10-K 1 v334411_10k.htm 10-K

 

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
   
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012
   
Commission file number: 000-31207
   
  BANK MUTUAL CORPORATION  
  (Exact name of registrant as specified in its charter)  
   
Wisconsin 39-2004336
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
   
4949 West Brown Deer Road, Milwaukee, Wisconsin 53223
(Address of principal executive offices) (Zip Code)
   
Registrant's telephone number, including area code: (414) 354-1500
   
Securities registered pursuant to Section 12(b) of the Act:
   
Common Stock, $0.01 Par Value The NASDAQ Stock Market LLC
(Title of each class) (Name of each exchange on which registered)
 
Securities registered pursuant to Section 12(g) of the Act:
   
NONE
       

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act

Yes ¨   No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes ¨   No x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x   No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)

Yes x   No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the act).

Yes ¨   No x

 

As of February 28, 2013, 46,420,084 shares of Common Stock were validly issued and outstanding. The aggregate market value of the Common Stock (based upon the $4.41 last sale price on The NASDAQ Global Select Market on June 29, 2012, the last trading date of the Company’s second fiscal quarter) held by non-affiliates (excluding outstanding shares reported as beneficially owned by directors and executive officers; does not constitute an admission as to affiliate status) was approximately $189.9 million.

 

    Part of Form 10-K Into Which
Documents Incorporated by Reference   Portions of Document are Incorporated
     
Proxy Statement for Annual Meeting of Shareholders on May 6, 2013   Part III

 

 
 

 

BANK MUTUAL CORPORATION
 

FORM 10-K ANNUAL REPORT TO

THE SECURITIES AND EXCHANGE COMMISSION

FOR THE YEAR ENDED DECEMBER 31, 2012

 

Table of Contents

 

Item   Page
       
Part I      
       
1 Business   3
       
1A Risk Factors   22
       
1B Unresolved Staff Comments   27
       
2 Properties   27
       
3 Legal Proceedings   27
       
4 Mine Safety Disclosures   27
       
Part II      
       
5 Market for Registrant's Common Equity, Related Stockholders Matters, and Issuer Purchases of Equity Securities   28
       
6 Selected Financial Data   30
       
7 Management's Discussion and Analysis of Financial Condition and Results of Operations   32
       
7A Quantitative and Qualitative Disclosures About Market Risk   56
       
8 Financial Statements and Supplementary Data   60
       
9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   104
       
9A Controls and Procedures   104
       
9B Other Information   106
       
Part III      
       
10 Directors, Executive Officers, and Corporate Governance   107
       
11 Executive Compensation   107
       
12 Security Ownership of Certain Beneficial Owners, Management, and Related Stockholder Matters   107
       
13 Certain Relationships and Related Transactions and Director Independence   107
       
14 Principal Accountant Fees and Services   107
       
Part IV      
       
15 Exhibits, Financial Statement Schedules   108
       
SIGNATURES     109

 

2
 

 

Part I

 

Cautionary Statement

 

This report contains or incorporates by reference various forward-looking statements concerning the Company's prospects that are based on the current expectations and beliefs of management. Forward-looking statements may contain, and are intended to be identified by, words such as “anticipate,” “believe,” “estimate,” “expect,” “objective,” “projection,” “intend,” and similar expressions; the use of verbs in the future tense and discussions of periods after the date on which this report is issued are also forward-looking statements. The statements contained herein and such future statements involve or may involve certain assumptions, risks, and uncertainties, many of which are beyond the Company's control, that could cause the Company's actual results and performance to differ materially from what is stated or expected. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company: general economic conditions, including volatility in credit, lending, and financial markets; declines in the real estate market, which could further affect both collateral values and loan activity; continuing relatively high unemployment and other factors which could affect borrowers’ ability to repay their loans; negative developments affecting particular borrowers, which could further adversely impact loan repayments and collection; legislative and regulatory initiatives and changes, including action taken, or that may be taken, in response to difficulties in financial markets and/or which could negatively affect the right of creditors; monetary and fiscal policies of the federal government; the effects of further regulation and consolidation within the financial services industry, including substantial changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”); regulators’ increasing expectations for financial institutions’ capital levels and restrictions imposed on institutions, as to payments of dividends or otherwise, to maintain or achieve those levels, including the possible effects of potential new regulatory capital requirements under Basel III; pending and/or potential rulemaking or other actions by the Consumer Financial Protection Bureau (“CFPB”); potential regulatory or other actions affecting the Company or the Bank; potential changes in the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), which could impact the home mortgage market; increased competition and/or disintermediation within the financial services industry; changes in tax rates, deductions and/or policies; potential further changes in Federal Deposit Insurance Corporation (“FDIC”) premiums and other governmental assessments; changes in deposit flows; changes in the cost of funds; fluctuations in general market rates of interest and/or yields or rates on competing loans, investments, and sources of funds; demand for loan or deposit products; illiquidity of financial markets and other negative developments affecting particular investment and mortgage-related securities, which could adversely impact the fair value of and/or cash flows from such securities; changes in customers’ demand for other financial services; the Company’s potential inability to carry out business plans or strategies; changes in accounting policies or guidelines; natural disasters, acts of terrorism, or developments in the war on terrorism; the risk of failures in computer or other technology systems or data maintenance, or breaches of security relating to such systems; and the factors discussed in “Item 1A. Risk Factors,” as well as Part II, “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.”

 

Item 1. Business

 

The discussion in this section should be read in conjunction with “Item 1A. Risk Factors,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Item 7A. Quantitative and Qualitative Disclosures about Market Risk,” and “Item 8. Financial Statements and Supplementary Data.”

 

General

 

Bank Mutual Corporation (the “Company”) is a Wisconsin corporation headquartered in Milwaukee, Wisconsin. The Company owns 100% of the common stock of Bank Mutual (the “Bank”) and currently engages in no substantial activities other than its ownership of such stock. Consequently, the Company’s net income and cash flows are derived primarily from the Bank’s operations and capital distributions. The Company is regulated as a savings and loan holding company by the Board of Governors of the Federal Reserve (“FRB”). The Company’s common stock trades on The NASDAQ Global Select Market under the symbol BKMU.

 

The Bank was founded in 1892 and is a federally-chartered savings bank headquartered in Milwaukee, Wisconsin. It is regulated by the Office of the Comptroller of the Currency (“OCC”) and its deposits are insured within limits established by the FDIC. The Bank's primary business is community banking, which includes attracting deposits from and making loans to the general public and private businesses, as well as governmental and non-profit entities. In addition to deposits, the Bank obtains funds through borrowings from the Federal Home Loan Bank (“FHLB”) of Chicago. These funding sources are principally used to originate loans, including one- to four-family residential loans, multi-family residential loans, commercial real estate loans, commercial business loans and lines of credit, and consumer loans and lines of credit. From time-to-time the Bank also purchases and/or participates in loans from third-party financial institutions and is an active seller of residential loans in the secondary market. It also invests in mortgage-related and other investment securities.

 

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The Company’s principal executive office is located at 4949 Brown Deer Road, Milwaukee, Wisconsin, 53223, and its telephone number at that location is (414) 354-1500. The Company’s website is www.bankmutualcorp.com. The Company will make available through that website, free of charge, its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, as soon as reasonably practical after the Company files those reports with, or furnishes them to, the Securities and Exchange Commission (“SEC”). Also available on the Company’s website are various documents relating to the corporate governance of the Company, including its Code of Ethics and its Code of Conduct.

 

Market Area

 

At December 31, 2012, the Company had 75 banking offices in Wisconsin and one in Minnesota. At June 30, 2012, the Company had a 1.50% market share of all deposits held by FDIC-insured institutions in Wisconsin. The Company is the fourth largest financial institution headquartered in Wisconsin, based on deposit market share.

 

The largest concentration of the Company’s offices is in southeastern Wisconsin, consisting of the Milwaukee Metropolitan Statistical Area (“MSA”), the Racine MSA, and the Kenosha, Wisconsin, and Lake County, Illinois MSA. The Company has 26 offices in these MSAs. The Company has also five offices in south central Wisconsin, consisting of the Madison MSA and the Janesville/Beloit MSA, as well as six other offices in communities in east central Wisconsin.

 

The Company also operates 20 banking offices in northeastern Wisconsin, including the Green Bay MSA. A few of the offices in this region are located near the Michigan border. Therefore, the Company also draws customers from the upper peninsula of Michigan. Finally, the Company has 18 offices in northwestern Wisconsin, including the Eau Claire MSA, and one office in Woodbury, Minnesota, which is located near the Wisconsin state border on the eastern edge of the Minneapolis-St. Paul MSA.

 

The services provided through the Company's banking offices are supplemented by services offered through a customer service call center, 24-hour phone banking, internet banking services, and ATMs located in the Company’s market areas.

 

Competition

 

The Company faces significant competition in attracting deposits, making loans, and selling other financial products and services. Wisconsin has many banks, savings banks, savings and loan associations, and tax-exempt credit unions, which offer the same types of banking products and services as the Company. The Company also faces competition from other types of financial service companies, such as mortgage brokerage firms, finance companies, insurance companies, investment brokerage firms, and mutual funds. As a result of electronic commerce, the Company also competes with financial service providers outside of Wisconsin.

 

Many of the Company’s competitors have greater resources and/or offer services that the Company currently does not provide. For example, the Company does not offer trust services. However, the Company does offer mutual fund investments, tax-deferred annuities, credit life and disability insurance, property and casualty insurance, and brokerage services through a subsidiary, BancMutual Financial & Insurance Services, Inc.

 

Lending Activities

 

General At December 31, 2012, the Company’s total loans receivable was $1.4 billion or 58.0% of total assets. The Company’s loan portfolio consists primarily of mortgage loans, which includes loans secured by one- to four-family residences, multi-family properties, and commercial real estate properties, as well as construction and development loans secured by the same types of properties and land. To a lesser degree, the loan portfolio includes consumer loans consisting principally of home equity lines of credit, fixed and adjustable-rate home equity loans, student loans, and automobile loans. Finally, the Company’s loan portfolio also contains commercial business loans, to which it has given increased emphasis in recent years. The nature, type, and terms of loans originated or purchased by the Company are subject to federal and state laws and regulations. The Company has no significant concentrations of loans to particular borrowers or to borrowers engaged in similar activities. In addition, the Company limits its lending activities primarily to borrowers and related loan collateral located in its market areas, which consist of Wisconsin and contiguous regions of Illinois, Minnesota, and northern Michigan, as previously described. For specific information related to the Company’s loans receivable for the periods covered by this report, refer to “Financial Condition—Loans Receivable” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

4
 

 

Residential Mortgage Lending The Company originates and purchases first mortgage loans secured by one- to four-family properties. At December 31, 2012, the Company’s portfolio of these types of loans was $465.2 million or 31.0% of its gross loans receivable. Most of these loans are owner-occupied; however, the Company also originates first mortgage loans secured by second homes, seasonal homes, and investment properties.

 

The Company originates primarily conventional fixed-rate residential mortgage loans and adjustable-rate residential mortgage (“ARM”) loans with maturity dates up to 30 years. Such loans generally are underwritten to Fannie Mae standards. In general, ARM loans are retained by the Company in its loan portfolio. Conventional fixed-rate residential mortgage loans are generally sold in the secondary market without recourse, although the Company typically retains the servicing rights to such loans. From time-to-time, the Company may elect to retain in its loan portfolio conventional fixed-rate loans with maturities of up to 15 years. The Company also originates “jumbo” single family mortgage loans in excess of the Fannie Mae maximum loan amount, which was $417,000 for single family homes in its primary market areas in 2012. Fannie Mae has higher limits for two-, three- and four-family homes. The Company generally retains fixed-rate jumbo single family mortgage loans in its portfolio.

 

From time-to-time the Company also originates fixed-rate and ARM loans under special programs for low- to moderate-income households and first-time home buyers. These programs are offered to help meet the credit needs of the communities the Company serves and are retained by the Company in its loan portfolio. Among the features of these programs are lower down payments, no mortgage insurance, and generally less restrictive requirements for qualification compared to the Company’s conventional one- to four-family mortgage loans. These loans generally have maturities up to 30 years.

 

From time-to-time the Company also originates loans under programs administered by various federal and state government agencies such as the State Veteran’s Administration (“State VA”), the Wisconsin Housing and Economic Development Authority (“WHEDA”), the U.S. Department of Agriculture (“USDA”) Guaranteed Rural Housing Program, and the Federal Housing Administration (“FHA”). Loans originated under these programs may or may not be held by the Company in its loan portfolio and the Company may or may not retain the servicing rights for such loans.

 

ARM loans pose credit risks different from the risks inherent in fixed-rate loans, primarily because as interest rates rise, the underlying payments from the borrowers increase, which increases the potential for payment default. At the same time, the marketability and/or value of the underlying property may be adversely affected by higher interest rates. ARM loans generally have an initial fixed-rate term of one to seven years. Thereafter, they are adjusted on an annual basis up to a maximum of 200 basis points per year. The Company originates ARM loans with lifetime caps set at 6% above the origination rate. Monthly payments of principal and interest are adjusted when the interest rate adjusts. The Company does not offer ARM loans with negative amortization or with interest-only payment features. The Company currently utilizes the monthly average yield on United States treasury securities, adjusted to a constant maturity of one year (“constant maturity treasury index”) as the base index to determine the interest rate payable upon the adjustment date of ARM loans. Some of the ARM loans are granted with conversion options that provide for terms of up to seven years in which the borrower may convert the ARM loan to a fixed-rate mortgage loan. The terms at which the ARM loan may be converted to a fixed-rate loan are established at the date of loan origination and are set to allow the Company to sell the loan into the secondary market upon conversion. The volume and types of ARM loans the Company originates have been affected by the level of market interest rates, competition, consumer preferences, and the availability of funds. ARM loans are susceptible to early prepayment during periods of lower interest rates as borrowers refinance into fixed-rate loans.

 

The Company requires an appraisal of the real estate that secures a residential mortgage loan, which must be performed by an independent certified appraiser approved by the board of directors. A title insurance policy is required for all real estate first mortgage loans. Evidence of adequate hazard insurance and flood insurance, if applicable, is required prior to closing. Borrowers are required to make monthly payments to fund principal and interest as well as private mortgage insurance and flood insurance, if applicable. With some exceptions for lower loan-to-value ratio loans, borrowers are also generally required to escrow in advance for real estate taxes. Generally, no interest is paid on these escrow deposits. If borrowers with loans having a lower loan-to-value ratio want to handle their own taxes and insurance, an escrow waiver fee is charged. With respect to escrowed real estate taxes, the Company generally makes this disbursement directly to the borrower as obligations become due.

 

5
 

 

The Company’s staff underwriters review all pertinent information prior to making a credit decision on an application. All recommendations to deny are reviewed by a designated senior officer of the Company, in addition to staff underwriters, prior to the final disposition of the application. The Company’s lending policies generally limit the maximum loan-to-value ratio on single family mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or purchase price of the property. This limit is lower for loans secured by two-, three-, and four-family homes. Loans above 80% loan-to-value ratios are subject to private mortgage insurance to reduce the Company’s exposure to less than 80% of value, except for certain low to moderate income loan program loans.

 

In addition to servicing the loans in its own portfolio, the Company continues to service most of the loans that it sells to Fannie Mae and other third-party investors (“loans serviced for others”). Servicing mortgage loans, whether for its own portfolio or for others, includes such functions as collecting monthly principal and interest payments from borrowers, maintaining escrow accounts for real estate taxes and insurance, and making certain payments on behalf of borrowers. When necessary, servicing of mortgage loans also includes functions related to the collection of delinquent principal and interest payments, loan foreclosure proceedings, and disposition of foreclosed real estate. As of December 31, 2012, loans serviced for others amounted to $1.1 billion. These loans are not reflected in the Company’s Consolidated Statements of Financial Condition.

 

When the Company services loans for others, it is compensated through the retention of a servicing fee from borrowers' monthly payments. The Company pays the third-party investors an agreed-upon yield on the loans, which is generally less than the interest agreed to be paid by the borrowers. The difference, typically 25 basis points or more, is retained by the Company and recognized as servicing fee income over the lives of the loans, net of amortization of capitalized mortgage servicing rights (“MSRs”). The Company also receives fees and interest income from ancillary sources such as delinquency charges and float on escrow and other funds.

 

Management believes that servicing mortgage loans for third parties provides a natural hedge against other risks inherent in the Company's mortgage banking operations. For example, fluctuations in volumes of mortgage loan originations and resulting gains on sales of such loans caused by changes in market interest rates will generally be offset by opposite changes in the amortization of the MSRs. These fluctuations are usually the result of actual loan prepayment activity and/or changes in management expectations for future prepayment activity, which impacts the amount of MSRs amortized in a given period. However, fluctuations in the recorded value of MSRs may also be caused by valuation adjustments required to be recognized under generally accepted accounting principles (“GAAP”). That is, the value of servicing rights may fluctuate because of changes in the future prepayment assumptions or discount rates used to periodically value the MSRs. Although most of the Company's serviced loans that prepay are replaced by new serviced loans (thus preserving the future servicing cash flow), GAAP requires impairment losses resulting from a change in future prepayment assumptions to be recorded when the change occurs. MSRs are particularly susceptible to impairment losses during periods of declining interest rates during which prepayment activity typically accelerates to levels above that which had been anticipated when the servicing rights were originally recorded. Alternatively, in periods of increasing interest rates, during which prepayment activity typically declines, the Company could potentially recapture through earnings all or a portion of a previously established valuation allowance for impairment.

 

Multi-family and Commercial Real Estate Loans At December 31, 2012, the Company’s aggregate portfolio of multi-family and commercial real estate loans was $527.8 million or 35.2% of its gross loans receivable. The Company’s multi-family and commercial real estate loan portfolios consist of fixed-rate and adjustable-rate loans originated at prevailing market rates usually tied to various market indices. This portfolio generally consists of loans secured by apartment buildings, office buildings, retail centers, warehouses, and industrial buildings. Loans in this portfolio may be secured by either owner or non-owner occupied properties. Loans in this portfolio typically do not exceed 80% of the lesser of the purchase price or an independent appraisal by an appraiser designated by us. Loans originated with balloon maturities are generally amortized on a 25 to 30 year basis with a typical balloon term of 3 to 5 years.

 

6
 

 

Loans secured by multi-family and commercial real estate are granted based on the income producing potential of the property, the financial strength and/or income producing potential of the borrower, and the appraised value of the property. In most cases, the Company also obtains personal guarantees from the principals involved. The Company’s approval process includes a review of the other debt obligations and overall sources of cash flow available to the borrower and guarantors. The property’s net operating income must be sufficient to cover the payments relating to the outstanding debt. The Company generally requires an assignment of rents or leases to be assured that the cash flow from the property will be used to repay the debt. Appraisals on properties securing multi-family and larger commercial real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors. Title and hazard insurance are required as well as flood insurance, if applicable. Environmental assessments are performed on certain multi-family and commercial real estate loans in excess of $1.0 million, as well as all loans secured by certain properties that the Company considers to be “environmentally sensitive.” In addition, the Company performs an annual credit review of its multi-family and commercial real estate loans over $1.0 million.

 

Loans secured by multi-family and commercial real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans. Such loans typically involve large balances to single borrowers or groups of related borrowers. The Bank has internal lending limits to single borrowers or a group of related borrowers that are adjusted from time-to-time, but are generally well below the Bank’s legal lending limit of approximately $40.0 million as of December 31, 2012. Because payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. Furthermore, borrowers’ problems in areas unrelated to the properties that secure the Company’s loans may have an adverse impact on such borrowers’ ability to comply with the terms of the Company’s loans.

 

Construction and Development Loans At December 31, 2012, the Company’s portfolio of construction and development loans was $129.3 million or 8.6% of its gross loans receivable. These loans typically have terms of 18 to 24 months, are interest-only, and carry variable interest rates tied to the prime rate. Disbursements on these loans are based on draw requests supported by appropriate lien waivers. As a general matter, construction loans convert to permanent loans and remain in the Company’s loan portfolio upon the completion of the project. Development loans are typically repaid as the underlying lots or housing units are sold. Construction and development loans are generally considered to involve a higher degree of risk than mortgage loans on completed properties. The Company's risk of loss on a construction and development loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction, the estimated cost of construction, the appropriate application of loan proceeds to the work performed, and the borrower's ability to advance additional construction funds if necessary. In addition, in the event a borrower defaults on the loan during its construction phase, the construction project often needs to be completed before the full value of the collateral can be realized by the Company. The Company performs an annual credit review of its construction and development loans over $1.0 million.

 

Commercial Business Loans At December 31, 2012, the Company’s portfolio of commercial business loans was $132.4 million or 8.9% of its gross loans receivable. This portfolio consists of loans to businesses for equipment purchases, working capital, debt refinancing or restructuring, business acquisition or expansion, Small Business Administration (“SBA”) loans, and domestic standby letters of credit. Typically, these loans are secured by general business security agreements and personal guarantees. The Company offers variable, adjustable, and fixed-rate commercial business loans. The Company also has commercial business loans that have an initial period where interest rates are fixed, generally one to five years, and thereafter are adjustable based on various market indices. Fixed-rate loans are priced at either a margin over various market indices with maturities that correspond to the maturities of the notes or to match competitive conditions and yield requirements. Term loans are generally amortized over a three to seven year period. Commercial lines of credit generally have a term of one year and are subject to annual renewal thereafter. The Company performs an annual credit review of all commercial business borrowers having an exposure to the Company of $500,000 or more.

 

Consumer Loans At December 31, 2012, the Company’s portfolio of consumer loans was $246.9 million or 16.5% of its gross loans receivable. Consumer loans include fixed term home equity loans, home equity lines of credit, home improvement loans, automobile loans, recreational vehicle loans, boat loans, deposit account loans, overdraft protection lines of credit, unsecured consumer loans, and to a lesser extent, unsecured consumer loans through credit card programs that are administered by third parties. The Company no longer originates student loans through programs guaranteed by the federal government. Student loans that continue to be held by the Company are administered by a third party.

 

7
 

 

The Company’s primary focus in consumer lending has been the origination of loans secured by real estate, which includes home equity loans, home improvement loans, and home equity lines of credit. These loans are typically secured by junior liens on owner-occupied one- to four-family residences, but in many instances are secured by first liens on such properties. Underwriting procedures for the home equity and home equity lines of credit loans include a comprehensive review of the loan application, an acceptable credit score, verification of the value of the equity in the home, and verification of the borrower’s income. Home equity and home improvement loan originations are developed through cross-sales to existing customers, advertisements in local media, the Bank’s website, and from time-to-time, direct mail.

 

The Company originates fixed-rate home equity and home improvement term loans with loan-to-value ratios of up to 89.99% (when combined with any other mortgage on the property). Pricing on fixed-rate home equity and home improvement term loans is periodically reviewed by management. Generally, loan terms are in the three to fifteen year range in order to minimize interest rate risk.

 

The Company also originates home equity lines of credit. Home equity lines of credit are variable-rate loans secured by first liens or junior liens on owner-occupied one- to four-family residences. Current interest rates on home equity lines of credit are tied to an index rate, adjust monthly after an initial interest rate lock period, and generally have floors that vary depending on the loan-to-value ratio. Home equity line of credit loans are made for terms up to 10 years and require minimum monthly payments.

 

Consumer loans generally have shorter terms and higher rates of interest than conventional mortgage loans, but typically involve more credit risk because of the nature of the collateral and, in some instances, the absence of collateral. In general, consumer loans are more dependent upon the borrower's continuing financial stability, more likely to be affected by adverse personal circumstances, and often secured by rapidly depreciating personal property such as automobiles. In addition, various laws, including bankruptcy and insolvency laws, may limit the amount that may be recovered from a borrower. However, such risks are mitigated to some extent in the case of home equity loans and lines of credit. These types of loans are secured by a first or second mortgage on the borrower's residence for which the total principal balances outstanding (including the first mortgage) does not generally exceed 89.99% of the property's value at the time of the loan.

 

The Company believes that the higher yields earned on consumer loans compensate for the increased risk associated with such loans and that consumer loans are important to the Company’s efforts to increase the interest rate sensitivity and shorten the average maturity of its loan portfolio.

 

In conjunction with its consumer lending activities, the Company offers customers credit life and disability insurance products underwritten and administered by an independent insurance provider. The Company receives commission revenue related to the sales of these products, although such amounts are not a material source of revenue for the Company.

 

Asset Quality

 

General The Company has policies and procedures in place to manage its exposure to credit risk related to its lending operations. As a matter of policy, the Company limits its lending to geographic areas in which it has substantial familiarity and/or a physical presence. Currently, this is limited to certain specific market areas in Wisconsin and contiguous states. In addition, from time-to-time the Company will prohibit or restrict lending in situations in which the underlying business operations and/or collateral exceed management’s tolerance for risk. The Company obtains appraisals of value prior to the origination of mortgage loans or other secured loans. It also manages its exposure to risk by regularly monitoring loan payment status, conducting periodic site visits and inspections, obtaining regular financial updates from large borrowers and/or guarantors, corresponding regularly with large borrowers and/or guarantors, and/or updating appraisals as appropriate, among other things. These procedures are emphasized when a borrower has failed to make scheduled loan payments, has otherwise defaulted on the terms of the loan agreement, or when management has become aware of a significant adverse change in the financial condition of the borrower, guarantor, or underlying collateral. For specific information relating to the Company’s asset quality for the periods covered by this report, refer to “Financial Condition—Asset Quality” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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Internal Risk Ratings and Classified Assets OCC regulations require thrift institutions to review and, if necessary, classify their assets on a regular basis. Accordingly, the Company has internal policies and procedures in place to internally evaluate risk ratings on all of its loans and certain other assets. In general, these internal risk ratings correspond with regulatory requirements to adversely classify problem loans and certain other assets as “substandard,” “doubtful,” or “loss.” A loan or other asset is adversely classified as substandard if it is determined to involve a distinct possibility that the Company could sustain some loss if deficiencies associated with the loan are not corrected. A loan or other asset is adversely classified as doubtful if full collection is highly questionable or improbable. A loan or other asset is adversely classified as loss if it is considered uncollectible, even if a partial recovery could be expected in the future. The regulations also provide for a “special mention” designation, described as loans or assets which do not currently expose the Company to a sufficient degree of risk to warrant adverse classification, but which demonstrate clear trends in credit deficiencies or potential weaknesses deserving management's close attention (refer to the following paragraph for additional discussion). As of December 31, 2012, $37.7 million or 2.7% the Company’s loans were classified as special mention and $57.6 million or 4.1% were classified as substandard. The latter includes all loans placed on non-accrual in accordance with the Company’s policies, as described below. In addition, as of December 31, 2012, $35.9 million of the Company’s mortgage-related securities, consisting of private-label collateralized mortgage obligations (“CMOs”) rated less than investment grade, were classified as substandard in accordance with regulatory guidelines. The Company had no loans or other assets classified as doubtful or loss at December 31, 2012.

 

Loans that are not classified as special mention or adversely classified as substandard, doubtful, or loss are classified as “pass” or “watch” in accordance with the Company’s internal risk rating policy. Pass loans are generally current on contractual loan and principal payments, comply with other contractual loan terms, and have no noticeable credit deficiencies or potential weaknesses. Watch loans are also generally current on payments and in compliance with loan terms, but a particular borrower’s financial or operating conditions may exhibit early signs of credit deficiencies or potential weaknesses that deserve management’s close attention. Such deficiencies and/or weaknesses typically include, but are not limited to, the borrower’s financial or operating condition, deterioration in liquidity, increased financial leverage, declines in the condition or value of related collateral, recent changes in management or business strategy, or recent developments in the economic, competitive, or market environment of the borrower. If adverse observations noted in these areas are not corrected, further downgrade of the loan may be warranted.

 

Delinquent Loans When a borrower fails to make required payments on a loan, the Company takes a number of steps to induce the borrower to cure the delinquency and restore the loan to a current status. In the case of one- to four-family mortgage loans, the Company’s loan servicing department is responsible for collection procedures from the 15th day of delinquency through the completion of foreclosure. Specific procedures include late charge notices, telephone contacts, and letters. If these efforts are unsuccessful, foreclosure notices will eventually be sent. The Company may also send either a qualified third party inspector or a loan officer to the property in an effort to contact the borrower. When contact is made with the borrower, the Company attempts to obtain full payment or work out a repayment schedule to avoid foreclosure of the collateral. Many borrowers pay before the agreed upon payment deadline and it is not necessary to start a foreclosure action. The Company follows collection procedures and guidelines outlined by Fannie Mae, Freddie Mac, State VA, WHEDA, and the Guaranteed Rural Housing Program.

 

The collection procedures for consumer loans, excluding student loans and credit card loans, include sending periodic late notices to a borrower and attempts to make direct contact with a borrower once a loan becomes 30 days past due. If collection activity is unsuccessful, the Company may pursue legal remedies itself, refer the matter to legal counsel for further collection effort, seek foreclosure or repossession of the collateral (if any), and/or charge-off the loan. All student loans are serviced by a third party, which guarantees that its servicing complies with all U.S. Department of Education guidelines. The Company’s student loan portfolio is guaranteed under programs sponsored by the U.S. government. Credit card loans are serviced by a third party administrator.

 

The collection procedures for multi-family, commercial real estate, and commercial business loans include sending periodic late notices to a borrower once a loan is past due. The Company attempts to make direct contact with a borrower once a loan becomes 15 days past due. The Company’s managers of the multi-family and commercial real estate loan areas review loans 10 days or more delinquent on a regular basis. If collection activity is unsuccessful, the Company may refer the matter to legal counsel for further collection effort. After 90 days, loans that are delinquent are typically proposed for repossession or foreclosure.

 

In working with delinquent borrowers, if the Company cannot develop a repayment plan that substantially complies with the original terms of the loan agreement, the Company’s practice has been to pursue foreclosure or repossession of the underlying collateral. As a matter of practice, the Company has not restructured or modified troubled loans in a manner that has resulted in a loss under accounting rules. However, the Company’s policies do not preclude such practice and the Company may elect in the future to restructure certain troubled loans in a manner that could result in losses under accounting rules. In most cases the Company continues to report restructured or modified troubled loans as non-performing loans unless the borrower has clearly demonstrated the ability to service the loan in accordance with the new terms.

 

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The Company’s policies require that management continuously monitor the status of the loan portfolio and report to the board of directors on a monthly basis. These reports include information on classified loans, delinquent loans, restructured or modified loans, allowance for loan losses, and foreclosed real estate.

 

Non-Accrual Policy With the exception of student loans that are guaranteed by the U.S. government, the Company generally stops accruing interest income on loans when interest or principal payments are 90 days or more in arrears or earlier when the future collectability of such interest or principal payments may no longer be certain. In such cases, borrowers have often been able to maintain a current payment status, but are experiencing financial difficulties and/or the properties that secure the loans are experiencing increased vacancies, declining lease rates, and/or delays in unit sales. In such instances, the Company generally stops accruing interest income on the loans even though the borrowers are current with respect to all contractual payments. Although the Company generally no longer accrues interest on these loans, the Company may continue to record periodic interest payments received on such loans as interest income provided the borrowers remain current on the loans and provided, in the judgment of management, the Company’s net recorded investment in the loans are deemed to be collectible. The Company designates loans on which it stops accruing interest income as non-accrual loans and establishes a reserve for outstanding interest that was previously credited to income. All loans on non-accrual are considered to be impaired. The Company returns a non-accrual loan to accrual status when factors indicating doubtful or uncertain collection no longer exist. In general, non-accrual loans are also classified as substandard, doubtful, or loss in accordance with the Company’s internal risk rating policy. As of December 31, 2012, $25.8 million or 1.84% of the Company’s loans were considered to be non-performing in accordance with the Company’s policies.

 

Foreclosed Properties and Repossessed Assets As of December 31, 2012, $14.0 million or 0.6% of the Company’s total assets consisted of foreclosed properties and repossessed assets. In the case of loans secured by real estate, foreclosure action generally starts when the loan is between the 90th and 120th day of delinquency following review by a senior officer and the executive loan committee of the board of directors. If, based on this review, the Company determines that repayment of a loan is solely dependent on the liquidation of the collateral, the Company will typically seek the shortest redemption period possible, thus waiving its right to collect any deficiency from the borrower. Depending on whether the Company has waived this right and a variety of other factors outside the Company’s control (including the legal actions of borrowers to protect their interests), an extended period of time could transpire between the commencement of a foreclosure action by the Company and its ultimate receipt of title to the property.

 

When the Company ultimately obtains title to the property through foreclosure or deed in lieu of foreclosure, it transfers the property to “foreclosed properties and repossessed assets” on the Company’s Consolidated Statements of Financial Condition. In cases in which a borrower has surrendered control of the property to the Company or has otherwise abandoned the property, the Company may transfer the property to foreclosed properties as an “in substance foreclosure” prior to actual receipt of title. Foreclosed properties and repossessed assets are adversely classified in accordance with the Company’s internal risk rating policy.

 

Foreclosed real estate properties are initially recorded at the lower of the recorded investment in the loan or fair value. Thereafter, the Company carries foreclosed real estate at fair value less estimated selling costs (typically 5% to 10%). Foreclosed real estate is inspected periodically to evaluate its condition. Additional outside appraisals are obtained as deemed necessary or appropriate. Additional write-downs may occur if the property value deteriorates further after it is acquired. These additional write-downs are charged to the Company’s results of operations as they occur.

 

In the case of loans secured by assets other than real estate, action to repossess the underlying collateral generally starts when the loan is between the 90th and 120th day of delinquency following review by management. The accounting for repossessed assets is similar to that described for real estate, above.

 

Loan Charge-Offs The Company typically records loan charge-offs when foreclosure or repossession becomes likely or legal proceedings related to such have commenced, the secondary source of repayment (consisting of a guarantor or operating entity) files for bankruptcy, or the loan is otherwise deemed uncollectible. The amount of the charge-off will depend on the fair market value of the underlying collateral, if any, and may be zero if the fair market value exceeds the loan amount. All charge-offs are recorded as a reduction to allowance for loan losses. All charge-off activity is reviewed by the board of directors.

 

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Allowance for Loan Losses As of December 31, 2012, the Company’s allowance for loan losses was $21.6 million or 1.54% of loans receivable and 83.6% of non-performing loans. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on factors such as the size and current risk characteristics of the portfolio, an assessment of individual problem loans and pools of homogenous loans within the portfolio, and actual loss, delinquency, and/or risk rating experience within the portfolio. The Company also considers current economic conditions and/or events in specific industries and geographical areas, including unemployment levels, trends in real estate values, peer comparisons, and other pertinent factors, including regulatory guidance. Finally, as appropriate, the Company also considers individual borrower circumstances and the condition and fair value of the loan collateral, if any. For additional information relating to the Company’s allowance for loan losses for the periods covered by this report, refer to “Results of Operations—Provision for Loan Losses” and “Financial Condition—Asset Quality” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Determination of the allowance is inherently subjective as it requires significant management judgment and estimates, including the amounts and timing of expected future cash flows on loans, the fair value of underlying collateral (if any), estimated losses on pools of homogeneous loans based on historical loss experience, changes in risk characteristics of the loan portfolio, and consideration of current economic trends, all of which may be susceptible to significant change. Higher rates of loan defaults than anticipated would likely result in a need to increase provisions in future years. Also, increases in the Company’s multi-family, commercial real estate, construction and development, and commercial business loan portfolios could result in a higher allowance for loan losses as these loans typically carry a higher risk of loss. Finally, various regulatory agencies, as an integral part of their examination processes, periodically review the Company’s loan and foreclosed real estate portfolios and the related allowance for loan losses and valuation allowance for foreclosed real estate. One or more of these agencies, particularly the OCC, may require the Company to increase the allowance for loan losses or the valuation allowance for foreclosed real estate based on their judgments of information available to them at the time of their examination, thereby adversely affecting the Company’s results of operations. As a result of applying management judgment, it is possible that there may be periods when the amount of the allowance and/or its percentage to total loans or non-performing loans may decrease even though non-performing loans may increase.

 

Periodic adjustments to the allowance for loan loss are recorded through provision for loan losses in the Company’s Consolidated Statements of Income. Actual losses on loans are charged off against the allowance for loan losses. In the case of loans secured by real estate, charge-off typically occurs when foreclosure or repossession is likely or legal proceedings related to such have commenced, when the secondary source of repayment (consisting of a guarantor or operating entity) files for bankruptcy, or when the loan is otherwise deemed uncollectible in the judgment of management. Loans not secured by real estate, as well as unsecured loans, are charged off when the loan is determined to be uncollectible in the judgment of management. Recoveries of loan amounts previously charged off are credited to the allowance as received. Management reviews the adequacy of the allowance for loan losses on a monthly basis. The board of directors reviews management’s judgments related to the allowance for loan loss on at least a quarterly basis.

 

The Company maintains general allowances for loan loss against certain homogenous pools of loans. These pools generally consist of smaller one- to four-family, multi-family, commercial real estate, consumer, and commercial business loans that do not warrant individual review due to their size. In addition, pools may also consist of larger multi-family, commercial real estate, and commercial business loans that have not been individually identified as impaired by management. Certain of these pools, such as the one- to four-family and consumer loan pools, are further segmented according to the nature of the collateral that secures the loans. For example, the consumer loan pool is segmented by collateral type, such as loans secured by real estate, loans secured by automobiles, and loans secured by other collateral. The various loan pools are further segmented by management’s internal risk rating of the loans. Management has developed factors for each pool or segment based on the historical loss experience of each pool or segment, recent delinquency performance, internal risk ratings, and consideration of current economic trends, in order to determine what it believes is an appropriate level for the general allowance. Given the significant amount of management judgment involved in this process there could be significant variation in the Company’s allowance for loan losses and provision for loan losses from period to period.

 

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The Company maintains specific allowances for loan loss against individual loans that have been identified by management as impaired. These loans are generally larger loans, but management may also establish specific allowances against smaller loans from time-to-time. The allowance for loan loss established against these loans is based on one of two methods: (1) the present value of the future cash flows expected to be received from the borrower, discounted at the loan’s effective interest rate, or (2) the fair value of the loan collateral, if the loan is considered to be collateral dependent. In the Company’s experience, loss allowances using the first method have been rare. In working with problem borrowers, if the Company cannot develop a repayment plan that substantially complies with the original terms of the loan agreement, the Company’s practice has been to pursue foreclosure or repossession of the underlying collateral. As a matter of practice, the Company does not restructure troubled loans in a manner that results in a loss under the first method. As a result, most loss allowances are established using the second method because the related loans have been deemed collateral dependent by management.

 

Management considers loans to be collateral dependent when, in its judgment, there is no source of repayment for the loan other than the ultimate sale or disposition of the underlying collateral and foreclosure is probable. Factors management considers in making this determination typically include, but are not limited to, the length of time a borrower has been delinquent with respect to loan payments, the nature and extent of the financial or operating difficulties experienced by the borrower, the performance of the underlying collateral, the availability of other sources of cash flow or net worth of the borrower and/or guarantor, and the borrower’s immediate prospects to return the loan to performing status. In some instances, because of the facts and circumstances surrounding a particular loan relationship, there could be an extended period of time between management’s identification of a problem loan and a determination that it is probable that such loan is or will become collateral dependent. Based on recent experience, however, management has noted the length of time has shortened between when a loan is classified as non-performing and when it is considered to be collateral dependent. Management believes this is a trend that will continue as long as economic conditions and/or commercial real estate values remain depressed.

 

Management generally measures impairment of impaired loans whether or not foreclosure is probable based on the estimated fair value of the underlying collateral. Such estimates are based on management’s judgment or, when considered appropriate, on an updated appraisal or similar evaluation. Updated appraisals are also typically obtained on or about the time of foreclosure or repossession of the underlying collateral. Prior to receipt of the updated appraisal, management has typically relied on the original appraisal and knowledge of the condition of the collateral, as well as the current market for the collateral, to estimate the Company’s exposure to loss on impaired loans. In the judgment of management, this practice was acceptable in periods of relative stability in real estate markets. However, as a result of deterioration in commercial real estate markets since 2008, as well as the Company’s recent experience, management believes that as long as economic conditions and/or real estate markets remain depressed updated appraisals will continue to be obtained on impaired loans earlier in the evaluation process than may have been typical during periods of more stable real estate markets.

 

Investment Activities

 

At December 31, 2012, the Company’s portfolio of mortgage-related securities available-for-sale was $550.2 million or 22.8% of its total assets. As of the same date its portfolio of mortgage-related securities held-to-maturity was $157.6 million or 6.5% of total assets. Mortgage-related securities consist principally of mortgage-backed securities (“MBSs”), real estate mortgage investment conduits (“REMICs”), and CMOs. Most of the Company’s mortgage-related securities are directly or indirectly insured or guaranteed by Freddie Mac, Fannie Mae, or the Government National Mortgage Association (“Ginnie Mae”). The remaining securities are private-label CMOs. Private-label CMOs generally carry higher credit risks and higher yields than mortgage-related securities insured or guaranteed by the aforementioned agencies of the U.S. Government. Although the latter securities have less exposure to credit risk, like private-label CMOs they remain exposed to fluctuating interest rates and instability in real estate markets, which may alter the prepayment rate of underlying mortgage loans and thereby affect the fair value of the securities. For additional information related to the Company’s mortgage-related securities, refer to “Financial Condition—Mortgage-Related Securities Available-for-Sale” and “Financial Condition—Mortgage-Related Securities Held-to-Maturity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

In addition to the mortgage-related securities previously described, the Company’s investment policy authorizes investment in various other types of securities, including U.S. Treasury obligations, federal agency obligations, state and municipal obligations, certain certificates of deposit of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements, federal funds, commercial paper, mutual funds, and, subject to certain limits, corporate debt and equity securities.

 

The objectives of the Company’s investment policy are to meet the liquidity requirements of the Company and to generate a favorable return on investments without compromising objectives related to overall exposure to risk, including interest rate risk, credit risk, and investment portfolio concentrations. In addition, the Company pledges eligible securities as collateral for certain deposit liabilities, FHLB of Chicago advances, and other purposes permitted or required by law.

 

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The Company’s investment policy requires that securities be classified as trading, available-for-sale, or held-to-maturity at the date of purchase. The Company’s available-for-sale securities are carried at fair value with the change in fair value recorded as a component of shareholders’ equity rather than affecting the statement of operations. The Company’s held-to-maturity securities are carried at amortized cost. The Company has not engaged in trading activities.

 

The Company’s investment policy allows the use of hedging instruments such as financial futures, options, forward commitments, and interest rate swaps, but only with prior approval of the board of directors. Other than forward commitments related to its sale of residential loans in the secondary market, the Company did not have any investment hedging transactions in place at December 31, 2012. The Company’s investment policy prohibits the purchase of non-investment grade securities, although the Company may continue to hold investments that are reduced to less than investment grade after their purchase. Securities rated less than investment grade are adversely classified as substandard in accordance with federal guidelines (refer to Asset Quality—Internal Ratings and Classified Assets,” above).

 

Deposit Liabilities

 

At December 31, 2012, the Company’s deposit liabilities were $1.9 billion or 77.2% of its total liabilities and equity. The Company offers a variety of deposit accounts having a range of interest rates and terms for both retail and business customers. The Company currently offers regular savings accounts (consisting of passbook and statement savings accounts), interest-bearing demand accounts, non-interest-bearing demand accounts, money market accounts, and certificates of deposit. The Company also offers IRA time deposit accounts and health savings accounts. When the Company determines its deposit rates, it considers rates offered by local competitors, benchmark rates on U.S. Treasury securities, and rates on other sources of funds such as FHLB of Chicago advances. For additional information, refer to “Financial Condition—Deposit Liabilities” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Deposit flows are significantly influenced by general and local economic conditions, changes in prevailing interest rates, pricing of deposits, and competition. The Company’s deposits are primarily obtained from the market areas surrounding its bank offices. The Company relies primarily on competitive rates, quality service, and long-standing relationships with customers to attract and retain these deposits. The Company does not rely on a particular customer or related group of individuals, organizations, or institutions for its deposit funding. From time to time the Company has used third-party brokers and a nationally-recognized reciprocal deposit gathering network to obtain wholesale deposits. As of December 31, 2012, the Company did not have any brokered deposits outstanding and had less than $500,000 in reciprocal deposits outstanding.

 

Borrowings

 

At December 31, 2012, the Company’s borrowed funds were $210.8 million or 8.7% of its total liabilities and equity. The Company borrows funds to finance its lending, investing, operating, and, when active, stock repurchase activities. Substantially all of its borrowings take the form of advances from the FHLB of Chicago and are on terms and conditions generally available to member institutions. The Company’s FHLB of Chicago borrowings typically carry fixed rates of interest, have stated maturities, and are generally subject to significant prepayment penalties if repaid prior to their stated maturity. The Company has pledged one- to four-family mortgage loans and certain multi-family mortgage loans and available-for-sale securities as blanket collateral for current and future advances. For additional information regarding the Company’s outstanding advances from the FHLB of Chicago as of December 31, 2012, refer to “Financial Condition—Borrowings” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Shareholders’ Equity

 

At December 31, 2012, the Company’s shareholders’ equity was $271.9 million or 11.24% of its total liabilities and equity. The Company is not currently required to maintain minimum regulatory capital at the holding company level. However, refer to “Regulation and Supervision—Regulation of the Company,” below, for additional information related to regulatory capital requirements for the Company.

 

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Although the Company is not currently required to maintain minimum regulatory capital, the Bank is required to maintain specified amounts of regulatory capital pursuant to regulations promulgated by the OCC and the FDIC. The Bank’s objective is to maintain its regulatory capital in an amount sufficient to be classified in the highest regulatory category (i.e., as a “well capitalized” institution). At December 31, 2012, the Bank exceeded all regulatory minimum requirements, as well as the amount required to be classified as a “well capitalized” institution. For additional discussion relating to regulatory capital standards refer to “Regulation and Supervision of the Bank—Regulatory Capital Requirements” and “—Prompt Corrective Action,” below. For additional information related to the Company’s equity and the Bank’s regulatory capital for the periods covered by this report, refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data.”

 

The Company has paid quarterly cash dividends since its initial stock offering in 2000. The payment of dividends is discretionary with the Company’s board of directors and depends on the Company’s operating results, financial condition, compliance with regulatory capital requirements, and other considerations. In addition, the Company’s ability to pay dividends is highly dependent on the Bank’s ability to pay dividends to the Company. As such, there can be no assurance that the Company will be able to continue the payment of dividends or that the level of dividends will not be reduced in the future. For additional information, refer to “Regulation and Supervision of the Bank—Dividend and Other Capital Distribution Limitations,” below.

 

From time to time, the Company has repurchased shares of its common stock, and such repurchases have had the effect of reducing the Company’s capital. However, as with the payment of dividends above, the repurchase of common stock is discretionary with the Company’s board of directors and depends on a variety of factors, including market conditions for the Company’s stock, the financial condition of the Company and the Bank, compliance with regulatory capital requirements, and other considerations. The Company does not have a current stock repurchase program. As a result of these considerations, there can be no assurances as to if or when the Company will be able to resume repurchases of its common stock.

 

Subsidiaries

 

BancMutual Financial & Insurance Services, Inc. (“BMFIS”), a wholly-owned subsidiary of the Bank, provides investment, brokerage, and insurance services to the Bank’s customers and the general public. Investment services include tax-deferred and tax-free investments, mutual funds, and government securities. Personal insurance, business insurance, life and disability insurance, mortgage protection products, and investment advisory services are also offered by BMFIS. Certain of BMFIS’s brokerage services are provided through an operating agreement with a third-party, registered broker-dealer.

 

Mutual Investment Corporation (“MIC”), a wholly-owned subsidiary of the Bank, owns and manages investment and mortgage-related securities. First Northern Investment Inc. (“FNII”), a wholly-owned subsidiary of the Bank, also owns and manages investment and mortgage-related securities, as well a small number of one- to four-family mortgage loans.

 

MC Development LTD (“MC Development”), a wholly-owned subsidiary of the Bank, is involved in land development and sales. It owns five parcels of developed land totaling 15 acres in Brown Deer, Wisconsin. In addition, in 2004, MC Development established Arrowood Development LLC with an independent third party to develop approximately 300 acres for residential purposes in Oconomowoc, Wisconsin. In the initial transaction, the third party purchased approximately one-half interest in that land, all of which previously had been owned by MC Development.

 

In addition, the Bank has four wholly-owned subsidiaries that are inactive, but are reserved for possible future use in related or other areas.

 

Employees

 

At December 31, 2012, the Company employed 639 full time and 81 part time associates. Management considers its relations with its associates to be good.

 

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Regulation and Supervision

 

General

 

The Company is a Wisconsin corporation and a registered savings and loan holding company under federal law. The Company files reports with and is subject to regulation and examination by the FRB. As a Wisconsin corporation, the Company is subject to the provisions of the Wisconsin Business Corporation Law, and as a public company, it is subject to regulation by the SEC. The Bank is a federally-chartered savings bank and is subject to OCC requirements as well as those of the FDIC. Any change in these laws and regulations, whether by the FRB, the OCC, the FDIC, or through legislation, could have a material adverse impact on the Company, the Bank, and the Company’s shareholders.

 

Certain current laws and regulations applicable to the Company and the Bank, and other material consequences of recent legislation, are summarized below. These summaries do not purport to be complete and are qualified in their entirety by reference to such laws, regulations, or administrative considerations.

 

Termination of Memoranda of Understanding

 

In May 2011 the Company and the Bank agreed to address certain items identified by the Office of Thrift Supervision (“OTS”), their former regulator, during a regular examination by each entering into a separate Memorandum of Understanding (“MOU”) with the OTS. An MOU is an agreement between the regulator and a financial institution which requires the institution to exercise reasonable good faith efforts to comply with the requirements of the MOU. In addition to other requirements, under their respective MOUs the Company and the Bank were required to obtain the prior written non-objection or approval of federal regulators prior to declaring or paying cash dividends and, in the case of the Company, prior to repurchasing common shares, or incurring, issuing, increasing, modifying or redeeming any debt or lines of credit. However, as a result of the Company’s and Bank’s compliance with the requirements of the MOUs, as well as their improved financial condition and operating results, the FRB and OCC recently terminated the MOUs with the Company and Bank, respectively.

 

Financial Services Industry Legislation and Related Actions

 

In response to instability in the U.S. financial system, lawmakers and federal banking agencies have taken various actions intended to stabilize the financial system and housing markets, and to strengthen U.S. financial institutions.

 

Dodd-Frank Act In 2010 Congress enacted the Dodd-Frank Act, which significantly changed the U.S. financial institution regulatory structure, as well as the lending, investment, trading, and operating activities of financial institutions and their holding companies. In 2011 the Dodd-Frank Act eliminated the OTS and transferred all of its functions and authority relating to federal thrifts, such as the Bank, to the OCC. In addition, the FRB acquired supervisory and rule-making authority over all savings and loan holding companies, such as the Company. The Dodd-Frank Act also requires the FRB to apply to savings and loan holding companies the current consolidated leverage and risk-based capital standards that insured depository institutions must follow, which will include capital requirements for the Company effective in July 2015 (refer to “Regulation and Supervision—Regulation of the Company,” below, for additional information related to regulatory capital requirements for the Company). Further, the Dodd-Frank Act has imposed new disclosure and governance requirements on publicly-held companies, such as the Company.

 

The Dodd-Frank Act also created the Consumer Financial Protection Bureau (“CFPB”) with broad powers to supervise and enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, such as the Bank. However, institutions with $10 billion or less in assets, such as the Bank, will be examined for CFPB compliance by their applicable bank regulators, rather than the CFPB itself.

 

The Dodd-Frank Act broadened the base for FDIC insurance assessments, which beginning in April 2011 was based on the average consolidated total assets less tangible equity capital of a financial institution. Prior to that time insurance assessments had been based on an insured institution’s domestic deposits. The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for insured institutions to $250,000 per depositor.

 

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Many of the provisions of the Dodd-Frank Act are subject to future rule-making procedures and studies, and the full effects of the Dodd-Frank Act on the Company and/or the Bank cannot yet be determined. The OCC is continuing a complete review of former OTS regulations that it now administers, with a goal of achieving consistency with the OCC's regulations for national banks and has already updated certain regulations and pronouncements. These provisions and reviews, or any other regulatory or legislative changes to laws applicable to the financial industry, if enacted or adopted, may impact the profitability of the Company's or the Bank's business activities or change certain of their business practices, including the Bank’s ability to offer new products, obtain financing, attract deposits, make loans, and achieve satisfactory interest spreads, and could expose the Company to additional costs, including increased compliance costs. These changes also may require the Company to invest significant management attention and resources to make any necessary changes to operations in order to comply and could therefore also materially affect the Company's and the Bank's business, financial condition, and results of operations.

 

Regulation and Supervision of the Bank

 

General As a federally-chartered, FDIC-insured savings bank, the Bank is subject to extensive regulation by the OCC, as well as the regulations of the FDIC. Lending activities and other investments must comply with federal statutory and regulatory requirements. This federal regulation and supervision establishes a comprehensive framework of activities in which a federal savings bank may engage and is intended primarily for the protection of the FDIC and depositors rather than the shareholders of the Company. This regulatory structure gives authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies regarding the classification of assets and the establishment of adequate loan loss reserves.

 

The OCC regularly examines the Bank and issues a report on its examination findings to the Bank’s board of directors. The Bank’s relationships with its depositors and borrowers are also regulated by federal law, especially in such matters as the ownership of savings accounts and the form and content of the Bank’s loan documents.

 

The Bank must file reports with the OCC and the FDIC concerning its activities and financial condition, and must obtain regulatory approvals prior to entering into transactions such as mergers or acquisitions.

 

Regulatory Capital Requirements OCC regulations require savings associations such as the Bank to meet three capital standards. The minimum standards are tangible capital equal to at least 1.5% of adjusted total assets, Tier 1 (“core”) capital equal to at least 4% of adjusted total assets (also known as the “leverage ratio”), and total risk-based capital equal to at least 8% of total risk-weighted assets. If a savings association is rated in the OCC’s highest supervisory category, the minimum leverage ratio is reduced to 3%. These capital standards are in addition to the capital standards promulgated by the OCC under its prompt corrective action regulations and standards required by the FDIC, which in some cases are more stringent than the above standards.

 

In the Bank’s case, core capital is equal to tangible capital. Core capital generally consists of common shareholders’ equity, noncumulative perpetual preferred stock and related surplus, and minority interests in the equity accounts of consolidated subsidiaries, less goodwill, other intangible assets, and certain deferred tax assets. Supplemental bank capital generally consists of core capital plus the allowance for loan and lease losses (up to a maximum of 1.25% of risk-weighted assets), cumulative perpetual preferred stock, long-term preferred stock and any related surplus, certain hybrid capital investments, term subordinated debt instruments and related surplus, and up to 45% of the pretax net unrealized holding gains on various instruments and other assets. Supplemental capital may not represent more than 50% of the total capital for the risk-based capital standard.

 

A savings association calculates its risk-weighted assets by multiplying each asset and off-balance sheet item by various risk factors as determined by the OCC, which range from 0% for cash to 100% for delinquent loans, property acquired through foreclosure, commercial loans, and other assets. In addition, certain available-for-sale securities rated less than investment grade are assigned a risk factor of 200%.

 

The Bank’s objective is to maintain its regulatory capital in an amount sufficient to be classified in the highest regulatory category (i.e., as a “well capitalized” institution). At December 31, 2012, the Bank exceeded all regulatory minimum requirements, as well as those required to be classified as a “well capitalized” institution. For additional information related to the Bank’s regulatory capital for the periods covered by this report, refer to “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data.”

 

Prompt Corrective Action The FDIC has established a system of prompt corrective action to resolve the problems of undercapitalized insured institutions and has a broad range of grounds under which it may appoint a receiver or conservator for an insured depository institution, particularly when an institution fails to meet adequate capitalization requirements. The OCC has adopted the FDIC’s regulations governing the supervisory actions that may be taken against undercapitalized institutions, the severity of which increases as a bank’s capital decreases with the three undercapitalized categories defined in the regulations. These regulations establish and define five capital categories, in the absence of a specific capital directive, as follows:

 

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   Total Risk-Based   Tier 1   Tier 1 
   Capital to Risk   Capital to Risk   Capital to 
Category:  Weighted Assets   Weighted Assets   Total Assets 
Well capitalized   

≥ 10

%   

≥ 6

%   

≥ 5

%
Adequately capitalized   

≥ 8

%   

≥ 4

%   

≥ 4

%(1)
Under capitalized   

< 8

%   

< 4

%   

< 4

%(2)
Significantly undercapitalized   

< 6

%   

< 3

%   

< 3

%
Critically undercapitalized (3)               

(1) ≥ 3% if the bank receives the highest rating under the uniform system.

(2) < 3% if the bank receives the highest rating under the uniform system.

(3) Tangible assets to capital of equal to or less than 2%.

 

Proposed Regulatory Capital Requirements In 2012 the federal banking agencies issued proposed rules that would implement certain revisions to regulatory capital requirements as specified by the Basel Committee of Banking Supervision (known as Basel III). The proposed rules, if adopted, are expected to have a significant impact on the minimum regulatory requirements of regulated financial institutions such as the Bank. However, management believes the regulatory capital of the Bank will exceed the minimum requirements established in the proposed rules and that the implementation or timing of the rules will not have a significant adverse impact on the financial condition, liquidity, or operations of the Bank. It is not known at this time when the proposed rules will become effective or whether the proposed rules will be substantially modified prior to their becoming effective.

 

Dividend and Other Capital Distribution Limitations OCC regulations generally govern capital distributions by savings associations such as the Bank, which include cash dividends and stock repurchases. A savings association must file an application with the OCC for approval of a capital distribution if, among other things, the total amount of capital distributions for the applicable calendar year exceeds the sum of the savings association’s net income for that year to date plus the savings association’s retained net income for the preceding two years.

 

In addition, even if an application is not required, a savings association must give the OCC notice at least 30 days before the board of directors declares a dividend or approves a capital distribution if the savings association is a subsidiary of a savings and loan holding company (as is the Bank) or the proposed distribution would negatively affect the adequacy of capital. In the case of a subsidiary, there is an exception; if the subsidiary is filing a notice for a cash dividend and neither an application (discussed above) or a notice (discussed in this paragraph) with the OCC is otherwise required, then the subsidiary need only file an informational copy of such notice with the OCC, in which case the subsidiary dividend to the holding company is also subject to the approval or non-objection of the FRB.

 

The OCC may disapprove a notice or application if (i) the savings association would be undercapitalized, significantly undercapitalized or critically undercapitalized following the distribution; (ii) the proposed capital distribution raises safety and soundness concerns; or (iii) the capital distribution would violate any applicable statute, regulation, agreement or OCC-imposed condition. The OCC has substantial discretion in making these decisions. The FRB may disapprove a dividend for similar reasons.

 

For additional discussion related to the Bank and Company’s dividends and the Company’s share repurchases refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.”

 

Qualified Thrift Lender Test Federal savings associations must meet a qualified thrift lender (“QTL”) test or they become subject to operating restrictions. The Bank met the QTL test as of December 31, 2012, and anticipates that it will maintain an appropriate level of mortgage-related investments (which must be at least 65% of portfolio assets) and will otherwise continue to meet the QTL test requirements. Portfolio assets are all assets minus goodwill and other intangible assets, property used by the institution in conducting its business, and liquid assets not exceeding 20% of total assets. Compliance with the QTL test is determined on a monthly basis in nine out of every twelve months.

 

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Liquidity Standards Each federal savings association must maintain sufficient liquidity to ensure its safe and sound operations. Management of the Bank believes it has established policies, procedures, and practices to maintain sufficient liquidity to meet the Bank’s obligations and otherwise ensure its safe and sound operation.

 

Federal Home Loan Bank System The Bank is a member of the FHLB of Chicago, one of twelve regional Federal Home Loan Banks. Each Federal Home Loan Bank serves as a reserve or central bank for its members within its region. It is funded primarily from funds deposited by member financial institutions and proceeds from the sale of consolidated obligations of the Federal Home Loan Bank System. The FHLB of Chicago makes loans (“advances”) to members pursuant to policies and procedures established by its board of directors. The FHLB of Chicago imposes limits on advances made to member banks, including limitations relating to the amount and type of collateral and the amount of advances.

 

As a member of the FHLB of Chicago, the Bank must meet certain eligibility requirements and must purchase and maintain common stock in the FHLB of Chicago in an amount equal to the greater of (i) 1% of its mortgage-related assets at the most recent calendar year end, (ii) 5% of its outstanding advances from the FHLB of Chicago, or (iii) $10,000. At December 31, 2012, the Bank owned $15.8 million in FHLB of Chicago common stock, which was approximately $5.3 million more than the Bank would otherwise be required to own under minimum guidelines established by the FHLB of Chicago. Management believes the FHLB of Chicago will repurchase this excess common stock in 2013, although there can be no assurances. During 2012, the FHLB of Chicago repurchased $30.3 million of excess common stock that had been owned by the Bank. For additional discussion related to the Bank’s investment in the common stock of the FHLB of Chicago, refer to “Item 1A. Risk Factors” and “Financial Condition—Other Assets” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Deposit Insurance The deposit accounts held by customers of the Bank are insured by the FDIC up to maximum limits, as provided by law. Insurance on deposits may be terminated by the FDIC if it finds that the Bank has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OCC. The management of the Bank does not know of any practice, condition, or violation that might lead to termination of the Bank’s deposit insurance.

 

The FDIC sets deposit insurance premiums based upon the risks a particular bank or savings association poses to its deposit insurance funds. Under the risk-based assessment system, the FDIC assigns an institution to one of three capital categorizations based on the institution’s financial information. With respect to these three categorizations, institutions are classified as well capitalized, adequately capitalized or undercapitalized using ratios that are substantially similar to the prompt corrective action capital ratios discussed above. The FDIC also assigns an institution to one of three supervisory sub-categorizations within each capital group. This assignment is based on a supervisory evaluation provided by the institution’s primary federal regulator and information that the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance fund.

 

An institution’s assessment rate depends on the capital categorizations and supervisory sub-categorizations to which it is assigned. Under the risk-based assessment system, there are then four assessment risk categories to which different assessment rates are applied (refer to the next paragraph for a description of these assessment rates). Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.

 

Effective in April 2011 the FDIC changed the definition of a financial institution’s deposit insurance assessment base and revised the deposit insurance risk-based assessment rate schedule, among other things. Under the revised rule the assessment base changed from an insured institution’s domestic deposits (minus certain allowable exclusions) to an insured institution’s average consolidated total assets minus average tangible equity and certain other adjustments. In addition, the assessment rates were established in a range of 2.5 to 45 basis points, depending on the institution’s capital category and supervisor sub-category, as previously described. For additional discussion, refer to “Results of Operations—Non-Interest Expense” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

In 2008 the FDIC created the Transaction Account Guarantee Program (“TAGP”), which provided participating banks with full deposit insurance coverage for non-interest-bearing transaction deposit accounts, regardless of dollar amount through December 31, 2012 (as subsequently extended). As of January 1, 2013, however, FDIC-insured financial institutions’ non-interest-bearing transaction deposit accounts are no longer fully-insured under this program. This development is not expected to have a material impact on the Bank or the deposit insurance premiums paid by the Bank.

 

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Transactions With Affiliates Sections 23A and 23B of the Federal Reserve Act and FRB Regulation W govern transactions between an insured federal savings association, such as the Bank, and any of its affiliates, such as the Company. An affiliate is any company or entity that controls, is controlled by or is under common control with it. Sections 23A and 23B limit the extent to which an institution or a subsidiary may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such savings association’s capital stock and surplus, and limit all such transactions with all affiliates to 20% of such stock and surplus. The term “covered transaction” includes the making of loans, purchase of assets, issuance of guarantees, derivatives transactions, securities borrowing, and lending transactions to the extent that they result in credit exposure to an affiliate. Further, most loans by a savings association to any of its affiliates must be secured by specified collateral amounts. All such transactions must be on terms that are consistent with save and sound banking practices and must be on terms that are at least as favorable to the savings association as those that would be provided to a non-affiliate. At December 31, 2012, the Company and Bank did not have any covered transactions.

 

Acquisitions and Mergers Under the federal Bank Merger Act, any merger of the Bank with or into another institution would require the approval of the OCC, or the primary federal regulator of the resulting entity if it is not an OCC-regulated institution. Refer also to “Regulation and Supervision of the Company—Acquisition of Bank Mutual Corporation,” below.

 

Prohibitions Against Tying Arrangements Savings associations are subject to the prohibitions of 12 U.S.C. Section 1972 on certain tying arrangements. A savings association is prohibited, subject to exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor.

 

Uniform Real Estate Lending Standards The federal banking agencies adopted uniform regulations prescribing standards for extensions of credit that are secured by liens on interests in real estate or are made to finance the construction of a building or other improvements to real estate. All insured depository institutions must adopt and maintain written policies that establish appropriate limits and standards for such extensions of credit. These policies must establish loan portfolio diversification standards, prudent underwriting standards that are clear and measurable, loan administration procedures, and documentation, approval and reporting requirements.

 

These lending policies must reflect consideration of the Interagency Guidelines for Real Estate Lending Policies that have been adopted by the federal bank regulators. These guidelines, among other things, require a depository institution to establish internal loan-to-value limits for real estate loans that are not in excess of specified supervisory limits, which generally vary and provide for lower loan-to-value limits for types of collateral that are perceived as having more risk, are subject to fluctuations in valuation, or are difficult to dispose. Although there is no supervisory loan-to-value limit for owner-occupied one- to four-family and home equity loans, the guidelines provide that an institution should require credit enhancement in the form of mortgage insurance or readily marketable collateral for any such loan with a loan-to-value ratio that equals or exceeds 90% at origination. The guidelines also clarify expectations for prudent appraisal and evaluation policies, procedures, and practices, and make other changes, in light of the Dodd-Frank Act and other recent federal statutory changes affecting appraisals.

 

Community Reinvestment Act Under the Community Reinvestment Act (“CRA”), any insured depository institution, including the Bank, must, consistent with its safe and sound operation, help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community. The CRA requires the OCC to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution, including applications for additional branches and acquisitions.

 

Among other things, the CRA regulations contain an evaluation system that rates an institution based on its actual performance in meeting community needs. In particular, the evaluation system focuses on three tests: (i) a lending test, to evaluate the institution’s record of making loans in its service areas, (ii) an investment test, to evaluate the institution’s record of making community development investments, and (iii) a service test, to evaluate the institution’s delivery of services through its branches, ATMs and other offices. The CRA requires the OCC to provide a written evaluation of the Bank’s CRA performance utilizing a four-tiered descriptive rating system and requires public disclosure of the CRA rating. The Bank received a “satisfactory” overall rating in its most recent CRA examination.

 

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Safety and Soundness Standards Each federal banking agency, including the OCC, has guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, customer privacy, liquidity, earnings, and compensation and benefits. The guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines also prohibit excessive compensation as an unsafe and unsound practice.

 

Loans to Insiders A savings association’s loans to its executive officers, directors, any owner of more than 10% of its stock (each, “an insider”) and certain entities affiliated with any such person (an insider’s “related interest”) are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the FRB’s Regulation O thereunder. Under these restrictions, the aggregate amount of the loans to any insider and related interests may not exceed the loans-to-one-borrower limit applicable to national banks. All loans by a savings association to all insiders and related interests in the aggregate may not exceed the savings association’s unimpaired capital and surplus. With certain exceptions, the Bank’s loans to an executive officer (other than certain education loans and residential mortgage loans) may not exceed $100,000. Regulation O also requires that any proposed loan to an insider or a related interest be approved in advance by a majority of the Bank’s board of directors, without the vote of any interested director, if such loan, when aggregated with any existing loans to that insider and related interests, would exceed $500,000. Generally, such loans must be made on substantially the same terms as, and follow credit underwriting procedures that are no less stringent than, those for comparable transactions with other persons and must not present more than a normal risk of collectability. There is an exception for extensions of credit pursuant to a benefit or compensation plan of a savings association that is widely available to employees that does not give preference to officers, directors, and other insiders. As of December 31, 2012, total loans to insiders were $411,000 (including $138,000 which relates to residential mortgages that have been sold in the secondary market).

 

Regulation and Supervision of the Company

 

General The Company is a registered savings and loan holding company under federal law and is subject to regulation, supervision, and enforcement actions by the FRB. Among other things, this authority permits the FRB to restrict or prohibit activities that are determined to be a risk to the Bank and to monitor and regulate the Company’s capital and activities such as dividends and share repurchases that can affect capital. Under long-standing FRB policy, holding companies are expected to serve as a source of strength for their depository subsidiaries, and may be called upon to commit financial resources and support to those subsidiaries. The requirement that the Company act as a source of strength for the Bank, and the future capital requirements at the Company level (refer to “Regulatory Capital Requirements,” below), may affect the Company's ability to pay dividends or make other distributions.

 

The Company may engage in activities permissible for a savings and loan holding company, a bank holding company, or a financial holding company, which generally encompass a wider range of activities that are financial in nature. The Company may not engage in any activities beyond that scope without the approval of the FRB.

 

Federal law prohibits a savings and loan holding company from acquiring control of another savings institution or holding company without prior written regulatory approval. With some exceptions, it also prohibits the acquisition or retention of more than 5% of the equity securities of a company engaged in activities that are not closely related to banking or financial in nature or acquiring an institution that is not federally-insured. In evaluating applications to acquire savings institutions, the regulator must consider the financial and managerial resources, future prospects of the institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors.

 

Regulatory Capital Requirements The Company is not currently required by the FRB to maintain minimum regulatory capital at the consolidated level. However, under the Dodd-Frank Act, the FRB is required to impose capital requirements on savings and loan holding companies effective in 2015. Management believes these capital requirements will be substantially the same as those currently required for bank holding companies. Management also believes the Company would have exceeded all regulatory minimum capital requirements as of December 31, 2012, had it been subject to bank holding company capital requirements as of that date.

 

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Proposed Regulatory Capital Requirements In 2012 the federal banking agencies issued proposed regulatory capital rules under Basel III, as previously described. The proposed rules, if adopted, are expected to have a significant impact on the minimum regulatory requirements of regulated financial institutions such as the Company, to include accelerating the timing of the regulatory capital requirements for the Company at the consolidated level, as discussed in the previous paragraph. However, management believes the regulatory capital of the Company will exceed the minimum requirements established in the proposed rules and that the implementation or timing of the rules will not have a significant adverse impact on the financial condition, liquidity, or operations of the Company. It is not known at this time when the proposed rules will become effective or whether the proposed rules will be substantially modified prior to their becoming effective.

 

Federal Securities Laws The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934. The Company is therefore subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act. As a publicly-traded company, the Company is also subject to legislation intended to strengthen the securities markets and public confidence in them. Because some FRB accounting and governance regulations also refer to the SEC’s regulations, the SEC rules may also affect the Bank.

 

Acquisition of Bank Mutual Corporation No person may acquire control of the Company without first obtaining the approval of such acquisition by the appropriate federal regulator. Currently, under the federal Change in Bank Control Act and the Savings and Loan Holding Company Act, any person, including a company, or group acting in concert, seeking to acquire 10% or more of the outstanding shares of the Company must, depending on the circumstances, obtain the approval of, and/or file a notice with the FRB. Also, any person or group acting in concert seeking to acquire more than 25% of the Company’s common stock must obtain the prior approval of the FRB.

 

Federal and State Taxation

 

Federal Taxation The Company and its subsidiaries file a calendar year consolidated federal income tax return, reporting income and expenses using the accrual method of accounting. The federal income tax returns for the Company’s subsidiaries have been examined and audited or closed without audit by the Internal Revenue Service for tax years prior to 2007.

 

State Taxation The Company and its subsidiaries are subject to combined reporting in the state of Wisconsin. which includes the Bank’s out-of-state investment subsidiaries since 2009. For additional discussion regarding the impact of this change, refer to “Results of Operations—Income Tax Expense (Benefit)” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Also, refer to “Item 1A. Risk Factors,” for additional discussion.

 

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Item 1A. Risk Factors

 

In addition to the discussion and analysis set forth in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the cautionary statements set forth in “Item 1. Business,” the following risk factors should be considered when evaluating the Company’s results of operations, financial condition, and outlook. These risk factors should also be considered when evaluating any investment decision with respect to the Company’s common stock.

 

The Global Credit Market Volatility and Weak Economic Conditions May Significantly Affect the Company’s Liquidity, Financial Condition, and Results of Operations

 

Global financial markets continue to be unstable and unpredictable, and economic conditions have been relatively weak. Developments relating to the federal budget, federal borrowing authority, or other political issues could also negatively impact these markets, as could global developments such as the European sovereign debt crisis. Continued, and potentially increased, volatility, instability and weakness could affect the Company’s ability to sell investment securities and other financial assets, which in turn could adversely affect the Company’s liquidity and financial position. These factors could also affect the prices at which the Company could make any such sales, which could adversely affect its results of operations and financial condition. Conditions could also negatively affect the Company’s ability to secure funds or raise capital for acquisitions and other projects, which in turn, could cause the Company to use deposits or other funding sources for such projects.

 

In addition, the volatility of the markets and weakness of the economy could affect the strength of the Company’s customers or counterparties, their willingness to do business with, and/or their ability or willingness to fulfill their obligations to the Company, which could further affect the Company’s results of operations. Current conditions, including relatively high unemployment, weak corporate performance, and soft real estate markets, could negatively affect the volume of loan originations and prepayments, the value of the real estate securing the Company’s mortgage loans, and borrowers’ ability or willingness to repay loan obligations, all of which could adversely impact the Company’s results of operations and financial condition.

 

The Company’s Actual Loan Losses May Exceed its Allowance for Loan Losses, Which Could Have a Material Adverse Affect on the Company’s Results of Operations

 

The Company has policies and procedures in place to manage its exposure to risk related to its lending operations. However, despite these practices, the Company’s loan customers may not repay their loans according to the terms of the loans and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. Economic weakness, including high unemployment rates and lower values for the collateral underlying loans, may affect borrowers’ ability or willingness to repay their loan obligations that could lead to increased loan losses or provisions. As a result, the Company may experience significant loan losses, including losses that may exceed the amounts established in the allowance for loan losses, which could have a material adverse effect on its operating results and capital.

 

Further Declines in Real Estate Values May Continue to Adversely Affect Collateral Values and the Company’s Results of Operations

 

The Company’s market areas have generally experienced lower real estate values, higher levels of residential and non-residential tenant vacancies, and weakness in the market for sale of new or existing properties, for both commercial and residential real estate. These developments could continue to negatively affect the value of the collateral securing the Company’s mortgage and related loans. That decrease in value could in turn lead to increased losses on loans in the event of foreclosures. Increased losses would affect the Company’s loan loss allowance and may cause it to increase its provision for loan losses resulting in a charge to earnings and capital.

 

Some of the Company’s Lending Activities Are Riskier than One- to Four-Family Real Estate Loans

 

The Company has identified commercial real estate, commercial business, construction, and consumer loans as areas for lending emphasis and has augmented its personnel in recent periods to increase its penetration in the commercial lending market. While the Company is pursuing this lending diversification for the purpose of increasing net interest income, these types of loans historically have carried greater risk of payment default than residential real estate loans. As the volume of these types of loans increases, credit risk increases. In the event of continued substantial borrower defaults and/or increased defaults resulting from these diverse types of lending, the Company’s provision for loan losses would further increase and loans may be written off, and therefore, earnings would be reduced.

 

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Further, as the portion of the Company's loans secured by the assets of commercial enterprises increases, the Company becomes increasingly exposed to environmental liabilities and compliance burdens. Even though the Company is subject to environmental requirements in connection with residential real estate lending, the possibility of liability increases in connection with commercial lending, particularly in industries that use hazardous materials and/or generate waste or pollution or that own property that was the subject of prior contamination. If the Company does not adequately assess potential environment risks, the value of the collateral it holds may be less than it expects, and it may be exposed to liability for remediation or other environmental compliance.

 

Regulators Are Becoming Increasingly Stringent, which may Affect the Company's Business and Results of Operations

 

In addition to new laws and increasing amounts of regulation, the regulatory climate in the U.S., particularly for financial institutions, has become increasingly strict and stringent. As a consequence, regulatory activity affecting specific institutions has also increased in recent periods. Further, because the responsibility for regulating savings associations and their holding companies has transitioned to different regulatory agencies, the FRB and the OCC, these agencies may approach that regulation in different or stricter ways than the predecessor agency, which also could affect the Company's and the Bank's costs of compliance and results of operations.

 

The Bank’s Ability to Pay Dividends to the Company Is Subject to Current and Potential Future Limitations That May Affect the Company’s Ability to Pay Dividends to Its Shareholders and Repurchase Its Stock

 

The Company is a separate legal entity from the Bank and engages in no substantial activities other than its ownership of the common stock of the Bank. Consequently, the Company’s net income and cash flows are derived primarily from the Bank’s operations and capital distributions. The availability of dividends from the Bank to the Company is limited by various statutes and regulations, including those of the OCC and FRB; as a result, it is possible, depending on the results of operations and the financial condition of the Bank and other factors, that the OCC and/or the FRB could restrict the payment by the Bank of dividends or other capital distributions or take other actions which could negatively affect the Bank's results and dividend capacity. The federal regulators have become increasingly stringent in their interpretation, application and enforcement of banks' capital requirements, which could affect the regulators’ willingness to allow Bank dividends to the Company. If the Bank is required to reduce its dividends to the Company, or is unable to pay dividends at all, or the FRB separately does not allow the Company to pay dividends, the Company may not be able to pay dividends to its shareholders at existing levels or at all and/or may not be able to repurchase its common stock.

 

Future Events May Result in a Valuation Allowance Against the Company’s Deferred Tax Asset Which May have a Significant Effect On the Company’s Results of Operations and Financial Condition

 

As of December 31, 2012, the Company’s net deferred tax asset was $34.2 million. Management evaluates this asset on an on-going basis to determine if a valuation allowance is required. Management determined that no valuation allowance was required to be recorded against the Company’s net deferred tax asset as of December 31, 2012. This determination required significant management judgment based on positive and negative considerations. Such considerations included the Company’s cumulative three-year net loss, the nature of the components of such cumulative loss, recent trends in earnings excluding one-time charges (such as the FHLB prepayment penalty in 2010 and the goodwill impairment in 2011), expectations for the Company’s future earnings, the duration of federal and state net operating loss carryforward periods, and other factors. Future events or circumstances could result in conditions that differ significantly from management’s current assessment of these positive and negative considerations, particularly as such relate to the Company’s future earnings. Changes in these considerations could result in a significant valuation allowance being recorded against the Company’s net deferred tax asset, which could have a significant effect on the Company’s future results of operations and financial condition.

 

Recent and Future Legislation and Rulemaking in Response to Market and Economic Conditions May Significantly Affect the Company’s Results of Operations and Financial Condition

 

Instability, volatility, and failures in the credit and financial institutions markets in recent years have led regulators and legislators to consider and/or adopt proposals that will significantly affect financial institutions and their holding companies, including the Company. Legislation such as the Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009, and the Dodd-Frank Act of 2010, as well as programs such as the Troubled Assets Relief Program, were adopted. In addition, in 2012 the federal banking agencies issued proposed rules to implement certain revisions to regulatory capital requirements as specified by Basel III. Although designed to address capital and liquidity issues in the banking system, there can be no assurance as to the ultimate impact of these actions on financial markets, which could have a material, adverse effect on the Company’s business, financial condition, results of operations, access to credit or the value of the Company’s securities. Further legislative and regulatory proposals to reform the U.S. financial system would also affect the Company and the Bank.

 

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The Dodd-Frank Act created the CFPB, which has broad rulemaking and enforcement authority with respect to entities, including financial institutions, that offer to consumers covered financial products and services. The CFPB is required to adopt rules identifying practices or acts that are unfair, deceptive or abusive relating to any customer transaction for a consumer financial product or service, or the offering of a consumer financial product or service. The full scope of the impact of this authority has not yet been determined as related rules have not all yet been adopted. The Company cannot yet determine the costs and limitations related to these additional regulatory requirements; however, the costs of compliance and the effect on its business may have a material adverse effect on the Company's operations and results.

 

Recently enacted laws, proposed acts, taxes and fees, or any other legislation or regulations ultimately enacted, could materially affect the Company, the Bank and their operations and profitability by imposing additional regulatory burdens and costs, imposing limits on fees and other sources of income, and otherwise more generally affecting the conduct of their business.

 

The Interest Rate Environment May Have an Adverse Impact on the Company’s Net Interest Income

 

Volatile interest rate environments make it difficult for the Company to coordinate the timing and amount of changes in the rates of interest it pays on deposits and borrowings with the rates of interest it earns on loans and securities. In addition, volatile interest rate environments cause corresponding volatility in the demand by individuals and businesses for the loan and deposit products offered by the Company. These factors have a direct impact on the Company’s net interest income, and consequently, its net income. Future interest rates could continue to be volatile and management is unable to predict the impact such volatility would have on the net interest income and profits of the Company.

 

Changes in Market Interest Rates or Other Conditions May Have an Adverse Impact on the Fair Value of the Company’s Available-for-Sale Securities, Shareholders’ Equity, and Profits

 

GAAP requires the Company to carry its available-for-sale securities at fair value on its balance sheet. Unrealized gains or losses on these securities, reflecting the difference between the fair market value and the amortized cost, net of its tax effect, are included as a component of shareholders’ equity. When market rates of interest increase, the fair value of the Company’s securities available-for-sale generally decreases and equity correspondingly decreases. When rates decrease, fair value generally increases and shareholders’ equity correspondingly increases. However, due to significant disruptions in global financial markets, such as those which occurred in 2008, this usual relationship can be disrupted. Despite a generally declining interest rate environment since that time, certain of the Company’s available-for-sale securities (specifically, its private-label CMOs) from time-to-time have experienced fair values substantially less than amortized cost. Management expects continued volatility in the fair value of its private-label CMOs and is not able to predict when or if the fair value of such securities will fully recover.

 

Wisconsin Tax Developments Could Reduce the Company’s Net Income

 

Like many Wisconsin financial institutions, the Company has established non-Wisconsin subsidiaries that hold and manage investment assets and loans, the income from which had not previously been subject to Wisconsin tax prior to 2009. Under a Wisconsin Department of Revenue (the “Department”) audit program specifically aimed at financial institutions’ out-of-state investment subsidiaries, the Department has asserted the position that some or all of the income of the out-of-state subsidiaries in years prior to 2009 was taxable in Wisconsin. In 2010 the Department’s auditor issued a Notice of Proposed Audit Report to the Bank which proposes to tax all of the income of the Bank’s out-of-state investment subsidiaries for all periods that are still open under the statute of limitations, which includes tax years back to 1997. This is a preliminary determination made by the auditor and does not represent a formal assessment. The Bank’s outside legal counsel has met with representatives of the Department to discuss, and object to, the auditor’s proposed adjustments. The Department has requested further information to support the Company’s position, which the Company has provided. The Company is awaiting a further response from the Department.

 

24
 

 

Management continues to believe that the Bank has reported income and paid Wisconsin taxes in prior periods in accordance with applicable legal requirements and the Department’s long-standing interpretations of them and that the Bank’s position will prevail in discussions with the Department, court proceedings, or other actions that may occur. Ultimately, however, an adverse resolution of these matters could result in additional Wisconsin tax obligations for prior periods, which could have a substantial negative impact on the Bank’s earnings in the period such resolution is reached. The Bank may also incur further costs in the future to address and defend these issues.

 

Strong Competition Within the Company’s Market Area May Affect Net Income

 

The Company encounters strong competition both in attracting deposits and originating real estate and other loans. The Company competes with commercial banks, savings institutions, mortgage banking firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms. The Company’s market area includes branches of several commercial banks that are substantially larger than the Company in terms of deposits and loans. In addition, tax-exempt credit unions operate in most of the Company’s market area and aggressively price their products and services to a large part of the population. If competitors succeed in attracting business from the Company’s customers, its deposits and loans could be reduced, which would likely affect earnings.

 

Developments in the Marketplace, Such as Alternatives to Traditional Financial Institutions, or Adverse Publicity Could Affect the Company's Ongoing Business

 

Changes in the marketplace are allowing consumers to use alternative means to complete financial transactions that previously had been conducted through banks. For example, consumers can increasingly maintain funds in accounts other than bank deposits or through on-line alternatives, or complete payment transactions without the assistance of banks. Continuation or acceleration of these trends, including newly developing means of communications and technology, could cause consumers to utilize fewer of the Company's services, which could have a material adverse affect on its results.

 

Financial institutions such as the Company are increasingly under governmental, media and other scrutiny as to the conduct of their businesses, and potential issues and adverse developments (real and perceived) are receiving widespread media attention. If there were to be significant adverse publicity about the Company, that publicity could affect its reputation in the marketplace. If the Company's reputation is diminished, it could affect its business and results of operations as well as the price of the Company's common stock.

 

The Company Is Subject to Security Risks and Failures and Operational Risks Relating to the Use of Technology that Could Damage Its Reputation and Business

 

Security breaches in the Company’s internet, telephonic, or other electronic banking activities could expose it to possible liability and damage its reputation. Any compromise of the Company’s security also could deter customers from using its internet banking services that involve the transmission of confidential information. The Company relies on standard internet and other security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect the Company’s systems from compromises or breaches of its security measures, which could result in damage to the Company’s reputation and business and affect its results of operations.

 

Additionally, as a financial institution, the Company’s business is data intensive. Beyond the inherent nature of a financial institution that requires it to process and track extremely large numbers of financial transactions and accounts, the Company is required to collect and maintain significant data about its customers. These operations require the Company to obtain and maintain technology and security-related systems that are mission critical to its business. The Company’s failure to do so could significantly affect its ability to conduct business and its customers' confidence in it. Further, the Company outsources a large portion of its data processing to third parties. If these third party providers encounter technological or other difficulties or if they have difficulty in communicating with the Company, it will significantly affect the Company’s ability to adequately process and account for customer transactions, which would significantly affect business operations.

 

Further, the technology affecting the financial institutions industry and consumer financial transactions is rapidly changing, with the frequent introduction of new products, services, and alternatives. The future success of the Company requires that it continue to adapt to these changes in technology to address its customers' needs. Many of the Company's competitors have greater technological resources to invest in these improvements. These changes could be costly to the Company and if the Company does not continue to offer the services and technology demanded by the marketplace, this failure to keep pace with change could materially affect its business, financial condition, and results of operation.

 

25
 

 

Future FDIC Increases in Deposit Insurance Premiums Could Increase the Company’s Expenses

 

In 2009 the FDIC significantly increased the initial base assessment rates paid by financial institutions for deposit insurance and imposed a special assessment. These measures were partly in response to the high level of bank failures which has caused an increase in FDIC resolution costs and a reduction in the deposit insurance fund. Effective in April 2011 the FDIC issued a new rule that changed the assessment base and risk-based assessment rates of all insured financial institutions. Although this latest development benefited the Company by lowering the total dollar amount of its FDIC deposit insurance premiums, future changes in the assessment base and/or rates, if any, may have an adverse affect on the earnings of the Company.

 

The Company’s Ability to Grow May Be Limited if It Cannot Make Acquisitions

 

The Company will continue to seek to expand its banking franchise by growing internally, acquiring other financial institutions or branches, acquiring other financial services providers, and opening new offices. The Company’s ability to grow through selective acquisitions of other financial institutions or branches will depend on successfully identifying, acquiring, and integrating those institution or branches. The Company has not made any acquisitions in recent years, as management has not identified acquisitions for which it was able to reach an agreement on terms management believed were appropriate and/or that met its acquisition criteria. The Company cannot provide any assurance that it will be able to generate internal growth, identify attractive acquisition candidates, make acquisitions on favorable terms, or successfully integrate any acquired institutions or branches.

 

The Company Depends on Certain Key Personnel and the Company’s Business Could Be Harmed by the Loss of Their Services or the Inability to Attract Other Qualified Personnel

 

The Company’s success depends in large part on the continued service and availability of its management team, and on its ability to attract, retain and motivate qualified personnel. The management team has been augmented to attempt to increase the Company's penetration into the commercial lending market. The Company may need to attract further talent in the future. The competition for these individuals can be significant, and the loss of key personnel could harm the Company’s business. The Company cannot provide assurances that it will be able to retain existing key personnel or attract additional qualified personnel.

 

If the Company is Unable to Maintain Effective Internal Control Over Its Financial Reporting, Investors Could Lose Confidence in the Reliability of Its Financial Statements, Which Could Result in a Reduction in the Value of Its Common Stock

 

Under the Sarbanes-Oxley Act, public companies must include a report of management regarding companies' control over financial reporting in their annual reports and that report must contain an assessment by management of the effectiveness of the companies' internal control over financial reporting. In addition, the independent registered public accounting firm that audits a company's financial statements must attest to and report on the effectiveness of the company’s internal control over financial reporting.

 

If the Company is unable to maintain the required effective internal control over financial reporting, including in connection with regulatory changes and/or changes in accounting rules and standards that apply to it, this could lead to a failure to meet its reporting obligations to the SEC. Such a failure in turn could result in an adverse reaction to the Company in the marketplace or a decline in value of the Company's common stock, due to a loss of confidence in the reliability of the Company's financial statements.

 

The Cost to Provide Employee Healthcare Insurance and/or Benefits Could Increase in the Future

 

The Affordable Care Act (the “ACA”), which was adopted in 2010 and is being phased in over several years, significantly affects the provision of both health care services and benefits in the United States. It is possible that ACA the will negatively affect the Company’s cost of providing health insurance and/or benefits, and may also impact various other aspects of the Company’s business. While the ACA did not have a material impact on the Company in 2012, 2011 or 2010, the Company is continuing to assess the possible future impact of the ACA on its health care benefit costs.

 

26
 

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

The Company and its subsidiaries conduct their business through an executive office and 76 banking offices, which had an aggregate net book value of $48.1 million as of December 31, 2012, excluding furniture, fixtures, and equipment. As of December 31, 2012, the Company owned the building and land for 69 of its property locations and leased the space for eight.

 

The Company also owns 15 acres of developed land in a suburb of Milwaukee, Wisconsin, through its MC Development subsidiary, as well as approximately 300 acres of undeveloped land in another community located near Milwaukee through MC Development’s 50% ownership in Arrowood Development LLC. The net book value of these parcels of land was $5.4 million at December 31, 2012.

 

Item 3. Legal Proceedings

 

The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Management believes that these routine legal proceedings, in the aggregate, are immaterial to the Company’s financial condition, results of operations, and cash flows. Refer also to “Item 1A. Risk Factors—Wisconsin Tax Developments Could Reduce the Company’s Net Income” regarding certain Wisconsin income tax developments.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

27
 

 

Part II

 

Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters’ and Issuer Purchase of Equity Securities

 

The common stock of the Company is traded on The NASDAQ Global Select Market under the symbol BKMU.

 

As of February 28, 2013, there were 46,420,084 shares of common stock outstanding and approximately 8,800 shareholders of record.

 

The Company paid a total cash dividend of $0.05 per share in 2012. A cash dividend of $0.02 per share was paid on March 1, 2013, to shareholders of record on February 15, 2013. For additional discussion relating to the Company’s dividends, refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The payment of dividends in the future is discretionary with the Company’s board of directors and will depend on the Company’s operating results, financial condition, and other considerations. Interest on deposits will be paid prior to payment of dividends on the Company’s common stock. Refer also to “Item 1. Business—Regulation and Supervision” for information relating to regulatory limitations on the Company’s payment of dividends to shareholders, as well as the payment of dividends by the Bank to the Company, which in turn could affect the payment of dividends by the Company.

 

The high and low trading prices of the Company’s common stock from January 1, 2011, through December 31, 2012, by quarter, and the dividends paid in each quarter, were as follows:

 

   2012 Stock Prices   2011 Stock Prices   Cash Dividends Paid 
   High   Low   High   Low   2012   2011 
1st Quarter  $4.45   $3.15   $5.08   $3.81   $0.01   $0.03 
2nd Quarter   4.41    3.43    4.28    3.54    0.01    0.01 
3rd Quarter   4.69    3.95    3.91    2.57    0.01    0.01 
4th Quarter   4.64    4.03    3.68    2.43    0.02    0.01 
                   Total    $0.05   $0.06 

 

From January 1, 2013, to February 28, 2013, the trading price of the Company's common stock ranged between $4.43 to $5.88 per share, and closed this period at $5.72 per share.

 

The Company did not repurchase any of its common stock during 2012 and the Company’s board of directors has not authorized a new stock repurchase program. For additional discussion relating to the Company’s repurchase of its common stock, refer to “Item 1. Business—Shareholders’ Equity” and “Item 1. Business—Regulation and Supervision.”

 

 

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Set forth below is a line graph comparing the cumulative total shareholder return on Company common stock, based on the market price of the common stock and assuming reinvestment of cash dividends, with the cumulative total return of companies on the NASDAQ Stock Market U.S. Index (“NASDAQ Composite Index”) and the NASDAQ Stock Market Bank Index. The graph assumes that $100 was invested on December 31, 2007, in Company common stock and each of those indices.

 

 

   Period Ending 
Index  12/31/07   12/31/08   12/31/09   12/31/10   12/31/11   12/31/12 
Bank Mutual Corporation   100.00    112.94    70.63    50.37    34.04    46.61 
NASDAQ Composite Index   100.00    61.17    87.93    104.13    104.69    123.85 
NASDAQ Bank Index   100.00    72.91    60.66    72.13    64.51    77.18 

 

29
 

 

Item 6. Selected Financial Data

 

The following table provides selected financial data for the Company for its past five fiscal years. The data is derived from the Company’s audited financial statements, although the table itself is not audited. The following data should be read together with the Company’s consolidated financial statements and related notes and “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.”

   At December 31 
   2012   2011   2010   2009   2008 
   (Dollars in thousands, except number of shares and per share amounts) 
Selected financial condition data:                         
Total assets  $2,418,264   $2,498,484   $2,591,818   $3,512,064   $3,489,689 
Loans receivable, net   1,402,246    1,319,636    1,323,569    1,506,056    1,829,053 
Loans held-for-sale   10,739    19,192    37,819    13,534    19,030 
Investment securities available-for-sale           228,023    614,104    419,138 
Mortgage-related securities available-for-sale   550,185    781,770    435,234    866,848    850,867 
Mortgage-related securities held-to-maturity   157,558                 
Foreclosed properties and repossessed assets   13,961    24,724    19,293    17,689    4,768 
Goodwill           52,570    52,570    52,570 
Mortgage servicing rights, net   6,821    7,401    7,769    6,899    3,703 
Deposit liabilities   1,867,899    2,021,663    2,078,310    2,137,508    2,128,277 
Borrowings   210,786    153,091    149,934    906,979    907,971 
Shareholders' equity   271,853    265,771    312,953    402,477    399,611 
Tangible shareholders' equity (1)   271,853    265,771    260,383    349,907    347,041 
Number of shares outstanding, net of treasury stock   46,326,484    46,228,984    45,769,443    46,165,635    47,686,759 
Book value per share  $5.87   $5.75   $6.84   $8.72   $8.38 
Tangible shareholders’ equity per share (1)  $5.87   $5.75   $5.69   $7.58   $7.28 

 

   For the Year Ended December 31 
   2012   2011   2010   2009   2008 
   (Dollars in thousands, except per share amounts) 
Selected operating data:                         
Total interest income  $83,022   $89,345   $112,569   $151,814   $177,556 
Total interest expense   21,641    26,756    66,276    83,784    104,191 
Net interest income   61,381    62,589    46,293    68,030    73,365 
Provision for loan losses   4,545    6,710    49,619    12,413    1,447 
Total non-interest income   29,259    23,158    40,603    31,681    17,881 
Total non-interest expense (2)   76,057    124,900    159,825    68,155    63,550 
Income (loss) before income taxes   10,038    (45,863)   (122,548)   19,143    26,250 
Income tax expense (benefit)   3,336    1,752    (49,909)   5,418    9,094 
Net income (loss) before non-controlling interest   6,702    (47,615)   (72,639)   13,725    17,155 
Net loss (income) attributable to non-controlling interest   52    50    (1)       1 
Net income (loss)  $6,754   $(47,565)  $(72,640)  $13,725   $17,156 
Earnings (loss) per share-basic  $0.15   $(1.03)  $(1.59)  $0.29   $0.36 
Earnings (loss) per share-diluted  $0.15   $(1.03)  $(1.59)  $0.29   $0.35 
Cash dividends paid per share  $0.05   $0.06   $0.20   $0.34   $0.36 

  

(1)This is a non-GAAP measure. Tangible shareholders’ equity is total shareholders’ equity minus goodwill.
(2)Total non-interest expense in 2011 includes a goodwill impairment of $52.6 million and in 2010 includes $89.3 million in loss on early repayment of FHLB borrowings.
30
 

 

   At or For the Year Ended December 31 
   2012   2011   2010   2009   2008 
Selected financial ratios:                         
Net interest margin (3)   2.67%   2.76%   1.47%   2.09%   2.21%
Net interest rate spread   2.57    2.64    1.26    1.82    1.85 
Return on average assets   0.27    (1.87)   (2.12)   0.39    0.48 
Return on average shareholders' equity   2.50    (16.37)   (18.47)   3.40    4.15 
Efficiency ratio (4)   84.04    85.07    99.36    73.32    68.77 
Non-interest expense as a percent of adjusted average assets (5)   3.03    2.84    2.06    1.95    1.80 
Shareholders' equity to total assets   11.24    10.64    12.07    11.39    11.45 
Tangible shareholders' equity to adjusted total assets (6)   11.24    10.64    10.25    10.09    10.07 
                          
Selected asset quality ratios:                         
Non-performing loans to loans receivable, net   1.84%   5.69%   9.29%   2.83%   1.81%
Non-performing assets to total assets   1.64    4.00    5.49    1.72    1.08 
Allowance for loan losses to non-performing loans   83.64    37.17    39.03    39.99    36.89 
Allowance for loan losses to total loans receivable, net   1.54    2.12    3.63    1.13    0.67 
Charge-offs to average loans   0.78    1.96    1.26    0.45    0.05 

 

(3)Net interest margin is calculated by dividing net interest income by average earnings assets.
(4)Efficiency ratio is calculated by dividing non-interest expense (excluding goodwill impairment and loss on early repayment of FHLB borrowings) by the sum of net interest income and non-interest income (excluding gains and losses on investments).
(5)The ratio in 2011 excludes the impact of the goodwill impairment and in 2010 excludes the impact of the prepayment penalty on the early repayment of FHLB borrowings.
(6)This is a non-GAAP measure. The ratio is calculated by dividing total shareholders’ equity less intangible assets (net of deferred taxes) divided by total assets less intangible assets (net). Intangible assets consist of goodwill and other intangible assets. Deferred taxes have been established only on other intangible assets and are immaterial in amount.

 

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Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations

 

The discussion and analysis in this section should be read in conjunction with “Item 8. Financial Statements and Supplementary Data,” and “Item 7A. Quantitative and Qualitative Disclosures about Market Risk,” as well as “Item 1. Business” and “Item 1A. Risk Factors.”

 

Results of Operations

 

Overview The Company’s net income (loss) for the years ended December 31, 2012, 2011, and 2010, was $6.8 million, $(47.6) million, and $(72.6) million, respectively. Diluted earnings (loss) per share during these periods were $0.15, $(1.03), and $(1.59), respectively.

 

The Company’s net income in 2012 was impacted by the following favorable developments compared to 2011:

 

a one-time $52.6 million loss in 2011 on the impairment of goodwill;

 

a $7.2 million or 121% increase in gain on loan sales activities; and

 

a $2.2 million or 32.3% decrease in provision for loan losses.

 

These favorable developments were partially offset by the following unfavorable developments in 2012 compared to 2011:

 

a $3.5 million or 8.9% increase in compensation-related costs;

 

a $1.5 million unfavorable change in net loan-related fees and servicing revenue;

 

a $1.2 million or 1.9% decrease in net interest income; and

 

a $1.6 million or 90.4% increase in income tax expense.

 

The Company’s net loss in 2011 was impacted by the following unfavorable developments compared to 2010:

 

a one-time $52.6 million loss in 2011 on the impairment of goodwill;

 

a $14.9 million or 93.0% decrease in gain on investments;

 

a $2.8 million or 7.9% increase in compensation-related expenses;

 

a $2.6 million or 30.4% decrease in gain on loan sales activities; and

 

• a $51.7 million change in income taxes from a benefit of $49.9 million in 2010 to an expense of $1.8 million in 2011.

 

These unfavorable developments were partially offset by the following favorable developments in 2011 compared to 2010:

 

• a one-time $89.3 million loss in 2010 on early repayment of FHLB borrowings;

 

• a $42.9 million or 86.5% decrease in provision for loan losses;

 

• a $16.3 million or 35.2% increase in net interest income; and

 

• a $1.2 million or 14.6% decrease in net losses and expenses on foreclosed real estate.

 

The following paragraphs discuss these developments in greater detail, as well as other changes in the components of net income (loss) during the years ended December 31, 2012, 2011, and 2010.

 

32
 

 

Net Interest Income Net interest income declined by $1.2 million or 1.9% during the year ended December 31, 2012, compared to 2011. This decline was primarily attributable to a decrease in the Company’s net interest margin, which was 2.67% in 2012 compared to 2.76% in 2011. This decline was primarily the result of a lower interest rate environment in 2012, which reduced the return on the Company’s earning assets more than the cost of its funding sources. Contributing to the reduction in the cost of the Company’s funding sources in 2012 was its repayment of $100.0 million in high-cost borrowings from the FHLB of Chicago that matured during the period.

 

The impact of a lower net interest margin in 2012 was partially offset by the favorable impact of higher average earning assets during the year. In 2012 the Company purchased $158.9 million in held-to-maturity securities that were funded by term borrowings from the FHLB of Chicago (for additional discussion refer to “Financial Condition—Mortgage-Related Securities Held-to-Maturity”). In addition, during 2012 average total loans increased by $21.9 million or 1.6% compared to 2011.

 

Net interest income increased by $16.3 million or 35.2% during the year ended December 31, 2011, compared to 2010. This increase was primarily attributable to an improvement in the Company’s net interest margin, which increased to 2.76% in 2011 from 1.47% in 2010. This improvement was primarily the result of the Company’s early repayment of $756.0 million in high-cost borrowings from the FHLB of Chicago in December 2010, as described below. The repayment resulted in a significant decline in the average cost of interest-bearing liabilities in 2011 compared to 2010. Also contributing to the improvement in the Company’s net interest margin in 2011 was a decline in its average cost of deposits. The Company’s average cost of deposits declined by 40 basis points in 2011 compared to 2010. Also contributing to the improvement in the net interest margin in 2011 was a 38 basis point improvement in the yield on interest-earning assets compared to the previous year. This improvement was caused by a favorable change in the mix of earning assets from lower-yielding assets, such as overnight investments and short-term securities, to higher-yielding assets, such as loans receivable. Partially offsetting the favorable impact of this improved asset mix was a decrease in the average yield on loans receivable and available-for-sale securities in 2011 compared to 2010. These decreases were caused by a declining interest rate environment that resulted in lower yields on these assets in 2011. In addition, the Company sold a substantial number of higher-yielding securities in 2010 at gains, as noted below, which reduced the overall yield on its securities portfolio in 2011 compared to 2010.

 

In December 2010 the Company repaid $756.0 million in fixed-rate borrowings from the FHLB of Chicago prior to the stated maturities of the borrowings. As a result of this prepayment, the Company recognized a one-time charge of $89.3 million in 2010. At the time, the borrowings had an average remaining maturity of six years and a weighted-average interest cost of 4.17%. The Company considered it prudent to repay these borrowings prior to their stated maturities due to the lack of acceptable investment or lending alternatives that could provide sufficient yield to justify the high cost of the borrowings.

 

33
 

 

 

The following table presents certain details regarding the Company's average balance sheet and net interest income for the periods indicated. The tables present the average yield on interest-earning assets and the average cost of interest-bearing liabilities. The yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods shown. The average balances are derived from daily balances over the periods indicated. Interest income includes fees, which are considered adjustments to yields. Net interest spread is the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin is derived by dividing net interest income by average interest-earning assets. No tax equivalent adjustments were made since the Company does not have any tax exempt investments.

 

   Year Ended December 31 
   2012   2011   2010 
       Interest   Avg.       Interest   Avg.       Interest   Avg. 
   Average   Earned/   Yield/   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Cost   Balance   Paid   Cost   Balance   Paid   Cost 
  (Dollars in thousands) 
Assets:                                             
Interest-earning assets:                                             
Loans receivable, net (1)  $1,389,313   $65,478    4.71%  $1,367,450   $69,936    5.11%  $1,478,433   $79,266    5.36%
Mortgage-related securities   792,989    17,309    2.18    656,343    16,374    2.49    589,070    17,445    2.96 
Investment securities (2)   25,443    73    0.29    156,793    2,877    1.83    840,424    15,428    1.84 
Interest-earning deposits   91,801    162    0.18    84,505    158    0.19    250,909    430    0.17 
Total interest-earning assets   2,299,546    83,022    3.61    2,265,091    89,345    3.94    3,158,836    112,569    3.56 
Non-interest-earning assets   210,599              278,872              266,270           
Total average assets  $2,510,145             $2,543,963             $3,425,106           
                                              
Liabilities and equity:                                             
Interest-bearing liabilities:                                             
Savings deposits  $217,255    63    0.03   $212,644    78    0.04   $208,544    104    0.05 
Money market accounts   434,549    716    0.16    405,033    1,696    0.42    347,906    2,075    0.60 
Interest-bearing demand accounts   219,038    51    0.02    199,909    85    0.04    200,292    107    0.05 
Certificates of deposit   954,047    13,825    1.45    1,069,708    17,709    1.66    1,234,411    26,320    2.13 
Total deposit liabilities   1,824,889    14,655    0.80    1,887,294    19,568    1.04    1,991,153    28,606    1.44 
Advance payment by borrowers for taxes and insurance   21,141    2    0.01    19,551    5    0.03    19,606    6    0.03 
Borrowings   227,573    6,984    3.07    156,521    7,183    4.59    871,212    37,664    4.32 
Total interest-bearing liabilities   2,073,603    21,641    1.04    2,063,366    26,756    1.30    2,881,971    66,276    2.30 
                                              
Non-interest-bearing liabilities:                                             
Non-interest-bearing deposits   130,734              110,784              96,370           
Other non-interest-bearing liabilities   35,208              79,314              53,506           
Total non-interest-bearing liabilities   165,942              190,098              149,876           
Total liabilities   2,239,545              2,253,464              3,031,847           
Total equity   270,600              290,499              393,259           
Total average liabilities and equity  $2,510,145             $2,543,963             $3,425,106           
Net interest income and net interest rate spread       $61,381    2.57%       $62,589    2.64%       $46,293    1.26%
Net interest margin             2.67%             2.76%             1.47%
Average interest-earning assets to interest-bearing liabilities   1.11x             1.10x             1.10x          

 

(1)For the purposes of these computations, non-accruing loans and loans held-for-sale are included in the average loans outstanding.
(2)FHLB of Chicago stock is included in investment securities.

 

34
 

 

The following tables present the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to the change attributable to change in volume (change in volume multiplied by prior rate), the change attributable to change in rate (change in rate multiplied by prior volume), and the net change. The change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate.

 

   Year Ended December 31, 2012, 
   Compared to Year Ended December 31, 2011 
   Increase (Decrease) 
   Volume   Rate   Net 
  (Dollars in thousands) 
Interest-earning assets:               
Loans receivable  $1,084   $(5,542)  $(4,458)
Mortgage-related securities   3,129    (2,194)   935 
Investment securities   (1,395)   (1,409)   (2,804)
Interest-earning deposits   13    (9)   4 
Total interest-earning assets   2,831    (9,154)   (6,323)
Interest-bearing liabilities:               
Savings deposits   6    (21)   (15)
Money market deposits   116    (1,096)   (980)
Interest-bearing demand deposits   7    (41)   (34)
Certificates of deposit   (1,808)   (2,076)   (3,884)
Advance payment by borrowers for taxes and insurance       (3)   (3)
Borrowings   2,637    (2,836)   (199)
Total interest-bearing liabilities   958    (6,073)   (5,115)
Net change in net interest income  $1,873   $(3,081)  $(1,208)

 

   Year Ended December 31, 2011, 
   Compared to Year Ended December 31, 2010 
   Increase (Decrease) 
   Volume   Rate   Net 
  (Dollars in thousands) 
Interest-earning assets:               
Loans receivable  $(5,740)  $(3,590)  $(9,330)
Mortgage-related securities   1,882    (2,953)   (1,071)
Investment securities   (12,511)   (40)   (12,551)
Interest-earning deposits   (311)   39    (272)
Total interest-earning assets   (16,680)   (6,544)   (23,224)
Interest-bearing liabilities:               
Savings deposits   (5)   (21)   (26)
Money market deposits   307    (686)   (379)
Interest-bearing demand deposits       (22)   (22)
Certificates of deposit   (3,216)   (5,395)   (8,611)
Advance payment by borrowers for taxes and insurance       (1)   (1)
Borrowings   (32,668)   2,187    (30,481)
Total interest-bearing liabilities   (35,582)   (3,938)   (39,520)
Net change in net interest income  $18,902   $(2,606)  $16,296 

 

Provision for Loan Losses The Company’s provision for loan losses was $4.5 million, $6.7 million, and $49.6 million during the years ended December 31, 2012, 2011, and 2010, respectively. In 2012 the Company recorded loss provisions of $6.3 million against a number of multi-family, commercial real estate, and business loan relationships, as well as residential and consumer loans. The losses on these loans were based on updated independent appraisals and/or internal management evaluations of the collateral that secures the loan, as well as management’s knowledge of current market conditions. This development was partially offset by $1.8 million in loss recaptures related to certain non-performing loans that paid off during the period and to recoveries related to previously charged-off loans.

 

35
 

 

In 2011 the Company recorded $11.8 million in loss provisions against a number of larger multi-family, commercial real estate, and business loan relationships, as well as certain smaller residential and consumer loans. The losses on these loans were based on updated independent appraisals and/or internal management evaluations of the collateral that secures the loan, as well as management’s knowledge of current market conditions. In addition, during 2011 the Company recorded approximately $2.4 million in additional loss provisions that reflected management’s general concerns at the time related to continued economic weakness, elevated levels of unemployment, depressed real estate values, and the internal downgrades of certain loans. These developments were partially offset by $7.5 million in loss recaptures on loans that were paid-off during the period, were upgraded to performing status, or improved in performance and/or prospects.

 

In 2010 the Company noted increased vacancy rates, declining rents, and/or delays in unit sales for many of the properties that secure Company’s loans. In many instances, management’s observations included loans that borrowers and/or loan guarantors had managed to keep current despite underlying difficulties with the collateral properties. In view of those developments and their expected continuation, as well an increasingly strict regulatory environment, management concluded in 2010 that the probability of a number of its loans being collateral dependent had increased, which resulted in a significant increase in provision for loan losses. In 2010 the Company recorded $31.0 million in loss provisions against 34 larger loan relationships aggregating $91.6 million. These loans were secured by commercial real estate, multi-family real estate, undeveloped land, and, in the case of a few commercial business loans, certain other non-real estate assets. During 2010 the Company also recorded $10.0 million in loss provisions on a large number of smaller commercial real estate, multi-family real estate, and commercial business loan relationships, as well as $1.3 million in loss provisions on one- to four-family loans and consumer loans. In general, these losses were based on updated independent appraisals that were received during 2010, but in some cases were based on management judgment. Finally, during 2010 the Company recorded $7.3 million in additional loss provisions that reflected management’s general concerns at the time related to declines in commercial real estate values, weak economic conditions, and high levels of unemployment.

 

The Company’s provision for loan losses was substantially lower in 2012 and 2011 than it was in 2010. This trend is directionally consistent with declines in the Company’s non-performing loans and classified loans, as described in “Financial Condition—Asset Quality,” below, and is consistent with general trends in the banking industry. It should be noted, however, that the Company’s loan portfolio continues to be impacted by slow economic growth, persistent unemployment, and low real estate values. These conditions are particularly challenging for borrowers whose loans are secured by commercial real estate, multi-family real estate, and land. As such, there can be no assurances that non-performing loans and/or classified loans will continue to trend lower in future periods or that the Company’s provision for loan losses will not vary considerably in future periods. Refer to “Item 1. Business—Asset Quality,” above, for additional discussion related to the Company’s policies and procedures related to its provision for loan losses, allowance for loan losses, and asset quality.

 

Non-Interest Income Total non-interest income for the years ended December 31, 2012, 2011, and 2010, was $29.3 million, $23.2 million, and $40.6 million, respectively. The following paragraphs discuss the principal components of non-interest income and primary reasons for their changes from 2011 to 2012, as well as 2010 to 2011.

 

Service charges on deposits were $6.9 million, $6.4 million, and $6.1 million in 2012, 2011, and 2010, respectively. Management attributes the improvements in 2012 and 2011 to an increase in the Company’s average checking accounts, which increased by $39.1 million or 11.8% in 2012 compared to 2011 and $14.0 million or 4.7% in 2011 compared to 2010. In addition, enhancements in recent periods to the Company’s commercial deposit products and services generated increased fee revenue in these years, particularly related to treasury management services.

 

Brokerage and insurance commissions were $3.0 million, $2.8 million, and $3.1 million for the years ended December 31, 2012, 2011, and 2010, respectively. This revenue item consists of commissions earned on sales of tax-deferred annuities, mutual funds, and certain other securities, as well as personal and business insurance products. Commission revenue in 2012 benefited from a lower interest rate environment that encouraged customers to purchase tax-deferred annuities due to higher returns compared to deposit-related products. Commission revenue in 2010 benefited from favorable trends in equity markets in the first half of that year, which resulted in increased revenue from sales of mutual funds and other equity investments relative to 2012 and 2011.

 

36
 

 

Net loan-related fees and servicing revenue was a loss of $1.9 million and $402,000 in 2012 and 2011, respectively, and income of $103,000 in 2010. The following table presents the primary components of net loan-related fees and servicing revenue for the periods indicated:

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Gross servicing fees  $2,826   $2,718   $2,584 
MSR amortization   (3,904)   (2,747)   (3,277)
MSR valuation (loss) recovery   (1,528)   (862)   281 
Loan servicing revenue, net   (2,606)   (891)   (412)
Other loan fee income   695    489    515 
Loan-related fees and servicing revenue, net  $(1,911)  $(402)  $103 

 

Gross servicing fees increased in 2012 and 2011 due to an increase in the amount of loans the Company services for third-party investors. During 2012, 2011, and 2010, the Company serviced an average of $1.13 billion, $1.09 billion, and $1.03 billion, respectively, in loans for third-party investors. Loans serviced for third-party investors have increased the past two years due to increased sales of loans by the Company in the secondary market, as described below. The Company typically retains the servicing on these loans. Related amortization of MSRs was higher in the 2012 and 2010 periods due to generally lower market interest rates for one- to four-family mortgage loans in those periods, which resulted in increased loan prepayments and faster amortization of the MSRs in such years.

 

Loan-related fees and servicing revenue is also impacted by changes in the valuation allowance that is established against MSRs. The change in this allowance is recorded as a recovery or charge, as the case may be, in the period in which the change occurs. In 2012 the valuation allowance increased by $1.5 million due principally to a decline in market interest rates, which resulted in increased loan prepayment expectations. The valuation allowance increased by $862,000 in 2011 due to a decline in market interest rates during the last few months of that year.

 

The valuation of MSRs, as well as the periodic amortization of MSRs, is significantly influenced by the level of market interest rates and loan prepayments. If market interest rates for one- to four-family loans increase and/or actual or expected loan prepayment expectations decrease in future periods, the Company could recover all or a portion of its previously established allowance on MSRs, as well as record reduced levels of MSR amortization expense. Alternatively, if interest rates continue to decrease and/or prepayment expectations increase, the Company could potentially record additional charges to earnings related to increases in the valuation allowance on its MSRs. In addition, amortization expense could increase further due to likely increases in loan prepayment activity. Lower interest rates also typically cause an increase in actual mortgage loan prepayment activity, which generally results in an increase in the amortization of MSRs.

 

Net gains on loan sales activities were $13.2 million, $6.0 million, and $8.6 million during the years ended December 31, 2012, 2011, and 2010, respectively. The Company’s policy is to sell substantially all of its fixed-rate, one- to four-family mortgage loan originations in the secondary market. During 2012, 2011, and 2010 sales of one- to four-family mortgage loans were $454.6 million, $292.7 million, and $409.4 million, respectively. Loan sales were elevated in the 2012 and 2010 periods as a result of generally lower market interest rates for one- to four-family mortgage loans in those periods, which encouraged a larger number of borrowers to refinance higher-rate loans into lower-rate loans during those years. Also contributing to the increase in gains on sales of loans in 2012 was an increase in the Company’s average gross profit margin on the sales of loans. In 2012 the average gross profit margin was 2.91% compared to 2.04% and 2.09% in 2011 and 2010, respectively. Management attributed this improvement to the burden that increased consumer demand has placed on the loan production capacity of the mortgage banking industry as a whole, which has caused gross profit margins to increase.

 

Market interest rates for one- to four-family mortgage loans have increased modestly in recent weeks and the pace of the Company’s loan originations and sales has diminished compared to 2012. In addition, the Company has experienced a decline in its gross profit margin on individual loan sales in recent months as production capacity within the mortgage banking industry has become less constrained. Absent a further decline in market interest rates for one- to four-family mortgage in 2013, management believes the Company’s gains on sales of loans will be substantially lower in 2013 than they were in 2012. However, management believes the impact of lower gains on sales will be partially offset by continued recovery of previously established MSR valuation allowances, as previously noted, as well as lower MSR amortization. However, there can be no assurances.

 

37
 

 

Net gain on sales of investments in 2012, 2011, and 2010 was $543,000, $1.1 million, and $16.0 million, respectively. In 2012 the Company sold $20.4 million in mortgage-related securities to provide additional liquidity to fund the repayment of $100.0 million in borrowings from the FHLB of Chicago that matured in third quarter of the year. In 2011 the Company sold its remaining investment in a mutual fund that management did not expect would perform well in future periods. In 2010 the Company sold mortgage-related and certain other securities to provide liquidity to fund the repayment of $756.0 million FHLB of Chicago borrowings in that year, as previously described.

 

The Company’s operating results in 2012 and 2011 included $400,000 and $389,000 in net OTTI charges, respectively. These losses consisted of the credit portion of the total OTTI loss related to the Company’s investment in certain private-label CMOs rated less than investment grade. Management attributes the net OTTI losses in these periods to low real estate values for residential properties on a nationwide basis. None of the Company’s remaining private-label CMOs were deemed to be other-than-temporarily impaired as of December 31, 2012. However, the collection of the amounts due on private-label CMOs is subject to numerous factors outside of the Company’s control and a future determination of OTTI could result in additional losses being recorded through earnings in future periods. As of December 31, 2012, the Company’s total investment in private-label CMOs was $50.6 million, of which $35.9 million was rated less than investment grade. Refer to “Financial Condition—Available-for-Sale Securities,” below, for additional discussion.

 

The Company’s operating results in 2010 included a $700,000 loss on a $2.6 million investment in partially-developed land that is held for development and sale. In the judgment of management at the time, a decline in real estate values justified the recognition of the loss.

 

Increase in cash surrender value of life insurance investments was $2.1 million, $2.4 million, and $2.4 million for the years ended December 31, 2012, 2011, and 2010, respectively. Management attributes the decrease in 2012 to a declining interest rate environment that has reduced the return on this type of investment, as well as lower payouts associated with excess death benefits.

 

Other non-interest income was $5.8 million, $5.2 million, and $5.1 million for the years ended December 31, 2012, 2011, and 2010, respectively. The changes between years were due primarily to increases in the fair value of assets held in trust for certain non-qualifying employee benefit plans, due to the effects of changes in interest rates and equity markets.

 

Non-Interest Expense Total non-interest expense for the years ended December 31, 2012, 2011, and 2010 was $76.1 million, $124.9 million, and $159.8 million, respectively. Results in 2011 included a $52.6 million non-cash goodwill impairment recorded by the Company in the second quarter of that year. This impairment had no effect on the liquidity, operations, tangible capital, or regulatory capital of the Company or the Bank (for additional discussion refer to “Note 1. Basis of Presentation” of the Company’s consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data,” below). Results in 2010 included a one-time prepayment penalty of $89.3 million related to the Company’s repayment of $756.0 million in borrowings from the FHLB of Chicago prior to their scheduled maturities, as previously discussed. Excluding the goodwill impairment and prepayment penalty, total non-interest expense in 2012, 2011, and 2010 was $76.1 million, $72.3 million and $70.5 million, respectively. The following paragraphs discuss the principal components of non-interest expense and the primary reasons for their changes from 2011 to 2012, as well as 2010 to 2011.

 

Compensation and related expenses were $42.3 million, $38.8 million, and $36.0 million during the years ended December 31, 2012, 2011, and 2010, respectively. The increases in 2012 and 2011 were due principally to the Company’s hiring in recent years of certain senior management personnel, a number of commercial relationship managers, and certain other key administrative personnel, as well as annual merit increases for all employees. Also contributing was an increase in certain incentive and bonus payments during these years, including stock based compensation. Finally, the increases in compensation-related expense in 2012 and 2011 were also caused by an increase in costs related to the Company’s defined benefit pension plan, due to a decline in the discount rate used to determine the present value of the pension obligation. In 2011 these developments were partially offset by a decline in employee stock ownership plan (“ESOP”) expense compared to 2010 (due to the end in 2010 of the 10-year commitment to the ESOP), as well as a decline in the overall number of employees employed by the Company.

 

38
 

 

Effective January 1, 2013, the Company’s board of directors closed the qualified defined benefit pension plan to employees not eligible to participate in the plan as of that date, as well as any employees hired after that date. In addition, effective for service performed after March 1, 2013, the Company’s board of directors reduced certain future benefits formerly provided under the qualified and supplemental plans, but did not reduce all future benefits. Finally, effective January 1, 2013, employees that are not eligible to participate in the qualified plan will be eligible for an enhanced employer contribution in the Company’s defined contribution savings plan. Management does not expect the Company’s pension expense to be impacted significantly in the near term as a result of these actions, because it is anticipated that any cost savings from these actions will be substantially offset by the adverse impact of a continued decline in the discount rate used to determine the present value of the Company’s remaining pension obligations. For additional discussion refer to “Note 10. Employee Benefit Plans” of the Company’s consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data,” below.

 

As of December 31, 2012, the Company had 639 full-time associates and 81 part-time associates. This compared to 648 full-time and 71 part-time employees at December 31, 2011, and 682 full-time and 82 part-time associates at December 31, 2010.

 

Occupancy and equipment expense during the years ended December 31, 2012, 2011, and 2010 was $11.4 million, $11.5 million, and $11.2 million, respectively. The decrease in 2012 was principally caused by lower utility and snow removal costs due to a mild winter, reduced expenditures for maintenance and repair, and lower rental expense due to the closure of three leased banking offices. The impact of these developments was partially offset by an increase in data processing costs due to certain product and system enhancements implemented in 2012. The increase in 2011 was primarily caused by higher levels of repair and maintenance costs and rent expense in 2011 compared to 2010.

 

Federal insurance premiums were $3.3 million, $3.2 million, and $4.1 million during 2012, 2011, and 2010, respectively. In the second quarter of 2011 the FDIC implemented a new rule that changed the deposit insurance assessment base from an insured institution’s domestic deposits (minus certain allowable exclusions) to an insured institution’s average consolidated assets (minus average tangible equity and certain other adjustments). The Company benefited from the implementation of this new rule, which resulted in lower deposit insurance costs in 2012 and 2011 compared to 2010. Due to its improved operating results and financial condition, management believes the Company’s federal insurance premiums could be up to 25% lower in 2013 than they were in 2012 under the FDIC’s risk-based assessment system (for additional information, refer to “Regulation and Supervision of the Bank—Deposit Insurance” in Item 1. Business—Regulation and Supervision,” above). However, there can be no assurances.

 

Advertising and marketing expenses were $2.1 million, $2.0 million, and $2.1 million in 2012, 2011, and 2010, respectively. The Company has maintained its advertising and marketing expenses at approximately the same level since 2010. However, such expenditures depend on future management decisions and there can be no assurances that such expenditures will remain at this level in the future.

 

Net losses and expenses on foreclosed properties were $6.7 million, $7.1 million and $8.3 million during 2012, 2011, and 2010, respectively. Although the Company’s losses and expenses on foreclosed real estate have trended lower since 2010, such losses and expenses have remained elevated due to low real estate values and slow economic growth.

 

Other non-interest expense was $10.2 million, $9.7 million, and $8.8 million during the years ended December 31, 2012, 2011, and 2010, respectively. The increases in 2012 and 2011 were caused by higher legal, consulting, and accounting fees related to loan workouts and related professional services. In recent months, however, these expenses have declined as the Company has reduced its level of non-performing loans.

 

Income Tax Expense (Benefit) Income tax expense (benefit) was $3.3 million, $1.8 million, and $(49.9) million in 2012, 2011, and 2010, respectively. The large income tax benefit in 2010 was caused by the Company’s pre-tax loss, which was primarily the result of the FHLB prepayment penalty and the large provision for loan losses in that year, as previously described. Excluding the impact of the goodwill impairment in 2011 (which was not deductible for income tax purposes), the Company’s effective tax rate (“ETR”) in 2012, 2011, and 2010 was 33.2%, 26.1%, and 40.7%, respectively. The Company’s ETR will vary from period to period depending primarily on the impact of non-taxable revenue, such as earnings from bank-owned life insurance (“BOLI”). The ETR will generally be lower in periods in which non-taxable revenue comprises a larger portion of pre-tax income or loss, such as in 2011. For additional information related to an open issue related to the Company's income taxes in Wisconsin, refer to “Item 1A. Risk Factors.”

 

39
 

 

Financial Condition

 

Overview The Company’s total assets decreased by $80.2 million or 3.2% during the twelve months ended December 31, 2012. During the period the Company’s securities available-for-sale declined by $231.6 million, its cash and cash equivalents declined by $33.9 million, its investment in common stock of the FHLB of Chicago (which is a component of other assets) declined by $30.3 million, its foreclosed and repossessed assets declined by $10.8 million, and its loans held-for-sale declined by $8.5 million. These developments were partially offset by an $82.6 million increase in the Company’s loan portfolio. Net cash flows from the changes in these assets were used to fund a $153.8 million decline in deposit liabilities during the year ended December 31, 2012, as well as the repayment of a $100.0 million term advance from the FHLB of Chicago. In addition, during 2012 the Company funded a $157.6 million increase in securities held-to-maturity using term advances from the FHLB of Chicago. The Company’s total shareholders’ equity increased from $265.8 million at December 31, 2011, to $271.9 million at December 31, 2012. Non-performing assets decreased from $99.9 million or 4.00% of total assets at December 31, 2011, to $39.8 million or 1.64% at December 31, 2012. The following paragraphs describe these changes in greater detail, as well as other changes in the Company’s financial condition during the twelve months ended December 31, 2012.

 

Cash and Cash Equivalents Cash and cash equivalents decreased from $120.9 million at December 31, 2011, to $87.1 million at December 31, 2012. This decrease was due to the funding of increases in the Company’s loan portfolio, as well as decreases in its deposit liabilities, as previously described.

 

Mortgage-Related Securities Available-for-Sale The Company’s portfolio of mortgage-related securities available-for-sale decreased by $231.6 million or 29.6% during the year ended December 31, 2012. This decrease was principally caused by periodic repayments and security sales that exceeded the Company’s purchase of new securities during the year.

 

The following table presents the carrying value of the Company’s mortgage-related securities available-for-sale at the dates indicated (carrying value is equal to fair value for all securities and for all periods presented):

 

   December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Freddie Mac  $343,682   $548,944   $314,067 
Fannie Mae   155,895    170,020    30,810 
Ginnie Mae   42    778    2,755 
Private-label CMOs   50,566    62,028    87,602 
Total  $550,185   $781,770   $435,234 

 

The following table presents the activity in the Company’s portfolio of mortgage-related securities available-for-sale for the periods indicated:

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Carrying value at beginning of period  $781,770   $435,234   $866,848 
Purchases   51,374    507,052    819,675 
Sales   (20,395)       (1,058,055)
Principal repayments   (260,953)   (167,587)   (187,664)
Premium amortization, net   (4,152)   (3,922)   (2,383)
Other-than-temporary impairment   (400)   (389)    
Increase (decrease) in net unrealized gain or loss   2,941    11,383    (3,187)
Net increase (decrease)   (231,585)   346,536    (431,614)
Carrying value at end of period  $550,185   $781,770   $435,234 

 

40
 

 

The table below presents information regarding the carrying values, weighted average yields, and contractual maturities of the Company’s mortgage-related securities available-for-sale at December 31, 2012:

 

   One Year or Less   More Than One Year
to Five Years
   More Than Five
Years to Ten Years
   More Than Ten Years   Total 
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
 
  (Dollars in thousands) 
Securities by issuer and type:                                                  
Freddie Mac, Fannie Mae, and Ginnie Mae pass-throughs  $17    6.42%  $887    7.03%  $27,815    2.60%  $41    6.71%  $28,760    2.74%
Freddie Mac, Fannie Mae, and Ginnie Mae REMICs                   32,611    1.79    438,248    2.35    470,859    2.31 
Private-label CMOs                   18,698    5.11    31,868    3.17    50,566    3.86 
Total  $17    6.42%  $887    7.03%  $79,124    2.86%  $470,157    2.41%  $550,185    2.47%
Securities by coupon:                                                  
Adjustable-rate coupon                          $54,710    2.04%  $54,710    2.04%
Fixed-rate coupon  $17    6.42%  $887    7.03%  $79,124    2.86%   415,447    2.46    495,475    2.53 
Total  $17    6.42%  $887    7.03%  $79,124    2.86%  $470,157    2.41%  $550,185    2.47%

 

Changes in the fair value of mortgage-related securities available-for-sale are recorded through accumulated other comprehensive income (loss), net of related income tax effect, which is a component of shareholders’ equity. The fair value adjustment on the Company’s mortgage-related securities available-for-sale was a net unrealized gain of $10.7 million at December 31, 2012, compared to a net unrealized gain of $7.7 million at December 31, 2011. This increase was primarily caused by lower market interest rates at December 31, 2012, compared to December 31, 2011. Lower market interest rates typically result in higher fair values for the types of securities owned by the Company.

 

The Company maintains an investment in private-label CMOs that were purchased from 2004 to 2006 and are secured by prime residential mortgage loans. The securities were all rated “triple-A” by various credit rating agencies at the time of their purchase. However, all of the securities in the portfolio have been downgraded since their purchase. Securities rated less than investment grade are adversely classified as substandard in accordance with regulatory guidelines (refer to “Item 1. Business—Asset Quality”). The following table presents the credit ratings, carrying values, and unrealized losses of the Company’s private-label CMO portfolio as of the dates indicated (in instances of split ratings, each security has been classified according to its lowest rating):

 

   December 31, 2012   December 31, 2011 
   Carrying
Value
   Net
Unrealized
Gain (Loss)
   Carrying
Value
   Net
Unrealized
Gain (Loss)
 
Credit rating:  (Dollars in thousands) 
AAA/Aaa          $5,386   $210 
AA/Aa           2,512    58 
A  $7,400   $228    6,951    (271)
BBB/Baa   7,248    175    10,428    (366)
Less than investment grade   35,918    (33)   36,751    (5,357)
Total private-label CMOs  $50,566   $370   $62,028   $(5,726)

 

During 2012 and 2011 management determined that it was unlikely the Company would collect all amounts due according to the contractual terms on certain of its securities rated less than investment grade. Accordingly, the Company recorded $400,000 and $389,000 in net OTTI loss on such securities in those periods, respectively (for additional discussion refer to “Results of Operations—Non-Interest Income,” above). As of December 31, 2012, management determined that none of the Company’s private-label CMOs had incurred additional OTTI as of that date. The Company does not intend to sell these securities and it is unlikely it would be required to sell them before recovery of their amortized cost. However, collection is subject to numerous factors outside of the Company’s control and a future determination of OTTI could result in significant losses being recorded through earnings in future periods. For additional discussion refer to “Critical Accounting Policies—Other-Than-Temporary Impairment,” below, and “Item 1. Business—Investment Activities” and “Item 1A. Risk Factors,” above.

 

41
 

 

Mortgage-Related Securities Held-to-Maturity During the twelve months ended December 31, 2012, the Company purchased $158.9 million in held-to-maturity securities that consisted of fixed-rate mortgage-backed securities issued and guaranteed by Fannie Mae and backed by multi-family residential loans. The Company funded the purchase of these securities with $158.9 million in term advances from the FHLB of Chicago. The securities had a an original weighted-average life of 7.7 years, an original weighted-average yield of 2.31%, and yield-maintenance fees that discourage the underlying borrowers from prepaying the underlying loans. The term advances have a weighted-average life of 5.5 years and cost of 1.47%. The purpose of this transaction was to supplement growth in the Company’s earning assets. The Company classified these securities as held-to-maturity because it has the ability and intent to hold them until they mature.

 

The following table presents the activity in the Company’s portfolio of mortgage-related securities held-to-maturity for the periods indicated:

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Carrying value at beginning of period            
Purchases  $158,915         
Sales            
Principal repayments   (902)        
Premium amortization   (455)        
Net increase  $157,558         
Carrying value at end of period  $157,558         

 

All of the Company’s mortgage-related securities held-to-maturity as of December 31, 2012, had final maturities of five to ten years. The weighted-average yield on these securities was 2.20%.

 

Investment Securities Available-for-Sale In prior periods the Company has held investment securities available-for-sale, which have primarily consisted of mutual funds and U.S. government and federal agency obligations. However, the Company held no such securities as of December 31, 2012 or 2011. The following table presents the Company’s investment securities and mortgage-related securities activities for the periods indicated.

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Carrying value at beginning of period      $228,024   $614,104 
Purchases           3,118,204 
Sales       (20,837)   (709)
Calls       (205,825)   (3,506,718)
Discount accretion           314 
Increase (decrease) in net unrealized loss       (1,362)   2,828 
Net decrease in investment securities       (228,024)   (386,080)
Carrying value at end of period          $228,024 

 

As of December 31, 2010, the Company’s investment securities available-for-sale consisted of mutual funds with a carrying value of $22.1 million and U.S. government and federal agency obligations with a carrying value of $206.0 million.

 

42
 

 

Loans Held-for-Sale The Company’s policy is to sell substantially all of its fixed-rate, one- to four-family mortgage loan originations in the secondary market. The following table presents a summary of the activity in the Company’s loans held-for-sale for the periods indicated:

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $19,192   $37,819   $13,534 
Origination of loans intended for sale (1)   446,358    272,785    434,388 
Principal balance of loans sold   (454,584)   (292,720)   (409,369)
Change in net unrealized gains or losses (2)   (227)   1,308    (734)
Total loans held-for-sale  $10,739   $19,192   $37,819 

 

(1)Does not include one- to four-family loans originated for the Company’s loan portfolio.
(2)Refer to “Note 1. Basis of Presentation” in the Company’s consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data.”

 

The origination of one- to four-family mortgage loans intended for sale and the corresponding sales of such loans were elevated in the 2012 and 2010 periods as a result of generally lower market interest rates in those periods, which encouraged a larger number of borrowers to refinance higher-rate loans into lower rate loans during those years. For additional discussion, refer to “Results of Operations—Non-Interest Income,” above.

 

Loans Receivable Loans receivable increased by $82.6 million or 6.3% as of December 31, 2012, compared to December 31, 2011. Total loans originated for portfolio increased by $164.8 million or 41.5% during this year compared to 2011. A portion of this improvement came from increased originations of commercial business loans, which increased by $40.5 million or 57.6% during the twelve months ended December 31, 2012, compared to 2011. Management attributed this increase to recent efforts to improve the Company’s share of the mid-tier commercial banking market (defined as business entities with sales revenues of $5 to $100 million), which was a new market segment for the Company in 2011. In the past two years the Company has added experienced leaders to its senior management team and has hired a number of commercial relationship managers and support personnel experienced in managing and selling financial services to the mid-tier commercial banking market. In the near term the Company expects to add additional professionals capable of serving this market segment, although there can be no assurances as to the extent or timing of such staff additions or the impact on operating results.

 

Originations of multi-family mortgage loans, both permanent and construction, also increased substantially during the period, which management believes reflects a general decline in the level of home ownership in recent periods. Finally, originations of consumer loans, which consist principally of home equity term loans and lines of credit, increased by $23.7 million or 25.8% during the twelve months ended December 31, 2012, due to more competitive pricing and increased marketing efforts for these types of loans.

 

The Company’s portfolio of one- to four-family loans declined from $508.5 million at December 31, 2011, to $465.2 million at December 31, 2012. In 2012 loan repayments exceeded the Company’s origination of one- to four-family loans that it retains in portfolio, which consists principally of adjustable-rate loans and, from time-to-time, fixed-rate loans with maturity terms of up to 15 years. The Company also retains certain 30-year, fixed-rate loans in its portfolio under an internal low-income lending program. Repayments of one- to four-family loans have been elevated in recent years due to lower market interest rates that encourage borrowers to refinance adjustable-rate loans, as well as higher-cost fixed-rate loans, into longer-term, fixed-rate loans that the Company sells in the secondary market. The Company’s originations of one- to four-family loans that it retains in portfolio were $89.0 million in 2012 compared to $91.0 million in 2011.

 

43
 

 

The following table presents the composition of the Company’s loan portfolio in dollar amounts and in percentages of the total portfolio at the dates indicated.

 

   December 31 
   2012   2011   2010   2009   2008 
   Amount   Percent
of 
Total
   Amount   Percent
of
Total
   Amount   Percent
of
 Total
   Amount   Percent
 of
 Total
   Amount   Percent
 of
 Total
 
  (Dollars in thousands) 
Mortgage loans:                                                  
Permanent mortgage loans:                                                  
One- to four-family  $465,170    30.98%  $508,503    36.59%  $531,874    37.87%  $644,852    41.45%  $867,810    45.82%
Multi-family   264,013    17.58    247,040    17.77    247,210    17.60    200,222    12.87    199,709    10.54 
Commercial real estate   263,775    17.57    226,195    16.27    248,253    17.68    262,855    16.90    222,462    11.74 
Total permanent mortgages   992,958    66.12    981,738    70.63    1,027,337    73.15    1,107,929    71.22    1,289,981    68.10 
Construction and development:                                                  
One- to four-family   18,502    1.23    16,263    1.17    13,479    0.96    11,441    0.74    17,517    0.92 
Multi-family   86,904    5.79    29,409    2.12    19,308    1.37    52,323    3.36    74,208    3.92 
Commercial real estate   11,116    0.74    19,907    1.43    24,939    1.78    27,040    1.74    82,795    4.37 
Land   12,826    0.85    16,429    1.18    25,764    1.83    33,758    2.17    43,601    2.30 
Total construction and development loans   129,348    8.61    82,008    5.90    83,490    5.94    124,562    8.01    218,121    11.51 
Total mortgage loans   1,122,306    74.74    1,063,746    76.53    1,110,827    79.09    1,232,491    79.23    1,508,102    79.61 
Consumer loans:                                                  
Fixed term home equity   116,988    7.79    102,561    7.38    103,619    7.38    124,519    8.00    173,104    9.14 
Home equity lines of credit   81,898    5.45    86,540    6.23    87,383    6.24    88,796    5.71    86,962    4.59 
Student   12,915    0.86    15,711    1.13    17,695    1.25    19,793    1.27    21,469    1.13 
Home improvement   24,910    1.66    24,237    1.74    24,551    1.76    28,441    1.83    36,023    1.90 
Automobile   1,814    0.12    2,228    0.16    2,814    0.20    4,077    0.26    11,775    0.62 
Other   8,388    0.56    7,177    0.52    7,436    0.52    9,871    0.63    8,740    0.46 
Total consumer loans   246,913    16.44    238,454    17.16    243,498    17.35    275,497    17.71    338,073    17.84 
Commercial business loans   132,436    8.82    87,715    6.31    50,123    3.56    47,708    3.07    48,277    2.55 
Gross loans receivable   1,501,655    100.00%   1,389,915    100.00%   1,404,448    100.00%   1,555,696    100.00%   1,894,452    100.00%
Undisbursed loan proceeds   (76,703)        (41,859)        (32,345)        (32,690)        (54,187)     
Allowance for loan losses   (21,577)        (27,928)        (47,985)        (17,028)        (12,208)     
Deferred fees and costs, net   (1,129)        (492)        (549)        78         996      
Total loans receivable, net  $1,402,246        $1,319,636        $1,323,569        $1,506,056        $1,829,053      

 

 

44
 

 

The following table presents a summary of the Company’s activity in loans receivable for the periods indicated.

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $1,319,636   $1,323,569   $1,506,056 
Originations:               
One- to four-family loans (1)   88,993    91,042    44,929 
Multi-family loans   66,724    55,859    25,091 
Commercial real estate loans   70,200    63,376    22,068 
Construction and development loans   109,908    24,921    29,029 
Total mortgage loan originations   335,825    235,198    121,117 
Consumer loans   115,344    91,685    78,198 
Commercial business loans   110,941    70,404    34,530 
Total originations   562,110    397,287    233,845 
Principal payments and repayments:               
Mortgage loans   (264,211)   (232,814)   (220,673)
Consumer loans   (106,885)   (96,729)   (110,197)
Commercial business loans   (66,220)   (32,812)   (32,115)
Total principal payments and repayments   (437,316)   (362,355)   (362,985)
Transfers to foreclosed properties, real estate owned, and repossessed assets   (13,054)   (49,465)   (22,108)
Net change in undisbursed loan proceeds, allowance for loan losses, and deferred fees and costs   (29,130)   10,600    (31,239)
Total loans receivable, net  $1,402,246   $1,319,636   $1,323,569 

 

(1)Does not include one- to four-family loans originated for sale.

 

The following table presents the contractual maturity of the Company’s construction and development loans and its commercial business loans at December 31, 2012. The table does not include the effect of prepayments or scheduled principal amortization.

 

   December 31, 2012 
   Commercial
Business Loans
   Construction and
Development
Loans
   Total 
Amounts due:  (Dollars in thousands) 
Within one year or less  $60,477   $11,216   $71,693 
After one year through five years   69,821    92,535    162,356 
After five years   2,138    25,597    27,735 
Total due after one year   71,959    118,132    190,091 
Total commercial and construction loans  $132,436   $129,348   $261,784 

 

The following table presents, as of December 31, 2012, the dollar amount of the Company’s construction and development loans and its commercial loans due after one year and whether these loans have fixed interest rates or adjustable interest rates.

 

   Due After One Year 
   Fixed Rate   Adjustable
Rate
   Total 
   (Dollars in thousands) 
Commercial business loans  $45,346   $26,613   $71,959 
Construction and development loans   49,741    68,391    118,132 
Total loans due after one year  $95,087   $95,004   $190,091 

 

45
 

 

Foreclosed Properties and Repossessed Assets The following table summarizes the Company’s foreclosed properties and repossessed assets as of the dates indicated:

 

   December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Commercial real estate  $8,698   $13,115   $7,313 
One- to four-family   1,710    6,557    5,554 
Multi-family   146    3,890    4,079 
Land   3,407    1,162    2,329 
Consumer           18 
Total  $13,961   $24,724   $19,293 

 

The decrease in the Company’s foreclosed properties and repossessed assets during the twelve months ended December 31, 2012, was caused by increased sales of foreclosed real estate, as well as continued charge-offs of foreclosed properties as management worked to aggressively reduce the Company’s level of non-performing assets. These developments were partially offset by foreclosures related to a number of smaller commercial real estate mortgage loans and, to a lesser extent, one- to four-family mortgage loans. The increase in foreclosed properties and repossessed assets in 2011 reflected management efforts to aggressively reduce the elevated level of non-performing loans held by the Company in 2011 and earlier periods. For additional discussion refer to “Financial Condition—Asset Quality,” below.

 

Mortgage Servicing Rights The carrying value of the Company’s MSRs was $6.8 million at December 31, 2012, compared to $7.4 million at December 31, 2011, net of valuation allowances of $2.4 million and $868,000, respectively. As of both December 31, 2012 and 2011, the Company serviced $1.1 billion in loans for third-party investors. For additional information refer to “Results of Operations—Non-Interest Income” and “Item 1. Business—Lending Activities,” above.

 

Other Assets Other assets consist of the following items on the dates indicated:

 

   December 31 
   2012   2011 
  (Dollars in thousands) 
Accrued interest receivable:          
Mortgage-related securities  $1,610   $1,320 
Investment securities   11    537 
Loans receivable   4,636    4,664 
Total accrued interest receivable   6,257    6,521 
Bank-owned life insurance   58,609    56,604 
Premises and equipment   50,536    50,423 
Federal Home Loan Bank stock, at cost   15,841    46,092 
Deferred tax asset, net   34,211    37,454 
Prepaid FDIC insurance premiums   2,477    5,673 
Other assets   21,764    22,059 
Total other assets  $189,695   $224,826 

 

BOLI is long-term life insurance on the lives of certain current and past employees where the insurance policy benefits and ownership are retained by the employer. Its cash surrender value is an asset that the Company uses to partially offset the future cost of employee benefits. The cash value accumulation on BOLI is permanently tax deferred if the policy is held to the insured person’s death and certain other conditions are met. The increase in BOLI in 2012 was a result of the increase in the accumulated cash value of the insurance policies during the period.

 

The Company and its subsidiaries conduct their business through an executive office and 76 banking offices, which had an aggregate net book value of $48.1 million as of December 31, 2012, excluding furniture, fixtures, and equipment. As of December 31, 2012, the Company owned the building and land for 69 of its office locations and leased the space for eight.

 

46
 

 

The FHLB of Chicago requires its members to own its common stock as a condition of membership, which is redeemable at par (for additional information refer to “Regulation and Supervision of the Bank—Federal Home Loan Bank System” in “Item 1. Business—Regulation and Supervision”). In 2012 the FHLB of Chicago redeemed $30.3 million of the common stock owned by the Company that was in excess of the amount the Company was required to own under the minimum guidelines established by the FHLB of Chicago. As of December 31, 2012, the Company continued to own approximately $5.3 million more in such common stock than required under the minimum guidelines. The Company anticipates that the FHLB of Chicago will redeem this remaining amount in 2013, although there can be no assurances. For additional discussion refer to the section entitled “Federal Home Loan Bank System” in “Item 1. Business—Regulation and Supervision.”

 

The Company’s net deferred tax asset decreased by $3.2 million or 8.7% during the year ended December 31, 2012. Management evaluates this asset on an on-going basis to determine if a valuation allowance is required. Management determined that no valuation allowance was required as of December 31, 2012. The evaluation of the net deferred tax asset requires significant management judgment based on positive and negative evidence. Such evidence includes the Company’s cumulative three-year net loss, the nature of the components of such cumulative loss, recent trends in earnings, expectations for the Company’s future earnings, the duration of federal and state net operating loss carryforward periods, and other factors. There can be no assurance that future events, such as adverse operating results, court decisions, regulatory actions or interpretations, changes in tax rates and laws, or changes in positions of federal and state taxing authorities will not differ from management’s current assessments. The impact of these matters could be significant to the consolidated financial condition, results of operations, and capital of the Company.

 

Prepaid FDIC insurance premiums declined from $5.7 million at December 31, 2011, to $2.5 million at December 31, 2012. In 2009 the FDIC required insured financial institutions to prepay a certain amount of their estimated FDIC deposit insurance premiums. The regular quarterly payments to the FDIC that are otherwise required from the Company were applied against this amount and expensed on a quarterly basis, which is the reason for the decline in the prepaid balance during 2012.

 

Deposit Liabilities Deposit liabilities decreased by $153.8 million or 7.6% during the twelve months ended December 31, 2012, to $1.9 billion compared to $2.0 billion at December 31, 2011. Core deposits, consisting of checking, savings and money market accounts, increased by $77.3 million or 7.9% during the period while certificates of deposits declined by $231.0 million or 22.2%. The Company continues to closely manage the rates it offers on certificates of deposit to control its overall liquidity position, which has resulted in a decline in certificates of deposit in recent periods. Core deposits have increased in recent years in response to management’s efforts to increase sales of such products and related services to commercial businesses, as well as efforts to focus its retail sales efforts on such products and related services. Also contributing to the increase in core deposits in recent periods, however, is customer reaction to the low interest rate environment. Management believes that this environment has encouraged some customers to switch to core deposits in an effort to retain flexibility in the event interest rates rise in the future.

 

The following table presents the distribution of the Company’s deposit accounts at the dates indicated by dollar amount and percent of portfolio, and the weighted average rate.

 

   December 31 
   2012   2011   2010 
       Percent   Weighted       Percent   Weighted       Percent   Weighted 
       of Total   Average       of Total   Average       of Total   Average 
       Deposit   Nominal       Deposit   Nominal       Deposit   Nominal 
   Amount   Liabilities   Rate   Amount   Liabilities   Rate   Amount   Liabilities   Rate 
   (Dollars in thousands) 
Non-interest-bearing demand  $143,684    7.69%   0.00%  $112,211    5.55%   0.00%  $94,446    4.54%   0.00%
Interest-bearing demand   236,380    12.65    0.01    229,990    11.38    0.01    219,136    10.54    0.02 
Money market savings   458,762    24.56    0.19    432,248    21.38    0.19    423,923    20.40    0.57 
Savings accounts   217,170    11.63    0.03    204,263    10.10    0.03    210,334    10.12    0.04 
Total demand accounts   1,055,996    56.53    0.09    978,712    48.41    0.09    947,839    45.60    0.27 
Certificates of deposit:                                             
With original maturities of:                                             
Three months or less   9,259    0.50    0.07    9,988    0.49    0.11    12,922    0.62    0.25 
Over three to 12 months   184,194    9.86    0.20    162,949    8.06    0.50    194,458    9.36    0.94 
Over 12 to 24 months   315,189    16.87    0.77    569,485    28.17    1.10    663,576    31.93    1.60 
Over 24 to 36 months   148,503    7.95    1.94    138,677    6.86    1.98    92,268    4.44    2.10 
Over 36 to 48 months   -    0.00    0.00    1,282    0.06    4.31    5,137    0.25    4.36 
Over 48 to 60 months   154,758    8.29    3.48    160,570    7.95    3.68    162,110    7.81    3.81 
Total certificates of deposit   811,903    43.47    1.36    1,042,951    51.59    1.51    1,130,471    54.40    1.84 
Total deposit liabilities  $1,867,899    100.00%   0.64%  $2,021,663    100.00%   0.82%  $2,078,310    100.00%   1.12%

 

47
 

 

At December 31, 2012, the Company had certificates of deposit with balances of $100,000 and over maturing as follows:

 

   Amount 
  (In thousands) 
Maturing in:     
Three months or less  $53,926 
Over three months through six months   54,785 
Over six months through 12 months   58,891 
Over 12 months through 24 months   47,169 
Over 24 months through 36 months   2,693 
Over 36 months   3,459 
Total certificates of deposits greater than $100,000  $220,923 

 

The following table presents the Company’s activity in its deposit liabilities for the periods indicated:

 

   Year Ended December 31 
   2012   2011   2010 
   (Dollars in thousands) 
Total deposit liabilities at beginning of period  $2,021,663   $2,078,310   $2,137,508 
Net withdrawals   (167,096)   (74,632)   (85,039)
Interest credited, net of penalties   13,332    17,986    25,841 
Total deposit liabilities at end of period  $1,867,899   $2,021,663   $2,078,310 

  

Borrowings Borrowings, which consist of advances from the FHLB of Chicago, increased by $53.1 million or 37.7% during the twelve months ended December 31, 2012. As previously noted, during the period the Company borrowed $158.9 million in term advances from the FHLB of Chicago to fund the purchase of held-to-maturity securities. This development was partially offset by the repayment of $100.0 million in borrowings from the FHLB of Chicago that had a rate of 4.52% and that matured during the third quarter of the year.

 

Management believes that additional funds are available to be borrowed from the FHLB of Chicago or other sources in the future to fund loan originations or security purchases or to fund existing advances as they mature if needed or desirable. However, there can be no assurances of the future availability of borrowings or any particular level of future borrowings. For additional information refer to “Item 1. Business—Borrowings.”

 

The following table sets forth certain information regarding the Company’s borrowings at the end of and during the periods indicated:

 

   At or For the Year Ended December 31 
   2012   2011   2010   2009   2008 
  (Dollars in thousands) 
Balance outstanding at end of year:                         
FHLB term advances  $210,786   $153,091   $149,934   $906,979   $907,971 
Overnight borrowings from FHLB                    
Weighted average interest rate at end of year:                         
FHLB term advances   2.34%   4.69%   4.79%   4.26%   4.26%
Overnight borrowings from FHLB                    
Maximum amount outstanding during the year:                         
FHLB term advances  $311,419   $199,493   $906,979   $907,971   $912,459 
Overnight borrowings from FHLB   5,000                5,000 
Other borrowings                   1,103 
Average amount outstanding during the year:                         
FHLB term advances  $227,573   $156,521   $871,212   $907,443   $910,517 
Overnight borrowings from FHLB   14                22 
Other borrowings                   3 
Weighted average interest rate during the year:                         
FHLB term advances   3.07%   4.59%   4.32%   4.32%   4.34%
Overnight borrowings from FHLB   0.30%               3.75%
Other borrowings                   1.92%

 

Shareholders’ Equity The Company’s shareholders’ equity increased from $265.8 million at December 31, 2011, to $271.9 million at December 31, 2012. This increase was caused by net income during the period, as well as lower accumulated other comprehensive loss due to an increase in the fair value of available-for-sale securities. These developments were partially offset by the payment of cash dividends to shareholders during the year. The book value of the Company’s common stock was $5.87 per share at December 31, 2012, compared to $5.75 per share at December 31, 2011.

 

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The Company’s ratio of shareholders’ equity to total assets was 11.24% at December 31, 2012, compared to 10.64% at December 31, 2011. The increase in this ratio was due primarily to a decrease in Bank Mutual’s total assets, as well as an increase in shareholders’ equity, as described in the previous paragraph. The Company is not currently required to maintain minimum capital for regulatory purposes. However, the Bank is required to maintain specified amounts of regulatory capital pursuant to regulations promulgated by the OCC and the FDIC. The Bank is “well capitalized” for regulatory capital purposes. As of December 31, 2012, the Bank had a total risk-based capital ratio of 18.02% and a Tier 1 capital ratio of 10.28%. The minimum ratios to be considered “well capitalized” under current supervisory regulations are 10% for total risk-based capital and 6% for Tier 1 capital. The minimum ratios to be considered “adequately capitalized” are 8% and 4%, respectively. For additional discussion refer to “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data,” as well as “Item 1. Business—Regulation and Supervision.”

 

On February 4, 2013, the Company’s board of directors announced that it had declared a $0.02 per share dividend payable on March 1, 2013, to shareholders of record on February 15, 2013. In 2012 the Company did not repurchase any shares of its common stock and the Company does not currently have a program authorizing the purchase of shares.

 

The payment of dividends or the repurchase of common stock by the Company is highly dependent on the ability of the Bank to pay dividends or otherwise distribute capital to the Company. Such payments are subject to any requirements imposed by law or regulations and to the application and interpretation thereof by the OCC and FRB, which have become increasingly strict as to the amount of capital it expects financial institutions to maintain. The Company cannot provide any assurances that dividends will continue to be paid, the amount of any such dividends, or the possible future resumption of share repurchases. For further information about factors which could affect the Company’s payment of dividends, refer to “Item 1. Business—Regulation and Supervision,” as well as “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchase of Equity Securities,” above.

 

Asset Quality The following table presents information regarding non-accrual mortgage loans, consumer loans, commercial business loans, accruing loans delinquent 90 days or more, and foreclosed properties and repossessed assets as of the dates indicated.

 

   December 31 
   2012   2011   2010   2009   2008 
   (Dollars in thousands) 
Non-accrual mortgage loans:    
One- to four-family  $8,192   $14,868   $18,684   $12,126   $8,185 
Multi-family   6,824    22,905    31,660    3,357    13,255 
Commercial real estate   6,994    23,997    41,244    18,840    5,573 
Construction and development   937    9,368    26,563    4,859    2,847 
Total non-accrual mortgage loans   22,947    71,138    118,151    39,182    29,860 
Non-accrual consumer loans:                         
Secured by real estate   1,514    1,457    1,369    1,433    759 
Other consumer loans   59    207    275    212    400 
Total non-accrual consumer loans   1,573    1,664    1,644    1,645    1,159 
Non-accrual commercial business loans   693    1,642    2,779    923    1,494 
Total non-accrual loans   25,213    74,444    122,574    41,750    32,513 
Accruing loans delinquent 90 days or more (1)   584    696    373    834    576 
Total non-performing loans   25,797    75,140    122,947    42,584    33,089 
Foreclosed real estate and repossessed assets   13,961    24,724    19,293    17,689    4,768 
Total non-performing assets  $39,758   $99,864   $142,240   $60,273   $37,857 
                          
Non-performing loans to total loans   1.84%   5.69%   9.29%   2.83%   1.81%
Non-performing assets to total assets   1.64%   4.00%   5.49%   1.72%   1.08%
Interest income that would have been recognized if non-accrual loans had been current  $1,998   $4,535   $4,734   $2,671   $2,519 

 

(1)Consists of student loans that are guaranteed under programs sponsored by the U.S. government.

 

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The Company’s non-performing loans were $25.8 million or 1.84% of loans receivable as of December 31, 2012, compared to $75.1 million or 5.69% of loans receivable as of December 31, 2011. Non-performing assets, which includes non-performing loans, were $39.8 million or 1.64% of total assets and $99.9 million or 4.00% of total assets as of these same dates, respectively. The decline in non-performing loans in 2012 was due principally to a $41.5 million or 73.8% aggregate decrease in non-performing commercial real estate, multi-family, and construction loans. This decrease was primarily attributable to eight larger loans that aggregated $25.2 million that were paid off, six larger loans that aggregated $6.6 million that were transferred to foreclosed real estate, and one loan for $2.5 million that was returned to performing status due to the improved condition of the borrower. All of these loans were secured by commercial and multi-family real estate. In addition, non-performing one- to four-family loans declined by $6.7 million or 44.9% and non-performing commercial business loans declined by $949,000 or 57.8% during the twelve months ended December 31, 2012. In addition, foreclosed properties and repossessed assets, which is a component of non-performing assets, declined by $10.8 million or 43.5% during the twelve months ended December 31, 2012, for reasons previously described.

 

In 2011 the Company’s non-performing loans declined by $47.8 million or 38.9%. Most of this decline was attributable to a $43.2 million aggregate decrease in non-performing commercial real estate, multi-family, and construction loans. In 2011 six larger loan relationships that aggregated $14.5 million were paid off, six larger loan relationships that aggregated $17.8 million were foreclosed, and the Company recorded $8.9 million in charge-offs related to seven larger loan relationships that that continued to be classified as non-performing as of the end of that year. The aggregate balance for these latter loans was $19.4 million (prior to the charge-offs). Finally, non-performing one- to four-family loans and non-performing commercial business loans declined by $3.8 million and $1.1 million, respectively, during the twelve months ended December 31, 2011. Also in 2011, the Company’s foreclosed properties and repossessed assets, which is a component of non-performing assets, increased by $5.4 million or 28.2%, due principally to the aforementioned foreclosures during the year. This development was partially offset by sales of foreclosed real estate, as well as continued charge-offs of foreclosed properties.

 

In 2010 the Company’s non-performing assets increased by $82.0 million or 136%. This increase was due in part to 15 unrelated loan relationships that aggregated $38.1 million that were current with respect to principal and interest payments. Management determined that these loans should be classified as non-performing as of December 31, 2010, in light of underlying difficulties with the properties that secure the loans, as well as an increasingly strict regulatory environment. These loans were secured by commercial real estate, multi-family real estate, undeveloped land, and commercial business assets. Also contributing to the increase in non-performing assets in 2010 were 16 larger loan relationships that aggregated $49.2 million that defaulted during the year. These loans were secured by commercial real estate, multi-family real estate, single-family real estate, undeveloped land, and commercial business assets. Also in 2010, non-performing one- to four-family loans increased by $4.0 million, smaller non-performing commercial business loans increased by $5.8 million, smaller non-performing commercial and multi-family real estate loans increased by $2.0 million, and foreclosed real estate and repossessed assets increased by $1.6 million. These developments were partially offset by the combined effects of loan charge-offs and a small decline in non-performing student loans during the year.

 

In 2009 the Company’s non-performing assets increased by $22.4 million or 59.2%. This increase was primarily caused by the default of $15.4 million in loans to seven borrowers that were secured by office and retail buildings, townhomes, and improved land. Also contributing was a $3.9 million increase in non-performing one- to four-family residential loans and a $744,000 increase in non-performing consumer and student loans. Foreclosed real estate and repossessed assets also increased by $12.9 million during 2009, due primarily to the foreclosure of a $9.1 million loan secured by a completed condominium development project that had defaulted in the prior year. These developments were partially offset by the combined effects of loan charge-offs and a small decline in non-performing commercial business loans during the year.

 

Non-performing assets are classified as “substandard” in accordance with the Company’s internal risk rating policy. In addition to non-performing assets, at December 31, 2012, management was closely monitoring $31.8 million in additional loans that were adversely classified as “substandard” and $37.7 million in additional loans that were classified as “special mention” in accordance with the Company’s internal risk rating policy. These amounts compared to $28.5 million and $51.6 million, respectively, as of December 31, 2011. The substantial decrease in loans classified as “special mention” during 2012 was due to loans that were further downgraded during the year to “substandard” or were upgraded because of improved performance. As of December 31, 2012, most of the additional loans classified as “substandard” or “special mention” were secured by commercial real estate, multi-family real estate, land, and certain commercial business assets. Although these additional loans were performing in accordance with their contractual terms and were not included in non-performing assets, management deemed their classification as “substandard” or “special mention” to be prudent in light of deterioration in the financial strength of the borrowers and/or the performance of the collateral, including an assessment of occupancy rates, lease rates, unit sales, and/or estimated changes in the value of the collateral. Further deterioration in the borrowers or related collateral could result in these additional loans becoming non-performing assets in future periods. The Company does not expect to incur a loss on these additional loans at this time, although there can be no assurance.

 

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The Company’s classified loans and non-performing assets have declined substantially in recent periods. However, this trend is subject to many factors that are outside of Company’s control, such as economic and market conditions. As such, there can be no assurances that Company’s classified loans and non-performing loans and assets will continue to decline in future periods or that there will not be significant variability in the Company’s provision for loan losses from period to period.

 

In the third quarter of 2012 the OCC issued accounting and reporting guidance related to instances in which borrowers on one- to four-family mortgage loans have had debt discharged in bankruptcy and have not reaffirmed obligations related to their mortgage debt. The Company does not have a material exposure to one- to four-family mortgage loans that meet the criteria specified in the OCC guidance.

 

Loans considered to be impaired by the Company at December 31, 2012, totaled $25.8 million as compared to $75.1 million at December 31, 2011, $131.4 million at December 31, 2010, $42.6 million at December 31, 2009, and $33.1 million at December 31, 2008. The average annual balance of loans impaired as of December 31, 2012, was $52.4 million and the interest received and recognized on these loans while they were impaired was $1.2 million.

 

The following table presents the activity in the Company’s allowance for loan losses at or for the periods indicated.

 

   At or For the Year Ended December 31 
   2012   2011   2010   2009   2008 
   (Dollars in thousands) 
Balance at beginning of period  $27,928   $47,985   $17,028   $12,208   $11,774 
Provision for loan losses   4,545    6,710    49,619    12,413    1,447 
Charge-offs:                         
One- to four-family   (3,182)   (3,047)   (528)   (397)   (167)
Multi-family   (857)   (5,035)   (140)   (4,523)    
Commercial real estate   (4,894)   (15,286)   (11,621)   (1,989)   (446)
Construction and development   (2,693)   (2,737)   (3,515)        
Consumer   (812)   (1,036)   (776)   (527)   (411)
Commercial business   (136)   (551)   (2,140)   (210)   (34)
Total charge-offs   (12,574)   (27,692)   (18,720)   (7,646)   (1,058)
Recoveries:                         
One- to four-family   86    49    20    1     
Multi-family   568    248             
Commercial real estate   956    40    1    19     
Construction and development   1    550             
Consumer   41    20    37    33    45 
Commercial business   26    18             
Total recoveries   1,678    925    58    53    45 
Net charge-offs   (10,896)   (26,768)   (18,662)   (7,593)   (1,013)
Balance at end of period  $21,577   $27,928   $47,985   $17,028   $12,208 
                          
Net charge-offs to average loans   0.78%   1.96%   1.26%   0.45%   0.05%
Allowance for loan losses to total loans   1.54%   2.12%   3.63%   1.13%   0.67%
Allowance for loan losses to non-performing loans   83.64%   37.17%   39.03%   39.99%   36.89%

 

The changes in the Company’s allowance for loan losses in recent years has been consistent with overall changes in the Company’s level of non-performing loans, changes in loan charge-off activity, and industry trends. The changes are also consistent with changes in management’s assessment of overall economic conditions, unemployment, and real estate values during the periods. The Company’s ratio of allowance for loan losses as a percent of non-performing loans increased from 37.2% at December 31, 2011, to 83.6% at December 31, 2012. This increase was caused by a substantial decline in non-performing loans relative to the allowance for loan losses. This change is to be expected when non-performing loans (which are generally evaluated for impairment on an individual basis) decline in a period and, as a result, a larger portion of the allowance for loan losses relates to loans that are evaluated for impairment on a collective basis (refer to “Note 3. Loans Receivable” in “Item 8. Financial Statements and Supplementary Data”).

 

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Although management believes the Company’s present level of allowance for loan losses is adequate, there can be no assurances that future adjustments to the allowance will not be necessary, which could adversely affect the Company’s results of operations. For additional discussion, refer to “Item 1. Business—Asset Quality,” above, and “Critical Accounting Policies—Allowance for Loan Losses,” below.

 

The following table represents the Company’s allocation of its allowance for loan losses by loan category on the dates indicated:

 

   December 31 
   2012   2011   2010   2009   2008 
   Amount   Percentage in
Category to
Total
   Amount   Percentage 
in Category 
to Total
   Amount   Percentage
in Category 
to Total
   Amount   Percentage
in Category
to Total
   Amount   Percentage
 in Category
to Total
 
   (Dollars in thousands) 
Loan category:                                                  
Mortgage loans:                                                  
One- to four-family  $3,267    15.14%  $3,201    11.46%  $3,726    7.76%  $2,806    16.47%  $3,038    24.89%
Multi-family   5,195    24.08    7,442    26.65    9,265    19.31    3,167    18.60    4,197    34.38 
Commercial real estate   7,354    34.08    9,467    33.90    21,885    45.61    5,715    33.56    1,113    9.12 
Construction/development   2,617    12.13    4,506    16.13    10,141    21.13    1,172    6.88    400    3.28 
Total mortgage loans   18,433    85.43    24,616    88.14    45,017    93.81    12,860    75.52    8,748    71.66 
Consumer   1,458    6.76    1,214    4.35    1,427    2.97    2,243    13.17    2,125    17.41 
Commercial business   1,686    7.81    2,098    7.51    1,541    3.21    1,925    11.31    1,335    10.94 
Total allowance for loan losses  $21,577    100.00%  $27,928    100.00%  $47,985    100.00%  $17,028    100.00%  $12,208    100.00%

 

Critical Accounting Policies

 

There are a number of accounting policies that the Company has established which require a significant amount of management judgment. A number of the more significant policies are discussed in the following paragraphs.

 

Allowance for Loan Losses Establishing the amount of the allowance for loan losses requires the use of management judgment. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on factors such as the size and current risk characteristics of the portfolio, an assessment of individual problem loans and pools of homogenous loans within the portfolio, and actual loss, delinquency, and/or risk rating experience within the portfolio. The Company also considers current economic conditions and/or events in specific industries and geographical areas, including unemployment levels, trends in real estate values, peer comparisons, and other pertinent factors, to include regulatory guidance. Finally, as appropriate, the Company also considers individual borrower circumstances and the condition and fair value of the loan collateral, if any.

 

Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on loans, the fair value of underlying collateral (if any), estimated losses on pools of homogeneous loans based on historical loss experience, changes in risk characteristics of the loan portfolio, and consideration of current economic trends, all of which may be susceptible to significant change. Higher rates of loan defaults than anticipated would likely result in a need to increase provisions in future years. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary. If management misjudges a major component of the allowance and the Company experiences an unanticipated loss, it will likely affect earnings. Developments affecting loans can also cause the allowance to vary significantly between quarters. Management consistently challenges itself in the review of the risk components to identify any changes in trends and their causes.

 

Other-Than-Temporary Impairment Generally accepted accounting principles require enterprises to determine whether a decline in the fair value of an individual debt security below its amortized cost is other than temporary. If the decline is deemed to be other than temporary, the cost basis of the security must be written down through a charge to earnings. Determination of OTTI requires significant management judgment relating to the probability of future cash flows, the financial condition and near-term prospects of the issuer of the security, and/or the collateral for the security, the duration and extent of the decline in fair value, and the ability and intent of the Company to retain the security, among other things. Future changes in management’s assessment of OTTI on its securities could result in significant charges to earnings in future periods.

 

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Income Taxes The assessment of the Company’s tax assets and liabilities involves the use of estimates, forecasts, assumptions, interpretations, and judgment concerning the Company’s estimated future results of operations, as well as certain accounting pronouncements and federal and state tax codes. Management evaluates the Company’s net deferred tax asset on an on-going basis to determine if a valuation allowance is required. This evaluation requires significant management judgment based on positive and negative evidence. Such evidence includes the Company’s cumulative three-year net loss, the nature of the components of such cumulative loss, recent trends in earnings excluding one-time charges (such as the FHLB prepayment penalty in 2010 and the goodwill impairment in 2011), expectations for the Company’s future earnings, the duration of federal and state net operating loss carryforward periods, and other factors. There can be no assurance that future events, such as adverse operating results, court decisions, regulatory actions or interpretations, changes in tax rates and laws, or changes in positions of federal and state taxing authorities will not differ from management’s current assessments. The impact of these matters could be significant to the consolidated financial conditions and results of operations.

 

The Company describes all of its significant accounting policies in “Note 1. Basis of Presentation” in “Item 8. Financial Statements and Supplementary Data.”

 

Contractual Obligations, Commitments, Contingent Liabilities, and Off-Balance Sheet Arrangements

 

The Company has various financial obligations, including contractual obligations and commitments, that may require future cash payments.

 

The following table presents, as of December 31, 2012, significant fixed and determinable contractual obligations to third parties by payment date. All amounts in the table exclude interest costs to be paid in the periods indicated, if applicable.

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Deposit liabilities without a stated maturity  $1,055,996               $1,055,996 
Certificates of deposit   618,487   $176,337   $17,079        811,903 
Borrowed funds   217    23,450    61,273   $125,846    210,786 
Operating leases   964    1,740    1,123    2,986    6,813 
Purchase obligations   1,680    3,360    3,360    2,940    11,340 
Deferred retirement plans and deferred compensation plans   1,080    2,041    2,155    6,211    11,487 

 

The Company’s operating lease obligations represent short- and long-term lease and rental payments for facilities, certain software and data processing and other equipment. Purchase obligations represent obligations under agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The purchase obligation amounts presented above primarily relate to certain contractual payments for services provided for information technology.

 

The Company also has obligations under its deferred retirement plan for directors as described in “Note 10. Employee Benefit Plans” in “Item 8. Financial Statements and Supplementary Data.”

 

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The following table details the amounts and expected maturities of significant off-balance sheet commitments as of December 31, 2012.

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Commitments to extend credit:                         
Commercial real estate  $13,430               $13,430 
Residential real estate   22,518                22,518 
Revolving home equity and credit card lines   152,109                152,109 
Standby letters of credit   256   $1,250       $6    1,512 
Commercial lines of credit   75,354                75,354 
Undisbursed commercial loans   2,740    10   $250        3,000 
Net commitments to sell mortgage loans   75,750                75,750 

 

Commitments to extend credit, including loan commitments, standby letters of credit, unused lines of credit and commercial letters of credit do not necessarily represent future cash requirements, since these commitments often expire without being drawn upon.

 

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Quarterly Financial Information

 

The following table sets forth certain unaudited quarterly data for the periods indicated:

 

   2012 Quarter Ended 
   March 31   June 30   September 30   December 31 
   (Dollars in thousands, except per share amounts) 
Interest income  $20,777   $21,079   $20,697   $20,467 
Interest expense   5,879    6,226    5,098    4,437 
Net interest income   14,898    14,853    15,599    16,030 
Provision for loan losses   51    1,730    657    2,107 
Total non-interest income   7,271    6,934    6,845    8,209 
Total non-interest expense   20,517    18,140    18,790    18,608 
Income before taxes   1,601    1,917    2,997    3,524 
Income tax expense   462    601    1,044    1,229 
Net loss attributable to non-controlling interest