10-K 1 a13-26332_110k.htm 10-K

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

Form 10-K

 

 T                                                                             ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2013

OR

£                                                                      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                        to                       

Commission file number    0-10537

 

OLD SECOND BANCORP, INC.          

(Exact name of registrant as specified in its charter)

 

Delaware       

 

           36-3143493      

(State of Incorporation)

 

(IRS Employer Identification Number)

 

 37 South River Street, Aurora, Illinois 60507       

(Address of principal executive offices, including zip code)

 

(630) 892-0202                

(Registrant's telephone number, including Area Code)

 

Securities registered pursuant to Section 12(b) of the Act:

Title of Class 

 

  Name of each exchange on which registered

Common Stock, $1.00 par value

 

The Nasdaq Stock Market

Preferred Securities of Old Second Capital Trust I

 

The Nasdaq Stock Market

Securities registered pursuant to Section 12(g) of the Act:

Preferred Share Purchase Rights

(Title of Class)

 

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

 

Yes £                                               No T

 

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

 

Yes £                                               No T

 

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 T                                               No £

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Yes T                                               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 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 £

Non-accelerated filer £

(Do not check if smaller reporting company)

Smaller reporting company T

 

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

 

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Yes £                                               No T

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, on June 30, 2013, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $70.1 million.  The number of shares outstanding of the registrant's common stock, par value $1.00 per share, was 13,923,843 at February 20, 2014.

 

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OLD SECOND BANCORP, INC.

Form 10-K

INDEX

 

PART I

 

 

 

Item 1

Business

 

 

Item 1A

Risk Factors

 

 

Item 1B

Unresolved Staff Comments

 

 

Item 2

Properties

 

 

Item 3

Legal Proceedings

 

 

Item 4

Mine Safety Disclosures

 

 

PART II

 

 

 

Item 5

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

 

Item 6

Selected Financial Data

 

 

Item 7

Management's Discussion and Analysis of Financial Condition and Results of Operations

 

 

Item 7A

Quantitative and Qualitative Disclosures about Market Risk

 

 

Item 8

Financial Statements and Supplementary Data

 

 

Item 9

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

 

Item 9A

Controls and Procedures

 

 

Item 9B

Other Information

 

 

PART III

 

 

 

Item 10

Directors, Executive Officers, and Corporate Governance

 

 

Item 11

Executive Compensation

 

 

Item 12

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

 

Item 13

Certain Relationships and Related Transactions, and Director Independence

 

 

Item 14

Principal Accountant Fees and Services

 

 

PART IV

 

 

 

Item 15

Exhibits and Financial Statement Schedules

 

 

 

Signatures

 

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PART I

 

Item 1.  Business

 

General

 

Old Second Bancorp, Inc. (the "Company" or the "Registrant") was organized under the laws of Delaware on September 8, 1981.  It is a registered bank holding company under the Bank Holding Company Act of 1956 (the "BHCA").  The Company's office is located at 37 South River Street, Aurora, Illinois 60507.

 

The Company conducts a full service community banking and trust business through the following wholly owned subsidiaries, which together with the Registrant are referred to as the “Company”:

 

·                 Old Second National Bank (the “Bank”).

·                 Old Second Capital Trust I, which was formed for the exclusive purpose of issuing trust preferred securities in an offering that was completed in July 2003.

·                 Old Second Capital Trust II, which was formed for the exclusive purpose of issuing trust preferred securities in an offering that was completed in April 2007.

·                 Old Second Affordable Housing Fund, L.L.C., which was formed for the purpose of providing down payment assistance for home ownership to qualified individuals.

·                 A series of limited liability companies wholly owned by the Bank and formed between 2008 and 2012 to hold property acquired by the Bank through foreclosure or in the ordinary course of collecting a debt previously contracted with borrowers.

·                 River Street Advisors, LLC, a wholly-owned subsidiary of the Bank, which was formed in May 2010 to provide investment advisory/management services.

 

Inter-company transactions and balances are eliminated in consolidation.

 

The Company provides financial services through its 27 banking locations that are located primarily in Aurora, Illinois, and its surrounding communities and throughout the Chicago metropolitan area.  These locations included retail offices located in Kane, Kendall, DeKalb, DuPage, LaSalle, Will and southwestern Cook counties in Illinois as of December 31, 2013.  The Company expanded its franchise from long standing offices in the western suburbs into Cook County and traditionally growing southern Chicago suburbs with an acquisition in February 2008.

 

Business of the Company and its Subsidiaries

 

The Bank’s full service banking businesses include the customary consumer and commercial products and services that banks provide including demand, NOW, money market, savings, time deposit, individual retirement and Keogh deposit accounts; commercial, industrial, consumer and real estate lending, including installment loans, student loans, agricultural loans, lines of credit and overdraft checking; safe deposit operations; trust services; wealth management services, and an extensive variety of additional services tailored to the needs of individual customers, such as the acquisition of U.S. Treasury notes and bonds, the sale of traveler's checks, money orders, cashiers’ checks and foreign currency, direct deposit, discount brokerage, debit cards, credit cards, and other special services. The Bank also offers a full complement of electronic banking services such as online and mobile banking and corporate cash management products including remote deposit capture, mobile deposit capture, investment sweep accounts, zero balance accounts, automated tax payments, ATM access, telephone banking, lockbox accounts, automated clearing house transactions, account reconciliation, controlled disbursement, detail and general information reporting, wire transfers, vault services for currency and coin, and checking accounts.  Commercial and consumer loans are made to corporations, partnerships and individuals, primarily on a secured basis.  Commercial lending focuses on business, capital, construction, inventory and real estate lending.  Installment lending includes direct and indirect loans to consumers and

 

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commercial customers.  Additionally, the Bank provides a wide range of wealth management, investment, agency, and custodial services for individual, corporate, and not-for-profit clients.  These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans, and charitable foundations.  The Bank also originates residential mortgages, offering a wide range of mortgage products including conventional, government, and jumbo loans.  Secondary marketing of those mortgages is also handled at the Bank.

 

Operating segments are components of a business about which separate financial information is available and that are evaluated regularly by the Company’s management in deciding how to allocate resources and assess performance.  Public companies are required to report certain financial information about operating segments.  The Company’s management evaluates the operations of the Company as one operating segment, i.e. community banking.  As a result, disclosure of separate segment information is not required.  The Company offers the products and services described above to its external customers as part of its customary banking business.

 

Market Area

 

The Company’s primary market area is Aurora, Illinois and its surrounding communities. The city of Aurora is located in northeastern Illinois, approximately 40 miles west of Chicago. The Bank operates primarily in Kane, Kendall, DeKalb, DuPage, LaSalle, Will and southwestern Cook counties in Illinois, and it has developed a strong presence in these counties. Based on 2012 estimates from the United States Census Bureau, these counties, excluding Cook County, represent a market of more than 2.4 million people, and the city of Aurora itself has a population of approximately 200,000 residents. In addition, in 2008, the Company added an office in southwestern Cook County, which has an estimated population of 5.2 million people. The Bank offers its services to retail, commercial, industrial, and public entity customers in the Aurora, North Aurora, Batavia, St. Charles, Burlington, Elburn, Elgin, Maple Park, Kaneville, Sugar Grove, Naperville, Lisle, Joliet, Yorkville, Plano, Wasco, Ottawa, Oswego, Sycamore, New Lenox, Frankfort, and Chicago Heights communities and surrounding areas.

 

Lending Activities

 

The Bank provides a broad range of commercial and retail lending services to corporations, partnerships, individuals and government agencies.  The Bank actively markets its services to qualified borrowers.  Lending officers actively solicit the business of new borrowers entering our market areas as well as long-standing members of the local business community.  The Bank has established and updated lending policies that include a number of underwriting factors to be considered in making a loan, including location, amortization, loan to value ratio, cash flow, pricing, documentation and the credit history of the borrower.  In 2013, the Bank originated approximately $409.4 million in loans.  Also in 2013, residential mortgage loans of just over $185.4 million (some of which were originated in 2012) were sold to investors.  The Bank’s loan portfolios are comprised primarily of loans in the areas of commercial real estate, residential real estate, construction, general commercial and consumer lending.  As of December 31, 2013, residential mortgages made up approximately 35% of the Bank’s loan portfolio, commercial real estate loans comprised approximately 51%, construction lending comprised approximately 3%, general commercial loans comprised approximately 9%, and consumer and other lending comprised less than 2%.  It is the Bank’s policy to comply at all times with the various consumer protection laws and regulations including, but not limited to, the Equal Credit Opportunity Act, the Fair Housing Act, the Community Reinvestment Act, the Truth in Lending Act, and the Home Mortgage Disclosure Act.  The Bank does not discriminate in application procedures, loan availability, pricing, structure, or terms on the basis of race, color, religion, national origin, sex, marital status, familial status, handicap, age (provided the applicant has the legal capacity to enter into a binding contract), whether income is derived from public assistance, whether a borrower resides, or his property is located, in a low- or moderate-income area, or whether a right was exercised under the Consumer Credit Protection Act. The Bank strives to offer all of its credit services throughout its market area, including low- and moderate-income areas.

 

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Commercial Loans.  The Bank continues to focus on growing commercial and industrial prospects in the new business pipeline with positive results, mostly occurring in fourth quarter.  As noted above, the Bank is an active commercial lender, primarily located west and south of the Chicago metropolitan area and active in other parts of the Chicago and Aurora metropolitan areas.  Commercial lending reflects revolving lines of credit for working capital, lending for capital expenditures on manufacturing equipment and lending to small business manufactures, service companies, medical and dental entities as well as specialty contractors.  The Bank also has commercial and industrial loans to customers with over $50 million in revenue in food product manufacturing, food process and packing, machinery tooling manufacturing as well as service and technology companies.  Collateral for these loans generally includes accounts receivable, inventory, equipment and real estate.  In addition, the Bank may take personal guarantees to help assure repayment.  Loans may be made on an unsecured basis if warranted by the overall financial condition of the borrower.  Commercial lines of credit are predominantly for a one to two year term and have floating rates.  Commercial term loans range principally from one to eight years with the majority falling in the one to five year range.  Interest rates are primarily fixed although some have interest rates tied to the prime rate or LIBOR.  While management would like to continue to diversify the loan portfolio, overall demand for working capital and equipment financing continued to be muted in the Bank’s primary market area in 2013.

 

Repayment of commercial loans is largely dependent upon the cash flows generated by the operations of the commercial enterprise.  The Bank’s underwriting procedures identify the sources of those cash flows and seek to match the repayment terms of the commercial loans to the sources.  Secondary repayment sources are typically found in collateralization and guarantor support.

 

Commercial Real Estate Loans.  While management has been actively working to reduce the Bank’s concentrations in real estate loans, including commercial real estate loans, a large portion of the loan portfolio continues to be comprised of commercial real estate loans.  As of December 31, 2013, approximately $294.4 million, or 52.5%, of the total commercial real estate loan portfolio of $560.2 million was to borrowers who secured the loan with owner occupied property.  A primary repayment risk for a commercial real estate loan is interruption or discontinuance of cash flows from operations.  Such cash flows are usually derived from rent in the case of nonowner occupied commercial properties.  Repayment could also be influenced by economic events, which may or may not be under the control of the borrower, or changes in governmental regulations that negatively impact the future cash flow and market values of the affected properties.  Repayment risk can also arise from general downward shifts in the valuations of classes of properties over a given geographic area such as the ongoing but diminished price adjustments that have been observed by the Company beginning in 2008.  Property valuations could continue to be affected by changes in demand and other economic factors, which could further influence cash flows associated with the borrower and/or the property.  The Bank attempts to mitigate these risks by staying apprised of market conditions and by maintaining underwriting practices that provide for adequate cash flow margins and multiple repayment sources as well as remaining in regular contact with the borrowers.  In most cases, the Bank has collateralized these loans and/or has taken personal guarantees to help assure repayment.  Commercial real estate loans are primarily made based on the identified cash flow of the borrower and/or the property at origination and secondarily on the underlying real estate acting as collateral.  Additional credit support is provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the real estate and enforcement of a personal guarantee, if any exists.

 

Construction Loans.  The Bank’s construction and development lending and related risks have greatly diminished from prior periods.  The construction and development portfolio no longer dominates the Bank’s commercial real estate portfolio.  While outside data sources report a considerable rise in national homebuilder activity, the Bank’s construction lending is very limited in the current economic environment.  Loans in this category decreased from $42.2 million at December 31, 2012, to $29.4 million at December 31, 2013.  The Bank uses underwriting and construction loan guidelines to determine

 

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whether to issue loans to reputable contractors on build-to-suit or build out of existing borrower properties.

 

Construction loans are structured most often to be converted to permanent loans at the end of the construction phase or, infrequently, to be paid off upon receiving financing from another financial institution.  Construction loans are generally limited to our local market area.  Lending decisions have been based on the appraised value of the property as determined by an independent appraiser, an analysis of the potential marketability and profitability of the project and identification of a cash flow source to service the permanent loan or verification of a refinancing source.  Construction loans generally have terms of up to 12 months, with extensions as needed.  The Bank disburses loan proceeds in increments as construction progresses and as inspections warrant.

 

Construction development loans involve additional risks.  Development lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of the borrower or guarantor to repay principal and interest.  This generally involves more risk than other lending because it is based on future estimates of value and economic circumstances.  While appraisals are required prior to funding, and loan advances are limited to the value determined by the appraisal, there is the possibility of an unforeseen event affecting the value and/or costs of the project.  Development loans are primarily used for single-family developments, where the sale of lots and houses are tied to customer preferences and interest rates.  If the borrower defaults prior to completion of the project, the Bank may be required to fund additional amounts so that another developer can complete the project.  The Bank is located in an area where a large amount of development activity has occurred as rural and semi-rural areas are being suburbanized.  This type of growth presents some economic risks should the shift in local demand for housing that occurred in conjunction with stressed economic conditions become permanent.  The Bank addresses these risks by closely monitoring local real estate activity, adhering to proper underwriting procedures, closely monitoring construction projects, and limiting the amount of construction development lending.

 

Activity in this sector slowed considerably with the downward economic trends in real estate and other markets that the Company and the U.S. economy have experienced since 2008.

 

Residential Real Estate Loans.  Residential first mortgage loans, second mortgages, and home equity line of credit mortgages are included in this category.  First mortgage loans may include fixed rate loans that are generally sold to investors.  The Bank is a direct seller to the Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”) and to several large financial institutions.  The Bank periodically retains servicing rights for sold mortgages.  The periodic retention of such servicing rights also allows the Bank an opportunity to have regular contact with mortgage customers and can help to solidify community involvement.  Other loans that are not sold include adjustable rate mortgages, lot loans, and constructions loans that are held in portfolio by the Bank.  In light of lower residential property prices, residential mortgage purchase activity has reflected a moderate level of activity as purchasers initiate a purchase transaction at a near market bottom price while locking in a comparatively low mortgage rate.  Home equity lending has continued to slow in the past year but is still a meaningful portion of the Bank’s business.

 

Consumer Loans.  The Bank also provides many types of consumer loans including motor vehicle, home improvement, signature loans and small personal credit lines. Consumer loans typically have shorter terms and lower balances with higher yields as compared to other loans but generally carry higher risks of default. Consumer loan collections are dependent on the borrower’s continuing financial stability and thus are more likely to be affected by adverse personal circumstances.

 

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Competition

 

The Company’s market area is highly competitive, and the Bank’s business and activities require us to compete with many other companies.  A number of these financial institutions are affiliated with large bank holding companies headquartered outside of our principal market area as well as other institutions that are based in Aurora's surrounding communities and in Chicago, Illinois.  All of these financial institutions operate banking offices in the greater Aurora area or actively compete for customers within the Company's market area.  The Bank also faces competition from finance companies, insurance companies, credit unions, mortgage companies, securities brokerage firms, money market funds, loan production offices and other providers of financial services.  Many of our nonbank competitors are not subject to the same extensive federal regulations that govern bank holding companies and banks, such as the Company and may, as a result, have certain competitive advantages.

 

The Bank competes for loans principally through the quality of its client service and its responsiveness to client needs in addition to competing on interest rates and loan fees.  Management believes that its long-standing presence in the community and personal one-on-one service philosophy enhances its ability to compete favorably in attracting and retaining individual and business customers.  The Bank actively solicits deposit-related clients and competes for deposits by offering personal attention, competitive interest rates, and professional services made available through practiced bankers and multiple delivery channels that fit the needs of its market.

 

The Bank operated 27 branches in the seven counties of Kane, Kendall, LaSalle, Will, DeKalb, DuPage, and southwestern Cook County as of December 31, 2013.  As of June 30, 2013, the Bank was a deposit market leader in Kane and Kendall Counties, the Bank faced competition from 196 bank branches representing 42 different financial institutions (including us) according to the June 30, 2013, Federal Deposit Insurance Corporation (“FDIC”) share of deposit data.  The Bank’s branches in the remaining counties in which it operates face many of these same competitors as well as competition from other non-FDIC insured credit unions and financial service firms.  The financial services industry will continue to become more competitive as further technological advances enable more companies to provide expanded financial services without having a physical presence in our market.

 

Employees

 

At December 31, 2013, the Company employed 492 full-time equivalent employees.  The Company places a high priority on staff development, which involves extensive training, including customer service training.  New employees are selected on the basis of both technical skills and customer service capabilities.  None of the Company's employees are covered by collective bargaining agreements.

 

Internet

 

The Company maintains a corporate website at http://www.oldsecond.com.  The Company makes available free of charge on or through its website the Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (the “SEC”).  Many of the Company’s policies, committee charters and other investor information including our Code of Business Conduct and Ethics, are available on the Company’s website.  The Company’s reports, proxy and informational statements and other information regarding the Company are available free of charge on the SEC’s website (www.sec.gov).  The Company will also provide copies of its filings free of charge upon written request to: J. Douglas Cheatham, Executive Vice President and Chief Financial Officer, Old Second Bancorp, Inc., 37 South River Street, Aurora, Illinois 60507.

 

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Forward-Looking Statements: This report may contain forward-looking statements.  Forward-looking statements are identifiable by the inclusion of such qualifications as expects, intends, believes, may, likely or other indications that the particular statements are not based upon facts but are rather based upon the Company’s beliefs as of the date of this release.  Actual events and results may differ significantly from those described in such forward-looking statements, due to changes in the economy, interest rates or other factors.  Additionally, all statements in this Form 10-K, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

 

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SUPERVISION AND REGULATION

 

General

 

Financial institutions, their holding companies and their affiliates are extensively regulated under federal and state law.  As a result, the growth and earnings performance of the Company may be affected not only by management decisions and general economic conditions, but also by requirements of federal and state statutes and by the regulations and policies of various bank regulatory agencies, including the Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”) and Consumer Financial Protection Bureau (the “CFPB”).  Furthermore, taxation laws administered by the Internal Revenue Service and state taxing authorities, accounting rules developed by the Financial Accounting Standards Board (the “FASB”) and securities laws administered by the Securities and Exchange Commission (the “SEC”) and state securities authorities have an impact on the business of the Company. The effect of these statutes, regulations, regulatory policies and accounting rules are significant to the operations and results of the Company and the Bank, and the nature and extent of future legislative, regulatory or other changes affecting financial institutions are impossible to predict with any certainty.

 

Federal and state banking laws impose a comprehensive system of supervision, regulation and enforcement on the operations of financial institutions, their holding companies and affiliates that is intended primarily for the protection of the FDIC-insured deposits and depositors of banks, rather than shareholders.  These federal and state laws, and the regulations of the bank regulatory agencies issued under them, affect, among other things, the scope of business, the kinds and amounts of investments banks may make, reserve requirements, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, the ability to merge, consolidate and acquire, dealings with insiders and affiliates and the payment of dividends.  Moreover, turmoil in the credit markets in recent years prompted the enactment of unprecedented legislation that has allowed the U.S. Department of the Treasury (the “Treasury”) to make equity capital available to qualifying financial institutions to help restore confidence and stability in the U.S. financial markets, which imposes additional requirements on institutions in which the Treasury has an investment.

 

This supervisory and regulatory framework subjects banks and bank holding companies to regular examination by their respective regulatory agencies, which results in examination reports and ratings that are not publicly available and that can impact the conduct and growth of their business. These examinations consider not only compliance with applicable laws and regulations, but also capital levels, asset quality and risk, management ability and performance, earnings, liquidity, and various other factors. The regulatory agencies generally have broad discretion to impose restrictions and limitations on the operations of a regulated entity where the agencies determine, among other things, that such operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies.

 

The following is a summary of the material elements of the supervisory and regulatory framework applicable to the Company and the Bank.  It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of those that are described.  The descriptions are qualified in their entirety by reference to the particular statutory and regulatory provision.

 

Financial Regulatory Reform

 

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law.  The Dodd-Frank Act represents a sweeping reform of the U.S. supervisory and regulatory framework applicable to financial institutions and capital markets in the wake of the global financial crisis, certain aspects of which are described below in more detail. In particular, and among other things, the Dodd-Frank Act: (i) created a Financial Stability Oversight Council as part of a regulatory structure for identifying emerging systemic risks and improving interagency cooperation; (ii) created the CFPB, which is authorized to regulate providers of consumer credit, savings, payment and

 

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other consumer financial products and services; (iii) narrowed the scope of federal preemption of state consumer laws enjoyed by national banks and federal savings associations and expanded the authority of state attorneys general to bring actions to enforce federal consumer protection legislation; (iv) imposed more stringent capital requirements on bank holding companies and subjected certain activities, including interstate mergers and acquisitions, to heightened capital conditions; (v) with respect to mortgage lending, (a) significantly expanded requirements applicable to loans secured by 1-4 family residential real property, (b) imposed strict rules on mortgage servicing, and (c) required the originator of a securitized loan, or the sponsor of a securitization, to retain at least 5% of the credit risk of securitized exposures unless the underlying exposures are qualified residential mortgages or meet certain underwriting standards; (vi) repealed the prohibition on the payment of interest on business checking accounts; (vii) restricted the interchange fees payable on debit card transactions for issuers with $10 billion in assets or greater; (viii) in the so-called “Volcker Rule”, subject to numerous exceptions, prohibited depository institutions and affiliates from certain investments in, and sponsorship of, hedge funds and private equity funds and from engaging in proprietary trading; (ix) provided for enhanced regulation of advisers to private funds and of the derivatives markets; enhanced oversight of credit rating agencies; and (x) prohibited banking agency requirements tied to credit ratings. These statutory changes shifted the regulatory framework for financial institutions, impacted the way in which they do business and have the potential to constrain revenues.

 

Numerous provisions of the Dodd-Frank Act are required to be implemented through rulemaking by the appropriate federal regulatory agencies.  Many of the required regulations have been issued and others have been released for public comment, but there remain a number that have yet to be released in any form. Furthermore, while the reforms primarily target systemically important financial service providers, their influence is expected to filter down in varying degrees to smaller institutions over time. Management of the Company and the Bank will continue to evaluate the effect of the Dodd-Frank Act changes; however, in many respects, the ultimate impact of the Dodd-Frank Act will not be fully known for years, and no current assurance may be given that the Dodd-Frank Act, or any other new legislative changes, will not have a negative impact on the results of operations and financial condition of the Company and the Bank.

 

The Increasing Regulatory Emphasis on Capital

 

Regulatory capital represents the net assets of a financial institution available to absorb losses. Because of the risks attendant to their business, depository institutions are generally required to hold more capital than other businesses, which directly affects earnings capabilities. While capital has historically been one of the key measures of the financial health of both bank holding companies and banks, its role is becoming fundamentally more important in the wake of the global financial crisis, as the banking regulators recognized that the amount and quality of capital held by banks prior to the crisis was insufficient to absorb losses during periods of severe stress. Certain provisions of the Dodd-Frank Act and Basel III, discussed below, establish strengthened capital standards for banks and bank holding companies, require more capital to be held in the form of common stock and disallow certain funds from being included in capital determinations. Once fully implemented, these standards will represent regulatory capital requirements that are meaningfully more stringent than those in place historically.

 

The Company and Bank Required Capital Levels.  Bank holding companies have historically had to comply with less stringent capital standards than their bank subsidiaries and were able to raise capital with hybrid instruments such as trust preferred securities. The Dodd-Frank Act mandated the Federal Reserve to establish minimum capital levels for bank holding companies on a consolidated basis that are as stringent as those required for insured depository institutions. As a consequence, the components of holding company permanent capital known as “Tier 1 Capital” are being restricted to capital instruments that are considered to be Tier 1 Capital for insured depository institutions. A result of this change is that the proceeds of hybrid instruments, such as trust preferred securities, are being excluded from Tier 1 Capital unless such securities were issued prior to May 19, 2010 by bank holding companies with less than $15 billion of assets. Because the Company has assets of less than $15 billion, it is able to maintain its trust preferred proceeds, subject to certain restrictions, as Tier 1 Capital but will

 

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have to comply with new capital mandates in other respects and will not be able to raise Tier 1 Capital in the future through the issuance of trust preferred securities.

 

Under current federal regulations, the Bank is subject to the following minimum capital standards:

 

·                 A leverage requirement, consisting of a minimum ratio of Tier 1 Capital to total adjusted book assets of 3% for the most highly-rated banks with a minimum requirement of at least 4% for all others;

 

·                 A risk-based capital requirement, consisting of a minimum ratio of Total Capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 Capital to total risk-weighted assets of 4%;

 

·                 For this purpose, “Tier 1 Capital” consists primarily of common stock, noncumulative perpetual preferred stock and related surplus less intangible assets (other than certain loan servicing rights and purchased credit card relationships).  Total Capital consists primarily of Tier 1 Capital plus “Tier 2 Capital,” which includes other non-permanent capital items, such as certain other debt and equity instruments that do not qualify as Tier 1 Capital, and a portion of the Bank’s allowance for loan and lease losses; and

 

·                 Further, risk-weighted assets for the purposes of the risk-weighted ratio calculations are balance sheet assets and off-balance sheet exposures to which required risk-weightings of 0% to 100% are applied.

 

The capital standards described above are minimum requirements and will be increased under Basel III, as discussed below. Bank regulatory agencies are uniformly encouraging banks and bank holding companies to be “well-capitalized” and, to that end, federal law and regulations provide various incentives for banking organizations to maintain regulatory capital at levels in excess of minimum regulatory requirements. For example, a banking organization that is “well-capitalized” may: (i) qualify for exemptions from prior notice or application requirements otherwise applicable to certain types of activities; (ii) qualify for expedited processing of other required notices or applications; and (iii) accept brokered deposits. Under the capital regulations of the OCC and Federal Reserve, in order to be “well-capitalized,” a banking organization, under current federal regulations, must maintain:

 

·           A leverage ratio of Tier 1 Capital to total assets of 5% or greater;

 

·           A ratio of Tier 1 Capital to total risk-weighted assets of 6% or greater; and

 

·           A ratio of Total Capital to total risk-weighted assets of 10% or greater.

 

The OCC and Federal Reserve guidelines also provide that banks and bank holding companies experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines indicate that the agencies will continue to consider a “tangible Tier 1 leverage ratio” (deducting all intangibles) in evaluating proposals for expansion or to engage in new activities.

 

Higher capital levels may also be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 Capital less all intangible assets), well above the minimum levels.

 

Prompt Corrective ActionA banking organization’s capital plays an important role in connection with regulatory enforcement as well.  Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions.  The extent of the regulators’ powers depends on whether the institution in question is “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation.  Depending upon the capital category to which an institution is assigned, the

 

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regulators’ corrective powers include: (i) requiring the institution to submit a capital restoration plan; (ii) limiting the institution’s asset growth and restricting its activities; (iii) requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; (iv) restricting transactions between the institution and its affiliates; (v) restricting the interest rate that the institution may pay on deposits; (vi) ordering a new election of directors of the institution; (vii) requiring that senior executive officers or directors be dismissed; (viii) prohibiting the institution from accepting deposits from correspondent banks; (ix) requiring the institution to divest certain subsidiaries; (x) prohibiting the payment of principal or interest on subordinated debt; and (xi) ultimately, appointing a receiver for the institution.

 

As of December 31, 2013, the Bank exceeded its minimum regulatory capital requirements under OCC capital adequacy guidelines.  As of December 31, 2013, the Bank exceeded the heightened regulatory capital ratios to which it had agreed.  As of December 31, 2013, the Company had regulatory capital in excess of the Federal Reserve’s requirements and met the Dodd-Frank Act requirements.

 

The Basel International Capital Accords. The current risk-based capital guidelines described above, which apply to the Bank and are being phased in for the Company, are based upon the 1988 capital accord known as “Basel I” adopted by the international Basel Committee on Banking Supervision, a committee of central banks and bank supervisors, as implemented by the U.S. federal banking regulators on an interagency basis. In 2008, the banking agencies collaboratively began to phase-in capital standards based on a second capital accord, referred to as “Basel II,” for large or “core” international banks (generally defined for United States’ purposes as having total assets of $250 billion or more, or consolidated foreign exposures of $10 billion or more). Basel II emphasized internal assessment of credit, market and operational risk, as well as supervisory assessment and market discipline in determining minimum capital requirements.

 

On September 12, 2010, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced agreement on a strengthened set of capital requirements for banking organizations around the world, known as Basel III, to address deficiencies recognized in connection with the global financial crisis. Basel III was intended to be effective globally on January 1, 2013, with phase-in of certain elements continuing until January 1, 2019, and it is currently effective in many countries.

 

United States Implementation of Basel III. After an extended rulemaking process that included a prolonged comment period, in July 2013, the U.S. federal banking agencies approved the implementation of the Basel III regulatory capital reforms in pertinent part, and, at the same time, promulgated rules effecting certain changes required by the Dodd-Frank Act (the “Basel III Rule”).  In contrast to capital requirements historically, which were in the form of guidelines, Basel III was released in the form of regulations by each of the agencies.  The Basel III Rule is applicable to all U.S. banks that are subject to minimum capital requirements, including federal and state banks and savings and loan associations, as well as to bank and savings and loan holding companies other than “small bank holding companies” (generally bank holding companies with consolidated assets of less than $500 million).

 

The Basel III Rule not only increases most of the required minimum capital ratios, but it introduces the concept of Common Equity Tier 1 Capital, which consists primarily of common stock, related surplus (net of Treasury stock), retained earnings, and Common Equity Tier 1 minority interests subject to certain regulatory adjustments.  The Basel III Rule also expanded the definition of capital as in effect currently by establishing more stringent criteria that instruments must meet to be considered Additional Tier 1 Capital (Tier 1 Capital in addition to Common Equity) and Tier 2 Capital.  A number of instruments that now qualify as Tier 1 Capital will not qualify, or their qualifications will change. For example, cumulative preferred stock and certain hybrid capital instruments, including trust preferred securities, will no longer qualify as Tier 1 Capital of any kind, with the exception, subject to certain restrictions, of such instruments issued before May 10, 2010, by bank holding companies with total consolidated assets of less than $15 billion as of December 31, 2009. For those institutions, trust preferred securities and other nonqualifying capital instruments currently included in consolidated Tier 1 Capital are permanently

 

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grandfathered under the Basel III Rule, subject to certain restrictions.  Noncumulative perpetual preferred stock, which now qualifies as simple Tier 1 Capital, will not qualify as Common Equity Tier 1 Capital, but will qualify as Additional Tier 1 Capital. The Basel III Rule also constrains the inclusion of minority interests, mortgage-servicing assets, and deferred tax assets in capital and requires deductions from Common Equity Tier 1 Capital in the event such assets exceed a certain percentage of a bank’s Common Equity Tier 1 Capital.

 

The Basel III Rule requires:

 

·                 A new required ratio of minimum Common Equity Tier 1 equal to 4.5% of risk-weighted assets;

 

·                 An increase in the minimum required amount of Tier 1 Capital from the current level of 4% of total assets to 6% of risk-weighted assets;

 

·                 A continuation of the current minimum required amount of Total Capital (Tier 1 plus Tier 2) at 8% of risk-weighted assets; and

 

·                 A minimum leverage ratio of Tier 1 Capital to total assets equal to 4% in all circumstances.

 

In addition, institutions that seek the freedom to make capital distributions (including for dividends and repurchases of stock) and pay discretionary bonuses to executive officers without restriction must also maintain 2.5% in Common Equity Tier 1 attributable to a capital conservation buffer to be phased in over three years beginning in 2016. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. Factoring in the fully phased-in conservation buffer increases the minimum ratios depicted above to 7% for Common Equity Tier 1, 8.5% for Tier 1 Capital and 10.5% for Total Capital.  The required leverage ratio is not impacted by the conservation buffer.

 

The Basel III Rule maintained the general structure of the current prompt corrective action framework, while incorporating the increased requirements. The prompt corrective action guidelines were also revised to add the Common Equity Tier 1 Capital ratio.  In order to be a “well-capitalized” depository institution under the new regime, a bank and holding company must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more; a Tier 1 Capital ratio of 8% or more; a Total Capital ratio of 10% or more; and a leverage ratio of 5% or more.  It is possible under the Basel III Rule to be well-capitalized while remaining out of compliance with the capital conservation buffer discussed above.

 

The Basel III Rule revises a number of the risk weightings (or their methodologies) for bank assets that are used to determine the capital ratios. For nearly every class of assets, the Basel III Rule requires a more complex, detailed and calibrated assessment of credit risk and calculation of risk weightings. While Basel III would have changed the risk-weighting for residential mortgage loans based on loan-to-value ratios and certain product and underwriting characteristics, there was concern in the United States that the proposed methodology for risk weighting residential mortgage exposures and the higher risk weightings for certain types of mortgage products would increase costs to consumers and reduce their access to mortgage credit. As a result, the Basel III Rule did not effect this change, and banks will continue to apply a risk weight of 50% or 100% to their exposure from residential mortgages, with the risk weighting depending on, among other things, whether the mortgage was a prudently underwritten first lien mortgage.

 

Furthermore, there was significant concern noted by the financial industry in connection with the Basel III rulemaking as to the proposed treatment of accumulated other comprehensive income (“AOCI”). Basel III requires unrealized gains and losses on available-for-sale securities to flow through to regulatory capital as opposed to the current treatment, which neutralizes such effects.  Recognizing the problem for community banks, the U.S. bank regulatory agencies adopted the Basel III Rule with a one-time election for smaller institutions like the Company and the Bank to opt out of including most elements of AOCI in regulatory capital.  This opt-out, which must be made in the first quarter of 2015, would exclude from regulatory capital both unrealized gains and losses on available-for-sale debt securities and accumulated

 

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net gains and losses on cash-flow hedges and amounts attributable to defined benefit post-retirement plans. The Company is currently evaluating whether it will make the opt-out election.

 

Generally, financial institutions (except for large, internationally active financial institutions) become subject to the new rules on January 1, 2015.  However, there will be separate phase-in/phase-out periods for: (i) the capital conservation buffer; (ii) regulatory capital adjustments and deductions; (iii) nonqualifying capital instruments; and (iv) changes to the prompt corrective action rules. The phase-in periods commence on January 1, 2016 and extend until 2019.

 

The Company

 

General.  The Company, as the sole shareholder of the Bank, is a bank holding company.  As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the “BHCA”).  In accordance with Federal Reserve policy, and as now codified by the Dodd-Frank Act, the Company is legally obligated to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where the Company might not otherwise do so.  Under the BHCA, the Company is subject to periodic examination by the Federal Reserve.  The Company is required to file with the Federal Reserve periodic reports of the Company’s operations and such additional information regarding the Company and its subsidiaries as the Federal Reserve may require.

 

Enforcement Action. On July 22, 2011, the Company entered into a Written Agreement with the Federal Reserve Bank of Chicago (the “Reserve Bank”) that was terminated on January 17, 2014 (the “Written Agreement”).  Under the terms of the Written Agreement, the Company was required to, among other things: (i) fully utilize its financial and managerial resources to serve as a source of strength to the Bank; (ii) obtain the written approval of the Reserve Bank (and in certain cases, the Federal Reserve) prior to the declaration or payment of any dividends, the acceptance of dividends or any other form of capital distribution from the Bank, and the payment of principal, interest, or other sums on subordinated debentures or trust preferred securities; (iii) obtain the written approval of the Reserve Bank prior to incurring, increasing, or guaranteeing any debt, or repurchasing or redeeming any stock; (iv) develop, submit to the Reserve Bank, and implement a capital plan, and notify the Reserve Bank if any of the Company’s quarterly capital ratios fell below the minimum ratios set forth in the approved capital plan, along with a written plan to increase any applicable capital ratio to or above the approved minimum level; and (v) for each calendar year that the Written Agreement was in effect, submit to the Reserve Bank annual cash flow projections.  The Company was also required to submit certain reports to the Reserve Bank with respect to the foregoing requirements. Although the Written Agreement has been terminated, the Company expects that it will continue to seek approval from the Reserve Bank prior to paying any dividends on its capital stock and incurring any additional indebtedness.

 

Acquisitions, Activities and Change in Control.  The primary purpose of a bank holding company is to control and manage banks.  The BHCA generally requires the prior approval of the Federal Reserve for any merger involving a bank holding company or any acquisition by a bank holding company of another bank or bank holding company.  Subject to certain conditions (including deposit concentration limits established by the BHCA and the Dodd-Frank Act), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States. In approving interstate acquisitions, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws that require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.  Furthermore, in accordance with the Dodd-Frank Act, bank holding companies must be well-capitalized and well-managed in order to effect interstate mergers or acquisitions.  For a discussion of the capital requirements, see “The Increasing Regulatory Emphasis on Capital” above.

 

The BHCA generally prohibits the Company from acquiring direct or indirect ownership or control of

 

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more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries.  This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve prior to November 11, 1999 to be “so closely related to banking ... as to be a proper incident thereto.”  This authority would permit the Company to engage in a variety of banking-related businesses, including the ownership and operation of a savings association, or any entity engaged in consumer finance, equipment leasing, the operation of a computer service bureau (including software development) and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.

 

Additionally, bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of nonbanking activities, including securities and insurance underwriting and sales, merchant banking and any other activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature or incidental to any such financial activity or that the Federal Reserve determines by order to be complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.  The Company does not currently operate as a financial holding company.

 

Federal law also prohibits any person or company from acquiring “control” of an FDIC-insured depository institution or its holding company without prior notice to the appropriate federal bank regulator.  “Control” is conclusively presumed to exist upon the acquisition of 25% or more of the outstanding voting securities of a bank or bank holding company, but may arise under certain circumstances between 10% and 24.99% ownership.

 

Capital Requirements.  Bank holding companies are required to maintain capital in accordance with Federal Reserve capital adequacy requirements, as affected by the Dodd-Frank Act and Basel III.  For a discussion of capital requirements, see “—The Increasing Regulatory Emphasis on Capital” above.

 

U.S. Government Investment in Bank Holding Companies.  Events in the United States and global financial markets leading up to the global financial crisis, including deterioration of the worldwide credit markets, created significant challenges for financial institutions throughout the country beginning in 2008.  In response to this crisis affecting the U.S. banking system and financial markets, on October 3, 2008, the U.S. Congress passed, and the President signed into law, the Emergency Economic Stabilization Act of 2008 (the “EESA”).  The EESA authorized the Secretary of the Treasury to implement various temporary emergency programs designed to strengthen the capital positions of financial institutions and stimulate the availability of credit within the U.S. financial system.  Financial institutions participating in certain of the programs established under the EESA are required to adopt the Treasury’s standards for executive compensation and corporate governance.

 

On October 14, 2008, the Treasury announced that it would provide Tier 1 capital (in the form of perpetual preferred stock and common stock warrants) to eligible financial institutions.  This program, known as the TARP Capital Purchase Program (the “CPP”), allocated $250 billion from the $700 billion authorized by the EESA to the Treasury for the purchase of senior preferred shares from qualifying financial institutions (the “CPP Preferred Stock”).  Under the program, eligible institutions were able to sell equity interests to the Treasury in amounts equal to between 1% and 3% of the institution’s risk-weighted assets.  The CPP Preferred Stock is non-voting and pays dividends at the rate of 5% per annum for the first five years and thereafter at a rate of 9% per annum.  In conjunction with the purchase of the CPP Preferred Stock, the Treasury received warrants to purchase common stock from the participating public institutions with an aggregate market price equal to 15% of the preferred stock investment.  Participating financial institutions were required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the CPP.  These requirements are discussed in more detail in item 11 of this Form 10-K.

 

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Pursuant to the CPP, on January 16, 2009, the Company entered into a Letter Agreement with the Treasury, pursuant to which the Company issued (i) 73,000 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B (the “Series B Preferred Stock”) and (ii) a warrant to purchase 815,339 shares of the Company’s common stock for an aggregate purchase price of $73.0 million in cash.  During the fourth quarter of 2012, the Treasury announced the continuation of individual auctions of the CPP Preferred Stock and informed the Company that its Series B Preferred Stock would be auctioned.  Auctions for the Company’s Series B Preferred Stock were held in the first quarter of 2013.  As a result of the auctions, all of the shares of the Company’s Series B Preferred Stock were sold to third parties, including certain of the Company’s directors.  The warrant to purchase 815,339 shares of the Company’s common stock was also sold to a third party in a separate auction.

 

Dividend Payments. The Company’s ability to pay dividends to its shareholders may be affected by both general corporate law considerations and policies of the Federal Reserve applicable to bank holding companies.  As a Delaware corporation, the Company is subject to the limitations of the Delaware General Corporation Law (the “DGCL”). The DGCL allows the Company to pay dividends only out of its surplus (as defined and computed in accordance with the provisions of the DGCL) or if the Company has no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.

 

As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should eliminate, defer or significantly reduce dividends to shareholders if:  (i) the company’s net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) the prospective rate of earnings retention is inconsistent with the company’s capital needs and overall current and prospective financial condition; or (iii) the company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.  The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.  Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.  Although the Written Agreement has been terminated, the Company expects that it will continue to seek approval from the Reserve Bank prior to paying any dividends on its capital stock and incurring any additional indebtedness.

 

Furthermore, the Company’s ability to pay dividends on its common stock is restricted by the terms of certain of its other securities.  For example, under the terms of certain of the Company’s junior subordinated debentures, it may not pay dividends on its capital stock unless all accrued and unpaid interest payments on the subordinated debentures have been fully paid.  On August 31, 2010, the Company announced that it had elected to begin deferring the interest payments due on the junior subordinated debentures described above, as well as the dividend payments due on the CPP Preferred Stock, and therefore may not pay common stock dividends until such time as these deferred payments have been made in full.

 

Federal Securities Regulation.  The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Consequently, the Company is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.

 

Corporate Governance.  The Dodd-Frank Act addresses many investor protection, corporate governance and executive compensation matters that will affect most U.S. publicly traded companies.  The Dodd-Frank Act increased shareholder influence over boards of directors by requiring companies to give shareholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizing the SEC to promulgate rules that would allow shareholders to nominate and solicit voters for their own candidates using a company’s proxy materials. The legislation also directed the Federal Reserve to promulgate rules prohibiting excessive compensation paid to executives of bank holding companies, regardless of whether such companies are publicly traded.

 

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The Bank

 

General.  The Bank is a national bank, chartered by the OCC under the National Bank Act.  The deposit accounts of the Bank are insured by the FDIC’s Deposit Insurance Fund (the “DIF”) to the maximum extent provided under federal law and FDIC regulations, and the Bank is a member of the Federal Reserve System.  As a national bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the OCC. The FDIC, as administrator of the DIF, also has regulatory authority over the Bank.

 

Enforcement Action.  On May 16, 2011, the Bank entered into a Consent Order with the OCC that was terminated on October 17, 2013 (the “Consent Order”).  Under the terms of the Consent Order, the Bank was required to, among other things: (i) adopt and adhere to a three-year written strategic plan that established objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in nonperforming assets and its product development; (ii) adopt and maintain a capital plan; (iii) by September 30, 2011, achieve and thereafter maintain a total risk-based capital ratio of at least 11.25% and a Tier 1 capital ratio of at least 8.75%; (iv) seek approval of the OCC prior to paying any dividends on its capital stock; (v) develop a program to reduce the Bank’s credit risk; (vi) obtain or update appraisals on certain loans secured by real estate; (vii) implement processes to ensure that real estate valuations conform to applicable standards; (viii) take certain actions related to credit and collateral exceptions; (ix) reaffirm the Bank’s liquidity risk management program; and (x) appoint a compliance committee of the Bank’s board of directors to help ensure the Bank’s compliance with the Consent Order.  The Bank was also required to submit certain reports to the OCC with respect to the foregoing requirements.  Even though the Consent Order has been terminated, the Bank is still subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighting of the Bank’s assets, developed by the OCC and the other bank regulatory agencies.  In connection with the current economic environment, the Bank’s current level of nonperforming assets and the risk-based capital guidelines, the Bank’s board of directors has determined the Bank should maintain a Tier 1 leverage ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%).  The Bank currently exceeds these thresholds.

 

Deposit Insurance.  As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC.  The FDIC has adopted a risk-based assessment system whereby FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification.  An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators.

 

Amendments to the Federal Deposit Insurance Act also revised the assessment base against which an insured depository institution’s deposit insurance premiums paid to the DIF are calculated.  Under the amendments, the assessment base is no longer the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity.  This may shift the burden of deposit insurance premiums toward those large depository institutions that rely on funding sources other than U.S. deposits.  Additionally, the Dodd-Frank Act made changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits, and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds.  The FDIC is given until September 3, 2020 to meet the 1.35% reserve ratio target. Several of these provisions could increase the Bank’s FDIC deposit insurance premiums.

 

The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks to $250,000 per insured depositor.

 

FICO Assessments.  The Financing Corporation (“FICO”) is a mixed-ownership governmental corporation chartered by the former Federal Home Loan Bank Board pursuant to the Competitive Equality Banking Act of 1987 to function as a financing vehicle for the recapitalization of the former Federal Savings and Loan Insurance Corporation.  FICO issued 30-year noncallable bonds of approximately $8.1 billion that mature in 2017 through 2019.  FICO’s authority to issue bonds ended on December 12, 1991.  Since 1996, federal legislation has required that all FDIC-insured depository

 

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institutions pay assessments to cover interest payments on FICO’s outstanding obligations.  These FICO assessments are in addition to amounts assessed by the FDIC for deposit insurance. The FICO assessment rate is adjusted quarterly and for the fourth quarter of 2013 was approximately 0.0064%, which reflects the changes from an assessment base computed on deposits to an assessment base computed on assets as required by the Dodd-Frank Act.

 

Supervisory Assessments.  National banks are required to pay supervisory assessments to the OCC to fund the operations of the OCC.  The amount of the assessment is calculated using a formula that takes into account the bank’s size and its supervisory condition.  During the year ended December 31, 2013, the Bank paid supervisory assessments to the OCC totaling $809,000.

 

Capital Requirements.  Banks are generally required to maintain capital levels in excess of other businesses.  For a discussion of capital requirements, see “—The Increasing Regulatory Emphasis on Capital” above.

 

Dividend Payments.  The primary source of funds for the Company is dividends from the Bank.  Under the National Bank Act, a national bank may pay dividends out of its undivided profits in such amounts and at such times as the bank’s board of directors deems prudent.  Without prior OCC approval, however, a national bank may not pay dividends in any calendar year that, in the aggregate, exceed the bank’s year-to-date net income plus the bank’s retained net income for the two preceding years.

 

The payment of dividends by any financial institution is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized.  As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2013.

 

Insider Transactions.  The Bank is subject to restrictions imposed by federal law on “covered transactions” between the Bank and its “affiliates.” The Company is an affiliate of the Bank for purposes of these restrictions, and covered transactions subject to the restrictions include extensions of credit to the Company, investments in the stock or other securities of the Company and the acceptance of the stock or other securities of the Company as collateral for loans made by the Bank.  The Dodd-Frank Act enhanced the requirements for certain transactions with affiliates as of July 21, 2011, including an expansion of the definition of “covered transactions” and an increase in the amount of time for which collateral requirements regarding covered transactions must be maintained.

 

Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiaries, to principal shareholders of the Company and to “related interests” of such directors, officers and principal shareholders.  In addition, federal law and regulations may affect the terms upon which any person who is a director or officer of the Company or the Bank, or a principal shareholder of the Company, may obtain credit from banks with which the Bank maintains a correspondent relationship.

 

Safety and Soundness Standards/Risk Management.  The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions.  The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

 

In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals.  If an institution fails to comply with any of the standards set forth in the guidelines, the institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the institution’s rate of growth, require the institution to increase its capital,

 

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restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.

 

During the past decade, the bank regulatory agencies have increasingly emphasized the importance of sound risk management processes and strong internal controls when evaluating the activities of the institutions they supervise.  Properly managing risks has been identified as critical to the conduct of safe and sound banking activities and has become even more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking markets.  The agencies have identified a spectrum of risks facing a banking institution including, but not limited to, credit, market, liquidity, operational, legal, and reputational risk. In particular, recent regulatory pronouncements have focused on operational risk, which arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses. The Bank is expected to have active board and senior management oversight; adequate policies, procedures, and limits; adequate risk measurement, monitoring, and management information systems; and comprehensive internal controls.

 

Branching Authority.  National banks headquartered in Illinois, such as the Bank, have the same branching rights in Illinois as banks chartered under Illinois law, subject to OCC approval.  Illinois law grants Illinois-chartered banks the authority to establish branches anywhere in the State of Illinois, subject to receipt of all required regulatory approvals.

 

Federal law permits state and national banks to merge with banks in other states subject to: (i) regulatory approval; (ii) federal and state deposit concentration limits; and (iii) state law limitations requiring the merging bank to have been in existence for a minimum period of time (not to exceed five years) prior to the merger.  The establishment of new interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) has historically been permitted only in those states the laws of which expressly authorize such expansion. However, the Dodd-Frank Act permits well-capitalized and well-managed banks to establish new branches across state lines without these impediments.

 

Financial Subsidiaries.  Under federal law and OCC regulations, national banks are authorized to engage, through “financial subsidiaries,” in any activity that is permissible for a financial holding company and any activity that the Secretary of the Treasury, in consultation with the Federal Reserve, determines is financial in nature or incidental to any such financial activity, except (i) insurance underwriting, (ii) real estate development or real estate investment activities (unless otherwise permitted by law), (iii) insurance company portfolio investments and (iv) merchant banking.  The authority of a national bank to invest in a financial subsidiary is subject to a number of conditions, including, among other things, requirements that the bank must be well-managed and well-capitalized (after deducting from capital the bank’s outstanding investments in financial subsidiaries).  The Bank has not applied for approval to establish any financial subsidiaries.

 

Transaction Account Reserves.  Federal Reserve regulations require depository institutions to maintain reserves against their transaction accounts (primarily NOW and regular checking accounts).  For 2014: the first $13.3 million of otherwise reservable balances are exempt from the reserve requirements; for transaction accounts aggregating more than $13.3 million to $89.0 million, the reserve requirement is 3% of total transaction accounts; and for net transaction accounts in excess of $89.0 million, the reserve requirement is $2,271,000 plus 10% of the aggregate amount of total transaction accounts in excess of $89.0 million.  These reserve requirements are subject to annual adjustment by the Federal Reserve.  The Bank is in compliance with the foregoing requirements.

 

Federal Home Loan Bank System.  The Bank is a member of the Federal Home Loan Bank of Chicago (the “FHLBC”), which serves as a central credit facility for its members. The FHLBC is funded primarily from proceeds from the sale of obligations of the FHLBC system. It makes loans to member banks in the form of FHLBC advances. All advances from the FHLBC are required to be fully collateralized as

 

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determined by the FHLBC.

 

Community Reinvestment Act Requirements.  The Community Reinvestment Act requires the Bank to have a continuing and affirmative obligation in a safe and sound manner to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods.  Federal regulators regularly assess the Bank’s record of meeting the credit needs of its communities. Applications for additional acquisitions would be affected by the evaluation of the Bank’s effectiveness in meeting its Community Reinvestment Act requirements.

 

Anti-Money Laundering.  The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”) is designed to deny terrorists and criminals the ability to obtain access to the U.S. financial system and has significant implications for depository institutions, brokers, dealers and other businesses involved in the transfer of money. The Patriot Act mandates financial services companies to have policies and procedures with respect to measures designed to address any or all of the following matters: (i) customer identification programs; (ii) money laundering; (iii) terrorist financing; (iv) identifying and reporting suspicious activities and currency transactions; (v) currency crimes; and (vi) cooperation between financial institutions and law enforcement authorities.

 

Commercial Real Estate Guidance.  The interagency Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices guidance (“CRE Guidance”) provides supervisory criteria, including the following numerical indicators, to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny: (i) commercial real estate loans exceeding 300% of risk-based capital and increasing 50% or more in the preceding three years; or (ii) construction and land development loans exceeding 100% of risk-based capital. The CRE Guidance does not limit banks’ levels of commercial real estate lending activities, but rather guides institutions in developing risk management practices and levels of capital that are commensurate with the level and nature of their commercial real estate concentrations. Based on the Bank’s current loan portfolio, the Bank does not exceed these guidelines.

 

Consumer Financial Services

 

There are numerous developments in federal and state laws regarding consumer financial products and services that impact the Bank’s business. Importantly, the current structure of federal consumer protection regulation applicable to all providers of consumer financial products and services changed significantly on July 21, 2011, when the CFPB commenced operations to supervise and enforce consumer protection laws. The CFPB has broad rulemaking authority for a wide range of consumer protection laws that apply to all providers of consumer products and services, including the Bank, as well as the authority to prohibit “unfair, deceptive or abusive” acts and practices. The CFPB has examination and enforcement authority over providers with more than $10 billion in assets. Banks and savings institutions with $10 billion or less in assets, like the Bank, will continue to be examined by their applicable bank regulators.  Below are additional recent regulatory developments relating to consumer mortgage lending activities.  The Company does not currently expect these provisions to have a significant impact on Bank operations; however, additional compliance resources will be needed to monitor changes.

 

Ability-to-Repay Requirement and Qualified Mortgage Rule. The Dodd-Frank Act contains additional provisions that affect consumer mortgage lending. First, it significantly expands underwriting requirements applicable to loans secured by 1-4 family residential real property and augments federal law combating predatory lending practices. In addition to numerous new disclosure requirements, the Dodd-Frank Act imposes new standards for mortgage loan originations on all lenders, including banks and savings associations, in an effort to strongly encourage lenders to verify a borrower’s ability to repay, while also establishing a presumption of compliance for certain “qualified mortgages.” In addition, the Dodd-Frank Act generally requires lenders or securitizers to retain an economic interest in the credit risk relating to loans that the lender sells, and other asset-backed securities that the securitizer issues, if the loans have not complied with the ability-to-repay standards. The risk retention requirement generally will be 5%, but could be increased or decreased by regulation.

 

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On January 10, 2013, the CFPB issued a final rule, effective January 10, 2014, that implements the Dodd-Frank Act’s ability-to-repay requirements and clarifies the presumption of compliance for “qualified mortgages.”  In assessing a borrower’s ability to repay a mortgage-related obligation, lenders generally must consider eight underwriting factors:  (i) current or reasonably expected income or assets; (ii) current employment status; (iii) monthly payment on the subject transaction; (iv) monthly payment on any simultaneous loan; (v) monthly payment for all mortgage-related obligations; (vi) current debt obligations, alimony, and child support; (vii) monthly debt-to-income ratio or residual income; and (viii) credit history.  The final rule also includes guidance regarding the application of, and methodology for evaluating, these factors.

 

Further, the final rule also clarifies that qualified mortgages do not include “no-doc” loans and loans with negative amortization, interest-only payments, balloon payments, terms in excess of 30 years, or points and fees paid by the borrower that exceed 3% of the loan amount, subject to certain exceptions.  In addition, for qualified mortgages, the monthly payment must be calculated on the highest payment that will occur in the first five years of the loan, and the borrower’s total debt-to-income ratio generally may not be more than 43%.  The final rule also provides that certain mortgages that satisfy the general product feature requirements for qualified mortgages and that also satisfy the underwriting requirements of Fannie Mae and Freddie Mac (while they operate under federal conservatorship or receivership) or the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service are also considered to be qualified mortgages.  This second category of qualified mortgages will phase out as the aforementioned federal agencies issue their own rules regarding qualified mortgages, the conservatorship of Fannie Mae and Freddie Mac ends, and, in any event, after seven years.

 

As set forth in the Dodd-Frank Act, subprime (or higher-priced) mortgage loans are subject to the ability-to-repay requirement, and the final rule provides for a rebuttable presumption of lender compliance for those loans. The final rule also applies the ability-to-repay requirement to prime loans, while also providing a conclusive presumption of compliance (i.e., a safe harbor) for prime loans that are also qualified mortgages. Additionally, the final rule generally prohibits prepayment penalties (subject to certain exceptions) and sets forth a 3-year record retention period with respect to documenting and demonstrating the ability-to-repay requirement and other provisions.

 

Changes to Mortgage Loan Originator Compensation. Effective April 2, 2011, previously existing regulations concerning the compensation of mortgage loan originators were amended. As a result of these amendments, mortgage loan originators may not receive compensation based on a mortgage transaction’s terms or conditions other than the amount of credit extended under the mortgage loan. Further, the new standards limit the total points and fees that a bank and/or a broker may charge on conforming and jumbo loans to 3% of the total loan amount. Mortgage loan originators may receive compensation from a consumer or from a lender, but not both. These rules contain requirements designed to prohibit mortgage loan originators from “steering” consumers to loans that provide mortgage loan originators with greater compensation. In addition, the rules contain other requirements concerning recordkeeping.

 

Foreclosure and Loan Modifications. Federal and state laws further impact foreclosures and loan modifications, with many of such laws having the effect of delaying or impeding the foreclosure process on real estate secured loans in default. Mortgages on commercial property can be modified, such as by reducing the principal amount of the loan or the interest rate, or by extending the term of the loan, through plans confirmed under Chapter 11 of the Bankruptcy Code. In recent years, legislation has been introduced in the U.S. Congress that would amend the Bankruptcy Code to permit the modification of mortgages secured by residences, although at this time the enactment of such legislation is not presently proposed. The scope, duration and terms of potential future legislation with similar effect continue to be discussed. The Company cannot predict whether any such legislation will be passed or the impact, if any, it would have on the Company’s business.

 

Servicing.  On January 17, 2013, the CFPB announced rules to implement certain provisions of the Dodd-Frank Act relating to mortgage servicing. The new servicing rules require servicers to meet certain

 

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benchmarks for loan servicing and customer service in general.  Servicers must provide periodic billing statements and certain required notices and acknowledgments, promptly credit borrowers’ accounts for payments received and promptly investigate complaints by borrowers and are required to take additional steps before purchasing insurance to protect the lender’s interest in the property.  The new servicing rules also call for additional notice, review and timing requirements with respect to delinquent borrowers, including early intervention, ongoing access to servicer personnel and specific loss mitigation and foreclosure procedures.  The rules provide for an exemption from most of these requirements for “small servicers.” A small servicer is defined as a loan servicer that services 5,000 or fewer mortgage loans and services only mortgage loans that they or an affiliate originated or own. The new servicing rules took effect on January 10, 2014.  Bank management is continuing to evaluate the full impact of these rules and their impact on mortgage servicing operations.

 

Additional Constraints on the Company and Bank

 

Monetary Policy.  The monetary policy of the Federal Reserve has a significant effect on the operating results of financial or bank holding companies and their subsidiaries. Among the tools available to the Federal Reserve to affect the money supply are open market transactions in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid on deposits.

 

The Volcker Rule.  In addition to other implications of the Dodd-Frank Act discussed above, the act amends the BHC Act to require the federal regulatory agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (defined as hedge funds and private equity funds).  This statutory provision is commonly called the “Volcker Rule.” On December 10, 2013, the federal regulatory agencies issued final rules to implement the prohibitions required by the Volcker Rule. Thereafter, in reaction to industry concern over the adverse impact to community banks of the treatment of certain collateralized debt instruments in the final rule, the federal regulatory agencies approved an interim final rule to permit banking entities to retain interests in collateralized debt obligations backed primarily by trust preferred securities (“TruPS CDOs”) from the investment prohibitions contained in the final rule. Under the interim final rule, the agencies permit the retention of an interest in or sponsorship of covered funds by banking entities under $15 billion in assets if the following qualifications are met:

 

·                 The TruPS CDO was established, and the interest was issued, before May 19, 2010;

 

·                 The banking entity reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in qualifying TruPS collateral; and

 

·                 The banking entity's interest in the TruPS CDO was acquired on or before December 10, 2013.

 

Although the Volcker Rule has significant implications for many large financial institutions, the Company sold its TruPS CDOs in December of 2013, and, consequently, the Company does not believe that the Volcker Rule will have a material effect on the operations of the Company or the Bank going forward.  The Company may incur costs if it is required to adopt additional policies and systems to ensure compliance with the Volcker Rule, but any such costs are not expected to be material.  Until the application of the final rules is fully understood, the precise financial impact of the rule on the Company, the Bank, its customers or the financial industry more generally, cannot be determined.

 

GUIDE 3 STATISTICAL DATA REQUIREMENTS

 

The statistical data required by Guide 3 of the Guides for Preparation and Filing of Reports and Registration Statements under the Securities Exchange Act of 1934 is set forth in the following pages.  This data should be read in conjunction with the consolidated financial statements, related notes and

 

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"Management's Discussion and Analysis of Financial Condition and Results of Operations" as set forth in Part II Items 7 and 8.  All dollars in the tables are expressed in thousands.

 

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I.                                       Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rate and Interest Differential.

 

The following table sets forth certain information relating to the Company’s average consolidated balance sheets and reflects the yield on average earning assets and cost of average liabilities for the years indicated.  Dividing the related interest by the average balance of assets or liabilities derives rates.  Average balances are derived from daily balances.

 

ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

Years ended December 31, 2013, 2012 and 2011

 

 

 

 

 

2013

 

 

 

 

 

2012

 

 

 

 

 

2011

 

 

 

 

Average

 

 

 

 

 

Average

 

 

 

 

 

Average

 

 

 

 

 

 

Balance

 

Interest

 

Rate

 

Balance

 

Interest

 

Rate

 

Balance

 

Interest

 

Rate

ASSETS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing deposits

 

 $

43,801

 

 $

108

 

0.24%

 

 $

48,820

 

 $

119

 

0.24%

 

 $

92,830

 

 $

230

 

0.24%

Federal funds sold

 

-

 

-

 

-

 

-

 

-

 

-

 

533

 

1

 

0.19

Securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

586,188

 

11,692

 

1.99

 

395,225

 

7,212

 

1.82

 

161,986

 

3,989

 

2.46

Non-taxable (tax equivalent)

 

14,616

 

904

 

6.19

 

10,350

 

640

 

6.18

 

13,220

 

749

 

5.67

Total securities

 

600,804

 

12,596

 

2.10

 

405,575

 

7,852

 

1.94

 

175,206

 

4,738

 

2.70

Dividends from FRB and FHLB stock

 

10,629

 

304

 

2.86

 

12,294

 

305

 

2.48

 

13,963

 

290

 

2.08

Loans and loans held-for-sale 1

 

1,106,447

 

56,417

 

5.03

 

1,270,162

 

67,110

 

5.20

 

1,535,054

 

80,513

 

5.17

Total interest earning assets

 

1,761,681

 

69,425

 

3.90

 

1,736,851

 

75,386

 

4.28

 

1,817,586

 

85,772

 

4.66

Cash and due from banks

 

26,871

 

-

 

-

 

26,197

 

-

 

-

 

27,402

 

-

 

-

Allowance for loan losses

 

(35,504)

 

-

 

-

 

(45,047)

 

-

 

-

 

(69,471)

 

-

 

-

Other noninterest-bearing assets

 

209,640

 

-

 

-

 

232,624

 

-

 

-

 

239,947

 

-

 

-

Total assets

 

 $

1,962,688

 

 

 

 

 

 $

1,950,625

 

 

 

 

 

 $

2,015,464

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

NOW accounts

 

 $

290,998

 

 $

255

 

0.09

 

 $

274,299

 

 $

270

 

0.10

 

 $

264,470

 

 $

422

 

0.16

Money market accounts

 

318,343

 

443

 

0.14

 

314,363

 

576

 

0.18

 

295,212

 

835

 

0.28

Savings accounts

 

226,404

 

161

 

0.07

 

211,632

 

216

 

0.10

 

191,857

 

322

 

0.17

Time deposits

 

493,855

 

6,774

 

1.37

 

552,489

 

8,809

 

1.59

 

701,189

 

14,478

 

2.06

Total interest bearing deposits

 

1,329,600

 

7,633

 

0.57

 

1,352,783

 

9,871

 

0.73

 

1,452,728

 

16,057

 

1.11

Securities sold under repurchase agreements

 

23,313

 

3

 

0.01

 

4,826

 

2

 

0.04

 

1,957

 

1

 

0.05

Other short-term borrowings

 

15,849

 

25

 

0.16

 

12,268

 

17

 

0.14

 

2,742

 

-

 

-

Junior subordinated debentures

 

58,378

 

5,298

 

9.08

 

58,378

 

4,925

 

8.44

 

58,378

 

4,577

 

7.84

Subordinated debt

 

45,000

 

811

 

1.78

 

45,000

 

903

 

1.97

 

45,000

 

822

 

1.80

Notes payable and other borrowings

 

500

 

16

 

3.16

 

500

 

17

 

3.34

 

500

 

16

 

3.16

Total interest bearing liabilities

 

1,472,640

 

13,786

 

0.94

 

1,473,755

 

15,735

 

1.07

 

1,561,305

 

21,473

 

1.37

Noninterest bearing deposits

 

362,871

 

-

 

-

 

377,624

 

-

 

-

 

354,196

 

-

 

-

Accrued interest and other liabilities

 

36,063

 

-

 

-

 

27,285

 

-

 

-

 

20,238

 

-

 

-

Stockholders’ equity

 

91,114

 

-

 

-

 

71,961

 

-

 

-

 

79,725

 

-

 

-

Total liabilities and stockholders’ equity

 

 $

1,962,688

 

 

 

 

 

 $

1,950,625

 

 

 

 

 

 $

2,015,464

 

 

 

 

Net interest income (tax equivalent)

 

 

 

 $

55,639

 

 

 

 

 

 $

59,651

 

 

 

 

 

 $

64,299

 

 

Net interest income (tax equivalent) to total earning assets

 

 

 

 

 

3.16%

 

 

 

 

 

3.43%

 

 

 

 

 

3.54%

Interest bearing liabilities to earnings assets

 

83.59%

 

 

 

 

 

84.85%

 

 

 

 

 

85.90%

 

 

 

 

 

1.  Interest income from loans  is shown tax equivalent as discussed below and includes fees of $2,547, $2,111 and $2,194 for 2013, 2012 and 2011, respectively. Nonaccrual loans are included in the above stated average balances.

 

Notes:  For purposes of discussion, net interest income and net interest income to earning assets have been adjusted to a non-GAAP tax equivalent (“TE”) basis using a marginal rate of 35% to more appropriately compare returns on tax-exempt loans and securities to other earning assets.  The table below provides a reconciliation of each non-GAAP TE measure to the GAAP equivalent:

 

 

 

 

 

Effect of Tax Equivalent Adjustment

 

 

 

 

 

 

2013

 

 

 

 

 

2012

 

 

 

 

 

2011

 

 

Interest income (GAAP)

 

 

 

 $

69,040

 

 

 

 

 

 $

75,081

 

 

 

 

 

 $

85,423

 

 

Taxable equivalent adjustment - loans

 

 

 

68

 

 

 

 

 

81

 

 

 

 

 

87

 

 

Taxable equivalent adjustment - securities

 

 

 

317

 

 

 

 

 

224

 

 

 

 

 

262

 

 

Interest income (TE)

 

 

 

69,425

 

 

 

 

 

75,386

 

 

 

 

 

85,772

 

 

Less: interest expense (GAAP)

 

 

 

13,786

 

 

 

 

 

15,735

 

 

 

 

 

21,473

 

 

Net interest income (TE)

 

 

 

 $

55,639

 

 

 

 

 

 $

59,651

 

 

 

 

 

 $

64,299

 

 

Net interest income (GAAP)

 

 

 

 $

55,254

 

 

 

 

 

 $

59,346

 

 

 

 

 

 $

63,950

 

 

Net interest income to total interest earning assets

 

 

 

3.14%

 

 

 

 

 

3.42%

 

 

 

 

 

3.52%

 

 

Net interest income to total interest earning assets (TE)

 

 

 

3.16%

 

 

 

 

 

3.43%

 

 

 

 

 

3.54%

 

 

 

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Table of Contents

 

The following table allocates the changes in net interest income to changes in either average balances or average rates for earnings assets and interest bearing liabilities.  The changes in interest due to both volume and rate have been allocated proportionately to the change due to balance and due to rate.  Interest income is measured on a tax-equivalent basis using a 35% rate as per the note to the analysis of averages balance table on the preceding page.

 

ANALYSIS OF YEAR-TO-YEAR CHANGES IN NET INTEREST INCOME

 

 

 

2013 Compared to 2012

 

2012 Compared to 2011

 

 

Change Due to

 

 

 

Change Due to

 

 

 

 

Average

 

Average

 

Total

 

Average

 

Average

 

Total

 

 

Balance

 

Rate

 

Change

 

Balance

 

Rate

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

EARNING ASSETS/INTEREST INCOME

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing deposits

 

 $

(13)

 

 $

2

 

 $

(11)

 

 $

(107)

 

 $

(4)

 

 $

(111)

Federal funds sold

 

-

 

-

 

-

 

-

 

(1)

 

(1)

Securities:

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

3,756

 

724

 

4,480

 

3,930

 

(707)

 

3,223

Tax-exempt

 

264

 

0

 

264

 

(188)

 

79

 

(109)

Dividends from FRB and FHLB Stock

 

8

 

(9)

 

(1)

 

(24)

 

39

 

15

Loans and loans held-for-sale

 

(8,550)

 

(2,143)

 

(10,693)

 

(13,771)

 

368

 

(13,403)

TOTAL EARNING ASSETS

 

(4,535)

 

(1,426)

 

(5,961)

 

(10,160)

 

(226)

 

(10,386)

 

 

 

 

 

 

 

 

 

 

 

 

 

INTEREST BEARING LIABILITIES/ INTEREST EXPENSE

 

 

 

 

 

 

 

 

 

 

 

 

NOW accounts

 

19

 

(34)

 

(15)

 

16

 

(168)

 

(152)

Money market accounts

 

7

 

(140)

 

(133)

 

58

 

(317)

 

(259)

Savings accounts

 

16

 

(71)

 

(55)

 

38

 

(144)

 

(106)

Time deposits

 

(878)

 

(1,157)

 

(2,035)

 

(2,733)

 

(2,936)

 

(5,669)

Securities sold under repurchase agreements

 

1

 

-

 

1

 

1

 

-

 

1

Other short-term borrowings

 

5

 

3

 

8

 

-

 

17

 

17

Junior subordinated debentures

 

-

 

373

 

373

 

-

 

348

 

348

Subordinated debt

 

-

 

(92)

 

(92)

 

-

 

81

 

81

Notes payable and other borrowings

 

-

 

(1)

 

(1)

 

-

 

1

 

1

INTEREST BEARING LIABILITIES

 

(830)

 

(1,119)

 

(1,949)

 

(2,620)

 

(3,118)

 

(5,738)

NET INTEREST INCOME

 

 $

(3,705)

 

 $

(307)

 

 $

(4,012)

 

 $

(7,540)

 

 $

2,892

 

 $

(4,648)

 

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II.        Investment Portfolio

 

The following table presents the composition of the securities portfolio by major category as of December 31 of each year indicated:

 

Securities Portfolio Composition

 

 

 

2013

 

2012

 

2011

 

 

 

Amortized

 

Fair

 

Amortized

 

Fair

 

Amortized

 

Fair

 

 

 

Cost

 

Value

 

Cost

 

Value

 

Cost

 

Value

 

Securities Available-For-Sale

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

 $

1,549

 

 $

1,544

 

 $

1,500

 

 $

1,507

 

 $

1,501

 

 $

1,524

 

U.S. government agencies

 

1,738

 

1,672

 

49,848

 

49,850

 

43,112

 

43,398

 

U.S. government agency mortgage-backed

 

-

 

-

 

127,716

 

128,738

 

152,473

 

154,007

 

States and political subdivisions

 

16,382

 

16,794

 

14,639

 

15,855

 

12,152

 

13,809

 

Corporate bonds

 

15,733

 

15,102

 

36,355

 

36,886

 

32,357

 

31,389

 

Collateralized mortgage obligations

 

66,766

 

63,876

 

168,795

 

169,600

 

25,616

 

25,122

 

Asset-backed securities

 

274,118

 

273,203

 

165,347

 

167,493

 

28,755

 

28,341

 

Collateralized debt obligations

 

-

 

-

 

17,941

 

9,957

 

17,892

 

9,974

 

Total Securities Available-For-Sale

 

 $

376,286

 

 $

372,191

 

 $

582,141

 

 $

579,886

 

 $

313,858

 

 $

307,564

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Held-To-Maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government agency mortgage-backed

 

 $

35,268

 

 $

35,240

 

 $

-

 

 $

-

 

 $

-

 

 $

-

 

Collateralized mortgage obligations

 

221,303

 

219,088

 

-

 

-

 

-

 

-

 

Total Held-To-Maturity

 

 $

256,571

 

 $

254,328

 

 $

-

 

 $

-

 

 $

-

 

 $

-

 

 

 

The Company’s holdings of U.S. government agency and U.S. government agency mortgage-backed securities are comprised of government-sponsored enterprises, such as Fannie Mae, Freddie Mac and the FHLB, which are not backed by the full faith and credit of the U.S. government.

 

Securities Portfolio Maturity and Yields

 

The following table presents the expected maturities or call dates and weighted average yield (nontax equivalent) of securities by major category as of December 31, 2013:

 

 

 

 

 

 

 

After One But

 

After Five But

 

 

 

 

 

 

 

 

 

 

Within One Year

 

Within Five Years

 

Within Ten Years

 

After Ten Years

 

Total

 

 

 

 

Amount

 

Yield

 

Amount

 

Yield

 

Amount

 

Yield

 

Amount

 

Yield

 

Amount

 

Yield

Securities Available-For-Sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

 $

-

 

-

 

 $

1,544

 

0.40%

 

 $

-

 

-

 

 $

-

 

-

 

 $

1,544

 

0.40%

U.S. government agencies

 

-

 

-

 

-

 

-

 

1,672

 

3.14%

 

-

 

0.00%

 

1,672

 

3.14%

States and political subdivisions

 

485

 

4.45%

 

3,479

 

4.70%

 

7,331

 

3.33%

 

5,499

 

4.37%

 

16,794

 

3.98%

Corporate bonds

 

300

 

2.17%

 

-

 

-

 

13,646

 

3.19%

 

1,156

 

4.41%

 

15,102

 

3.26%

 

 

785

 

3.58%

 

5,023

 

3.38%

 

22,649

 

3.23%

 

6,655

 

4.38%

 

35,112

 

3.48%

Mortgage-backed securities and collateralized mortgage obligations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

63,876

 

2.53%

Asset-backed securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

273,203

 

1.70%

Total Securities Available-For-Sale

 

 $

785

 

3.58%

 

 $

5,023

 

3.38%

 

 $

22,649

 

3.23%

 

 $

6,655

 

4.38%

 

 $

372,191

 

2.01%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Held-To-Maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage-backed securities and collateralized mortgage obligations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

256,571

 

3.06%

Total Held-To-Maturity

 

 $

-

 

0.00%

 

 $

-

 

0.00%

 

 $

-

 

0.00%

 

 $

-

 

0.00%

 

 $

256,571

 

3.06%

 

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As of December 31, 2013, net unrealized losses on available-for-sale securities and net losses not accreted on securities transferred from available-for-sale to held-to-maturity in the year of $11,965,000, offset by deferred income taxes of $4,927,000 results in an overall reduction to equity capital of $7,038,000.  As of December 31, 2012, net unrealized losses of $2,255,000, offset by deferred income taxes of $928,000, results in an overall reduction to equity capital of $1,327,000.  At December 31, 2013, there were four issuers where the book value of the Company’s holdings were greater than 10% of stockholders’ equity.

 

Issuers of Securities with an aggregate book value greater than 10% of stockholders equity at December 31, 2013.

 

 

 

 

December 31, 2013

 

 

 

Book

 

Fair

 

Issuer

 

Value

 

Value

 

 

 

 

 

 

 

Access Group

 

  $

24,220

 

  $

24,962

 

Northstar Education Finance

 

95,320

 

96,327

 

GCO Education Loan Funding Corp

 

39,664

 

38,085

 

Credit Suisse

 

28,872

 

26,319

 

 

 

III.       Loan Portfolio

 

Types of Loans

 

The following table presents the composition of the loan portfolio at December 31 for the years indicated:

 

 

 

2013

 

2012

 

2011

 

2010

 

2009

Commercial

 

 $

95,211

 

 $

87,136

 

 $

98,241

 

 $

173,718

 

 $

206,779

Real estate - commercial

 

560,233

 

579,687

 

704,415

 

821,101

 

925,013

Real estate - construction

 

29,351

 

42,167

 

70,919

 

129,601

 

273,719

Real estate - residential

 

389,931

 

414,141

 

477,196

 

556,609

 

642,335

Consumer

 

3,040

 

3,414

 

4,172

 

5,587

 

10,447

Overdraft

 

628

 

994

 

457

 

739

 

830

Lease Financing Receivables

 

10,069

 

6,060

 

2,087

 

2,774

 

3,703

Other

 

12,793

 

16,451

 

11,498

 

N/A

 

N/A

Gross loans

 

1,101,256

 

1,150,050

 

1,368,985

 

1,690,129

 

2,062,826

Allowance for loan losses

 

(27,281)

 

(38,597)

 

(51,997)

 

(76,308)

 

(64,540)

Loans, net

 

 $

1,073,975

 

 $

1,111,453

 

 $

1,316,988

 

 $

1,613,821

 

 $

1,998,286

 

The above loan totals include deferred loan fees and costs.

 

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Maturity and Rate Sensitivity Of Loans to Changes in Interest Rates

 

The following table sets forth the remaining contractual maturities for certain loan categories at December 31, 2013:

 

 

 

 

 

Over 1 Year

 

 

 

 

 

 

 

 

 

 

Through 5 Years

 

Over 5 Years

 

 

 

 

One Year

 

Fixed

 

Floating

 

Fixed

 

Floating

 

 

 

 

or Less

 

Rate

 

Rate

 

Rate

 

Rate

 

Total

Commercial

 

  $

36,900

 

  $

20,968

 

  $

25,552

 

  $

9,572

 

  $

2,219

 

  $

95,211

Real estate - commercial

 

84,479

 

302,273

 

32,681

 

109,658

 

31,142

 

560,233

Real estate - construction

 

10,252

 

16,168

 

840

 

326

 

1,765

 

29,351

Real estate - residential

 

45,170

 

62,844

 

73,287

 

45,092

 

163,538

 

389,931

Consumer

 

353

 

1,134

 

1,413

 

67

 

73

 

3,040

Overdraft

 

628

 

-

 

-

 

-

 

-

 

628

Lease financing receivables

 

35

 

9,961

 

-

 

73

 

-

 

10,069

Other

 

822

 

6,848

 

4,751

 

372

 

-

 

12,793

Total

 

  $

178,639

 

  $

420,196

 

  $

138,524

 

  $

165,160

 

  $

198,737

 

  $

1,101,256

 

The above loan total includes deferred loan fees and costs; column one includes demand notes.

 

While there are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, the real estate related categories represented 89.0% and 90.1% of the portfolio at December 31, 2013, and 2012, respectively.  The Company had no concentration of loans exceeding 10% of total loans, which were not otherwise disclosed as a category of loans at December 31, 2013.

 

Risk Elements

 

The following table sets forth the amounts of nonperforming assets at December 31, of the years indicated:

 

 

 

2013

 

2012

 

2011

 

2010

 

2009

Nonaccrual loans

 

$

38,911

 

$

77,519

 

$126,786

 

$212,225

 

$174,978

Nonperforming Troubled debt restructured loans accruing interest

 

796

 

4,987

 

11,839

 

15,637

 

14,171

Loans past due 90 days or more and still accruing interest

 

87

 

89

 

318

 

1,013

 

561

Total nonperforming loans

 

39,794

 

82,595

 

138,943

 

228,875

 

189,710

Other real estate owned

 

41,537

 

72,423

 

93,290

 

75,613

 

40,200

Receivable from foreclosed loan participation

 

-

 

-

 

-

 

-

 

1,505

Receivable from swap terminations

 

-

 

-

 

-

 

3,520

 

-

Total nonperforming assets

 

$

81,331

 

$ 155,018

 

$232,233

 

$308,008

 

$231,415

 

 

 

 

 

 

 

 

 

 

 

OREO as % of nonperforming assets

 

51.1%

 

46.7%

 

40.2%

 

24.5%

 

17.4%

 

Accrual of interest is discontinued on a loan when principal or interest is ninety days or more past due, unless the loan is well secured and in the process of collection.  When a loan is placed on nonaccrual status, interest previously accrued but not collected in the current period is reversed against current period interest income.  Interest income of approximately $333,000 and $813,000 was recorded and collected during 2013 and 2012, respectively, on loans that subsequently went to nonaccrual status by year-end.  Interest income, which would have been recognized during 2013 and 2012, had these loans been on an accrual basis throughout the year, was approximately $2,953,000 and $6,488,000, respectively.  As of December 31, 2013, and 2012, there were $4,837,000 and $5,441,000 respectively in restructured residential mortgage loans that were still accruing interest based upon their prior performance history.  Additionally, the nonaccrual loans above include $5,567,000 and $11,505,000 in restructured loans for the period ending December 31, 2013, and 2012, respectively.

 

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Potential Problem Loans

 

The Company utilizes an internal asset classification system as a means of reporting problem and potential problem assets.  At the scheduled board of directors meetings of the Bank, loan listings are presented, which show significant loan relationships listed as “Special Mention,” “Substandard,” and “Doubtful.”  Loans classified as Substandard include those that have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.  Assets classified as Doubtful have all the weaknesses inherent as those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.  Assets that do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that deserve management’s close attention, are deemed to be Special Mention.

 

Management defines potential problem loans as performing loans rated Substandard, that do not meet the definition of a nonperforming loan.  These potential problem loans carry a higher probability of default and require additional attention by management.  A more detailed description of these loans can be found in Note 4 to the Financial Statements.

 

IV.       Summary of Loan Loss Experience

 

Analysis of Allowance For Loan Losses

 

The following table summarizes, for the years indicated, activity in the allowance for loan losses, including amounts charged-off, amounts of recoveries, additions to the allowance charged to operating expense, and the ratio of net charge-offs to average loans outstanding:

 

 

 

2013

 

2012

 

2011

 

2010

 

2009

 

Average total loans (exclusive of loans held-for-sale)

 

  $

1,102,197

 

  $

1,263,172

 

  $

1,527,311

 

  $

1,900,604

 

  $

2,206,189

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance at beginning of year

 

38,597

 

51,997

 

76,308

 

64,540

 

41,271

 

Charge-offs:

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

316

 

344

 

366

 

2,247

 

3,493

 

Real estate - commercial

 

2,985

 

13,508

 

19,576

 

29,665

 

4,148

 

Real estate - construction

 

1,014

 

4,969

 

10,430

 

39,321

 

60,173

 

Real estate - residential

 

6,293

 

8,406

 

10,229

 

13,216

 

6,238

 

Consumer and other loans

 

597

 

638

 

568

 

560

 

926

 

Total charge-offs

 

11,205

 

27,865

 

41,169

 

85,009

 

74,978

 

Recoveries:

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

119

 

115

 

173

 

320

 

22

 

Real estate - commercial

 

5,325

 

3,576

 

3,947

 

900

 

-

 

Real estate - construction

 

1,266

 

3,420

 

1,262

 

3,674

 

1,123

 

Real estate - residential

 

1,221

 

583

 

1,807

 

1,799

 

47

 

Consumer and other loans

 

508

 

487

 

782

 

416

 

340

 

Total recoveries

 

8,439

 

8,181

 

7,971

 

7,109

 

1,532

 

Net charge-offs

 

2,766

 

19,684

 

33,198

 

77,900

 

73,446

 

Provision for loan losses

 

(8,550)

 

6,284

 

8,887

 

89,668

 

96,715

 

Allowance at end of year

 

  $

27,281

 

  $

38,597

 

  $

51,997

 

  $

76,308

 

  $

64,540

 

 

 

 

 

 

 

 

 

 

 

 

 

Net charge-offs to average loans

 

0.25%

 

1.56%

 

2.17%

 

4.10%

 

3.33%

 

Allowance at year end to average loans

 

2.48%

 

3.06%

 

3.40%

 

4.01%

 

2.93%

 

 

 

 

The provision for loan losses is based upon management’s estimate of losses inherent in the portfolio and its evaluation of the adequacy of the allowance for loan losses.  Factors which influence management’s judgment in estimating loan losses are the composition of the portfolio, past loss experience, loan delinquencies, nonperforming loans and other credit risk considerations that, in management’s judgment, deserve evaluation in estimating loan losses.  The Company has consistently followed GAAP and

 

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Table of Contents

 

regulatory guidance in all calculation methodologies with no significant criticism of those methodologies from outside third party evaluations.

 

Allocation of the Allowance For Loan Losses

 

The following table shows the Company’s allocation of the allowance for loan losses by types of loans and the amount of unallocated allowance at December 31 of the years indicated:

 

 

 

2013

 

2012

 

2011

 

2010

 

2009

 

 

 

 

Loan Type

 

 

 

Loan Type

 

 

 

Loan Type

 

 

 

Loan Type

 

 

 

Loan Type

 

 

 

 

to Total

 

 

 

to Total

 

 

 

to Total

 

 

 

to Total

 

 

 

to Total

 

 

Amount

 

Loans

 

Amount

 

Loans

 

Amount

 

Loans

 

Amount

 

Loans

 

Amount

 

Loans

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

  $

2,250

 

8.6%

 

  $

4,517

 

7.6%

 

  $

5,070

 

7.2%

 

  $

6,764

 

10.3%

 

  $

 4,547

 

10.0%

Real estate - commercial

 

16,763

 

50.9%

 

20,100

 

50.4%

 

30,770

 

51.5%

 

42,242

 

48.5%

 

24,598

 

44.8%

Real estate - construction

 

1,980

 

2.7%

 

3,837

 

3.7%

 

7,937

 

5.2%

 

18,344

 

7.7%

 

29,895

 

13.3%

Real estate - residential

 

2,837

 

35.4%

 

4,535

 

36.0%

 

6,335

 

34.9%

 

6,999

 

33.0%

 

3,770

 

31.2%

Consumer

 

1,439

 

0.3%

 

1,178

 

0.3%

 

884

 

0.3%

 

880

 

0.3%

 

703

 

0.5%

Lease financing receivables

 

-

 

0.9%

 

-

 

0.1%

 

-

 

0.1%

 

-

 

0.2%

 

-

 

0.2%

Unallocated

 

2,012

 

1.2%

 

4,430

 

1.9%

 

1,001

 

0.8%

 

1,079

 

-

 

1,027

 

-

Total

 

  $

27,281

 

100.0%

 

  $

38,597

 

100.0%

 

  $

51,997

 

100.0%

 

  $

76,308

 

100.0%

 

  $

 64,540

 

100.0%

 

The allowance for loan losses is a valuation allowance for loan losses, increased by the provision for loan losses and decreased by both loan loss reserve releases ($8.6 million loan loss reserve release in 2013) and charge-offs less recoveries.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for losses inherent in the loan portfolio.  In addition, the OCC, as part of their examination process, periodically reviews the allowance for loan losses.  Regulators can require management to record adjustments to the allowance level based upon their assessment of the information available to them at the time of examination.  The OCC, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on the allowance for loan losses.  The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines.  Generally, the policy statement recommends that (1) institutions have effective systems and controls to identify, monitor and address asset quality problems; (2) management has analyzed all significant factors that affect the collectability of the portfolio in a reasonable manner; and (3) management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement and that the Company is in full compliance with the policy statement.  Management believes it has established an adequate estimated allowance for probable loan losses.  Management reviews its process quarterly as evidenced by an extensive and detailed loan review process, makes changes as needed, and reports those results at meetings of our Audit Committee.  Although management believes the allowance for loan losses is sufficient to cover probable losses inherent in the loan portfolio, there can be no assurance that the allowance will prove sufficient to cover actual loan losses.  However, there can be no assurance that regulators, in reviewing the loan portfolio, would not request us to materially adjust our allowance for loan losses at the time of their examination.

 

V.        Deposits

 

The following table sets forth the amount and maturities of deposits of $100,000 or more at December 31 of the years indicated:

 

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2013

 

2012

 

3 months or less

 

  $

24,415

 

  $

20,701

 

Over 3 months through 6 months

 

21,137

 

15,594

 

Over 6 months through 12 months

 

77,718

 

52,609

 

Over 12 months

 

60,824

 

103,044

 

 

 

  $

184,094

 

  $

191,948

 

 

YTD Average Balances and Interest Rates

 

 

 

2013

 

2012

 

 

Average
Balance

 

Rate

 

Average
Balance

 

Rate

Noninterest bearing demand

 

  $

362,871

 

-

 

  $

377,624

 

-

Interest bearing:

 

 

 

 

 

 

 

 

NOW and money market

 

609,341

 

0.12%

 

588,662

 

0.14%

Savings

 

226,404

 

0.07%

 

211,632

 

0.10%

Time

 

493,855

 

1.37%

 

552,489

 

1.59%

Total deposits

 

  $

1,692,471

 

 

 

  $

1,730,407

 

 

 

 

 

VI.       Return on Equity and Assets

 

The following table presents selected financial ratios as of December 31 for the years indicated:

 

 

 

2013

 

2012

Return on average total assets

 

4.18%

 

0.00%

Return on average equity

 

90.09%

 

(0.10%)

Average equity to average assets

 

4.64%

 

3.69%

Dividend payout ratio

 

0.00%

 

0.00%

 

 

 

VII.     Short-Term Borrowings

 

There were no categories of short-term borrowings having an average balance greater than 30% of the Company’s stockholders’ equity as of December 31, 2013.

 

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Item 1.A.  Risk Factors

 

RISK FACTORS

 

The material risks that management believes affect the Company are described below. Before making an investment decision with respect to any of the Company’s securities, you should carefully consider the risks as described below, together with all of the information included herein. The risks described below are not the only risks the Company faces. Additional risks not presently known or currently deemed immaterial also may have a material adverse effect on the Company’s results of operations and financial condition. If any of the following risks actually occur, the Company’s results of operations and financial condition could suffer, possibly materially. The risks discussed below also include forward-looking statements, and actual results may differ substantially from those discussed or implied in these forward-looking statements.

 

Risks Relating to the Company’s Business

 

The Company has incurred net losses in the past and cannot ensure that the Company will not incur further net losses in the future.

 

Although the Company reported net income of $82.1 million for 2013, the Company incurred a net loss of $72,000 for 2012 and $6.5 million for 2011 as well as a net loss of $108.6 million for 2010. Despite a general improvement in the overall economy and the real estate market, the economic environment remains challenging and the stability of the real estate market is uncertain, and the Company cannot ensure it will not incur future losses. Any future losses may affect its ability to meet its expenses or raise additional capital and may delay the time in which the Company can resume dividend payments on its common stock.  In addition, future losses may cause the Company to re-establish a valuation allowance against its deferred tax assets.  Furthermore, any future losses would likely cause a decline in its holding company regulatory capital ratios, which could materially and adversely affect its financial condition, liquidity and results of operations.

 

Nonperforming assets take significant time to resolve, adversely affect the Company’s results of operations and financial condition and could result in further losses in the future.

 

At December 31, 2013, its nonperforming loans (which consist of nonaccrual loans and loans past due 90 days or more, still accruing interest and restructured loans still accruing interest) and its nonperforming assets (which include nonperforming loans plus OREO) are reflected in the table below (in millions):

 

 

 

12/31/2013 

 

12/31/2012 

 

 % Change

 

Nonperforming loans

 

  $

39.8  

 

  $

82.6  

 

(51.8)% 

 

OREO

 

41.5  

 

72.4  

 

(42.7)% 

 

Nonperforming assets

 

  $

81.3  

 

  $

155.0  

 

(47.5)% 

 

 

 

The Company’s nonperforming assets adversely affect its net income in various ways.  For example, the Company does not accrue interest income on nonaccrual loans and OREO may have expenses in excess of lease revenues collected, thereby adversely affecting its income and returns on assets and equity.  The Company’s loan administration costs also increase because of its nonperforming assets.  The resolution of nonperforming assets requires significant time commitments from management, which can be detrimental to the performance of their other responsibilities.  While the Company has made significant progress in reducing its nonperforming assets, there is no assurance that it will not experience increases in nonperforming assets in the future, or that its nonperforming assets will not result in further losses in the future.

 

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The Company’s loan portfolio is concentrated heavily in commercial and residential real estate loans, including construction loans, which involve risks specific to real estate values and the real estate markets in general, all of which have been experiencing significant weakness.

 

The Company’s loan portfolio generally reflects the profile of the communities in which the Company operates.  Because the Company operates in areas that saw rapid growth between 2000 and 2007, real estate lending of all types is a significant portion of its loan portfolio.  Total real estate lending is still, excluding deferred fees, at $979.8 million, or approximately 89.0% of the Company’s December 31, 2013, loan portfolio.  Given that the primary (if not only) source of collateral on these loans is real estate, additional adverse developments affecting real estate values in its market area could increase the credit risk associated with the Company’s real estate loan portfolio.

 

The effects of ongoing real estate challenges, combined with the ongoing correction in commercial and residential real estate market prices and reduced levels of home sales, have adversely affected the Company’s real estate loan portfolio and have the potential to further adversely affect such portfolio in several ways, each of which could further adversely impact its financial condition and results of operations.

 

Real estate market volatility and future changes in disposition strategies could result in net proceeds that differ significantly from fair value appraisals of loan collateral and OREO and could negatively impact the Company’s operating performance.

 

Many of the Company’s nonperforming real estate loans are collateral-dependent, meaning the repayment of the loan is largely dependent upon the successful operation of the property securing the loan. For collateral-dependent loans, the Company estimates the value of the loan based on appraised value of the underlying collateral less costs to sell. The Company’s OREO portfolio consists of properties acquired through foreclosure or deed in lieu of foreclosure in partial or total satisfaction of certain loans as a result of borrower defaults.  OREO is recorded at the lower of the recorded investment in the loans for which property served as collateral or estimated fair value, less estimated selling costs.  In determining the value of OREO properties and loan collateral, an orderly disposition of the property is generally assumed.  Significant judgment is required in estimating the fair value of property, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility.

 

A return of recessionary conditions could result in increases in the Company’s level of nonperforming loans and/or reduced demand for the Company’s products and services, which could lead to lower revenue, higher loan losses and lower earnings.

 

A return of recessionary conditions and/or continued negative developments in the domestic and international credit markets may significantly affect the markets in which the Company does business, the value of its loans and investments and its ongoing operations, costs and profitability.  Declines in real estate values and sales volumes and increased unemployment or underemployment levels may result in higher than expected loan delinquencies, increases in the Company’s levels of nonperforming and classified assets and a decline in demand for its products and services. These negative events may cause the Company to incur losses and may adversely affect its capital, liquidity and financial condition.

 

The Company’s allowance for loan losses may be insufficient to absorb potential losses in the Company’s loan portfolio.

 

The Company maintains an allowance for loan losses at a level the Company believes adequate to absorb estimated losses inherent in its existing loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; credit loss experience; current loan

 

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portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio.

 

Determination of the allowance is inherently subjective since it requires significant estimates and management judgment of credit risks and future trends, all of which may undergo material changes.  For example, the final allowance for December 31, 2012, and December 31, 2013, included an amount reserved for other not specifically identified risk factors.  Although improving, continued difficult economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of the Company’s control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review the Company’s allowance and may require an increase in the provision for loan losses or the recognition of additional loan charge-offs, based on judgments different from those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses, the Company will need additional provisions to increase the allowance. Any increases in the allowance will result in a decrease in net income and capital and may have a material adverse effect on the Company’s financial condition and results of operations.

 

While the Company had a loan loss reserve release in 2013, its provision for loan losses has been elevated during the last several years and the Bank may be required to make increases in the provision for loan losses and to charge-off additional loans in the future.

 

For the years ended December 31, 2013, and 2012, the Company recorded a loan loss reserve release of $8.6 million and a provision for loan losses of $6.3 million, respectively. The Company also recorded net loan charge-offs of $2.8 million and $19.7 million for the years ended December 31, 2013, and 2012, respectively. The Company’s nonperforming assets totaled $81.3 million, or 4.1% of total assets, at December 31, 2013. Additionally, classified assets were $103.8 million at December 31, 2013. If the economy and/or the real estate market continue to weaken, more of the Company’s classified assets may become nonperforming and the Company may be required to take additional provisions to increase its allowance for loan losses for these assets as the value of the collateral may be insufficient to pay any remaining net loan balance, which could have a negative effect on its results of operations. The Company maintains an allowance for loan losses to provide for loans in its portfolio that may not be repaid in their entirety. The Company believes that its allowance for loan losses is maintained at a level adequate to absorb probable losses inherent in its loan portfolio as of the corresponding balance sheet date. However, the Company’s allowance for loan losses may not be sufficient to cover actual loan losses and future provisions for loan losses could materially adversely affect its operating results.

 

The size of the Company’s loan portfolio has declined in recent periods, and, if the Company is unable to return to loan growth, its profitability may be adversely affected.

 

Since December 31, 2010, the Company’s gross loans held for investment have declined by 34.8% while its total assets have declined by 5.6%. During this period, the Company was managing its balance sheet composition to manage its capital levels and position the Bank to meet and exceed its targeted capital levels. Management’s efforts have reduced the Company’s nonperforming assets by 73.6% over this same period. Among other things, the Company’s current strategic plan calls for continued reductions in the amount of its nonperforming assets and returning to growth in its loan portfolio to improve its net interest margin and profitability. The Company’s ability to increase profitability in accordance with this plan will depend on a variety of factors, including its ability to originate attractive new lending relationships. While the Company believes it has the management resources and lending staff in place to successfully achieve its strategic plan, if the Company is unable to increase the size of its loan portfolio, its strategic plan may not be successful and its profitability may be adversely affected.

 

The Company’s business is concentrated in and dependent upon the welfare of several counties in

 

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Illinois specifically and the State of Illinois generally.

 

The Company’s primary market area is Aurora, Illinois, and surrounding communities as well as southwestern Cook County.  The city of Aurora is located in northeastern Illinois, approximately 40 miles west of Chicago.  The Bank operates primarily in Kane, Kendall, DeKalb, DuPage, LaSalle, Will and southwestern Cook counties in Illinois, and, as a result, the Company’s financial condition, results of operations and cash flows are subject to changes and fluctuations in the economic conditions in those areas.  The Company has developed a strong presence in the communities it serves, with a particular concentration in Aurora, Illinois, and surrounding communities.

 

The communities that the Company serves grew rapidly over the past decade, and the Company intends to continue concentrating its business efforts in these communities.  The Company’s future success is largely dependent upon the overall economic health of these communities.  However, since late 2007, the U.S. economy has generally experienced difficult economic conditions, and the State of Illinois’ financial condition continues to be among the most troubled of any state in the United States with both unemployment rates and foreclosure rates among the ten worst in the United States.  Weak economic conditions are characterized by, among other indicators, deflation, unemployment, fluctuations in debt and equity capital markets, increased delinquencies on mortgage, commercial and consumer loans, residential and commercial real estate price declines and lower home sales and commercial activity.  All of those factors are generally detrimental to the Company’s business.  If the overall economic conditions fail to significantly improve or decline further, particularly within the Company’s primary market areas, the Company could experience a lack of demand for its products and services, an increase in loan delinquencies and defaults and high or increased levels of problem assets and foreclosures.  Moreover, because of the Company’s geographic concentration, it is less able than other regional or national financial institutions to diversify its credit risks across multiple markets.

 

Similarly, the Company has credit exposure to entities or in industries that could be impacted by the continued financial difficulties at the state level.  Exposure to health care, construction and social services organizations has been reviewed to evaluate credit impact from a possible reorganization of state finances.  Credit downgrades, partial charge-offs and specific reserves could develop in this exposure with resulting impact on the Company’s financial condition if the State of Illinois encounters more severe payment issuance capabilities.

 

The repeal of federal prohibitions on payment of interest on business demand deposits could increase the Company’s interest expense and have a material adverse effect on the Company.

 

All federal prohibitions on the ability of financial institutions to pay interest on business demand deposit accounts were repealed as part of the Dodd-Frank Act.  As a result, some financial institutions have commenced offering interest on these demand deposits to compete for customers.  If competitive pressures require the Company to pay interest on these demand deposits to attract and retain business customers, the Company’s interest expense would increase and its net interest margin would decrease.  This could have a material adverse effect on the Company.  Further, the effect of the repeal of the prohibition could be more significant in a higher interest rate environment as business customers would have a greater incentive to seek interest on demand deposits.

 

The Company operates in a highly competitive industry and market area and may not be able to continue to effectively compete.

 

The Company faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources.  The Company’s competitors primarily include national and regional banks as well as community banks within the markets the Company serves.  The Company also faces competition from savings and loan associations, credit

 

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unions, personal loan and finance companies, retail and discount stockbrokers, investment advisors, mutual funds, insurance companies, and other financial intermediaries.  For example, in Kane and Kendall counties, the Bank faced competition from 196 bank branches representing 42 different financial institutions (including the Company) according to the June 30, 2013, FDIC share of deposit data.  The financial services industry could become even more competitive as a result of legislative and regulatory changes.  Banks, securities firms, and insurance companies can merge under the umbrella of a financial holding company, which can offer the wide spectrum of financial services to many customer segments.  Many large scale competitors can leverage economies of scale and be able to offer better pricing for products and services compared to what the Company can offer.

 

The Company’s ability to compete successfully depends on developing and maintaining long-term customer relationships, offering community banking services with features and pricing in line with customer interests and expectations, consistently achieving outstanding levels of customer service and adapting to many and frequent changes in banking as well as local or regional economies.  Failure to excel in these areas could significantly weaken the Company’s competitive position, which could adversely affect the Company’s growth and profitability. These weaknesses could have a significant negative impact on the Company’s business, financial condition, and results of operations.

 

The Company is a community bank and its ability to maintain its reputation is critical to the success of its business and the failure to do so may materially adversely affect its performance.

 

The Company is a community bank, and its reputation is one of the most valuable components of its business. As such, the Company strives to conduct its business in a manner that enhances its reputation. This is done, in part, by recruiting, hiring and retaining employees who share the Company’s core values: being an integral part of the communities the Company serves; delivering superior service to the Company’s customers; and caring about the Company’s customers and associates. If the Company’s reputation is negatively affected, by the actions of its employees or otherwise, its business and operating results may be adversely affected.

 

The Company is subject to interest rate risk, and a change in interest rates could have a negative effect on its net income.

 

The Company’s earnings and cash flows are largely dependent upon the Company’s net interest income. Interest rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions, the Company’s competition and policies of various governmental and regulatory agencies, particularly the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence the amount of interest the Company earns on loans and securities and the amount of interest it incurs on deposits and borrowings. Such changes could also affect the Company’s ability to originate loans and obtain deposits as well as the average duration of the Company’s securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Company’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.

 

Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on the Company’s results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Company’s financial condition and results of operations.

 

Monetary policies and regulations of the Federal Reserve could adversely affect the Company’s business, financial condition and results of operations.

 

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The policies of the Federal Reserve also have a significant impact on the Company.  Among other things, the Federal Reserve’s monetary policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits, and can also affect the value of financial instruments the Company holds and the ability of borrowers to repay their loans, which could have a material adverse effect on the Company.

 

If the Company fails to maintain sufficient capital, whether due to losses, an inability to raise additional capital or otherwise, its financial condition, liquidity and results of operations, as well as its ability to maintain regulatory compliance, would be adversely affected.

 

The Company and the Bank must meet minimum regulatory capital requirements and maintain sufficient liquidity.  The Company also faces significant capital and other regulatory requirements as a financial institution.  The Company’s ability to raise additional capital, when and if needed, will depend on conditions in the economy and capital markets, and a number of other factors – including investor perceptions regarding the Company, banking industry and market condition, and governmental activities – many of which are outside the Company’s control, and on the Company’s financial condition and performance.  Accordingly, the Company cannot assure you that it will be able to raise additional capital if needed or on terms acceptable to the Company.  If the Company fails to meet these capital and other regulatory requirements, its financial condition, liquidity and results of operations could be materially and adversely affected.

 

The Company could experience an unexpected inability to obtain needed liquidity.

 

Liquidity measures the ability to meet current and future cash flow needs as they become due. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows in deposits, and to take advantage of interest rate market opportunities and is essential to a financial institution’s business. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds.  The Company seeks to ensure that its funding needs are met by maintaining an appropriate level of liquidity through asset and liability management.  If the Company becomes unable to obtain funds when needed, it could have a material adverse effect on its business, financial condition and results of operations.

 

Loss of customer deposits due to increased competition could increase the Company’s funding