purchases of treasury stock (383) (2,995) (3,499)
Common stock cash dividends (1,839) (826) --
Payment of ESOP debt -- -- (63)
-------------------------------
Net cash provided (used) by financing activities (71) (2,956) 5,493
-------------------------------
Net change in cash and cash equivalents -- -- --
Cash and cash equivalents at beginning of year 2 2 2
-------------------------------
Cash and cash equivalents at end of year $ 2 $ 2 $ 2
===============================
40
STOCKHOLDER INFORMATION
D&N FINANCIAL CORPORATION
400 Quincy Street
Hancock, Michigan 49930
(906) 482-2700
363 W. Big Beaver, Ste. 100
Troy, Michigan 48084
(248) 528-0704
COMMON STOCK
D&N's common stock is listed on The Nasdaq Stock Market under the symbol DNFC.
The stock quotations appear in major daily newspapers under the listing D&N
Fncl. At December 31, 1998 there were approximately 7,600 holders of D&N common
stock.
FORM 10-K
The 1998 Annual Report and Form 10-K are available to shareholders at no cost
upon written request to the Company at the address above.
INDEPENDENT AUDITORS
PricewaterhouseCoopers LLP, Detroit, MI
41