10-K 1 v402523_10k.htm FORM 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, 2014

 

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.  ¨

 

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 27, 2015, 46,666,089 shares of Common Stock were validly issued and outstanding. The aggregate market value of the Common Stock (based upon the $5.80 last sale price on The NASDAQ Global Select Market on June 30, 2014, 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 $249.8 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 4, 2015   Part III

 

 
 

 

BANK MUTUAL CORPORATION

 

FORM 10-K ANNUAL REPORT TO

THE SECURITIES AND EXCHANGE COMMISSION

FOR THE YEAR ENDED DECEMBER 31, 2014

 

Table of Contents

 

Item     Page
       
Part I      
       
1 Business   3
       
1A Risk Factors   21
       
1B Unresolved Staff Comments   25
       
2 Properties   25
       
3 Legal Proceedings   25
       
4 Mine Safety Disclosures   25
       
Part II      
       
5 Market for Registrant's Common Equity, Related Stockholders Matters, and  Issuer Purchases of Equity Securities   26
       
6 Selected Financial Data   28
       
7 Management's Discussion and Analysis of Financial Condition and Results of Operations   30
       
7A Quantitative and Qualitative Disclosures About Market Risk   52
       
8 Financial Statements and Supplementary Data   56
       
9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   101
       
9A Controls and Procedures   101
       
9B Other Information   103
       
Part III      
       
10 Directors, Executive Officers, and Corporate Governance   104
       
11 Executive Compensation   104
       
12 Security Ownership of Certain Beneficial Owners, Management, and Related Stockholder Matters     104
       
13 Certain Relationships and Related Transactions and Director Independence   104
       
14 Principal Accountant Fees and Services   104
       
Part IV      
       
15 Exhibits, Financial Statement Schedules   105
       
SIGNATURES   106

 

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; weakness and declines in the real estate market, which could affect both collateral values and loan activity; periods of relatively high unemployment or economic weakness 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 rights of creditors; monetary and fiscal policies of the federal government; the effects of further regulation and consolidation within the financial services industry; regulators’ strict expectations for financial institutions’ capital levels and restrictions imposed on institutions, as to payments of dividends, share repurchases, or otherwise, to maintain or achieve those levels, including the possible effects of new regulatory capital requirements under Basel III; recent, 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 or other global conflicts; 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 “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 commercial and industrial loans, multi-family residential loans, non-residential commercial real estate loans, one- to four-family loans, home equity loans, and other consumer loans. 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, 2014, the Company had 75 banking offices in Wisconsin and one in Minnesota. At June 30, 2014, the Company had a 1.28% market share of all deposits held by FDIC-insured institutions in Wisconsin. The Company is the third largest financial institution headquartered in Wisconsin based on total assets and the fourth largest 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”), and Racine and Kenosha Counties. The Company has 26 offices in these areas. 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. Finally, the Company has 18 offices in northwestern Wisconsin, including the Eau Claire MSA, and one office in Woodbury, Minnesota, which is part of the Minneapolis-St. Paul MSA. A number of the Company’s banking offices are located near the northern Michigan and Illinois borders. Therefore, the Company may also draw customers from nearby regions in those states.

 

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

 

On February 9, 2015, the Company announced that it was closing seven retail branch offices in connection with an efficiency and expense reduction effort. Four of these offices are located in northwestern Wisconsin (including one in Eau Claire), two are located in northeastern Wisconsin (including one in Green Bay), and one is located in southeastern Wisconsin. Management anticipates the closures will be completed in the second quarter of 2015, and that the Company will continue to provide products and services to the affected customers through its other nearby locations, as well as its internet, mobile banking, and telephone channels. 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.”

 

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 wholly-owned subsidiary.

 

4
 

 

Lending Activities

 

General At December 31, 2014, the Company’s total loans receivable was $1.6 billion or 68.6% of total assets. The Company’s loan portfolio consists of loans to both commercial and retail borrowers. Loans to commercial borrowers include loans secured by real estate such as multi-family properties, non-residential commercial properties (referred to as “commercial real estate”), and construction and development projects secured by these same types of properties, as well as land. In addition, commercial loans include loans to businesses that are not secured by real estate (referred to as “commercial and industrial loans”). Loans to retail borrowers include loans to individuals that are secured by real estate such as one- to four-family first mortgages, home equity term loans, and home equity lines of credit. In addition, retail loans include student loans, automobile loans, and other loans not secured by real estate (collectively referred to as “other consumer loans”).

 

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 primary market areas, which consist of Wisconsin and contiguous regions of Illinois, Minnesota, and northern Michigan. However, from time-to-time the Company will make loans secured by properties outside of its primary market areas provided the borrowers are located within such areas and are well-known to the Company. 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.”

 

Commercial and Industrial Loans    At December 31, 2014, the Company’s portfolio of commercial and industrial loans was $226.5 million or 12.5% of its gross loans receivable. This portfolio consists of loans and lines of credit 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 and industrial loans. The Company also has commercial and industrial loans that have an initial period where interest rates are fixed, generally for 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 and industrial borrowers having an exposure to the Company of $500,000 or more.

 

Multi-family and Commercial Real Estate Loans    At December 31, 2014, the Company’s aggregate portfolio of multi-family and commercial real estate loans was $585.9 million or 32.2% 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. However, if a multi-family or commercial real estate borrower desires a fixed-rate with a balloon maturity beyond five years, the Company generally enters into a series of interest rate swap agreements with the borrower and a third-party financial institution which converts the Company’s interest rate risk exposure to floating rate. Refer to “Financial Derivatives,” below, for additional discussion.

 

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 assessment of which is also based on financial strength and/or income producing potential. 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 expected 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 $500,000.

 

5
 

 

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 $43.0 million as of December 31, 2014. 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, 2014, the Company’s portfolio of construction and development loans was $258.7 million or 14.2% 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. Construction loans typically convert to permanent loans at the completion of a project, but may or may not remain in the Company’s loan portfolio depending on the competitive environment for permanent financing at the end of the construction term. 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, the borrower's ability to advance additional construction funds if necessary, and the stabilization period for lease-up after the completion of construction. 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 $500,000.

 

Residential Mortgage Loans At December 31, 2014, the Company’s portfolio of one- to four-family first mortgage loans was $504.0 million or 27.7% of its gross loans receivable. Most of these loans are for owner-occupied residences; 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. When the Company sells residential mortgage loans in the secondary market, it makes representations and warranties to the purchasers about various characteristics of each loan, including the underwriting standards applied and the documentation being provided. Failure of the Company to comply with the requirements established by the purchaser of the loan may result in the Company being required to repurchase the loan. There have not been any material instances where the Company has been required to repurchase 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 2013. 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.

 

6
 

 

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.

 

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 third-party investors”). Servicing mortgage loans, whether for its own portfolio or for third-party investors, 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, 2014, loans serviced for third-party investors 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 third-party investors, 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.

 

7
 

 

Management believes that servicing mortgage loans for third-party investors partially mitigates 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 allowances 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 assess the impairment of 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.

 

Home Equity Loans At December 31, 2014, the Company’s portfolio of home equity loans was $219.7 million or 12.1% of its gross loans receivable. Home equity loans include fixed term home equity 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.

 

The Company originates fixed-rate home equity 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 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.

 

Other Consumer Loans At December 31, 2014, the Company’s portfolio of other consumer loans was $22.4 million or 1.2% of its gross loans receivable. Other consumer loans include student loans, automobile loans, recreational vehicle and boat loans, deposit account loans, overdraft protection lines of credit, and unsecured consumer loans, including 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.

 

Other 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, other 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. In addition, various laws, including bankruptcy and insolvency laws, may limit the amount that may be recovered from a borrower. The Company believes that the higher yields earned on other 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.

 

8
 

 

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.”

 

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 evaluate and/or maintain 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, 2014, $43.5 million or 2.7% the Company’s loans were classified as special mention and $45.4 million or 2.8% 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, 2014, $23.3 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, 2014.

 

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 retail 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 efforts, seek foreclosure or repossession of the collateral (if any), and/or charge-off the loan. All student loans are serviced by a third party that 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.

 

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The collection procedures for commercial 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 regularly review loans that are 10 days or more delinquent. 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.

 

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, 2014, $12.0 million or 0.74% 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, 2014, $4.7 million or 0.20% 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.

 

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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. 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 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.

 

Allowance for Loan Losses As of December 31, 2014, the Company’s allowance for loan losses was $22.3 million or 1.37% of loans receivable and 185.68% 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 and industrial 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 valuations of foreclosed real estate. One or more of these agencies, particularly the OCC, may require the Company to increase the allowance for loan losses or reduce the recorded value of 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 loans of all types that do not warrant individual review due to their size. In addition, pools may also consist of larger commercial loans that have not been individually identified as impaired by management. Certain of these 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 collateral dependent.

 

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 impaired loans on at least on annual basis or when foreclosure or repossession of the underlying collateral is considered to be imminent. Prior to receipt of an updated appraisal, management has typically relied on the latest 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.

 

Investment Activities

 

At December 31, 2014, the Company’s portfolio of mortgage-related securities available-for-sale was $321.9 million or 13.8% of its total assets. As of the same date its portfolio of mortgage-related securities held-to-maturity was $132.5 million or 5.7% of total assets. Mortgage-related securities consist principally of mortgage-backed securities (“MBSs”) 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.

 

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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, financial derivatives, and other purposes permitted or required by law.

 

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 results 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 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).

 

Financial Derivatives

 

The Company’s policies permit the use of financial derivatives such as financial futures, options, forward commitments, and interest rate swaps, to manage its exposure to interest rate risk, but only with prior approval of the board of directors. At December 31, 2014, the Company was using forward commitments to manage interest rate risk related to its sale of residential loans in the secondary market, as well as interest rate swaps to manage interest rate risk related to certain fixed-rate commercial loans. For additional information, refer to “Note 13. Financial Instruments with Off-Balance-Sheet Risk” in “Item 8. Financial Statements and Supplementary Data.”

 

Deposit Liabilities

 

At December 31, 2014, the Company’s deposit liabilities were $1.7 billion or 73.8% 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, 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.

 

Borrowings

 

At December 31, 2014, the Company’s borrowed funds were $256.5 million or 11.0% 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 certain one- to four-family first and second mortgage loans, as well as certain multi-family mortgage loans, as blanket collateral for current and future advances.

 

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Shareholders’ Equity

 

For additional information regarding the Company’s outstanding advances from the FHLB of Chicago as of December 31, 2014, refer to “Financial Condition—Borrowings” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

At December 31, 2014, the Company’s shareholders’ equity was $280.7 million or 12.06% of its total liabilities and equity. Beginning in 2015 the Company will be required to maintain minimum regulatory capital at the holding company level. Refer to “Regulation and Supervision—Regulation of the Company,” below, for additional information related to regulatory capital requirements for the Company.

 

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, 2014, 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,” 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 which has 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 currently has an active stock repurchase program in effect. However, because of the aforementioned considerations there can be no assurances the Company will repurchase shares of its common stock under the current stock repurchase program. For additional discussion relating to the Company’s current stock repurchase program, refer to “Financial Condition—Shareholders’ Equity,” in “Item 7. Management’s Discussion and Analysis.”

 

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”) and First Northern Investment Inc. (“FNII”) were wholly-owned subsidiaries of the Bank that formerly owned and managed certain mortgage-related securities and, in the case of FNII, a small amount of one- to four-family mortgage loans. In 2014 the Company transferred substantially all of the assets and liabilities of MIC and FNII to the Bank. Subsequent to the transfer, FNII was dissolved as a legal entity. MIC will continue as a legal entity in an inactive status. These developments did not have a significant impact on the Company’s financial condition or results of operations.

 

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.

 

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

 

Employees

 

At December 31, 2014, the Company employed 616 full time and 99 part time associates. Management considers its relations with its associates to be good.

 

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. 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.

 

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 Wall Street Reform and Consumer Protection Act (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. Many of the provisions of the Dodd-Frank Act have become effective since 2010 and management believes the Company and the Bank are in compliance with the new provisions, as applicable, and that the impacts of such provisions (if any) are fully reflected in the financial condition and/or results of operations of the Company and the Bank. However, a number of the provisions of the Dodd-Frank Act remain subject to future rule-making procedures and studies. As such, the full impact of such future provisions cannot yet be determined at this time, although management does not expect them to have a material adverse impact on the Company or the Bank. The Dodd-Frank Act requires the FRB to apply to savings and loan holding companies the same consolidated leverage and risk-based capital standards that insured depository institutions must follow, which include capital requirements for the Company effective in 2015 (refer to “Regulation and Supervision—Regulation of the Company,” below, for additional information related to regulatory capital requirements for the Company).

 

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. 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.

 

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Regulatory Capital Requirements In periods prior to January 1, 2015, federal regulations required savings associations such as the Bank to meet specified minimum regulatory capital standards to be classified as “adequately capitalized” under the regulations. At December 31, 2014, the Bank’s regulatory capital ratios exceeded the minimum requirements to be classified as “adequately capitalized,” as well as those necessary to be classified as a “well capitalized”. 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.”

 

On January 1, 2015, regulatory capital standards as specified by the Basel Committee of Banking Supervision (known as Basel III) became effective for financial institutions such as the Bank (although certain aspects of the new standards are phased in over the following four years). These new regulatory capital standards, which supersede the standards in effect prior to that date, require financial institutions such as the Bank to meet the following minimum regulatory capital standards to be classified as “adequately capitalized” under the regulations: (i) common equity Tier 1 (“CET1”) capital equal to at least 4.5% of total risk-weighted assets, (ii) Tier 1 capital equal to at least 4% of adjusted total assets (continuing as the “leverage ratio”), (iii) Tier 1 risk-based capital equal to at least 6% of total risk-weighted assets, and (iv) total risk-based capital equal to at least 8% of total risk-weighted assets. In the Bank’s case, the dollar amount of Tier 1 capital and total capital are expected to be substantially the same under the Basel III standards as they were under the previous regulatory capital standards. As such, the Bank’s ratio of Tier 1 capital to adjusted assets (leverage ratio) is not expected to be significantly impacted by the Basel III regulatory capital standards. However, the Bank’s Tier 1 risk-based capital ratio and total risk-based capital ratio could decline by up to 100 basis points each in 2015 due to changes required by Basel III that impact the computation of the Bank’s total risk-weighted assets. Despite this expectation, management anticipates that in 2015 all of these regulatory capital ratios will exceed the minimum requirements established by Basel III for the Bank to be classified as “adequately capitalized.” The Bank’s CET1 capital is expected to differ from its Tier 1 capital only to the extent of deferred tax assets, which will phase in as a disallowance to CET1 capital over the following four years. Similar to the other Basel III regulatory capital ratios, management anticipates that in 2015 the Bank’s ratio of CET1 capital to total risk-weighted assets will exceed the minimum requirement established by Basel III to be classified as “adequately capitalized.” Furthermore, management anticipates that all of the Bank’s Basel III regulatory capital ratios will exceed the minimums necessary for the Bank to be classified as a “well capitalized” institution under the new standards, which are higher than the percentages previously described.

 

In addition to the requirements described in the previous paragraph, the Basel III regulatory capital regulations also introduced an element known as the “capital conservation buffer.” In order to avoid limitations on capital distributions and certain discretionary bonus payments to executive officers, a banking organization such as the Bank must hold a capital conservation buffer composed of CET1 capital above the minimum risk-based capital requirements specified in the previous paragraph. This additional requirement is 2.5% of risk-weighted assets, although the requirement will phase-in at a rate of 0.625% per year from 2016 to 2019. Therefore, management’s objective is to maintain all of the Bank’s regulatory capital ratios in amounts that exceed than the Basel III minimums described in the preceding paragraph including the capital conservation buffer. As such, management does not believe the capital conservation buffer will have any impact on the Bank’s capital contributions or discretionary bonus payments to executive officers.

 

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. Currently, as a subsidiary of a savings and loan holding company, the Bank generally must give the FRB and the OCC at least 30 days notice before the board of directors declares a dividend or approves a capital distribution. In certain other circumstances, 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.

 

The FRB or 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 regulatory-imposed condition. The FRB and OCC have substantial discretion in making these decisions.

 

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For additional discussion related to the Bank and Company’s dividends and the Company’s common stock repurchases refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.” Also, the new requirements under Basel III, as discussed above, have the potential to impact capital distributions such as dividends and common stock repurchases. Refer to “Regulatory Capital Requirements,” above, for additional discussion.

 

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, 2014, and anticipates that it will maintain an appropriate level of mortgage-related investments (which must be at least 65% of portfolio assets as defined in the regulations) and will otherwise continue to meet the QTL test requirements.

 

Federal Home Loan Bank System The Bank is a member of the FHLB of Chicago. The FHLB of Chicago makes loans (“advances”) to its members and provides certain other financial services to its 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, 2014, the Bank owned $14.2 million in FHLB of Chicago common stock, which was in compliance with the minimum common stock ownership guidelines established by the FHLB of Chicago. 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 fund. Under the risk-based assessment system, the FDIC assigns an institution to one of three capital categorizations based on the institution’s financial information; institutions are classified as well capitalized, adequately capitalized or undercapitalized using ratios that are substantially similar to the 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 four assessment risk categories to which different assessment rates are applied. The assessment rates range from 2.5 to 45 basis points, depending on the institution’s capital category and supervisory sub-category. The assessment base used by the FDIC in determining deposit insurance premiums consists of an insured institution’s average consolidated total assets minus average tangible equity and certain other adjustments. 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.”

 

Consumer Financial Protection Bureau The CFPB, which was created by the Dodd-Frank Act, has broad rule-making and enforcement authority related to a wide range of consumer protection laws that apply to all banks and savings institutions, such as the Bank. Accordingly, the activities of the CFPB could have a significant impact on the financial condition and/or operations of the Company Management does not believe the activities of the CFPB have had a significant impact on the Bank to date. Although CFPB regulations apply to the Bank, institutions with $10 billion or less in assets (such as the Bank) are examined for compliance with CFPB directives by their applicable bank regulators rather than the CFPB itself.

 

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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 safe 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, 2014, 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.

 

Other Mortgage Lending Regulations In 2013 the CFPB issued a regulation commonly known as the “qualified mortgage” rule, which generally requires mortgage lenders such as the Bank to make a reasonable, good faith determination of a borrower’s ability to repay loans secured by single family residential properties (excluding home equity lines of credit and certain other types of loans) in order to obtain certain protections from liability under the rule for such qualified mortgages. These new rules were effective on January 10, 2014. This new rule has not had a significant impact on the Bank’s single family mortgage lending or sales operations.

 

In January 2015 federal regulators issued a regulation relating to risk retention requirements on sales of single family residential mortgage loans. The risk retention requirements generally require institutions such as the Bank to retain no less than 5% of the credit risk in loans it sells into a securitization and prohibits such institutions from directly or indirectly hedging or otherwise transferring the credit risk that the institution is required to retain, subject to limited exceptions. One significant exception is for securities entirely collateralized by “qualified residential mortgages” (“QRMs”), which are defined the same as the “qualified mortgage” rule issued by the CFPB, as discussed in the previous paragraph. The new risk retention requirements apply to securitizations of residential loans that are issued after December 24, 2015. Management does not expect this new requirement to have an impact on the Bank’s single family mortgage lending or sales operations.

 

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.

 

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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.

 

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, 2014, total loans to insiders were $624,000 (including $509,000 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 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.

 

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Regulatory Capital Requirements Prior to January 1, 2015, the Company was not required by the FRB to maintain minimum regulatory capital at the consolidated level. However, under the Dodd-Frank Act, the FRB imposed capital requirements on savings and loan holding companies beginning January 1, 2015. These capital requirements are substantially the same as those required for bank holding companies under Basel III, which also became effective on January 1, 2015 (although certain aspects of Basel III are phased in over the next four years). In particular, Basel III sets forth new minimum regulatory capital standards that affect which financial institutions or holding companies (including the Company) qualify as “adequately capitalized.” Basel III standards (and in particular a capital buffer requirement) may also affect the Company’s ability to make certain capital distributions, stock repurchases, and discretionary bonus payments. The minimum capital requirements applicable to banks, as described above, are separately applied to the Company on a consolidated basis. For more specific information on these requirements, and their potential impact, see “Regulation and Supervision of the Bank – Regulatory Capital Requirements,” above.

 

Management anticipates that the Company will be meet or exceed the requirements to be “well capitalized” for regulatory capital purposes at the consolidated level when it becomes subject to such capital requirements in 2015. In addition, management does not expect the new capital requirements to have a significant impact on the Company’s financial condition or results of operations.

 

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, any person, including a company, or group acting in concert, seeking to acquire 10% or more of the outstanding shares of the Company (or otherwise gain the ability to control the Company) must, depending on the circumstances, obtain the approval of, and/or file a notice with 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 and its subsidiaries have been examined or closed without examination by the Internal Revenue Service (“IRS”) for tax years prior to 2011.

 

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. The state income tax returns for the Company and its subsidiaries have been examined and closed by the Wisconsin Department of Revenue for tax years prior to 2010.

 

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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 Company’s Actual Loan Losses May Exceed its Allowance for Loan Losses, Which Could Have a Material Adverse Effect 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.

 

Declines in Real Estate Values Could Adversely Affect Collateral Values and the Company’s Results of Operations

 

From time-to-time the Company’s market areas have 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. Such developments could negatively affect the value of the collateral securing the Company’s mortgage and related loans and could in turn lead to increased losses on loans and foreclosed real estate. 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.

 

A Significant Portion of the Company’s Lending Activities Are Focused on Commercial Lending

 

The Company has identified multi-family, commercial real estate, commercial and industrial, and construction loans as areas for lending emphasis. In addition, the Company has employed the appropriate management, sales, and administrative personnel, as well as installed appropriate systems and procedures, to support this lending emphasis. However, these types of loans have historically carried greater risk of payment default than loans to retail borrowers. As the volume of commercial lending increases, credit risk increases. In the event of increased defaults from commercial borrowers, the Company’s provision for loan losses would further increase and loans may be written off and, therefore, earnings would be reduced. In addition, costs associated with the administration of problem loans increase and, therefore, earnings would be further reduced.

 

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 related compliance burdens. Even though the Company is also 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 environmental risks, the value of the collateral it holds may be less than it expects; further, regulations expose the Bank to potential liability for remediation and other environmental compliance.

 

Regulators Continue to be Strict, which may Affect the Company's Business and Results of Operations

 

In addition to the effect of new laws and regulations, the regulatory climate in the U.S., particularly for financial institutions, continues to be strict. As a consequence, regulatory activity affecting financial institutions relating to a wide variety of safety and soundness and compliance issues continues to be elevated. Such regulatory activity, if directed at the Company or the Bank, could have an adverse effect on the Company's or the Bank's costs of compliance and results of operations.

 

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The Bank’s Ability to Pay Dividends to the Company Is Subject to Limitations that May Affect the Company’s Ability to Pay Dividends to its Shareholders and/or 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. In addition, new requirements imposed by Basel III could limit the capital distributions of the Bank. 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 continue to be 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.

 

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 performance has been inconsistent in various countries. Developments relating to the federal budget, federal borrowing authority, and/or other political issues could also negatively impact these markets, as could global developments such as a foreign sovereign debt crisis. Volatility and/or instability in global financial markets could also 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 global economies 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. Conditions such as 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.

 

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, 2014, the Company’s net deferred tax asset was $25.6 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, 2014. This determination required significant management judgment based on positive and negative considerations. Such considerations included 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. 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 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, were adopted. Although designed to address safety, soundness, and compliance 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. Although management does not expect rules implemented to date to have a significant adverse impact on the Company, the full scope of the impact of the CFPB’s authority has not yet been determined as all 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.

 

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.

 

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

 

The Company encounters strong competition both in attracting deposits from customers and originating loans to commercial and retail borrowers. 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 the internet, 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 continue to be under a high level of governmental, media, and other scrutiny, as to the conduct of their businesses, and potential issues and adverse developments (real and perceived) often receive 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

 

The protection of customer data from potential breaches of the Company’s computer systems is an increasing concern, as is the potential for disruption of the Company’s internet banking services, through which it increasingly provides services, as well as other systems through which the Company provides services. The security of company and customer data and protection against disruptions of companies’ computer systems are increasing matters of industry, customer, and regulatory scrutiny given the significant potential consequences of failures in these matters and the potential negative publicity surrounding instances of cybersecurity breaches. In addition, these risks can be difficult to predict or defend against, as the persons committing such attacks often employ novel methods of accessing or disrupting the computer systems of their targets.

 

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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 or other banking services that involve the transmission and/or retention 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, maintain, and keep secure 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 or if there is a breach of security, it will significantly affect the Company’s ability to adequately process and account for customer transactions, which would significantly affect the Company’s business operations and reputation.

 

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.

 

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, particularly customer relationship managers. 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.

 

24
 

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

The Company and its subsidiaries currently conduct their business through an executive office and 76 banking offices, which had an aggregate net book value of $48.5 million as of December 31, 2014, excluding furniture, fixtures, and equipment. As of December 31, 2014, the Company owned the building and land for 69 of its property locations and leased the space for eight.

 

On February 9, 2015, the Company announced that it was closing seven retail branch offices in connection with an efficiency and expense reduction effort. The real property at these locations had an aggregate net book value of $1.2 million as of December 31, 2014. Furniture, fixtures, and equipment had an aggregate net book value of $108,000. Management anticipates that these closures will be completed in the second quarter of 2015. The Company owns the building and land for six of these locations and leases the space for one. 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.”

 

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 $6.2 million at December 31, 2014.

 

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.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

25
 

 

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 27, 2015, there were 46,666,089 shares of common stock outstanding and approximately 8,700 shareholders of record.

 

The Company paid a total cash dividend of $0.15 per share in 2014. A cash dividend of $0.04 per share was paid on February 27, 2015, to shareholders of record on February 13, 2015. 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, 2013, through December 31, 2014, by quarter, and the dividends paid in each quarter, were as follows:

 

   2014 Stock Prices   2013 Stock Prices   Cash Dividends Paid 
   High   Low   High   Low   2014   2013 
1st Quarter  $7.34   $6.21   $5.88   $4.43   $0.03   $0.02 
2nd Quarter   6.46    5.80    5.90    5.04    0.04    0.02 
3rd Quarter   6.62    5.93    6.73    5.65    0.04    0.03 
4th Quarter   6.99    6.17    7.17    6.04    0.04    0.03 
                   Total     $0.15   $0.10 

 

From January 1, 2015, to February 27, 2015, the trading price of the Company's common stock ranged between $6.37 to $7.22 per share, and closed this period at $7.17 per share.

 

The Company did not repurchase any of its common stock during 2014. However, the Company’s board of directors authorized a stock repurchase program on February 2, 2015. For additional information relating to this stock repurchase program, refer to “Financial Condition—Shareholders’ Equity,” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” For additional discussion relating to the Company’s ability to repurchase of its common stock, refer to “Item 1. Business—Shareholders’ Equity” and “Item 1. Business—Regulation and Supervision.”

 

26
 

 

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, 2009, in Company common stock and each of those indices.

 

 

       Period Ending December 31    
Index  2009   2010   2011   2012   2013   2014 
Bank Mutual Corporation   100.00    71.32    48.20    66.00    109.36    109.55 
NASDAQ Composite Index   100.00    118.02    117.04    137.47    192.62    221.02 
NASDAQ Bank Index   100.00    111.35    83.04    111.88    152.85    170.93 

 

27
 

 

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 
   2014   2013   2012   2011   2010 
   (Dollars in thousands, except number of shares and per share amounts) 
Selected financial condition data:                         
Total assets  $2,328,446   $2,347,349   $2,418,264   $2,498,484   $2,591,818 
Loans receivable, net   1,631,303    1,508,996    1,402,246    1,319,636    1,323,569 
Loans held-for-sale   3,837    1,798    10,739    19,192    37,819 
Investment securities available-for-sale                   228,023 
Mortgage-related securities available-for-sale   321,883    446,596    550,185    781,770    435,234 
Mortgage-related securities held-to-maturity   132,525    155,505    157,558         
Foreclosed properties and repossessed assets   4,668    6,736    13,961    24,724    19,293 
Goodwill                   52,570 
Mortgage servicing rights, net   7,867    8,737    6,821    7,401    7,769 
Deposit liabilities   1,718,756    1,762,682    1,867,899    2,021,663    2,078,310 
Borrowings   256,469    244,900    210,786    153,091    149,934 
Shareholders' equity   280,717    281,037    271,853    265,771    312,953 
Tangible shareholders' equity   280,717    281,037    271,853    265,771    260,383 
Number of shares outstanding, net of treasury stock   46,568,284    46,438,284    46,326,484    46,228,984    45,769,443 
Book value per share  $6.03   $6.05   $5.87   $5.75   $6.84 
Tangible shareholders’ equity per share   6.03    6.05    5.87    5.75    5.69 

 

   For the Year Ended December 31 
   2014   2013   2012   2011   2010 
   (Dollars in thousands, except per share amounts) 
Selected operating data:                         
Total interest income  $79,265   $79,456   $83,022   $89,345   $112,569 
Total interest expense   9,416    13,112    21,641    26,756    66,276 
Net interest income   69,849    66,344    61,381    62,589    46,293 
Provision for loan losses   233    4,506    4,545    6,710    49,619 
Total non-interest income   22,349    26,116    29,259    23,158    40,603 
Total non-interest expense (1)   68,461    71,504    76,057    124,900    159,825 
Income (loss) before income taxes   23,504    16,450    10,038    (45,863)   (122,548)
Income tax expense (benefit)   8,850    5,702    3,336    1,752    (49,909)
Net income (loss) before non-controlling interest   14,654    10,748    6,702    (47,615)   (72,639)
Net loss (income) attributable to non-controlling interest   11    48    52    50    (1)
Net income (loss)  $14,665   $10,796   $6,754   $(47,565)  $(72,640)
Earnings (loss) per share-basic  $0.32   $0.23   $0.15   $(1.03)  $(1.59)
Earnings (loss) per share-diluted   0.31    0.23    0.15    (1.03)   (1.59)
Cash dividends paid per share   0.15    0.10    0.05    0.06    0.20 

 

(1)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.

 

28
 

 

   At or For the Year Ended December 31 
   2014   2013   2012   2011   2010 
Selected financial ratios:                         
Net interest margin (2)   3.32%   3.11%   2.67%   2.76%   1.47%
Net interest rate spread   3.24    3.02    2.57    2.64    1.26 
Return on average assets   0.63    0.46    0.27    (1.87)   (2.12)
Return on average shareholders'  equity   5.14    3.93    2.50    (16.37)   (18.47)
Efficiency ratio (3)   74.34    77.34    84.04    85.07    99.36 
Non-interest expense as a percent of  adjusted average assets (4)   2.94    3.03    3.03    2.84    2.06 
Shareholders' equity to total assets   12.06    11.97    11.24    10.64    12.07 
Tangible shareholders' equity to  adjusted total assets (5)   12.06    11.97    11.24    10.64    10.25 
                          
Selected asset quality ratios:                         
Non-performing loans to loans receivable, net   0.74%   0.86%   1.84%   5.69%   9.29%
Non-performing assets to total assets   0.72    0.84    1.64    4.00    5.49 
Allowance for loan losses to non-performing loans   185.68    181.62    83.64    37.17    39.03 
Allowance for loan losses to total loans receivable, net   1.37    1.56    1.54    2.12    3.63 
Charge-offs to average loans   0.10    0.18    0.78    1.96    1.26 

 

(2)Net interest margin is calculated by dividing net interest income by average earnings assets.
(3)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).
(4)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.
(5)This 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.

 

29
 

 

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 for the years ended December 31, 2014, 2013, and 2012, was $14.7 million, $10.8 million, and $6.8 million, respectively. Diluted earnings per share during these periods were $0.31, $0.23, and $0.15, respectively. The Company’s net income during these periods represented a return on average assets (“ROA”) of 0.63%, 0.46%, and 0.27%, respectively, and a return on average equity (“ROE”) of 5.14%, 3.93%, and 2.50%, respectively.

 

The Company’s net income in 2014 was impacted by the following favorable developments compared to 2013:

 

a $3.5 million or 5.3% increase in net interest income;

 

a $4.3 million or 94.8% decrease in provision for loan losses;

 

a $2.6 million or 5.8% decrease in compensation-related expenses; and

 

a $1.3 million or 57.0% decrease in net losses and expenses on foreclosed real estate.

 

These favorable developments were partially offset by the following unfavorable developments in 2014 compared to 2013:

 

a $3.9 million or 56.5% decrease in net mortgage banking revenue;

 

a $906,000 or 7.6% increase in occupancy and equipment expense;

 

a $518,000 non-recurring charge related to state income taxes, net of federal benefit; and

 

a $2.6 million or 46.1% increase in income expense, excluding the non-recurring charge.

 

The Company’s net income in 2013 was impacted by the following favorable developments compared to 2012:

 

a $5.0 million or 8.1% increase in net interest income;

 

a $4.4 million or 65.9% decrease in net losses and expenses on foreclosed real estate; and

 

a $1.4 million or 43.7% decrease in federal deposit insurance premiums.

 

These favorable developments were partially offset by the following unfavorable developments in 2013 compared to 2012:

 

a $3.7 million or 35.1% decrease in net mortgage banking revenue;

 

a $1.6 million or 3.7% increase in compensation-related expenses; and

 

a $2.4 million or 70.9% increase in income tax expense.

 

The following paragraphs discuss these developments in greater detail, as well as other changes in the components of net income during the years ended December 31, 2014, 2013, and 2012.

 

Net Interest Income The Company’s net interest income increased by $3.5 million or 5.3% during the twelve months ended December 31, 2014, compared to 2013. This increase was primarily attributable to a 21 basis point increase in the Company’s net interest margin, from 3.11% in 2013 to 3.32% in 2014. This increase was due primarily to an improved earning asset mix and an improved funding mix in 2014 compared to 2013. Specifically, the Company’s average loans receivable increased by $109.3 million or 7.6% in 2014 compared to the prior year, and its average mortgage-related securities, investment securities, and overnight investments declined by $140.1 million or 20.0% in the aggregate in 2014 compared to 2013. Loans receivable generally have a higher yield than securities and overnight investments.

 

30
 

 

With respect to the Company’s funding mix, its average transaction deposits, which consist of checking, savings, and money market accounts, increased by $29.0 million or 3.1% in the aggregate in 2014 compared to 2013. In contrast, its average certificates of deposit declined by $148.5 million or 20.8% in 2014 compared to the prior year. Transaction deposits generally have a lower interest cost (or no interest cost) relative to certificates of deposit. Also contributing to the improvement in funding mix in 2014 was a $44.7 million or 21.6% increase in average borrowings from the FHLB of Chicago compared to 2013. This increase, which funded loan growth and net deposit outflows, had a marginal average interest cost in 2014 that was lower than the average cost of the Company’s certificates of deposit.

 

Also contributing to the improvement in net interest margin in 2014 was a 38 basis point decline in the average cost of the Company’s certificates of deposit compared to 2013. However, it should be noted that decline in the Company’s average cost of certificates of deposit slowed significantly during the last half of 2014. Also, in recent months the Company has increased the rates and lengthened maturity terms on certain of the certificates of deposit it offers customers. Accordingly, management believes that the average cost of the Company’s certificates of deposit is likely to increase in the near term and that such trend could continue for the foreseeable future.

 

Finally, net interest income was favorably impacted in 2014 by a $512,000 call premium the Company received on a $20.4 million mortgage-related security that was called by the issuer during the year. Excluding the impact of this premium, the Company’s net interest margin would have been two basis points lower in 2014.

 

The favorable impact of the aforementioned developments on net interest income in 2014 was partially offset by a $30.8 million or 1.4% decrease in average earning assets in 2014 compared to 2013. The Company’s earning assets have declined in recent years as it has used available cash flow to fund a net decrease in its deposit liabilities, particularly its certificates of deposit, as previously described. However, management anticipates that certificates of deposit will increase in 2015 (due in part to the change in pricing strategy described in above) and that such increase could be used to fund continued growth in the Company’s loan portfolio in 2015. As such, management anticipates that, unlike recent years, average earning assets will increase in 2015. However, there can be no assurances.

 

Management believes the Company’s net interest margin may begin to trend modestly lower in the near term due to the deposit pricing strategy mentioned above. In addition, management anticipates that the yield on earning assets will also trend lower due principally to a declining yield on the Company’s loan portfolio in the current rate environment. Although a decline in net interest margin would generally have a negative impact on the Company’s net interest income, management anticipates such impact will be more than offset by future growth in the Company’s earning assets, as described in the preceding paragraph.

 

Net interest income increased by $5.0 million or 8.1% during the year ended December 31, 2013, compared to 2012. This increase was primarily attributable to a 44 basis point improvement in the Company’s net interest margin, from 2.67% in 2012 to 3.11% in 2013. Similar to the improvement in 2014, this improvement was due in part to an improved earning asset mix and an improved deposit funding mix in 2013 compared to 2012. Also contributing was a 39 basis point decline in the average cost of the Company’s certificates of deposit, as well as the Company’s repayment of $100.0 million in high-cost borrowings from the FHLB of Chicago.

 

The favorable impact of the aforementioned developments on net interest income was partially offset by a $165.9 million or 7.2% decrease in average earning assets in 2013 compared to 2012. The Company’s earning assets declined in 2013 as it has used cash flows from its mortgage-related securities portfolio to fund a decline in its certificates of deposit.

 

31
 

 

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. The Company’s tax exempt investments are insignificant, so no tax equivalent adjustments have been made.

 

   Year Ended December 31 
   2014   2013   2012 
       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)  $1,541,879   $66,261    4.30%  $1,432,606   $64,638    4.51%  $1,389,313   $65,478    4.71%
Mortgage-related securities   533,902    12,850    2.41    626,084    14,666    2.34    792,989    17,309    2.18 
Investment securities (2)   13,633    139    1.02    12,168    54    0.44    25,443    73    0.29 
Interest-earning deposits   13,339    15    0.11    62,742    98    0.16    91,801    162    0.18 
Total interest-earning assets   2,102,753    79,265    3.77    2,133,600    79,456    3.72    2,299,546    83,022    3.61 
Non-interest-earning assets   225,444              228,010              210,599           
Total average assets  $2,328,197             $2,361,610             $2,510,145           
                                              
Liabilities and equity:                                             
Interest-bearing liabilities:                                             
Savings deposits  $222,930    55    0.02   $226,307    62    0.03   $217,255    63    0.03 
Money market accounts   503,090    735    0.15    478,938    694    0.14    434,549    716    0.16 
Interest-bearing demand accounts   228,578    30    0.01    220,381    32    0.01    219,038    51    0.02 
Certificates of deposit   564,505    3,834    0.68    713,043    7,537    1.06    954,047    13,825    1.45 
Total deposit liabilities   1,519,103    4,684    0.31    1,638,669    8,325    0.51    1,824,889    14,655    0.80 
Advance payment by borrowers for taxes and insurance   20,949    1    0.00    21,881    2    0.01    21,141    2    0.01 
Borrowings   252,128    4,731    1.88    207,404    4,785    2.31    227,573    6,984    3.07 
Total interest-bearing liabilities   1,792,180    9,416    0.53    1,867,954    13,112    0.70    2,073,603    21,641    1.04 
Non-interest-bearing liabilities:                                             
Non-interest-bearing deposits   184,479              122,677              130,734           
Other non-interest-bearing liabilities   66,067              96,215              35,208           
Total non-interest-bearing liabilities   250,546              218,892              165,942           
Total liabilities   2,042,726              2,086,846              2,239,545           
Total equity   285,471              274,764              270,600           
Total average liabilities and equity  $2,328,197             $2,361,610             $2,510,145           
Net interest income and net interest rate spread       $69,849    3.24%       $66,344    3.02%       $61,381    2.57%
Net interest margin             3.32%             3.11%             2.67%
Average interest-earning assets to interest-bearing liabilities   1.17x             1.14x             1.11x          

 

 

(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.

 

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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, 2014,
Compared to Year Ended December 31, 2013
 
   Increase (Decrease) 
   Volume   Rate   Net 
   (Dollars in thousands) 
Interest-earning assets:               
Loans receivable  $4,718   $(3,095)  $1,623 
Mortgage-related securities   (2,243)   427    (1,816)
Investment securities   7    78    85 
Interest-earning deposits   (61)   (22)   (83)
Total interest-earning assets   2,421    (2,612)   (191)
Interest-bearing liabilities:               
Savings deposits   16    (23)   (7)
Money market deposits   35    6    41 
Interest-bearing demand deposits   1    (3)   (2)
Certificates of deposit   (1,368)   (2,305)   (3,673)
Advance payment by borrowers for taxes and insurance       (1)   (1)
Borrowings   930    (984)   (54)
Total interest-bearing liabilities   (386)   (3,310)   (3,696)
Net change in net interest income  $2,807   $698   $3,505 

 

   Year Ended December 31, 2013,
Compared to Year Ended December 31, 2012
 
   Increase (Decrease) 
   Volume   Rate   Net 
   (Dollars in thousands) 
Interest-earning assets:               
Loans receivable  $1,989   $(2,829)  $(840)
Mortgage-related securities   (3,843)   1,200    (2,643)
Investment securities   (48)   29    (19)
Interest-earning deposits   (48)   (16)   (64)
Total interest-earning assets   (1,950)   (1,616)   (3,566)
Interest-bearing liabilities:               
Savings deposits   (1)       (1)
Money market deposits   67    (89)   (22)
Interest-bearing demand deposits       (19)   (19)
Certificates of deposit   (3,040)   (3,248)   (6,288)
Advance payment by borrowers for taxes and insurance            
Borrowings   (579)   (1,620)   (2,199)
Total interest-bearing liabilities   (3,553)   (4,976)   (8,529)
Net change in net interest income  $1,603   $3,360   $4,963 

 

Provision for Loan Losses The Company’s provision for loan losses was $233,000, $4.5 million, and $4.5 million during the years ended December 31, 2014, 2013, and 2012, respectively. The decline in the provision for loan loss in 2014 was due in part to an improvement in the general credit quality of the Company’s loan portfolio, as evidenced by a continued decrease in non-performing loans, as well as a decrease in the overall level of the Company’s classified loans, as described in “Financial Condition—Asset Quality,” below. These improvements resulted in a decline in the portion of the Company’s allowance for loan loss that is determined primarily by internal risk ratings and the level of loans within each rating. In addition, a continued decline in actual loan charge-off experience in 2014 had a favorable impact on the methodology the Company uses to compute general valuation allowances.

 

The Company’s provision in 2013 was due largely to increases in general loan loss allowances related to growth in its multi-family, commercial real estate, and commercial business loan portfolios, as well as an increase in classified loans during the period. In contrast, the provision in 2012 was influenced by $6.3 million in specific loan loss allowances on a number of multi-family, commercial real estate, and business loan relationships, as well as residential and other 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. These losses were partially offset by $1.8 million in loss recaptures related to certain non-performing loans that paid off in 2012, as well as recoveries related to previously charged-off loans.

 

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General economic, employment, and real estate conditions continue to improve in the Company’s markets. If such trends continue in the near term, management anticipates that the Company’s provision for loan losses may be nominal in 2015 or could even be a net recovery, as in the fourth quarter of 2014 (refer to “Quarterly Financial Information,” below). However, there can be no assurances that these trends will continue or that classified loans, non-performing loans, and/or loan charge-off experience will continue to trend lower in future periods. Finally, there can be no assurances that the Company’s provision for loan losses will not vary considerably from period to period.

 

Non-Interest Income Total non-interest income for the years ended December 31, 2014, 2013, and 2012, was $22.3 million, $26.1 million, and $29.3 million, respectively. The following paragraphs discuss the principal components of non-interest income and primary reasons for their changes from 2013 to 2014, as well as 2012 to 2013.

 

Deposit-related fees and charges were $12.0 million, $12.2 million, and $12.0 million in 2014, 2013, and 2012, respectively. Deposit-related fees and charges consist of overdraft fees, ATM and debit card fees, merchant processing fees, account services charges, and other revenue items related to services performed by the Company for its retail and commercial deposit customers. In previous years, the Company had reported ATM and debit card fees, merchant processing fees, and certain other items as a component of other income (for additional discussion refer to “Note 1. Summary of Significant Accounting Policies” in the Company’s Audited Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data”). Management attributes the decrease in deposit-related fees and charges in 2014 to changes in deposit customer spending behavior in recent years which have resulted in lower revenue from overdraft charges and from check printing commissions. These developments were partially offset by increased revenue from a debit card reward program that the Company implemented in 2013, as well as increased revenue from treasury management and merchant card processing services that the Company offers to commercial depositors.

 

Brokerage and insurance commissions were $2.6 million, $3.1 million, and $3.0 million for the years ended December 31, 2014, 2013, and 2012, 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. The decrease in 2014 was primarily due to a decline in customer demand for tax-deferred annuities. This development was offset somewhat by an increase in commission revenue from the sale of mutual funds and other securities. The increase in 2013 was due to increased customer demand for tax-deferred annuities, as well as higher commission revenue from sales of mutual funds and other securities. As a result of personnel, system, and product offering improvements made by the Company in recent months, management anticipates that brokerage and insurance commissions may increase in 2015. However, there can be no assurances.

 

Mortgage banking revenue, net, was $3.0 million, $6.9 million, and $10.6 million in 2014, 2013, and 2012, respectively. The following table presents the components of mortgage banking revenue, net, for the periods indicated (in previous years these components had been presented as separate line items in the Consolidated Statements of Income):

 

   Year Ended December 31 
   2014   2013   2012 
   (Dollars in thousands) 
Gross loan servicing fees  $2,796   $2,885   $2,826 
MSR amortization   (1,772)   (2,809)   (3,904)
MSR valuation (loss) recovery   1    2,395    (1,528)
    Loan servicing revenue, net   1,025    2,471    (2,606)
Gain on sales of loan activities, net   1,965    4,405    13,206 
    Mortgage banking revenue, net  $2,990   $6,876   $10,600 

 

Loan servicing revenue, net, was $2.7 million, $2.9 million, and $2.8 million in 2014, 2013, and 2012, respectively. Gross loan servicing fees are highly correlated with loans serviced for third-party investors. As of December 31, 2014, 2013, and 2012, loans serviced for third-party investors were $1.09 billion, $1.15 billion, and $1.15 billion, respectively.

 

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The change in the valuation allowance that the Company maintains against its MSRs is recorded as a recovery or loss, as the case may be, in the period in which the change occurs. Higher market interest rates for residential loans beginning in 2013 and continuing through much of 2014 resulted in lower future prepayment expectations on the loans underlying the Company’s MSRs, which resulted in a recovery of substantially all of the related valuation allowance in 2013 and the remainder in 2014. Higher rates during these years also resulted in a decline in MSR amortization in both years, due to lower levels of actual loan prepayment activity. In contrast, lower market interest rates in 2012 resulted in higher future prepayment expectations and in increase in the valuation allowance, as well as higher MSR amortization in that year. As of December 31, 2014 and 2013, the Company’s MSRs had a net book value of $7.9 and $8.7 million, respectively.

 

As of December 31, 2014, the Company did not have a valuation allowance against its MSRs. 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 decrease and/or actual or expected loan prepayment expectations increase in future periods, the Company could record significant charges to earnings related to increases in the valuation allowance on MSRs, as well as record increased levels of MSR amortization expense.

 

Net gains on loan sales activities were $2.0 million, $4.4 million, and $13.2 million during the years ended December 31, 2014, 2013, and 2012, 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 2014, 2013, and 2012, sales of one- to four-family mortgage loans were $77.8 million, $252.3 million, and $454.6 million, respectively. Higher market interest rates for mortgage loans in 2013 and much of 2014, as well as lackluster sales of new and used homes in the Company’s market areas, generally resulted in declining originations and sales of fixed-rate, one- to four-family loans during those years. In recent months, however, a decline in market interest rates for mortgage loans, combined with management expectations for an improved housing market in 2015, could result in a modest increase in originations and sales of one- to four-family mortgage loans by the Company in 2015 compared to 2014. However, the origination and sale of residential loans is subject to variations in market interest rates and other factors and conditions outside of management’s control. Accordingly, there can be no assurances that such originations and sales will increase or will not fluctuate considerably from period to period.

 

Income from BOLI was $2.8 million, $2.4 million, and $2.1 million during the years ended December 31, 2014, 2013, and 2012, respectively. The increases in 2014 and 2013 were primarily caused by higher payouts associated with excess death benefits, which can vary considerably from period to period. Excess death benefits were $948,000, $639,000, and zero in 2014, 2013, and 2012, respectively. Income from BOLI is also not subject to income taxes.

 

Gains on sales of investments in 2014 and 2012 were $102,000 and $543,000, respectively. The Company did not sell any securities in 2013. In 2014 the Company sold $17.6 million in mortgage-related securities that management felt no longer met its yield objectives for the portfolio. 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 that year.

 

The Company’s operating results in 2012 included $400,000 in net OTTI charges. This loss 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 that periods to low real estate values for residential properties on a nationwide basis. The Company did not record any OTTI losses in 2014 or 2013 and none of its private-label CMOs were deemed to be other-than-temporarily impaired as of the end of those years. 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, 2014, the Company’s total investment in private-label CMOs was $29.5 million, of which $22.8 million was rated less than investment grade. Refer to “Financial Condition—Available-for-Sale Securities,” below, for additional discussion.

 

Other non-interest income was $1.9 million, $1.5 million, and $1.4 million for the years ended December 31, 2014, 2013, and 2012, respectively. The increase in 2014 was due primarily to increased fee revenue from interest rate swaps related to certain commercial lending relationships. In late 2013 the Company began to mitigate the interest rate risk associated with these types of lending relationships by executing interest rate swaps, the accounting for which resulted in the recognition of a certain amount of fee revenue at the time the swap contracts were executed. Management expects that this source of revenue will vary from period to period depending on borrower preference for the types of lending relationships that generate the need for the interest rate swaps.

 

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Non-Interest Expense Total non-interest expense for the years ended December 31, 2014, 2013, and 2012 was $68.5 million, $71.5 million, and $76.1 million, respectively. The following paragraphs discuss the principal components of non-interest expense and the primary reasons for their changes from 2013 to 2014, as well as 2012 to 2013.

 

Compensation and related expenses were $41.3 million, $43.9 million, and $42.3 million during the years ended December 31, 2014, 2013, and 2012, respectively. The decrease in 2014 was caused in part by lower costs associated with the Company’s defined benefit pension plan due to an increase in the discount rate used to determine the present value of the pension obligation. Also contributing was a change in the manner in which the Company accounts for how employees earn vacation and other paid time off benefits. This change, which is non-recurring, reduced full-year compensation expense in 2014 by $1.5 million compared to 2013. These favorable developments were partially offset by an increase in employer contributions to the Company’s defined contribution savings plan. This increase was intended to partially offset the effects of the changes that were made to the defined benefit pension plan in 2013. Also offsetting the favorable developments in 2014 was the impact of normal annual merit increases granted to most employees during the year, as well as an increase in costs related to certain non-qualified employee benefit plans. This latter development, which is also not expected to be recurring, increased compensation expense by $602,000 in 2014 compared to 2013.

 

The increase compensation and related expenses in 2013 compared to 2012 was due primarily to annual merit increases, as well as increases in certain payroll taxes and pension-related costs. These developments were partially offset by a decline in commissions due to lower originations of single-family loans, as well as a modest decline in employee healthcare costs due to a renegotiation of such costs with the insurance provider.

 

In 2015 management expects the cost of the Company’s defined benefit plan to increase by approximately $2.0 million compared to 2014. Although benefits under the plan were frozen for most plan participants in 2013, the annual cost of the plan continues to be impacted by changes in actuarial assumptions such as the expected lives of plan participants and the discount rate used to determine the present value of the pension obligation. Adverse changes in both of these assumptions are expected to increase the Company’s pension expense in 2015 by the amount previously noted. In addition, as of December 31, 2014, these changes had an adverse impact on the Company’s accumulated other comprehensive loss, which is a component of stockholders’ equity. Refer to “Financial Condition—Shareholders’ Equity,” below, for additional discussion.

 

As of December 31, 2014, the Company had 616 full-time associates and 99 part-time associates. This compared to 637 full-time and 85 part-time employees at December 31, 2013, and 639 full-time and 81 part-time associates at December 31, 2012.

 

Occupancy and equipment expense during the years ended December 31, 2014, 2013, and 2012 was $12.8 million, $11.9 million, and $11.4 million, respectively. The increases in 2014 and 2013 were principally caused by increases in data processing costs, certain repairs and maintenance on the Company’s facilities, and snow removal and utility costs due to increasingly harsh winter conditions.

 

Federal insurance premiums were $1.5 million, $1.9 million, and $3.3 million in 2014, 2013, and 2012, respectively. The decreases in 2014 and 2013 were caused by continued improvements in the Company’s financial condition and operating results that, under the FDIC’s risk-based premium assessment system, resulted in lower insurance assessment rates. Also contributing to the decreases were lower levels of average total assets in both periods. The FDIC uses average total assets as the assessment base for determining the insurance premium. (for additional information, refer to “Regulation and Supervision of the Bank—Deposit Insurance” in Item 1. Business—Regulation and Supervision,” above).

 

Advertising and marketing expenses were $1.8 million, $1.8 million, and $2.1 million in 2014, 2013, and 2012, respectively. The Company reduced its advertising and marketing expenses in 2013 and maintained it in 2014 in an effort to control the growth of its overall expenses. Management expects that advertising and marketing expenditures in 2015 will continue to be managed in a manner consistent with recent periods. However, such expenditures depend on future management decisions and there can be no assurances that such expenditures will remain at the current level in the future.

 

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Net losses and expenses on foreclosed properties were $1.0 million, $2.3 million, and $6.7 million in 2014, 2013, and 2012, respectively. The Company has experienced lower losses and expenses on foreclosed real estate in recent periods due to lower levels of foreclosed properties. Management expects this trend to continue in the near term, although there can be no assurances.

 

Other non-interest expense was $10.1 million, $9.8 million, and $10.2 million during the years ended December 31, 2014, 2013, and 2012, respectively. The increase in 2014 compared to 2013 was due primarily to the payment of a $242,000 prepayment penalty to the FHLB of Chicago. In 2014 the Company prepaid $20.0 million in fixed-rate term advances that had been drawn in 2012 to fund the purchase of the mortgage-related security that was called by the issuer in 2014, as previously noted. Management elected to prepay the advances concurrent with the call of the security. The decrease in other non-interest income in 2013 compared to 2012 was primarily caused by lower professional fees, due principally to reduced expenditures for loan workouts, as well as lower regulatory assessments related to the Company’s improved financial condition.

 

On February 9, 2015, the Company announced that it was closing seven retail branch offices in connection an efficiency and expense reduction effort. Management anticipates that this action will result in annual net cost savings of approximately $1.5 million and that the closures will be completed in the second quarter of 2015. The Company will continue to provide products and services to affected customers through its other nearby locations, as well as its internet, mobile banking, and telephone channels. Management also believes that it will retain the majority of deposits and loans currently serviced through these locations, which were $76.1 million and $$26.4 million, respectively, at December 31, 2014, although there can be no assurances. In connection with the closures, management intends to dispose of the related properties and equipment and expects that the Company will incur one-time costs less than $600,000, composed primarily of asset disposition costs, employment severance costs, data processing costs, and professional fees. These costs will be recorded in the quarter ending March 31, 2015. For additional discussion, refer to “Item 1. Business—Market Area.”

 

Income Tax Expense Income tax expense was $8.9 million, $5.7 million, and $3.3 million in 2014, 2013, and 2012, respectively. The most recent year includes a non-recurring charge of $518,000 (net of federal income tax benefit) that was related to a payment by the Company to the Wisconsin Department of Revenue to settle a tax matter that was previously disclosed. Excluding the impact of this non-recurring charge, the Company’s effective tax rate (“ETR”) in 2014, 2013, and 2012 was 35.4%, 34.7%, and 33.2%, respectively. The Company’s ETR will vary from period to period depending primarily on the impact of non-taxable revenue, such as earnings from BOLI and tax-exempt interest income. The ETR will generally be higher in periods in which non-taxable revenue comprises a smaller portion of pre-tax income or loss.

 

Financial Condition

 

Overview Total assets decreased by $18.9 million or 0.8% during the year ended December 31, 2014. During the year the Company’s mortgage-related securities declined by $147.7 million due primarily to the receipt of periodic principal repayments, as well as the sale or call of certain securities, as previously described. In addition, other borrowings, which consist of advances from the FHLB of Chicago, increased by $11.6 million during the period. Cash flows from these sources funded a $122.3 million increase in the Company’s loans receivable and a $43.9 million decrease in its deposit liabilities. The Company’s total shareholders’ equity decreased slightly from $281.0 million at December 31, 2013, to $280.7 million at December 31, 2014. 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, 2014.

 

Mortgage-Related Securities Available-for-Sale The Company’s portfolio of mortgage-related securities available-for-sale decreased by $124.7 million or 27.9% during the year ended December 31, 2014. This decrease was principally caused by periodic repayments. Also contributing, however, was the sale of $17.6 million in securities, as previously described. The Company did not purchase any available-for-sale securities during 2014.

 

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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 
   2014   2013   2012 
   (Dollars in thousands) 
Freddie Mac  $169,168   $228,873   $343,682 
Fannie Mae   123,209    179,021    155,895 
Ginnie Mae   29    33    42 
Private-label CMOs   29,477    38,669    50,566 
    Total  $321,883   $446,596   $550,185 

 

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 
   2014   2013   2012 
   (Dollars in thousands) 
Carrying value at beginning of period  $446,596   $550,185   $781,770 
Purchases       88,094    51,374 
Sales   (17,692)       (20,395)
Principal repayments   (104,430)   (186,674)   (260,953)
Premium amortization, net   (1,213)   (1,460)   (4,152)
Other-than-temporary impairment           (400)
Increase (decrease) in net unrealized gain or loss   (1,378)   (3,549)   2,941 
    Net decrease   (124,713)   (103,589)   (231,585)
    Carrying value at end of period  $321,883   $446,596   $550,185 

 

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, 2014:

 

       More Than One Year   More Than Five                 
   One Year or Less   to Five Years   Years to Ten Years   More Than Ten Years   Total 
       Weighted       Weighted       Weighted       Weighted       Weighted 
   Carrying   Average   Carrying   Average   Carrying   Average   Carrying   Average   Carrying   Average 
   Value   Yield   Value   Yield   Value   Yield   Value   Yield   Value   Yield 
   (Dollars in thousands) 
Securities by issuer and type:                                                  
Freddie Mac, Fannie Mae, and Ginnie Mae MBSs  $5    7.23%  $170    6.43%  $83,601    2.18%  $29    6.68%  $83,805    2.19%
Freddie Mac and Fannie Mae CMOs           2,590    1.56    72,069    2.67    133,942    2.49    208,601    2.54 
Private-label CMOs           4,674    5.01    3,216    5.15    21,587    2.70    29,477    3.32 
Total  $5    7.23%  $7,434    3.84%  $158,886    2.46%  $155,558    2.52%  $321,883    2.52%
Securities by coupon:                                                  
Adjustable-rate coupon                  $434    1.60%  $20,643    2.56%  $21,077    2.54%
Fixed-rate coupon  $5    7.23%  $7,434    3.84%   158,452    2.47    134,915    2.52    300,806    2.52 
Total  $5    7.23%  $7,434    3.84%  $158,886    2.46%  $155,558    2.52%  $321,883    2.52%

 

Changes in the fair value of mortgage-related securities available-for-sale are recorded through accumulated other comprehensive 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 $5.7 million at December 31, 2014, compared to a net unrealized gain of $7.1 million at December 31, 2013.

 

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”). As of December 31, 2014 and 2013, the carrying value of the Company’s investment in private-label CMOs was $29.5 million and $38.7 million, respectively. The net unrealized gain on the securities as of such dates was $479,000 and $580,000, respectively. As of December 31, 2014, $23.3 million of the Company’s private-label CMOs were rated less than investment grade by at least one credit rating agency. These securities had a net unrealized gain of $480,000 as of that date. As of December 31, 2013, $28.8 million of the Company’s private-label CMOs were rated less than investment grade and had a net unrealized gain of $502,000.

 

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In 2012 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 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, 2014 and 2013, management determined that none of the Company’s private-label CMOs had incurred additional OTTI as of those dates. 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,” above.

 

Mortgage-Related Securities Held-to-Maturity The Company’s mortgage-related securities held-to-maturity consist of fixed-rate mortgage-backed securities issued and guaranteed by Fannie Mae and backed by multi-family residential loans. All of these securities had final maturities of five to ten years as of December 31, 2014. The weighted-average yield on these securities was 2.26% as of that date. The Company has 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 
   2014   2013   2012 
   (Dollars in thousands) 
Carrying value at beginning of period  $155,505   $157,558     
Purchases          $158,915 
Principal repayments   (21,977)   (1,354)   (902)
Premium amortization   (1,003)   (699)   (455)
    Net increase (decrease)   (22,980)   (2,053)   157,558 
    Carrying value at end of period  $132,525   $155,505   $157,558 

 

In 2014 a $20.4 million mortgage-related security held-for-investment was called by the issuer. The Company recorded a $512,000 call premium in connection with this call.

 

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 
   2014   2013   2012 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $1,798   $10,739   $19,192 
Origination of loans intended for sale (1)   79,714    243,669    446,358 
Principal balance of loans sold   (77,776)   (252,348)   (454,584)
Change in net unrealized gains or losses (2)   101    (262)   (227)
    Total loans held-for-sale  $3,837   $1,798   $10,739 

 

(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 have declined significantly since 2012 in response to generally higher market interest rates since that time, which resulted in fewer borrowers refinancing higher-rate loans into lower rate loans in 2014 and 2013. For additional discussion, refer to “Results of Operations—Non-Interest Income,” above.

 

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Loans Receivable Loans receivable increased by $122.3 million or 8.1% during the year ended December 31, 2014. In 2014 commercial and industrial loans increased by $59.7 million or 35.8% due to increased originations and credit line utilization by borrowers. Also, multi-family real estate loans increased by $56.6 million or 21.3% as a result of sustained demand from borrowers in this market segment. In addition, one- to four-family permanent loans increased by $30.9 million or 6.9% despite a lower level of originations in 2014 compared to 2013. This was caused by higher market interest rates during much of the year (as previously noted), which significantly reduced the amount of prepayment activity in the Company’s one- to four-family loan portfolio. In contrast to these increases, the Company’s portfolio of commercial real estate loans declined by $13.0 million or 4.7% during the year ended December 31, 2014, due to lower borrower demand and aggressive competition for these types of loans in recent periods. The Company’s portfolios of home equity and consumer loans have also declined in recent periods for similar reasons. Finally, construction loans, net of the undisbursed portion, decreased by $2.8 million or 2.3% during the twelve months ended December 31, 2014. Construction loans consist principally of loans secured by multi-family, commercial, and residential properties, and to a much lesser degree, developed and undeveloped land.

 

In light of current economic conditions and recent trends, management currently expects growth in the Company’s total loans in 2015 to be similar to what it has been in recent years. However, growth in loans is subject to economic, market, and competitive factors outside of its control and there can be no assurances that expected loan growth will continue or that total loans will not decrease in future periods.

 

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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 
   2014   2013   2012   2011   2010 
   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent 
   (Dollars in thousands) 
Commercial loans:                                                  
Commercial and industrial  $226,537    12.47%  $166,788    10.10%  $132,436    8.82%  $87,715    6.31%  $50,123    3.56%
Commercial real estate   263,512    14.50    276,547    16.75    263,775    17.57    226,195    16.27    248,253    17.68 
Multi-family   322,413    17.74    265,841    16.10    264,013    17.58    247,040    17.77    247,210    17.60 
Construction and development:                                                  
Commercial real estate   42,405    2.33    27,815    1.68    11,116    0.74    19,907    1.43    24,939    1.78 
Multi-family   211,239    11.62    164,685    9.97    86,904    5.79    29,409    2.12    19,308    1.37 
Land and land development   5,069    0.28    6,962    0.42    6,445    0.43    8,078    0.60    15,808    1.13 
Total construction and development loans   258,713    14.24    199,462    12.08    104,465    6.96    57,394    4.15    60,055    4.28 
Total commercial loans   1,071,175    58.94    908,638    55.03    764,689    50.93    618,344    44.50    605,641    43.12 
Retail loans:                                                  
One- to four-family first mortgages:                                                  
Permanent   480,102    26.42    449,230    27.21    471,551    31.40    516,854    37.17    541,830    35.58 
Construction   23,905    1.32    40,968    2.48    18,502    1.23    16,263    1.17    13,479    0.96 
Total first mortgages   504,007    27.73    490,198    29.69    490,053    32.63    533,117    38.34    555,309    39.54 
Home equity loans:                                                  
Fixed term home equity   139,046    7.65    148,688    9.01    141,898    9.45    126,798    9.12    128,170    9.13 
Home equity lines of credit   80,692    4.44    79,470    4.81    81,898    5.45    86,540    6.23    87,383    6.22 
Total home equity   219,738    12.09    228,158    13.82    223,796    14.90    213,338    15.35    215,553    15.35 
Other consumer loans:                                                  
Student   9,692    0.53    11,177    0.68    12,915    0.86    15,711    1.13    17,695    1.26 
Other   12,681    0.70    12,942    0.78    10,202    0.68    9,405    0.68    10,250    0.73 
Total other consumer   22,373    1.23    24,119    1.46    23,117    1.54    25,116    1.81    27,945    1.99 
Total retail loans   746,118    41.06    742,475    44.97    736,966    49.07    771,571    55.50    798,807    56.88 
Gross loans receivable   1,817,293    100.00%   1,651,113    100.00%   1,501,655    100.00%   1,389,915    100.00%   1,404,448    100.00%
Undisbursed loan proceeds   (162,471)        (117,439)        (76,703)        (41,859)        (32,345)     
Allowance for loan losses   (22,289)        (23,565)        (21,577)        (27,928)        (47,985)     
Deferred fees and costs, net   (1,230)        (1,113)        (1,129)        (492)        (549)     
Total loans receivable, net  $1,631,303        $1,508,996        $1,402,246        $1,319,636        $1,323,569      

  

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

 

   Year Ended December 31 
   2014   2013   2012 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $1,508,996   $1,402,246   $1,319,636 
Loan originations:               
Commercial loans:               
Commercial and industrial   73,630    52,701    110,941 
Commercial real estate   37,444    80,157    70,200 
Multi-family   101,260    50,323    66,724 
Construction and development   154,940    164,028    88,389 
Total commercial loans   367,274    347,209    336,254 
Retail loans:               
One- to four-family first mortgages (1)   75,402    84,822    110,512 
Home equity   33,850    52,827    71,832 
Other consumer   1,427    3,775    4,984 
Total retail loans   110,679    141,424    187,328 
Total loan originations   477,953    488,633    523,582 
Principal payments and repayments:               
Commercial loans   (204,737)   (199,507)   (183,540)
Retail loans   (104,782)   (134,225)   (215,248)
Total principal payments and repayments   (309,519)   (333,732)   (398,788)
Transfers to foreclosed properties, real estate owned, and repossessed assets   (2,254)   (5,443)   (13,054)
Net change in undisbursed loan proceeds, allowance for loan losses, and deferred fees and costs   (43,873)   (42,708)   (29,130)
Total loans receivable, net  $1,631,303   $1,508,996   $1,402,246 

 

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

 

The following table presents the contractual maturity of the Company’s commercial and industrial loans and construction and development loans at December 31, 2014. The table does not include the effect of prepayments or scheduled principal amortization.

 

   Commercial
and Industrial
   Construction and
Development
   Total 
   (Dollars in thousands) 
Amounts due:               
Within one year or less  $96,385   $38,550   $134,935 
After one year through five years   121,458    214,133    335,591 
After five years   8,694    29,935    38,629 
Total due after one year   130,152    244,068    374,220 
Total commercial and construction loans  $226,537   $282,618   $509,155 

 

The following table presents, as of December 31, 2014, the dollar amount of the Company’s commercial and industrial loans and construction and development 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 and industrial  $54,357   $75,795   $130,152 
Construction and development   27,475    216,593    244,068 
Total loans due after one year  $81,832   $292,388   $374,220 

 

Mortgage Servicing Rights The carrying value of the Company’s MSRs was $7.9 million at December 31, 2014, compared to $8.7 million at December 31, 2013, net of valuation allowances of zero and $1,400, respectively. As of December 31, 2014 and 2013, the Company serviced $1.09 billion and $1.15 billion in loans for third-party investors, respectively. For additional information refer to “Results of Operations—Non-Interest Income” and “Item 1. Business—Lending Activities,” above.

 

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

 

   December 31 
   2014   2013 
   (Dollars in thousands) 
Accrued interest receivable:          
Loans receivable  $4,748   $4,582 
Mortgage-related securities   1,027    1,328 
Total accrued interest receivable   5,775    5,910 
Foreclosed properties and repossessed assets:          
Commercial real estate   2,566    4,236 
Land and land development   1,693    2,171 
One- to four- family first mortgages   409    329 
Total foreclosed and repossessed assets   4,668    6,736 
Bank-owned life insurance   59,830    59,451 
Premises and equipment   52,594    51,565 
Deferred tax asset, net   25,595    27,387 
Federal Home Loan Bank stock, at cost   14,209    12,245 
Other assets   22,183    19,967 
Total other assets  $184,854   $183,261 

 

The Company’s foreclosed properties and repossessed assets were $4.7 million and $6.7 million at December 31, 2014 and 2013, respectively. Management expects foreclosed properties and repossessed assets to trend modestly lower in the near term. However, there can be no assurances that foreclosed properties and repossessed assets will not fluctuate significantly from period to period.

 

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 2014 was a result of the increase in the accumulated cash value of the insurance policies during the period, partially offset by the impact of death benefit payments.

 

The Company and its subsidiaries conduct their business through an executive office and 76 banking offices, which had an aggregate net book value of $48.5 million as of December 31, 2014, excluding furniture, fixtures, and equipment. As of December 31, 2014, the Company owned the building and land for 69 of its office locations and leased the space for eight. However, refer to “Results of Operations—Non-Interest Expense,” above, for discussion related to the Company’s expected closure of certain banking office locations in 2015.

 

The Company’s net deferred tax asset decreased by $1.8 million or 6.5% during the year ended December 31, 2014. 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, 2014. The evaluation of the net deferred tax asset requires significant management judgment based on positive and negative evidence. Such evidence includes the Company’s recent trend 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 conditions, results of operations, and capital of the Company.

 

The FHLB of Chicago requires its members to own its common stock as a condition of membership, which is redeemable at par. As of December 31, 2014, the Company’s ownership of FHLB of Chicago common stock exceeded the amount required under the FHLB of Chicago’s minimum guidelines. For additional discussion refer to the section entitled “Federal Home Loan Bank System” in “Item 1. Business—Regulation and Supervision.”

 

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Deposit Liabilities The Company’s deposit liabilities decreased by $43.9 million or 2.5% during the year ended December 31, 2014. Certificates of deposit declined by $109.8 million or 17.3% during the period while transaction deposits, consisting of checking, savings, and money market accounts, increased by $65.9 million or 5.8%. In recent months the Company has increased the rates and lengthened maturity terms on certain of the certificates of deposit it offers customers. Accordingly, management believes that the average cost of the Company’s certificates of deposit may increase modestly in the near term and that such trend could continue for the foreseeable future. Furthermore, management anticipates that certificates of deposit will increase in 2015 as a result of this strategy and that such increase will be used to fund continued growth in Company’s loan portfolio in 2015, although there can be no assurances.

 

The Company’s transaction deposits have increased in recent years largely 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 this increase in transaction deposits, however, has been customer reaction to the low interest rate environment for deposit products. Management believes that this environment has encouraged some customers to switch to transaction deposits in an effort to retain flexibility in the event interest rates increase in the future. If interest rates increase in the future, customer preference may shift from transaction deposits back to certificates of deposit, which typically have a higher interest cost to the Company. This development could increase the Company’s cost of funds in the future, which would have an adverse impact on its net interest margin.

 

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 
   2014   2013   2012 
       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  $187,852    10.93%   0.00%  $161,639    9.20%   0.00%  $143,684    7.69%   0.00%
Interest-bearing demand   253,595    14.76    0.01    245,923    13.95    0.01    236,380    12.65    0.01 
Money market savings   532,705    30.99    0.14    501,020    28.40    0.14    458,762    24.56    0.19 
Savings accounts   220,557    12.83    0.03    220,236    12.50    0.03    217,170    11.63    0.03 
Total demand accounts   1,194,709    69.51    0.07    1,128,818    64.05    0.07    1,055,996    56.53    0.09 
Certificates of deposit:                                             
With original maturities of:                                             
Three months or less   6,081    0.35    0.25    20,665    1.17    1.44    9,259    0.50    0.07 
Over three to 12 months   177,748    10.34    0.44    121,350    6.88    0.17    184,194    9.86    0.20 
Over 12 to 24 months   204,499    11.90    0.53    346,565    19.66    0.51    315,189    16.87    0.77 
Over 24 to 36 months   84,507    4.92    0.58    80,370    4.56    1.88    148,503    7.95    1.94 
Over 36 to 48 months                                    
Over 48 to 60 months   51,212    2.98    1.37    64,914    3.68    2.08    154,758    8.29    3.48 
Total certificates of deposit   524,047    30.49    0.58    633,864    35.95    0.81    811,903    43.47    1.36 
Total deposit liabilities  $1,718,756    100.00%   0.23%  $1,762,682    100.00%   0.34%  $1,867,899    100.00%   0.64%

 

At December 31, 2014, 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  $26,060 
Over three months through six months   80,641 
Over six months through 12 months   14,318 
Over 12 months through 24 months   13,944 
Over 24 months through 36 months   1,977 
Over 36 months   5,201 
Total certificates of deposit greater than $100,000  $142,141 

 

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

 

   Year Ended December 31 
   2014   2013   2012 
   (Dollars in thousands) 
Total deposit liabilities at beginning of period  $1,762,682   $1,867,899   $2,021,663 
Net withdrawals   (48,358)   (113,058)   (167,096)
Interest credited, net of penalties   4,432    7,841    13,332 
Total deposit liabilities at end of period  $1,718,756   $1,762,682   $1,867,899 

 

Borrowings Borrowings, which consist of advances from the FHLB of Chicago, increased by $11.6 million or 4.7% during the twelve months ended December 31, 2014. This increase, which was used to fund loan growth and deposit outflows during the year, was partially offset by the Company’s prepayment of $20.0 million in fixed-rate term advances during the year. These advances had been drawn in 2012 to fund the purchase of the mortgage-related security that was called by the issuer in 2014, as previously noted. Management elected to prepay the advances concurrent with the call of the security. Refer to “Results of Operations—Non-Interest Expense,” above, for additional discussion.

 

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 
   2014   2013   2012   2011   2010 
   (Dollars in thousands) 
Balance outstanding at end of year:                    
FHLB term advances  $213,669   $204,900   $210,786   $153,091   $149,934 
Overnight borrowings from FHLB   42,800    40,000             
Weighted-average interest rate at end of year:                         
FHLB term advances   2.01%   2.26%   2.34%   4.69%   4.79%
Overnight borrowings from FHLB   0.13%   0.13%            
Maximum amount outstanding during the year:                         
FHLB term advances  $234,085   $210,786   $311,419   $199,493   $906,979 
Overnight borrowings from FHLB   80,000    40,000    5,000         
Average amount outstanding during the year:                         
FHLB term advances  $213,566   $206,828   $227,573   $156,521   $871,212 
Overnight borrowings from FHLB   38,562    207    14         
Weighted-average interest rate during the year:                         
FHLB term advances   2.19%   2.31%   3.07%   4.59%   4.32%
Overnight borrowings from FHLB   0.13%   0.13%   0.30%        

 

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.”

 

Shareholders’ Equity The Company’s shareholders’ equity decreased slightly from $281.0 million at December 31, 2013, to $280.7 million at December 31, 2014. This decrease was due primarily to an $8.8 million increase in accumulated other comprehensive loss during the period, which was principally the result of an unrecognized loss related to the Company’s defined benefit pension obligation. This loss was caused by adverse changes in certain actuarial assumptions used to value the obligation (refer to “Results of Operations—Non-Interest Expense,” above, for additional information). Also contributing to the decrease in shareholders’ equity in 2014 was the payment of regular quarterly cash dividends. The impact of these developments on shareholders’ equity was almost entirely offset by net income during the period. The Company’s ratio of shareholders’ equity to total assets was 12.06% at December 31, 2014, compared to 11.97% at December 31, 2013. The increase in this ratio was due primarily to a decrease in the Company’s total assets, offset in part by the decrease in the shareholders’ equity during the year. The book value of the Company’s common stock was $6.03 per share at December 31, 2014, compared to $6.05 per share at December 31, 2013.

 

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, 2014, the Bank had a total risk-based capital ratio of 18.19% and a Tier 1 capital ratio of 11.44%. 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.” Beginning in 2015 the Bank will be subject to new regulatory capital standards as specified under Basel III. Management anticipates that all of the Bank’s Basel III regulatory capital ratios will exceed the minimums necessary for the Bank to be classified as a “well capitalized” institution under the new standards. For additional discussion refer to “Regulation and Supervision of the Bank” in “Item 1. Business—Regulation and Supervision.”

 

45
 

 

As of December 31, 2014, the Company was not required to maintain minimum regulatory capital at the consolidated level. However, this changes in 2015 and the Company is also required to maintain specified amounts of regulatory capital pursuant to regulations promulgated by the FRB. These capital regulations are substantially the same as those required for banks and bank holding companies under Basel III. Management anticipates that the Company will meet or exceed the requirements to be categorized as “well capitalized” for regulatory capital purposes at the consolidated level when it becomes subject to such capital requirements in 2015. For additional discussion refer to “Regulation and Supervision of the Company” in “Item 1. Business—Regulation and Supervision”.

 

On February 2, 2015, the Company’s board of directors declared a $0.04 per share dividend payable on February 27, 2015, to shareholders of record on February 13, 2015. On February 2, 2015, the Company’s board of directors also approved a plan to repurchase up to 2.3 million shares of its common stock. From February 2, 2015, to February 27, 2015, the Company repurchased 126,995 shares of its common stock at an average price of $7.04.

 

The payment of dividends and/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 requirements imposed by law or regulations and to the application and interpretation thereof by the OCC and FRB. The Company cannot provide any assurances that dividends will continue to be paid, the amount of any such dividends, or whether additional shares of common stock will be repurchased under its current stock repurchase plan. For further information regarding the factors which could affect the Company’s payment of dividends and/or the repurchase of its common stock, 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 loans, accruing loans delinquent 90 days or more, and foreclosed properties and repossessed assets as of the dates indicated.

 

   December 31 
   2014   2013   2012   2011   2010 
   (Dollars in thousands) 
Non-accrual commercial loans:                         
Commercial and industrial  $201   $284   $693   $1,642   $2,779 
Commercial real estate   4,309    4,401    6,994    23,997    41,244 
Multi-family   1,402    1,783    6,824    22,905    31,660 
Construction and development   803    728    865    9,108    26,559 
Total commercial loans   6,715    7,196    15,376    57,652    102,242 
Non-accrual retail loans:                         
One- to four-family first mortgages   4,148    4,556    8,264    15,128    18,888 
Home equity   493    676    1,514    1,457    1,369 
Other consumer   108    104    59    207    275 
Total non-accrual retail loans   4,749    5,336    9,837    16,792    20,532 
Total non-accrual loans   11,464    12,532    25,213    74,444    122,574 
Accruing loans delinquent 90 days or more (1)   540    443    584    696    373 
Total non-performing loans   12,004    12,975    25,797    75,140    122,947 
Foreclosed real estate and repossessed assets   4,668    6,736    13,961    24,724    19,293 
Total non-performing assets  $16,672   $19,711   $39,758   $99,864   $142,240 
                          
Non-performing loans to total loans   0.74%   0.86%   1.84%   5.69%   9.29%
Non-performing assets to total assets   0.72%   0.84%   1.64%   4.00%   5.49%
Interest income that would have been recognized if non-accrual loans had been current  $634   $1,265   $1,998   $4,535   $4,734 

 

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

 

46
 

 

The Company’s non-performing loans were $12.0 million or 0.74% of loans receivable as of December 31, 2014, compared to $13.0 million or 0.86% of loans receivable as of December 31, 2013. Non-performing assets, which includes non-performing loans, were $16.7 million or 0.72% of total assets and $19.7 million or 0.84% of total assets as of these same dates, respectively. Most of the declines in non-performing loans and non-performing assets in recent years have been caused by repayments of the related loans or disposition of the foreclosed properties. Contributing to a lesser degree were upgrades of loans to performing status due to improvements in the financial condition or performance of the borrowers and/or the underlying collateral, as permitted by the Company’s credit policies.

 

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, 2014, management was closely monitoring $43.5 million in additional loans that were classified as “special mention” and $33.4 million in additional loans that were classified as “substandard” in accordance with the Company’s internal risk rating policy. These amounts compared to $52.7 million and $36.1 million, respectively, as of December 31, 2013. As of December 31, 2014, most of these additional loans that were classified as “special mention” or “substandard” were secured by commercial real estate, multi-family real estate, land, and certain commercial business assets. The decrease in loans classified as “special mention” was due primarily to the downgrade of certain loans to “substandard” in 2014. Management does not believe any of these particular loans were impaired as of December 31, 2014, although there can be no assurances that the loans will not become impaired in future periods. The impact of these downgrades on total loans classified as “substandard” was more than offset by a number of other “substandard” loans that paid-off during the period or were upgraded due to the improved financial condition and operating results of the borrowers.

 

Trends in the credit quality of the Company’s loan portfolio are subject to many factors that are outside of the Company’s control, such as economic and market conditions. As such, there can be no assurances that there will not be significant fluctuations in the Company’s non-performing assets and/or classified loans in future periods or that there will not be significant variability in the Company’s provision for loan losses from period to period.

 

Loans considered to be impaired by the Company at December 31, 2014, were $12.0 million compared to $13.0 million at December 31, 2013, $25.8 million at December 31, 2012, $75.1 million at December 31, 2011, and $131.4 million at December 31, 2010. The average annual balance of loans impaired as of December 31, 2014, was $10.7 million and the interest received and recognized on these loans while they were impaired was $483,000.

 

47
 

 

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 
   2014   2013   2012   2011   2010 
   (Dollars in thousands) 
Balance at beginning of period  $23,565   $21,577   $27,928   $47,985   $17,028 
Provision for loan losses   233    4,506    4,545    6,710    49,619 
Charge-offs:                         
Commercial and industrial   (59)   (199)   (136)   (551)   (2,140)
Commercial real estate   (561)   (514)   (4,894)   (15,286)   (11,621)
Multi-family   (241)   (536)   (857)   (5,035)   (140)
Construction and development   (34)   (148)   (2,693)   (2,737)   (3,515)
One- to four-family first mortgages   (871)   (1,205)   (3,182)   (3,047)   (528)
Home equity   (103)   (1,000)   (327)   (524)   (211)
Other consumer   (431)   (389)   (485)   (512)   (565)
Total charge-offs   (2,300)   (3,991)   (12,574)   (27,692)   (18,720)
Recoveries:                         
Commercial and industrial   64    5    26    18     
Commercial real estate   169    666    956    40    1 
Multi-family   15    102    568    248     
Construction and development   142    109    1    550     
One- to four-family first mortgages   344    492    86    49    20 
Home equity   27    68    1         
Other consumer   30    31    40    20    37 
Total recoveries   791    1,473    1,678    925    58 
Net charge-offs   (1,509)   (2,518)   (10,896)   (26,768)   (18,662)
Balance at end of period  $22,289   $23,565   $21,577   $27,928   $47,985 
                          
Net charge-offs to average loans   0.10%   0.18%   0.78%   1.96%   1.26%
Allowance for loan losses to total loans   1.37%   1.56%   1.54%   2.12%   3.63%
Allowance for loan losses to non-performing loans   185.68%   181.62%   83.64%   37.17%   39.03%

 

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 83.6% at December 31, 2012, to 181.6% at December 31, 2013, and further to 185.68% at December 31, 2014. The increase over this two year period 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”).

 

Although management believes the Company’s allowance for loan losses at December 31, 2014, was 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.

 

48
 

 

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

 

   December 31 
   2014   2013   2012   2010   2010 
       Percent       Percent       Percent       Percent       Percent 
   Amount   to Total   Amount   to Total   Amount   to Total   Amount   to Total   Amount   to Total 
   (Dollars in thousands) 
Loan category:                                                  
Commercial and industrial  $2,349    10.54%  $2,603    11.05%  $1,686    7.81%  $2,098    7.51%  $1,541    3.21%
Commercial real estate   6,880    30.86    6,377    27.06    7,354    34.08    9,467    33.90    21,885    45.61 
Multi-family   6,078    27.27    5,931    25.17    5,195    24.08    7,442    26.65    9,265    19.31 
Construction and development   2,801    12.57    4,160    17.65    2,617    12.13    4,506    16.13    10,141    21.13 
One- to four-family first mortgages   3,004    13.48    3,220    13.66    3,267    15.14    3,201    11.46    3,726    7.76 
Home equity and other consumer   1,177    5.28    1,274    5.41    1,458    6.76    1,214    4.35    1,427    2.97 
Total allowance for loan losses  $22,289    100.00%  $23,565    100.00%  $21,577    100.00%  $27,928    100.00%  $47,985    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.

 

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 recent trends in 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.

 

49
 

 

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, 2014, 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  $1,194,709               $1,194,709 
 Certificates of deposit   383,814   $114,914   $25,319        524,047 
Borrowed funds   61,250    81,215    56,600   $57,404    256,469 
Operating leases   1,009    1,507    1,147    2,820    6,483 
Purchase obligations   2,400    4,800    4,200        11,400 
Deferred retirement plans and                         
deferred compensation plans   906    1,578    1,632    5,200    9,316 

 

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.”

 

The following table details the amounts and expected maturities of significant off-balance sheet commitments to extend credit as of December 31, 2014.

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Commercial lines of credit  $104,406               $104,406 
Commercial loans   4,491       $118        4,609 
Standby letters of credit   3,729   $45            3,774 
Multi-family and commercial real estate   227,647    1,168    50        228,865 
Residential real estate   20,889                20,889 
Revolving home equity and credit card lines   165,600                165,600 
Net commitments to sell residential loans   7,415                7,415 

 

50
 

 

 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.

 

Quarterly Financial Information

 

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

 

   2014 Quarter Ended 
   March 31   June 30   September 30   December 31 
   (Dollars in thousands, except per share amounts) 
Interest income  $19,673   $19,798   $19,671   $20,123 
Interest expense   2,526    2,396    2,291    2,203 
Net interest income   17,147    17,402    17,380    17,920 
Provision for loan losses   13    321    98    (199)
Total non-interest income   4,895    5,704    6,093    5,657 
Total non-interest expense   16,759    17,220    16,684    17,798 
Income before taxes   5,270    5,565    6,691    5,978 
Income tax expense   2,438    1,988    2,284    2,140 
Net loss (gain) attributable to non-controlling interest   12    1    2    (4)
Net income  $2,844   $3,578   $4,409   $3,834 
                     
Earnings per share-basic  $0.06   $0.08   $0.09   $0.08 
Earnings per share-diluted   0.06    0.08    0.09    0.08 
Cash dividend paid per share   0.03    0.04    0.04    0.04 

 

   2013 Quarter Ended 
   March 31   June 30   September 30   December 31 
   (Dollars in thousands, except per share amounts) 
Interest income  $20,175   $19,560   $19,758   $19,962 
Interest expense   3,990    3,371    2,977    2,773 
Net interest income   16,185    16,189    16,781    17,189 
Provision for loan losses   891    1,730    707    1,178 
Total non-interest income   7,432    7,067    6,143    5,475 
Total non-interest expense   18,996    17,411    17,825    17,272 
Income before taxes   3,730    4,115    4,392    4,214 
Income tax expense   1,199    1,478    1,497    1,529 
Net loss attributable to non-controlling interest   14    12    13    9 
Net income  $2,545   $2,649   $2,908   $2,694 
                     
Earnings per share-basic  $0.05   $0.06   $0.06   $0.06 
Earnings per share-diluted   0.05    0.06    0.06    0.06 
Cash dividend paid per share   0.02    0.02    0.03    0.03 

 

51
 

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

The Company’s ability to maintain net interest income depends upon earning a higher yield on assets than the rates it pays on deposits and borrowings. Fluctuations in market interest rates will ultimately impact both the level of income and expense recorded on a large portion of the Company’s assets and liabilities. Fluctuations in interest rates will also affect the market value of all interest-earning assets and interest-bearing liabilities, other than those with a very short term to maturity.

 

Interest rate sensitivity is a measure of the difference between amounts of interest-earning assets and interest-bearing liabilities which either reprice or mature during a given period of time. The difference, or the interest rate sensitivity “gap, ” provides an indication of the extent to which the Company’s interest rate spread will be affected by changes in interest rates. Refer to “Gap Analysis,” below. Interest rate sensitivity is also measured through analysis of changes in the present value of the Company’s equity. Refer to “Present Value of Equity,” below.

 

To achieve the objectives of managing interest rate risk, the Company’s executive management meets periodically to discuss and monitor the market interest rate environment and provides reports to the board of directors. Management seeks to coordinate asset and liability decisions so that, under changing interest rate scenarios, the Company’s earnings will remain within an acceptable range. The primary objectives of the Company’s interest rate management strategy are to:

 

·maintain earnings and capital within self-imposed parameters over a range of possible interest rate environments;

 

·coordinate interest rate risk policies and procedures with other elements of the Company’s business plan, all within the context of the current business environment and regulatory capital and liquidity requirements; and

 

·manage interest rate risk in a manner consistent with the approved guidelines and policies set by the board of directors.

 

The Company has employed certain strategies to manage the interest rate risk inherent in the asset/liability mix, including:

 

·emphasizing the origination of adjustable-rate mortgage loans and mortgage loans that mature or reprice within five years for portfolio, and selling most fixed-rate residential mortgage loans with maturities of 15 years or more in the secondary market;

 

·entering into interest rate swap arrangements to mitigate the interest rate exposure associated with specific commercial loan relationships at the time such loans are originated;

 

·emphasizing variable-rate and/or short- to medium-term, fixed-rate home equity and commercial and industrial loans;

 

·maintaining a significant level of mortgage-related and other investment securities available-for-sale that have weighted-average life of less than five years or interest rates that reprice in less than five years; and

 

·managing deposits and borrowings to provide stable funding.

 

Management believes these strategies reduce the Company’s interest rate risk exposure to acceptable levels.

 

Gap Analysis Repricing characteristics of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring a financial institution's interest rate sensitivity “gap.” An asset or liability is said to be “interest rate sensitive” within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period.

 

52
 

 

A gap is considered positive when the amount of interest-earning assets maturing or repricing within a specific time period exceeds the amount of interest-bearing liabilities maturing or repricing within that specific time period. A gap is considered negative when the amount of interest-bearing liabilities maturing or repricing within a specific time period exceeds the amount of interest-earning assets maturing or repricing within the same period. During a period of rising interest rates, a financial institution with a negative gap position would be expected, absent the effects of other factors, to experience a greater increase in the costs of its liabilities relative to the yields of its assets and thus a decrease in the institution's net interest income. An institution with a positive gap position would be expected, absent the effect of other factors, to experience the opposite result. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to reduce net interest income.

 

The following table presents the amounts of the Company’s interest-earning assets and interest-bearing liabilities outstanding at December 31, 2014, which management anticipates to reprice or mature in each of the future time periods shown. The information presented in the following table is based on the following assumptions:

 

·Loans—based upon contractual maturities, repricing date, if applicable, scheduled repayments of principal, and projected prepayments of principal based upon the Company’s historical experience or anticipated prepayments. Actual cash flows may differ substantially from these assumptions.

 

·Mortgage-related securities—based upon known repricing dates (if applicable) and an independent outside source for determining estimated prepayment speeds. Actual cash flows may differ substantially from these assumptions.

 

·Deposit liabilities—based upon contractual maturities and the Company’s historical decay rates. Actual cash flows may differ from these assumptions.

 

·Borrowings—based upon final maturity.

 

   December 31, 2014 
   Within   Three to   More than   More than         
   Three   Twelve   1 Year to   3 Years -   Over 5     
   Months   Months   3 Years   5 Years   Years   Total 
  (Dollars in thousands) 
Loans receivable:                              
Commercial loans:                              
 Fixed  $30,939   $72,440   $154,161   $98,872   $13,489   $369,901 
 Adjustable   367,690    63,524    96,330    33,343        560,887 
Retail loans:                              
 Fixed   17,616    36,791    75,271    49,531    97,616    276,825 
 Adjustable   112,502    147,066    83,657    43,989    53,460    440,674 
Interest-earning deposits   11,445                    11,445 
Mortgage-related securities:                              
Fixed   30,849    75,513    127,748    115,766    77,767    427,643 
Adjustable   21,038                    21,038 
Other interest-earning assets   14,209                    14,209 
Total interest-earning assets   606,288    395,334    537,167    341,501    242,332    2,122,622 
                               
Deposit liabilities:                              
 Non-interest-bearing demand accounts                   187,905    187,905 
Interest-bearing demand accounts                   253,585    253,585 
Savings accounts                   220,557    220,557 
Money market accounts   532,662                    532,662 
Certificates of deposit   128,574    263,107    107,044    25,323        524,048 
Advance payments by borrowers for taxes and insurance       4,742                4,742 
Borrowings   45,619    16,924    83,900    57,567    52,459    256,469 
 Total non-interest- and interest- bearing liabilities   706,855    284,773    190,944    82,890    714,506    1,979,968 
Interest rate sensitivity gap  $(100,567)  $110,561   $346,223   $258,611   $(472,174)  $142,654 
Cumulative interest rate sensitivity gap  $(100,567)  $9,994   $356,217   $614,828   $142,654      
Cumulative interest rate sensitivity gap as a percent of total assets   

-4.32

%   

0.43

%   

15.30

%   

26.41

%   

6.13

%     
Cumulative interest-earning assets as a percentage of non-interest- and interest-bearing liabilities   85.77%   101.01%   130.12%   148.59%   107.20%     

 

Based on the above gap analysis, at December 31, 2014, the Company’s interest-bearing liabilities maturing or repricing within

 

one year approximates its interest-earning assets maturing or repricing within the same period. Based on this information, over the course of the next year increases or decreases in market interest rates could have a neutral impact on the Company’s net interest income. However, it should be noted that the Company’s future net interest income is affected by more than just future market interest rates. Net interest income is also affected by absolute and relative levels of earning assets and interest-bearing liabilities, the level of non-performing loans and other investments, and by other factors outlined in “Item 1. Business—Cautionary Statement,” “Item 1A. Risk Factors,” and “Item 7. Management Discussion of Financial Condition and Results of Operations.”

 

53
 

 

In addition to not anticipating all of the factors that could impact future net interest income, gap analysis has certain shortcomings. For example, although certain assets and liabilities may mature or reprice in similar periods, the interest rates on such react by different degrees to changes in market interest rates, especially in instances where changes in rates are limited by contractual caps or floors or instances where rates are influenced by competitive forces. Interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. For example, it is the Company’s past experience that rate changes on most of its deposit liabilities generally lag changes in market interest rates. Certain assets, such as adjustable-rate loans, have features which limit changes in interest rates on a short term basis and over the life of the loan. If interest rates change, prepayment, and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of borrowers to make payments on their adjustable-rate loans may decrease if interest rates increase. Because of these shortcomings, management of the Company believes that gap analysis is a better indicator of the relative change in the Company’s interest rate risk exposure from period to period than it is an indicator of the direction or amount of future change in net interest income.

 

Present Value of Equity In addition to the gap analysis table, management also uses simulation models to monitor interest rate risk. The models report the present value of equity (“PVE”) in different interest rate environments, assuming an instantaneous and permanent interest rate shock to all interest rate sensitive assets and liabilities. The PVE is the difference between the present value of expected cash flows of interest rate sensitive assets and liabilities. The changes in market value of assets and liabilities due to changes in interest rates reflect the interest rate sensitivity of those assets and liabilities as their values are derived from the characteristics of the asset or liability (i.e., fixed rate, adjustable rate, caps, and floors) relative to the current interest rate environment. For example, in a rising interest rate environment, the fair market value of a fixed-rate asset will decline whereas the fair market value of an adjustable-rate asset, depending on its repricing characteristics, may not decline. Increases in the market value of assets will increase the PVE whereas decreases in market value of assets will decrease the PVE. Conversely, increases in the market value of liabilities will decrease the PVE whereas decreases in the market value of liabilities will increase the PVE.

 

The following table presents the estimated PVE over a range of interest rate change scenarios at December 31, 2014. The present value ratio shown in the table is the PVE as a percent of the present value of total assets in each of the different rate environments. For purposes of this table, management has made assumptions such as prepayment rates and decay rates similar to those used for the gap analysis table.

 

       Present Value of Equity 
       as Percent of 
Change in  Present Value of Equity   Present Value of Assets 
Interest Rates  Dollar   Dollar   Percent   Present Value   Percent 
(Basis Points)  Amount   Change   Change   Ratio   Change 
   (Dollars in thousands)             
+400  $304,608   $(108,066)   (26.2)%   13.99%   (20.1)%
+300   329,876    (82,798)   (20.1)   14.86    (15.2)
+200   357,500    (55,174)   (13.4)   15.79    (9.8)
+100   384,510    (28,164)   (6.8)   16.66    (4.9)
0   412,674            17.52     
-100   418,584    4,910    1.2    17.31    (1.2)

Based on the above analysis, the Company’s PVE could be adversely affected by an increase in interest rates. The decline in the PVE as a result of an increase in rates is attributable to the combined effects of a decline in the present value of the Company’s earning assets (which is further impacted by an extension in duration in rising rate environments due to slower prepayments on loan and mortgage-related securities), partially offset by a decline in the present value of deposit liabilities and FHLB of Chicago advances. Alternatively, it should be noted that the Company’s PVE could be favorably impacted by a decrease in interest rates. However, it should be noted that the Company’s PVE is impacted by more than changes in market interest rates. Future PVE is also affected by management’s decisions relating to reinvestment of future cash flows, decisions relating to funding sources, and by other factors outlined in “Item 1. Business—Cautionary Statement,” “Item 1A. Risk Factors,” and “Item 7. Management Discussion of Financial Condition and Results of Operations.”

 

54
 

 

As is the case with gap analysis, PVE analysis also has certain shortcomings. PVE modeling requires management to make assumptions about future changes in market interest rates that are unlikely to occur, such as immediate, sustained, and parallel (or equal) changes in all market rates across all maturity terms. PVE modeling also requires that management make assumptions which may not reflect the manner in which actual yields and costs respond to changes in market interest rates. For example, it is the Company’s past experience that rate changes on most of its deposit liabilities generally lag changes in market interest rates. In addition, management makes assumptions regarding the changes in prepayment speeds of mortgage loans and securities. Prepayments will accelerate in a falling rate environment and the reverse will occur in a rising rate environment. Management also assumes that decay rates on core deposits will accelerate in a rising rate environment and the reverse in a falling rate environment. The model assumes that the Company will take no action in response to the changes in interest rates, when in practice rate changes on most deposit liabilities lag behind market changes and/or may be limited by competition. In addition, prepayment estimates and other assumptions within the model are subjective in nature, involve uncertainties, and therefore cannot be determined with precision. Accordingly, although the PVE model may provide an estimate of the Company’s interest rate risk at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in interest rates on the Company’s PVE. Because of these shortcomings, management of the Company believes that PVE analysis is a better indicator of the relative change in the Company’s interest rate risk exposure from period to period than it is an indicator of the direction or amount of future change in net interest income.

 

55
 

 

Item 8. Financial Statements and Supplementary Data

 

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Shareholders of
Bank Mutual Corporation
Milwaukee, Wisconsin

 

We have audited the accompanying consolidated statements of financial condition of Bank Mutual Corporation and subsidiaries (the "Company") as of December 31, 2014 and 2013, and the related consolidated statements of income, total comprehensive income, equity, and cash flows for each of the three years in the period ended December 31, 2014. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Bank Mutual Corporation and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2014, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 6, 2015, expressed an unqualified opinion on the Company's internal control over financial reporting.

 

/s/ Deloitte & Touche LLP

 

Milwaukee, Wisconsin
March 6, 2015

 

56
 

 

Bank Mutual Corporation and Subsidiaries

 

Consolidated Statements of Financial Condition

 

  December 31 
   2014   2013 
  (Dollars in thousands) 
Assets        
         
Cash and due from banks  $34,727   $23,747 
Interest-earning deposits in banks   11,450    18,709 
   Cash and cash equivalents   46,177    42,456 
Mortgage-related securities available-for-sale, at fair value   321,883    446,596 
Mortgage-related securities held-to-maturity, at amortized cost (fair value of $134,117 in 2014 and $153,223 in 2013)   132,525    155,505 
Loans held-for-sale   3,837    1,798 
Loans receivable (net of allowance for loan losses of $22,289 in 2014 and $23,565 in 2013)   1,631,303    1,508,996 
Mortgage servicing rights, net   7,867    8,737 
Other assets   184,854    183,261 
           
Total assets  $2,328,446   $2,347,349 
           
Liabilities and equity          
           
Liabilities:          
Deposit liabilities  $1,718,756   $1,762,682 
Borrowings   256,469    244,900 
Advance payments by borrowers for taxes and insurance   4,742    3,431 
Other liabilities   63,988    52,414 
Total liabilities   2,043,955    2,063,427 
Equity:          
Preferred stock–$0.01 par value:          
Authorized–20,000,000 shares in 2014 and 2013
Issued and outstanding–none in 2014 and 2013
        
Common stock–$0.01 par value:          
Authorized–200,000,000 shares in 2014 and 2013
Issued–78,783,849 shares in 2014 and 2013
          
Outstanding–46,568,284 shares in 2014 and 46,438,284 in 2013   788    788 
    Additional paid-in capital   488,467    489,238 
    Retained earnings   159,065    151,384 
Accumulated other comprehensive loss   (11,136)   (2,319)
Treasury stock–32,215,565 shares in 2014 and 32,345,565 in 2013   (356,467)   (358,054)
Total shareholders' equity   280,717    281,037 
    Non-controlling interest in real estate partnership   3,774    2,885 
Total equity including non-controlling interest   284,491    283,922 
           
Total liabilities and equity  $2,328,446   $2,347,349 

 

Refer to Notes to Consolidated Financial Statements

 

57
 

 

Bank Mutual Corporation and Subsidiaries

 

Consolidated Statements of Income

 

   Year Ended December 31 
   2014   2013   2012 
   (Dollars in thousands, except per share data) 
Interest income:               
Loans  $66,261   $64,638   $65,478 
Mortgage-related securities   12,850    14,666    17,309 
Investment securities   139    54    73 
Interest-earning deposits   15    98    162 
          Total interest income   79,265    79,456    83,022 
Interest expense:               
Deposit liabilities   4,684    8,325    14,655 
Borrowings   4,731    4,785    6,984 
Advance payments by borrowers for taxes and insurance   1    2    2 
       Total interest expense   9,416    13,112    21,641 
       Net interest income   69,849    66,344