10-Q 1 mda0912e.htm 10-Q FORM 10-Q


UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

                                                                     --------------------

FORM 10-Q


 X    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.


For the quarterly period ended September 30, 2012


        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 0-18542

MID-WISCONSIN FINANCIAL SERVICES, INC.

 (Exact name of registrant as specified in its charter)


WISCONSIN

06-1169935

(State or other jurisdiction of incorporation or organization)

          (IRS Employer Identification No.)

   


132 West State Street

Medford, WI  54451

(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code:  715-748-8300



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 Web site, if any, every Interactive Date 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 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 a smaller reporting company) Smaller reporting company S



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).                     Yes  £            No  S


As of November 2, 2012 there were 1,657,119 shares of $0.10 par value common stock outstanding.  


1




MID-WISCONSIN FINANCIAL SERVICES, INC.


TABLE OF CONTENTS



PART I

FINANCIAL INFORMATION

 

PAGE

 


Item 1.


Financial Statements:

 

 

 


Consolidated Balance Sheets

September 30, 2012 (unaudited) and December 31, 2011 (derived from audited financial statements)



3

 

 


Consolidated Statements of Operations

Three Months and Nine Months Ended September 30, 2012 and 2011 (unaudited)



4

 

 


Consolidated Statements of Comprehensive Income (Loss)

Three Months and Nine Months Ended September 30, 2012 and 2011 (unaudited)



5

 

 


Consolidated Statements of Changes in Stockholders’ Equity

Nine Months Ended September 30, 2012 and 2011 (unaudited)



5

 

 


Consolidated Statements of Cash Flows

Nine Months Ended September 30, 2012 and 2011 (unaudited)



6

 

 


Notes to Consolidated Financial Statements


7-21

 


Item 2.


Management’s Discussion and Analysis of Financial Condition

and Results of Operations



22-44



Item 3.


Quantitative and Qualitative Disclosures About Market Risk


45

 


Item 4.


Controls and Procedures


45


PART II


OTHER INFORMATION

 

 

 


Item 1.


Legal Proceedings


45

 


Item 1A.


Risk Factors

 

45

 


Item 2.


Unregistered Sales of Equity Securities and Use of  Proceeds


46

 


Item 3.


Defaults Upon Senior Securities


46

 


Item 4.


Mine Safety Disclosures


46

 


Item 5.


Other Information


46

 


Item 6.    


Exhibits


46

 

     


Signatures


46

 

 


Exhibit Index


47


2


PART I – FINANCIAL INFORMATION

Item 1. Financial Statements:


                                                                         Mid-Wisconsin Financial Services, Inc. and Subsidiary

                                                                                      Consolidated Balance Sheets

 

                                                                              (In thousands, except per share data)

 

 

September 30, 2012

December 31, 2011

 

(Unaudited)

(Audited)

Assets

 

 

Cash and due from banks

$

11,896 

$

18,278 

Interest-bearing deposits in other financial institutions

21,042 

10 

Federal funds sold and securities purchased under agreements to sell

414 

13,072 

Investment securities available-for-sale, at fair value

110,335 

110,376 

Loans held for sale

2,287 

2,163 

Loans

307,589 

329,863 

Less:  Allowance for loan losses

(10,529)

(9,816)

Loans, net

297,060 

320,047 

Accrued interest receivable

1,635 

1,640 

Premises and equipment, net

7,582 

7,943 

Other investments, at cost

1,613 

2,616 

Other real estate owned

4,472 

4,404 

Net deferred tax asset

1,179 

Other assets

5,726 

6,448 

Total assets

$

464,062 

$

488,176 

Liabilities and Stockholders' Equity

 

 

Noninterest-bearing deposits

$

71,071 

$

70,790 

Interest-bearing deposits

293,333 

310,830 

  Total deposits

364,404 

381,620 

Short-term borrowings

13,167 

13,655 

Long-term borrowings

36,061 

40,061 

Subordinated debentures

10,310 

10,310 

Accrued interest payable

805 

878 

Accrued expenses and other liabilities

2,386 

2,139 

Total liabilities

427,133 

448,663 

Stockholders' equity:

 

 

Series A preferred stock

9,832 

9,745 

Series B preferred stock

517 

526 

Common stock

166 

166 

Additional paid-in capital

11,945 

11,945 

Retained earnings

12,825 

15,526 

Accumulated other comprehensive income

1,644 

1,605 

Total stockholders' equity

36,929 

39,513 

Total liabilities and stockholders' equity

$

464,062 

$

488,176 

Series A preferred stock authorized (no par value)

10,000 

10,000 

Series A preferred stock issued and outstanding

10,000 

10,000 

Series B preferred stock authorized (no par value)

500 

500 

Series B preferred stock issued and outstanding

500 

500 

Common stock authorized (par value $0.10 per share)

6,000,000 

6,000,000 

Common stock issued and outstanding

1,657,119 

1,657,119 

The accompanying condensed notes to the unaudited consolidated financial statements are an integral part of these statements.


3



ITEM 1.  Financial Statements Continued:


 

Mid-Wisconsin Financial Services, Inc. and Subsidiary

 

Consolidated Statements of Operations

 

(In thousands, except per share data)

 

(Unaudited)

 

Three Months Ended September 30, 2012

Three Months Ended September 30, 2011

Nine Months Ended September 30, 2012

Nine Months Ended September 30, 2011

Interest Income

 

 

 

 

  Loans, including fees

$

4,160 

$

4,598 

$

12,964 

$

14,100 

  Securities:

 

 

 

 

    Taxable

491 

651 

1,539 

1,980 

    Tax-exempt

89 

102 

273 

303 

  Other

23 

17 

60 

149 

Total interest income

4,763 

5,368 

14,836 

16,532 

Interest Expense

 

 

 

 

  Deposits

636 

1,104 

2,324 

3,573 

  Short-term borrowings

10 

35 

68 

87 

  Long-term borrowings

372 

410 

1,129 

1,223 

  Subordinated debentures

49 

45 

150 

135 

Total interest expense

1,067 

1,594 

3,671 

5,018 

Net interest income

3,696 

3,774 

11,165 

11,514 

Provision for loan losses

750 

900 

3,680 

3,850 

Net interest income after provision for loan losses

2,946 

2,874 

7,485 

7,664 

Noninterest Income

 

 

 

 

  Service fees

235 

226 

633 

731 

  Trust service fees

270 

270 

823 

803 

  Investment product commissions

55 

47 

131 

160 

  Mortgage banking

104 

94 

376 

327 

  Loss on sale of investments

(55)

  Other

313 

278 

948 

1,303 

Total noninterest income

977 

915 

2,911 

3,269 

Noninterest Expense

 

 

 

 

  Salaries and employee benefits

1,815 

2,133 

5,669 

6,360 

  Occupancy

391 

432 

1,238 

1,342 

  Data processing

161 

167 

477 

501 

  Foreclosure/OREO expense

119 

261 

668 

432 

  Legal and professional fees

227 

219 

668 

610 

  FDIC expense

253 

263 

767 

862 

  Other

573 

709 

1,971 

2,333 

Total noninterest expense

3,539 

4,184 

11,458 

12,440 

Income (loss) before income taxes

384 

(395)

(1,062)

(1,507)

Income tax (benefit) expense

(209)

1,152 

(761)

Net income (loss)

$

381 

($186)

($2,214)

($746)

Preferred stock dividends, discount and premium

(163)

(160)

(487)

(482)

Net income (loss) available to common equity

$

218 

($346)

($2,701)

($1,228)

Income (loss) per common share:

 

 

 

 

  Basic and diluted

$

0.13 

($0.21)

($1.63)

($0.74)

Cash dividends declared per common share

$

0.00 

$

0.00 

$

0.00 

$

0.00 

The accompanying condensed notes to the unaudited consolidated financial statements are an integral part of these statements.

 


 4



ITEM 1.  Financial Statements Continued:


 

Mid-Wisconsin Financial Services, Inc. and Subsidiary

 

Consolidated Statements of Comprehensive Income (Loss)

 

(In thousands)

 

(Unaudited)

 

   Three Months Ended

   Nine Months Ended

 

             September 30,

        September 30,

 

2012 

2011 

2012 

2011 

Net income (loss)

$

381 

($186)

($2,214)

($746)

Other comprehensive income (loss), net of tax:

 

 

 

 

Investment securities available-for-sale:

 

 

 

 

  Net unrealized gains (losses)

(8)

540 

64 

2,081 

  Reclassification adjustment for net losses realized in earnings

33 

  Income tax benefit (expense)

(216)

(25)

(882)

Total other comprehensive income (loss) net of tax

(4)

324 

39 

1,232 

Comprehensive income (loss)

$

377 

$

138 

($2,175)

$

486 

The accompanying condensed notes to the unaudited consolidated financial statements are an integral part of these statements.


Mid-Wisconsin Financial Services, Inc. and Subsidiary

 

 

Consolidated Statements of Changes in Stockholders' Equity

 

 

(In thousands)

 

 

(Unaudited)

 

 

 

 

 

 

 

 

 

Accumulated Other

 

 

         Preferred Stock

         Common Stock

Additional

Retained

Comprehensive

 

 

Shares

Amount

Shares

Amount

Paid-In Capital

Earnings

Income

Totals

Balance, December 31, 2010

10.5

$

10,172 

1,652

$

165

$

11,916

$

20,127 

$

590

$

42,970 

Comprehensive income:

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

(746)

 

(746)

Other comprehensive income

 

 

 

 

 

 

1,232

1,232 

Comprehensive income

 

 

 

 

 

 

 

486 

Accretion of preferred stock dividend

 

82 

 

 

 

(82)

 

Amortization of preferred stock premium

 

(8)

 

 

 

 

Issuance of common stock:

 

 

 

 

 

 

 

 

Proceeds from stock purchase plans

 

 

3

0

21

 

 

21 

Accrued and unpaid dividends - Preferred stock

 

 

 

 

 

(408)

 

(408)

Stock-based compensation

 

 

 

 

16

 

 

16 

Balance, September 30, 2011

10.5

$

10,246 

1,655

$

165

$

11,953

$

18,899 

$

1,822

43,085 


 

 

 

 

 

 

 

Accumulated Other

 

 

         Preferred Stock

         Common Stock

Additional

Retained

Comprehensive

 

 

Shares

Amount

Shares

Amount

Paid-In Capital

Earnings

Income

Totals

Balance, December 31, 2011

10.5

$

10,271 

1,657

$

166

$

11,945

$

15,526 

$

1,605

$

39,513 

Comprehensive loss:

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

(2,214)

 

(2,214)

Other comprehensive income

 

 

 

 

 

 

39

39 

Comprehensive loss

 

 

 

 

 

 

 

(2,175)

Accretion of preferred stock dividend

 

87 

 

 

 

(87)

 

Amortization of preferred stock premium

 

(9)

 

 

 

 

Accrued and unpaid dividends - Preferred stock

 

 

 

 

 

(409)

 

(409)

Balance, September 30, 2012

10.5

$

10,349 

1,657

$

166

$

11,945

$

12,825 

$

1,644

36,929 

The accompanying condensed notes to the unaudited consolidated financial statements are an integral part of these statements.

 

 

 


5


ITEM 1.  Financial Statements Continued:


 

Mid-Wisconsin Financial Services, Inc. and Subsidiary

 

Consolidated Statements of Cash Flows

 

(In thousands)

 

(Unaudited)

 

Nine Months Ended September 30, 2012

Nine Months Ended September 30, 2011

Cash flows from operating activities:

 

 

  Net loss

($2,214)

($746)

  Adjustments to reconcile net income to net cash provided by operating activities:

 

 

    Depreciation and amortization

705 

815 

    Provision for loan losses

3,680 

3,850 

    Provision for valuation allowance OREO

354 

318 

    Loss on sale of investment securities

55 

    Gain on premises and equipment disposals

(35)

    (Gain) loss on sale of foreclosed OREO

(135)

    Stock-based compensation

16 

    Valuation allowance - deferred taxes

1,152 

    Changes in operating assets and liabilities

 

 

                    Loans held for sale

(124)

5,992 

                    Other assets

728 

165 

                    Other liabilities

(234)

310 

Net cash provided by operating activities

4,049 

10,605 

Cash flows from investing activities:

 

 

  Net increase in interest-bearing deposits in other financial institutions

(21,032)

(2)

  Net decrease in federal funds sold

12,658 

18,504 

  Securities available for sale:

 

 

                    Proceeds from sales

641 

                    Proceeds from maturities

27,561 

22,229 

                    Payment for purchases

(27,639)

(32,709)

  FHLB stock redemption

1,003 

  Net (increase) decrease in loans

17,398 

(5,147)

  Capital expenditures

(178)

(505)

  Proceeds from sale of premises and equipment

17 

178 

  Proceeds from sale of OREO

1,485 

1,067 

Net cash provided by investing activities

11,273 

4,256 

Cash flows from financing activities:

 

 

  Net decrease in deposits

(17,216)

(14,637)

  Net increase (decrease) in short-term borrowings

(488)

1,715 

  Principal payments on long-term borrowings

(4,000)

(2,500)

  Proceeds from stock benefit plans

21 

  Cash dividends paid on preferred stock

(408)

Net cash used in financing activities

(21,704)

(15,809)

Net decrease in cash and due from banks

(6,382)

(948)

Cash and due from banks at beginning of period

18,278 

9,502 

Cash and due from banks at end of period

$

11,896 

$

8,554 

Supplemental disclosures of cash flow information:

 

 

  Cash paid during the period for:

 

 

    Interest

$

3,744 

$

5,166 

Noncash investing and financing activities:

 

 

    Loans transferred to OREO

$

2,158 

$

2,203 

    Loans charged-off

3,257 

4,406 

    Dividends declared but not yet paid on preferred stock

409 

340 

    Loans made in connection with the sale of OREO

249 

75 

The accompanying condensed notes to the unaudited consolidated financial statements are an integral part of these statements.


6


Mid-Wisconsin Financial Services, Inc. and Subsidiary

Notes to Unaudited Consolidated Financial Statements


Note 1 – Basis of Presentation


General


In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly Mid-Wisconsin Financial Services, Inc.’s (the “Company”) and Mid-Wisconsin Bank’s, its wholly owned banking subsidiary (the “Bank”), consolidated balance sheets, results of operations, comprehensive income (loss), changes in stockholders’ equity and cash flows for the periods presented, and all such adjustments are of a normal recurring nature.  The consolidated balance sheets include the accounts of all subsidiaries.  All material intercompany transactions and balances are eliminated.  The results of operations for the interim periods are not necessarily indicative of the results to be expected for the entire year. We have reviewed and evaluated subsequent events through the date this Form 10-Q was filed.


These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) have been omitted or abbreviated.  The information contained in the consolidated financial statements and footnotes in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”) should be referred to in connection with the reading of these unaudited interim financial statements.


Preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, fair value of financial instruments, the allowance for loan losses, useful lives for depreciation and amortization, deferred tax assets, uncertain income tax positions and contingencies. Management does not anticipate any material changes to estimates in the near term. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to:  external market factors such as market interest rates and employment rates, changes to operating policies and procedures, and changes in applicable banking regulations. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period.


Recent Accounting Pronouncements  


In May 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard that requires companies to disclose more of the processes for valuing items categorized as Level 3 in the fair value hierarchy, provide quantitative information about the significant unobservable inputs used in the measurement and, in certain cases, explain how sensitive the measurements are to changes in the inputs. Other than requiring additional disclosures, the adoption of this new guidance did not have a material impact on the Company’s financial condition, results of operations or liquidity.  The Company adopted this standard during the quarter ended March 31, 2012 and its implementation did not have a material impact on the consolidated financial statements of the Company.

 

In June 2011, the FASB issued an accounting standard that allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income.  The statement(s) are required to be presented with equal prominence as the other primary financial statements.  The accounting pronouncement eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity, but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.  The Company adopted this standard effective March 31, 2012, electing to present a consolidated statement of comprehensive income (loss) separate from, but consecutive to, its consolidated statement of operations.


7


Deregistration


On September 21, 2012, the Company filed a Form 15 with the Securities and Exchange Commission (“SEC”) to deregister the Company’s common stock under Section 12(g) of the Securities Exchange Act of 1934 (“Exchange Act”), as amended by the Jumpstart Our Business Startups Act (“JOBS Act”), and suspend the Company’s periodic reporting obligations under Section 13(a) of the Exchange Act. Among other things, the JOBS Act, which was signed into law on April 5, 2012, increased the threshold number of shareholders of record under which banks and bank holding companies are permitted to deregister their securities under Section 12(g) of the Exchange Act from 300 record shareholders to 1,200 record shareholders. The Company currently has less than 1,200 common stock shareholders of record and, therefore, may deregister its common stock under Section 12(g).  


The Company’s deregistration of its common stock under Section 12(g) will become effective in 90 days, or such shorter period as determined by the SEC.  During this period, the Company also anticipates seeking no-action relief from the SEC to relieve the Company of its periodic reporting obligations under Section 15(d) of the Exchange Act (including filing Forms 10-K, 10-Q, and 8-K and proxy statements).  Accordingly, the Company does not expect to have any further reporting obligations under the Exchange Act after December 20, 2012. Until the deregistration of its common stock is effective, the Company will continue to file all reports as required by the Exchange Act.


Note 2 – Earnings (Loss) per Common Share


Earnings (loss) per common share are calculated by dividing net income (loss) available to common equity by the weighted average number of common shares outstanding.  Diluted earnings (loss) per share is calculated by dividing net income (loss) available to common equity by the weighted average number of shares adjusted for the dilutive effect of common stock awards, if any.  Presented below are the calculations for basic and diluted earnings (loss) per common share.


 

   Three Months Ended

   Nine Months Ended

 

        September 30,

        September 30,

 

2012

2011

2012

2011

(In thousands, except per share data)

 

 

 

 

Net income (loss)

$

381 

($186)

($2,214)

($746)

Preferred dividends, discount and premium

(163)

(160)

(487)

(482)

Net income (loss) available to common equity

$

218 

($346)

($2,701)

($1,228)

Weighted average common shares outstanding

1,657 

1,654 

1,657 

1,654 

Effect of dilutive stock options

Diluted weighted average common shares outstanding

1,657 

1,654 

1,657 

1,654 

Basic and diluted earnings (loss) per common share

$

0.13 

($0.21)

($1.63)

($0.74)


8


Note 3- Securities


The amortized cost, gross unrealized gains and losses, and fair values of investment securities available-for-sale at September 30, 2012 and December 31, 2011 were as follows:


 

Amortized Cost

Gross Unrealized Gains

Gross Unrealized Losses

Fair Values

 

 

($ in thousands)

 

September 30, 2012

 

 

 

 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

$

11,941

$

340

$

0

$

12,281

Mortgage-backed securities

72,565

1,205

112

73,658

Obligations of states and political subdivisions

22,109

1,302

0

23,411

Corporate debt securities

831

3

0

834

Total debt securities

107,446

2,850

112

110,184

Equity securities

151

0

0

151

Total securities available-for-sale

$

107,597

$

2,850

$

112

$

110,335


 

Amortized Cost

Gross Unrealized Gains

Gross Unrealized Losses

Fair Values

 

 

($ in thousands)

 

December 31, 2011

 

 

 

 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

$

18,479

$

329

$

0

$

18,808

Mortgage-backed securities

66,622

1,110

79

67,653

Obligations of states and political subdivisions

21,619

1,316

3

22,932

Corporate debt securities

831

1

0

832

Total debt securities

107,551

2,756

82

110,225

Equity securities

151

0

0

151

Total securities available-for-sale

$

107,702

$

2,756

$

82

$

110,376


The following table represents gross unrealized losses and the related fair value of investment securities available-for-sale, aggregated by investment category and length of time individual securities have been in a continuous unrealized loss position, at September 30, 2012 and December 31, 2011.


 

  Less Than 12 Months

 

    12 Months or More

 

               Total

 

Fair Value

Unrealized Losses

 

Fair Value

Unrealized Losses

 

Fair Value

Unrealized Losses

 

 

 

 

    ($ in thousands)

 

 

 


September 30, 2012

 

 

 

 

 

 

 

 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

$

0

$

0

 

$

0

$

0

 

$

0

$

0

Mortgage-backed securities

9,660

83

 

1,632

29

 

11,292

112

Obligations of states and political subdivisions

0

0

 

0

0

 

0

0

Total

$

9,660

$

83

 

$

1,632

$

29

 

$

11,292

$

112

December 31, 2011

 

 

 

 

 

 

 

 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

$

0

$

0

 

$

0

$

0

 

$

0

$

0

Mortgage-backed securities

9,730

73

 

12

6

 

9,742

79

Obligations of states and political subdivisions

0

0

 

327

3

 

327

3

Total

$

9,730

$

73

 

$

339

$

9

 

$

10,069

$

82


The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment (“OTTI”) that may result due to adverse economic conditions or other, issuer-specific factors.


9


A determination as to whether a security’s decline in market value is temporary or OTTI takes into consideration numerous factors.  Significant inputs used to measure the amount related to credit loss include, but are not limited to:  (i) the length of time and extent to which fair value has been less than cost; (ii) the financial condition and near-term prospects of the issuer; and (iii) our intent and ability to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  When management identifies a specific security that has a rating lower than “A”, fair value less than 95% of the amortized cost, and has been in a continuous loss position for more than twelve months, a third party vendor may review the specific security for OTTI.  To determine OTTI, a discounted cash flow model is utilized to estimate the fair value of the security.  The use of a discounted cash flow model involves judgment, particularly of interest rates, estimated default rates and prepayment speeds.  Adjustments to market value that are considered temporary are recorded as separate components of equity, net of tax. If an impairment of a security is identified as OTTI it will be recorded in the Consolidated Statement of Operations.  


As of September 30, 2012 the Company has determined that there are no OTTI securities in the investment portfolio.


Based on the Company’s evaluation, management believes that any remaining unrealized losses at September 30, 2012, are primarily attributable to changes in interest rates and the current market conditions, and not credit deterioration.  Management believes that the Company currently has both the intent and ability to hold the securities that are in a continuous unrealized loss position for the time necessary to recover the amortized cost.


The amortized cost and fair values of investment debt securities available-for-sale at September 30, 2012, by contractual maturity, are shown below.  Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Fair values of securities are estimated based on financial models or prices paid for similar securities.  It is possible interest rates could change considerably, resulting in a material change in estimated fair value.


 

Amortized Cost

Fair Value

 

               ($ in thousands)

Due in one year or less

$

1,820

$

1,823

Due after one year but within five years

18,346

19,119

Due after five years but within ten years

13,358

14,183

Due after ten years or more

1,357

1,401

Mortgage-backed securities

72,565

73,658

Total debt securities available-for-sale

$

107,446

$

110,184


Note 4 – Loans, Allowance for Loan Losses, and Credit Quality


The period-end loan composition as of September 30, 2012 and December 31, 2011 are summarized as follows:


 

September 30, 2012

December 31, 2011

($ in thousands)

 

 

Commercial business

$

38,149

$

41,347

Commercial real estate

120,153

123,868

Real estate construction

20,679

28,708

Agricultural

44,833

45,351

Real estate residential

79,474

85,614

Installment

4,301

4,975

Total loans

$

307,589

$

329,863


The allowance for loan losses (“ALL”) represents management’s estimate of probable and inherent credit losses in the Bank’s loan portfolio at the balance sheet date. In general, estimating the amount of the ALL is a function of a number of factors, including but not limited to changes in the loan portfolio, net charge-offs, trends in past due and impaired loans, and the level of potential problem loans, all of which may be susceptible to significant change.  To the extent actual outcomes differ from management estimates, additional provisions for loan losses could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALL may


10


be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged-off or for which an actual loss is realized.


A year-to-date summary of the changes in the ALL by portfolio segment for the periods indicated is as follows:


 

Beginning Balance at 1/1/2012

Charge-offs

Recoveries

Provision

Ending Balance at 9/30/12

Ending balance:  individually evaluated for impairment

Ending balance:  collectively evaluated for impairment

September 30, 2012

($ in thousands)

Commercial business

$

1,004

($334)

$

46

$

230 

$

946

$

365

$

581

Commercial real estate

3,685

(1,617)

86

2,992 

5,146

2,701

2,445

Real estate construction

1,320

(219)

7

289 

1,397

693

704

Agricultural

1,139

(21)

85

(687)

516

14

502

Real estate residential

2,530

(1,037)

46

878 

2,417

955

1,462

Installment

138

(29)

20

(22)

107

40

67

Total

$

9,816

($3,257)

$

290

$

3,680 

$

10,529

$

4,768

$

5,761


 

Beginning Balance at 1/1/2011

Charge-offs

Recoveries

Provision

Ending Balance at 9/30/2011

Ending balance:  individually evaluated for impairment

Ending balance:  collectively evaluated for impairment

September 30, 2011

($ in thousands)

Commercial business

$

536

($100)

$

34

$

465

$

935

$

225

$

710

Commercial real estate

4,320

(1,856)

132

772

3,368

911

2,457

Real estate construction

1,278

(1,149)

14

1,166

1,309

147

1,162

Agricultural

1,146

(373)

107

371

1,251

34

1,217

Real estate residential

2,060

(855)

41

1,053

2,299

614

1,685

Installment

131

(73)

39

23

120

10

110

Total

$

9,471

($4,406)

$

367

$

3,850

$

9,282

$

1,941

$

7,341


The allocation methodology used by the Company includes specific allocations for impaired loans evaluated individually for impairment based on collateral values and for the remaining loan portfolio collectively evaluated for impairment primarily based on historical loss rates and other qualitative factors.  Loan charge-offs and recoveries are based on actual amounts charged-off or recovered by loan category.  Management allocates the ALL by pools of risk within each loan portfolio.  


The following table presents nonaccrual loans by portfolio segment as of the dates indicated as follows:


 

September 30, 2012

December 31, 2011

 

($ in thousands)

Commercial business

$

1,168

$

734

Commercial real estate

6,777

4,076

Real estate construction

357

2,519

Agricultural

294

134

Real estate residential

4,557

3,726

Installment

4

5

Total nonaccrual loans

$

13,157

$

11,194


Loans are generally placed on nonaccrual status when management has determined collection of the interest on a loan is doubtful or when a loan is contractually past due 90 days or more as to interest or principal payments.  When loans are placed on nonaccrual status or charged-off, all current year unpaid accrued interest is reversed against interest income. The interest on these loans is subsequently accounted for on the cash basis until qualifying for return to accrual status.  If collectability of the principal is in doubt, payments received are applied to loan principal.  Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.


11


A summary of loans by credit quality indicator based on internally assigned credit grade is as follows:


($ in thousands)

 

 

 

 

 

 

 

 

 

 

September 30, 2012

Highest Quality

High Quality

Quality

Moderate Risk

Acceptable

Special Mention

Substandard

Doubtful

Loss

Total

Commercial business

$

83

$

3,906

$

5,280

$

8,320

$

11,201

$

7,611

$

1,661

$

87

$

0

$

38,149

Commercial real estate

11

1,397

13,577

35,850

33,250

12,944

15,728

7,396

0

120,153

Real estate construction

159

1,352

3,857

2,947

7,195

1,524

3,288

357

0

20,679

Agricultural

85

366

3,358

6,050

26,030

4,745

3,906

293

0

44,833

Real estate residential

326

4,953

18,420

17,494

21,518

7,566

4,462

4,735

0

79,474

Installment

0

290

883

2,002

780

151

187

8

0

4,301

Total

$

664

$

12,264

$

45,375

$

72,663

$

99,974

$

34,541

$

29,232

$

12,876

$

0

$

307,589


December 31, 2011

Highest Quality

High Quality

Quality

Moderate Risk

Acceptable

Special Mention

Substandard

Doubtful

Loss

Total

Commercial business

$

188

$

4,268

$

5,153

$

8,688

$

10,898

$

8,333

$

3,068

$

751

$

0

$

41,347

Commercial real estate

0

1,521

15,061

35,596

36,947

14,811

13,828

6,104

0

123,868

Real estate construction

166

2,169

4,680

3,905

11,383

839

2,980

2,586

0

28,708

Agricultural

121

427

2,527

8,052

22,283

8,428

2,812

701

0

45,351

Real estate residential

466

6,273

19,181

20,856

22,300

6,678

5,911

3,949

0

85,614

Installment

6

430

1,258

2,205

759

273

39

5

0

4,975

Total

$

947

$

15,088

$

47,860

$

79,302

$

104,570

$

39,362

$

28,638

$

14,096

$

0

$

329,863


Loans risk rated acceptable or better are credits performing in accordance with the original terms, have adequate sources of repayment and little identifiable collectability risk.  Special mention credits have potential weaknesses that deserve management’s attention.  If left unremediated, these potential weaknesses may result in deterioration of the repayment of the credit.  Substandard loans typically have weaknesses in the paying capability of the obligor and/or guarantor or in collateral coverage.  These loans have a well-defined weakness that jeopardizes the liquidation of the debt and are characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Loans classified as doubtful have all the weaknesses of substandard loans with the added characteristic that the collection of all amounts due according to the original contractual terms is highly unlikely and the amount of the loss is reasonably estimable.  Loans classified as loss are considered uncollectible.  


The following table presents loans by past due status as of the dates indicated:


 

30 - 59 Days Past Due

60 - 89 Days Past Due

90 Days and Over

Total Past Due

Current

Total Loans

Recorded Investment > 90 Days and Accruing

September 30, 2012

 

 

($ in thousands)

 

 

 

Commercial business

$

248

$

0

$

87

$

335

$

37,814

$

38,149

$

0

Commercial real estate

3,024

1,159

2,675

$

6,858

113,295

120,153

0

Real estate construction

231

0

246

$

477

20,202

20,679

0

Agricultural

238

15

40

$

293

44,540

44,833

0

Real estate residential

1,721

252

962

$

2,935

76,539

79,474

0

Installment

0

24

4

$

28

4,273

4,301

0

Total

$

5,462

$

1,450

$

4,014

$

10,926

$

296,663

$

307,589

$

0


 

30 - 59 Days Past Due

60 - 89 Days Past Due

90 Days and Over

Total Past Due

Current

Total Loans

Recorded Investment > 90 Days and Accruing

December 31, 2011

 

 

($ in thousands)

 

 

 

Commercial business

$

50

$

14

$

612

$

676

$

40,671

$

41,347

$

0

Commercial real estate

787

830

2,885

4,502

119,366

123,868

0

Real estate construction

114

157

2,519

2,790

25,918

28,708

0

Agricultural

88

120

241

449

44,902

45,351

201

Real estate residential

989

176

3,044

4,209

81,405

85,614

0

Installment

29

0

0

29

4,946

4,975

21

Total

$

2,057

$

1,297

$

9,301

$

12,655

$

317,208

$

329,863

$

222


12


The following table presents impaired loans as of the dates indicated:


 

Recorded Investment

Unpaid Principal Balance

Related Allowance

Average Recorded Investment

Interest Income Recognized

 

 

 

($ in thousands)

 

September 30, 2012

 

 

 

 

With no related allowance:

 

 

 

 

 

Commercial business

$

362

$

362

$

0

$

221

$

17

Commercial real estate

8,069

8,069

0

4,334

321

Real estate construction

2,038

2,038

0

1,016

36

Agricultural

4,138

4,138

0

1,984

179

Real estate residential

4,454

4,454

0

2,030

144

Installment

13

13

0

6

0

With a related allowance:

 

 

 

 

 

Commercial business

$

1,022

$

1,387

$

365

$

1,542

$

23

Commercial real estate

12,355

15,056

2,701

13,661

519

Real estate construction

913

1,606

693

2,153

74

Agricultural

47

61

14

188

3

Real estate residential

3,788

4,743

955

5,198

141

Installment

142

182

40

74

11

Total:

 

 

 

 

 

Commercial business

$

1,384

$

1,749

$

365

$

1,763

$

40

Commercial real estate

20,424

23,125

2,701

17,995

840

Real estate construction

2,951

3,644

693

3,169

110

Agricultural

4,185

4,199

14

2,172

182

Real estate residential

8,242

9,197

955

7,228

285

Installment

155

195

40

80

11

Total

$

37,341

$

42,109

$

4,768

$

32,407

$

1,468

December 31, 2011

 

 

 

 

 

With no related allowance:

 

 

 

 

 

Commercial business

$

0

$

0

$

0

$

0

$

0

Commercial real estate

0

0

0

349

0

Real estate construction

0

0

0

96

0

Agricultural

0

0

0

8

0

Real estate residential

0

0

0

165

0

Installment

0

0

0

0

0

With a related allowance:

 

 

 

 

 

Commercial business

$

482

$

834

$

352

$

460

$

11

Commercial real estate

8,130

9,888

1,758

7,646

392

Real estate construction

2,103

2,563

460

2,080

51

Agricultural

270

305

35

233

4

Real estate residential

3,010

3,690

680

2,586

103

Installment

6

21

15

8

2

Total:

 

 

 

 

 

Commercial business

$

482

$

834

$

352

$

460

$

11

Commercial real estate

8,130

9,888

1,758

7,995

392

Real estate construction

2,103

2,563

460

2,176

51

Agricultural

270

305

35

241

4

Real estate residential

3,010

3,690

680

2,751

103

Installment

6

21

15

8

2

Total

$

14,001

$

17,301

$

3,300

$

13,631

$

563


 

Effective June 30, 2012, all substandard and doubtful loans are classified as impaired in the ALL calculation and are evaluated individually for impairment based on collateral values.  This change in methodology was a large reason for the increase in impaired loans, as previously only substandard and doubtful loans with collateral shortfalls were classified as impaired.   


13


Troubled Debt Restructurings


A loan is accounted for as a troubled debt restructuring (“TDR”) if the Company, for economic or legal reasons related to the borrower’s financial condition, grants a significant concession to the borrower that it would not otherwise consider to maximize the collection of amounts due.  A TDR may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate, a reduction of accrued interest, an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions.  The Company had no additional lending commitments at September 30, 2012 or December 31, 2011 to customers with outstanding loans classified as TDR.


Restructured loans can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accrual status depending on the individual facts and circumstances of the borrower.  Nonaccrual restructured loans are included with all other nonaccrual loans.  All accruing restructured loans are reported as troubled debt restructurings. Restructured loans remain on nonaccrual status until the customer has attained a sustained period of repayment performance under the modified loan terms which, by internal policy, is usually a minimum of nine months.  Performance prior to the restructuring, or significant events that coincide with the restructuring, are considered in assessing whether the borrower can meet the new terms and whether the loan should be returned to, or maintained on, accrual status.  If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan remains on nonaccrual.  


All restructured loans are considered impaired for reporting and measurement purposes.  


At September 30, 2012, there were $13,854 of TDR loans, of which $5,305 were classified as nonaccrual loans and $8,549 were reclassified as restructured loans and accruing.  At December 31, 2011, there were $12,887 of TDR loans, of which $5,346 were classified as nonaccrual and $7,541 were classified as restructured loans and accruing.


The following table provides the number of loans modified and classified as trouble debt restructurings by loan category during the three months and nine months ended September 30, 2012 and 2011.   


 

   Three Months Ended September 30, 2012

Nine Months Ended September 30, 2012

 

Number of Loans

Pre-Modification Recorded Balance

Post-Modification Recorded Balance

Number of Loans

Pre-Modification Recorded Balance

Post-Modification Recorded Balance

($ in thousands)

 

 

 

 

 

 

Commercial business

1

$

1,050

$

1,050

3

$

1,730

$

1,730

Commercial real estate

0

0

0

21

9,103

9,103

Real estate construction

0

0

0

8

2,633

2,633

Agricultural

0

0

0

5

621

621

Real estate residential

3

166

166

15

2,313

2,313

Installment

0

0

0

1

22

22

 

4

$

1,216

$

1,216

53

$

16,422

$

16,422


 

   Three Months Ended September 30, 2011

Nine Months Ended September 30, 2011

 

Number of Loans

Pre-Modification Recorded Balance

Post-Modification Recorded Balance

Number of Loans

Pre-Modification Recorded Balance

Post-Modification Recorded Balance

($ in thousands)

 

 

 

 

 

 

Commercial business

2

$

131

$

131

3

$

722

$

722

Commercial real estate

9

2,832

2,832

15

6,711

6,711

Real estate construction

0

0

0

6

1,326

1,326

Agricultural

3

208

208

4

249

249

Real estate residential

7

1,115

1,115

14

2,745

2,742

Installment

1

22

22

1

22

22

 

22

$

4,308

$

4,308

43

$

11,775

$

11,772


During the three months ended September 30, 2012, restructured loan modifications made in commercial business and real estate residential segments primarily included maturity date extensions and payment modifications.


14


The following table summarizes troubled debt restructuring during the previous twelve months that subsequently defaulted during the nine months ended September 30, 2012.


 

   Three Months Ended September 30, 2012

       Nine Months Ended September 30, 2012

 

Number of Loans

Recorded Investment

Number of Loans

Recorded Investment

  ($ in thousands)

 

 

 

 

Commercial business

0

$

0

0

$

0

Commercial real estate

3

1,886

6

2,596

Real estate construction

0

0

0

0

Agricultural

0

0

0

0

Real estate residential

0

0

0

0

Installment

0

0

0

0

 

3

$

1,886

6

$

2,596


 

   Three Months Ended September 30, 2011

       Nine Months Ended September 30, 2011

 

Number of Loans

Recorded Investment

Number of Loans

Recorded Investment

  ($ in thousands)

 

 

 

 

Commercial business

0

$

0

1

$

89

Commercial real estate

4

1,328

7

2,963

Real estate construction

1

20

5

884

Agricultural

2

22

4

249

Real estate residential

0

0

10

2,311

Installment

0

0

0

0

 

7

$

1,370

27

$

6,496


All loans modified in a troubled debt restructuring are evaluated for impairment.  The nature and extent of impairment of restructured loans, including those which have experienced a subsequent payment default, are considered in the determination of an appropriate level of the ALL.


Note 5 – Other Real Estate Owned (“OREO”)


A summary of OREO, net of valuation allowances, for the periods indicated is as follows:


 

                     Three months ended

                   Nine months ended

 

September 30, 2012

September 30, 2011

September 30, 2012

September 30, 2011

($ in thousands)

 

 

 

 

Balance at beginning of period

$

4,707 

$

4,225 

$

4,404 

$

4,230 

Transfer of loans at net realizable value to OREO

625 

1,317 

2,158 

2,203 

Sale proceeds

(560)

(270)

(1,485)

(1,067)

Loans made in sale of OREO

(249)

(249)

(75)

Net gain (loss) from sale of OREO

34 

46 

(2)

135 

Provision for write-downs charged to operations

(85)

(210)

(354)

(318)

Balance at end of period

$

4,472 

$

5,108 

$

4,472 

$

5,108 



An analysis of the valuation allowance on OREO, included in the above table, is as follows:


 

                     Three months ended

                   Nine months ended

 

September 30, 2012

September 30, 2011

September 30, 2012

September 30, 2011

($ in thousands)

 

 

 

 

Balance at beginning of period

$

475 

$

2,851 

$

410 

$

2,788 

Provision for write-downs charged to operations

85 

210 

354 

318 

Amounts related to OREO disposed of

(212)

(60)

(416)

(105)

Balance at end of period

$

348 

$

3,001 

$

348 

$

3,001 


15


The properties held as OREO at September 30, 2012 consisted of $3,448 of commercial real estate (the largest being $1,744 related to a hotel/water park project), $267 of real estate construction loans, and $757 of residential real estate.  OREO as of December 31, 2011 consisted of $3,170 of commercial real estate (the largest being $1,744 related to a hotel/water park project), $946 of real estate construction, and $288 of residential real estate.  Management monitors properties held to minimize the Company’s risk of loss. Evaluations of the fair market value of the OREO properties are done quarterly and valuation adjustments, if necessary, are recorded in our consolidated financial statements.


Note 6- Short-term Borrowings


Short-term borrowings consisted of $13,167 and $13,655 of securities sold under repurchase agreements at September 30, 2012 and December 31, 2011, respectively.


The Company pledges securities available-for-sale as collateral for repurchase agreements.  The fair value of securities pledged for short-term borrowings totaled $17,879 at September 30, 2012 and $19,481 at December 31, 2011.


The following information relates to federal funds purchased, securities sold under repurchase agreements, and the Bank’s Federal Home Loan Bank of Chicago (“FHLB”) open line of credit for the following periods.


 

                     Three months ended

                   Nine months ended

 

September 30, 2012

September 30, 2011

September 30, 2012

September 30, 2011

($ in thousands)

 

 

 

 

Weighted average rate

0.10%

0.45%

0.10%

0.45%

For the period:

 

 

 

 

  Highest month-end balance

$

18,356  

$

15,817  

$

18,356  

$

15,817  

  Daily average balance

$

15,242  

$

14,078  

$

14,526  

$

11,543  

  Weighted average rate

0.26%

1.00%

0.47%

0.46%


Note 7- Long-term Borrowings


Long-term borrowings were as follows:


 

As of

As of

 

September 30, 2012

December 31, 2011

 

($ in thousands)

FHLB advances

$

26,061

$

30,061

Other borrowed funds

10,000

10,000

  Total long-term borrowings

$

36,061

$

40,061


FHLB Advances – Long-term advances from the FHLB have maturities through 2015 and had a weighted-average interest rate of 4.05% and 3.90% at September 30, 2012 and December 31, 2011, respectively.  

  

Other borrowed funds – Other borrowed funds consist of structured repurchase agreements.  The fixed rate structured repurchase agreements mature in 2014 and 2015, are callable in 2013, and had weighted-average interest rates of 4.24% at September 30, 2012 and December 31, 2011.


Note 8 – Income Taxes


During the second quarter of 2012, the Company’s results were negatively impacted by the establishment of a full valuation reserve against its remaining net deferred tax asset which resulted in an additional write-off of $1,149 recognized in income tax expense. At December 31, 2011, management had determined that a valuation allowance relating to a portion of the Company's net deferred tax asset was necessary and accordingly, a partial valuation allowance of $3,081 was recognized. Continuing losses and general uncertainty surrounding future economic and business conditions contributed to management’s determination to write-off the remaining $1,149 of its net deferred tax asset in the second quarter of 2012. Deferred tax assets are analyzed quarterly for changes affecting realization and accordingly, the valuation allowance may be adjusted which would change current tax expense in future periods.


16


For the third quarter of 2012, management has determined the full valuation allowance against the deferred tax asset continues to be warranted.  The current quarter income tax expense of $3 reported represents the change in the deferred tax asset valuation allowance recorded to offset the change in the deferred tax liability for available-for-sale securities.  The deferred tax liability associated with the market adjustment for marked to market securities decreased by $3 during the third quarter of 2012.  The $3 of income tax expense recorded offsets this reduction in deferred tax liability and results in a net deferred tax asset of zero for financial statement purposes.


Note 9 - Fair Value Measurements


Fair value represents the estimated price at which an orderly transaction to sell an asset or to transfer a liability would take place between market participants at the measurement date under current market conditions (i.e., an exit price concept).   As there is no active market for many of the Company’s financial instruments, estimates are made using discounted cash flow or other valuation techniques. Inputs into the valuation methods are subjective in nature, involve uncertainties, and require significant judgment and therefore cannot be determined with precision. Accordingly, the derived fair value estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. Assets and liabilities are categorized into three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy in which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability. Below is a brief description of each fair value level.


Level 1 – Fair value measurement is based on quoted prices for identical assets or liabilities that the Company has the ability to access.


Level 2 – Fair value measurement is based on: (i) quoted prices for similar assets or liabilities in active markets; (ii) quoted prices for similar assets or liabilities in markets that are not active; or (iii) valuation models and methodologies for which all significant assumptions are or can be corroborated by observable market data.


Level 3 – Fair value measurement is based on valuation models and methodologies that incorporate unobservable inputs, which are typically based on an entity’s own assumptions, as there is little related market activity.

 

The following is a description of the valuation methodology used for the Company’s more significant instruments measured on a recurring basis at fair value, including the general classification of such instruments pursuant to the valuation hierarchy.


Investment securities available-for-sale – Securities available-for-sale may be classified as Level 1, Level 2, or Level 3 measurements within the fair value hierarchy.  The fair value measurement of a Level 1 security is based on the quoted price in an active market.  Level 1 investment securities primarily include U.S. Treasury securities.  The fair value measurement of a Level 2 security is obtained from an independent pricing service and is based on pricing models, quoted prices of securities with similar characteristics or discounted cash flows, with consideration given to the nature of the quote and the relationship of recently evidenced market activity to the fair value estimate. Examples of these investment securities include Federal agency securities, obligations of states and political subdivisions, asset-backed securities, and mortgage related securities.  In certain cases where there is limited activity or less transparency around inputs to the estimated fair value, securities are classified within Level 3 of the fair value hierarchy.  Level 3 securities primarily include trust preferred securities. To validate the fair value estimates, assumptions, and controls, the Company looks to transactions for similar instruments and utilizes relevant market indices. While none of these sources are solely indicative of fair value, they serve as directional indicators for the appropriateness of the Company’s fair value estimates. The Company has determined that the fair value measures of its investment securities are classified predominantly within Level 2 of the fair value hierarchy.  


Loans held for sale – Loans held for sale, which consist generally of current production of certain fixed-rate, first-lien residential mortgage loans, are carried at the lower of cost or estimated fair value.  The estimated fair value of the residential mortgage loans held for sale was based on current secondary market prices for similar loans, which is considered to be Level 2 in the fair value hierarchy of valuation techniques.  


The fair value of loans held for sale is based on observable current prices in the secondary market in which loans trade. All loans held for sale are categorized based on commitments received from secondary sources that the loans


17


qualify for placement at the time of underwriting and at an agreed upon price. A gain or loss is recognized at the time of sale reflecting the present value of the difference between the contractual interest rate of the loan and the yield to investors.


The table below presents the Company’s investment securities available-for-sale and loans held for sale measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011, aggregated by the level in the fair value hierarchy within which those measurements fall.

 

Assets Measured at Fair Value on a Recurring Basis

 

 

 

 

 

 

   Fair Value Measurements Using

 

September 30, 2012

Level 1

Level 2

Level 3

 

 

    ($ in thousands)

Investment securities available-for-sale:

 

 

 

 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

$

12,281

$

0

$

12,281

$

0

Mortgage-backed securities

73,658

0

73,658

0

Obligations of states and political subdivisions

23,411

0

22,884

527

Corporate debt securities

834

0

9

825

Equity securities

151

0

51

100

Total investment securities available-for-sale

$

110,335

$

0

$

108,883

$

1,452

Loans held for sale

$

2,287

$

0

$

2,287

$

0


 

 

   Fair Value Measurements Using

 

December 31, 2011

Level 1

Level 2

Level 3

Investment securities available-for-sale:

 

 

 

 

U.S. Treasury securities and obligations of U.S. government corporations and agencies

$

18,808

$

0

$

18,808

$

0

Mortgage-backed securities

67,653

0

67,641

12

Obligations of states and political subdivisions

22,932

0

22,405

527

Corporate debt securities

832

0

7

825

Equity securities

151

0

51

100

Total investment securities available-for-sale

$

110,376

$

0

$

108,912

$

1,464

Loans held for sale

$

2,163

$

0

$

2,163

$

0


The table below presents a roll forward of the balance sheet amounts for the nine months ended September 30, 2012 and for the year ended December 31, 2011, for assets measured on a recurring basis and classified within Level 3 of the fair value hierarchy.


Assets Measured at Fair Value Using Significant Unobservable Inputs (Level 3)

($ in thousands)

 

 

Investment Securities Available-for-Sale

Balance at December 31, 2010

$

2,299 

Unrealized holding losses arising during the period:

 

  Included in earnings

(55)

  Included in other comprehensive income

Principal repayments

(146)

Sales

(641)

Transfers in to/out of Level 3

Balance at December 31, 2011

1,464 

 

 

Unrealized holding losses arising during the period:

 

  Included in earnings

  Included in other comprehensive income

Principal repayments

(13)

Sales

Transfers in to/out of Level 3

Balance at September 30, 2012

$

1,452 


18


Level 3 available-for-sale securities include corporate debt and equity securities.  The market for these securities was not active as of September 30, 2012.  


The following is a description of the valuation methodologies used for the Company’s more significant instruments measured on a nonrecurring basis at fair value.


Impaired loans – The Company considers a loan impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement, including principal and interest.   Loans considered to be impaired are measured at fair value on a nonrecurring basis.  For individually evaluated impaired loans, the amount of impairment is based upon the fair value of the underlying collateral.  


At September 30, 2012, loans with a carrying amount of $42,109 were considered impaired and were written down to their estimated fair value of $37,341.  As a result, the Company recognized a specific valuation allowance against these impaired loans totaling $4,768.  At December 31, 2011 loans with a carrying amount of $17,301 were considered impaired and were written down to their estimated fair value of $14,001.  As a result, the Company recognized a specific valuation allowance against these impaired loans totaling $3,300. Effective June 30, 2012, all substandard and doubtful loans are classified as impaired in the ALL calculation and evaluated for specific allocation.  This change in methodology was a large reason for the increase in impaired loans at June 30, 2012 and thereafter relative to prior dates, as previously only substandard and doubtful loans with collateral shortfalls were classified as impaired and evaluated for specific allocations in the ALL calculation.


OREO – Real estate acquired through or in lieu of loan foreclosure is recorded in our consolidated balance sheets at the lower of cost or fair value.  Fair value is determined based on third party appraisals and, if less than the carrying value of the loan, the carrying value of the loan is adjusted to the fair value.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  Given the significance of the adjustments made to the appraised values necessary to estimate the fair value of the properties, OREO is considered to be Level 3 in the fair value hierarchy of valuation techniques.  Valuation adjustments to OREO totaled $354 during the nine months ended September 30, 2012 and $628 during the year ended December 31, 2011, and recorded in Foreclosure/OREO expense.  At September 30, 2012 and December 31, 2011, OREO totaled $4,472 and $4,404, respectively.


The table below presents the Company’s impaired loans and OREO measured at fair value on a nonrecurring basis as of September 30, 2012 and December 31, 2011, aggregated by the level in the fair value hierarchy in which those measurements fall.


Assets Measured at Fair Value on a Nonrecurring Basis

 

 

   Fair Value Measurements Using

 

September 30, 2012

Level 1

Level 2

Level 3

 

 

    ($ in thousands)

 

Impaired loans (1)

$

37,341

$

0

$

0

$

37,341

OREO

4,472

0

0

4,472


 

 

   Fair Value Measurements Using

 

December 31, 2011

Level 1

Level 2

Level 3

 

 

    ($ in thousands)

 

Impaired loans (1)

$

14,001

$

0

$

0

$

14,001

OREO

4,404

0

0

4,404

(1) Represents individually evaluated loans, net of the related allowance for loan losses.


For Level 3 assets measured at fair value on a recurring or non-recurring basis as of September 30, 2012, the Company utilized the following valuation techniques and significant unobservable inputs.


Investment securities available-for-sale:  In valuing the investment securities available-for-sale classified within Level 3, the Company reviewed the underlying collateral and other relevant data in developing the assumptions for these investment securities.


Impaired loans:  Fair value measurement of collateral for collateral-dependent impaired loans primarily relates to discounting criteria applied to independent appraisals received with respect to the collateral.  Discounts applied to the appraisals are dependent on the appraisal.  As of September 30, 2012, discounts applied to appraisals ranged from 15% to 30%.


19


OREO:  Fair value measurement of OREO primarily relates to estimated disposition costs and discounting criteria applied to independent appraisals received with respect to the property.  Discounts applied to the appraisals are dependent on the appraisal and marketability of the property.  As of September 30, 2012, discounts applied to appraisals ranged from 15% to 30%.


The estimated fair value of the Company’s financial instruments on the balance sheet at September 30, 2012 and December 31, 2011 were as follows:


 

 

 

September 30, 2012

 

 

Carrying

 

    Fair Value Measurements Using

 

Amount

Fair Value

Level 1

Level 2

Level 3

Financial assets:

 

 

 

 

 

  Cash and short-term investments

$

33,352

$

33,352

$

33,352

$

0

$

0

  Investment securities available-for-sale

110,335

110,335

0

108,883

1,452

  Other investments

1,613

1,613

0

1,613

0

  Loans held for sale

2,287

2,287

0

2,287

0

  Net loans

297,060

293,753

0

0

293,753

  Accrued interest receivable

1,635

1,635

0

0

1,635

Financial liabilities:

 

 

 

 

 

  Deposits

$

364,404

$

364,912

$

0

$

0

$

364,912

  Short-term borrowings

13,167

13,167

0

0

13,167

  Long-term borrowings

36,061

38,844

0

0

38,844

  Subordinated debentures

10,310

4,818

0

0

4,818

  Accrued interest payable

805

805

0

0

805


 

 

 

December 31, 2011

 

 

Carrying

 

    Fair Value Measurements Using

 

Amount

Fair Value

Level 1

Level 2

Level 3

Financial assets:

 

 

 

 

 

  Cash and short-term investments

$

31,360

$

31,360

$

31,360

$

0

$

0

  Investment securities available-for-sale

110,376

110,376

0

108,912

1,464

  Other investments

2,616

2,616

0

2,616

0

  Loans held for sale

2,163

2,163

0

2,163

0

  Net loans

320,047

317,805

0

0

317,805

  Accrued interest receivable

1,640

1,640

0

0

1,640

Financial liabilities:

 

 

 

 

 

  Deposits

$

381,620

$

383,520

$

0

$

0

$

383,520

  Short-term borrowings

13,655

13,655

0

0

13,655

  Long-term borrowings

40,061

42,525

0

0

42,525

  Subordinated debentures

10,310

4,818

0

0

4,818

  Accrued interest payable

878

878

0

0

878


The following is a description of the valuation methodologies used to estimate the fair value of financial instruments.


Cash and short-term investments – The carrying amounts reported in the Consolidated Balance Sheets for cash and due from banks, interest-bearing deposits in other financial institutions, and federal funds sold approximate the fair value of these assets.


Investment securities available-for-sale – The fair value of investment securities available-for-sale is based on quoted prices in active markets, or, if quoted prices are not available for a specific security, the fair values are estimated by using pricing models, quoted price with similar characteristics, or discounted cash flows.


Other investments – Other investments consists of FHLB and Bankers’ Bank of Wisconsin stock.  The carrying amount is a reasonable fair value estimate of other investments given their “restricted” nature.


Loans held for sale – The estimated fair value of the residential mortgage loans held for sale is based on current secondary market prices for similar loans.


20


Net loans – Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, residential mortgage, and other consumer. The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s repayment schedules for each loan classification. In addition, for impaired loans, marketability and appraisal values for collateral are considered in the fair value determination.


Deposits – The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, NOW accounts, and money market accounts, is equal to the amount payable on demand at the reporting date. The fair value of certificates of deposit is based on the discounted value of contractual cash flows.  The discount rate reflects the credit quality and operating expense factors of the Company.


Short-term borrowings – The carrying amount reported in the Consolidated Balance Sheets for short-term borrowings approximates the liability’s fair value.


Long-term borrowings – The fair values are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.


Subordinated debentures – The fair value is estimated by discounting future cash flows using the current interest rates at which similar borrowings would be made.


Accrued interest – The carrying amount of accrued interest approximates its fair value.


Off-balance sheet instruments – The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current interest rates, and the present creditworthiness of the counter parties. Since this amount is immaterial, no amounts for fair value are presented.


Limitations – Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of particular financial instruments. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include premises and equipment, intangibles, other assets and other liabilities. In addition, the tax ramifications related to the realization of the unrealized gains or losses can have a significant effect on fair value estimates and have not been considered in the estimates.


Because of the wide range of valuation techniques and the numerous assumptions which must be made, it may be difficult to compare the Company’s determination of fair value to that of other financial institutions. It is important that the many assumptions discussed above be considered when using the estimated fair value disclosures and to realize that because of the uncertainties, the aggregate fair value should in no way be construed as representative of the underlying value of the Company.  


ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION


We operate as a one-bank holding company and own all of the outstanding capital stock of the Bank.  The Bank, chartered as a state bank in Wisconsin, is engaged in general commercial and retail banking services, including wealth management services.  


The following management’s discussion and analysis is presented to assist in the understanding and evaluation of our consolidated financial condition as of September 30, 2012 and December 31, 2011 and results of operations for the three-month and nine-month periods ended September 30, 2012 and 2011.  It is intended to supplement the unaudited financial statements, condensed footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction therewith.  This discussion should be read in conjunction with the interim consolidated financial statements and the condensed notes thereto included with this report and with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the financial statements and notes related thereto included in our 2011


21


Form 10-K.  Quarterly comparisons reflect continued consistency of operations and do not reflect any significant trends or events other than those noted in the comments.


Forward-Looking Statements


Statements made in this document and in documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of management’s plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements generally may be identified by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “estimate,” “should,” “will,” “intend,” or similar expressions. Stockholders should note that many factors, some of which are discussed elsewhere in this document, could affect the future financial results of the Company and could cause those results to differ materially from those expressed in forward-looking statements contained in this document. These factors, many of which are beyond the Company’s control, include, but are not necessarily limited to the following:


·

operating, legal and regulatory risks, including the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations promulgated thereunder, as well as the rules proposed by the Federal bank regulatory agencies to implement the Basel III capital accord;

·

economic, political and competitive forces affecting our banking and wealth management businesses;

·

changes in monetary policy and general economic conditions, which may impact our net interest income;

·

the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful; and

·

other factors discussed under Item 1A, “Risk Factors” in our 2011 Form 10-K and elsewhere therein and herein, and from time to time in our other filings with the Securities and Exchange Commission after the date of this report.


These factors should be considered in evaluating the forward-looking statements, and you should not place undue reliance on such statements. We specifically disclaim any obligation to update factors or to publicly announce the results of revisions to any of the forward-looking statements or comments included herein to reflect future events or developments.

 

Critical Accounting Policies


The financial condition and results of operations presented in the consolidated financial statements, accompanying notes to the consolidated financial statements, selected financial data appearing elsewhere within this report, and management’s discussion and analysis are dependent upon the Company’s accounting policies.  The selection and application of these accounting policies involve judgments about matters that affect the amounts reported in the financial statements and accompanying notes.  The Company made no significant changes in its critical accounting policies and significant estimates from those disclosed in its 2011 Form 10-K other than the change to the historical loss rates and other factors which impacted the ALL as discussed in Note 4 to the consolidated financial statements contained herein.

 

All remaining information included in this Management’s Discussion and Analysis of Financial Condition and Results of Operations is shown in thousands of dollars, except per share data.


RESULTS OF OPERATIONS


Overview


The Company reported net income available to common shareholders of $218, or $0.13 per common share, for the three months ended September 30, 2012, compared to a net loss to common shareholders of $346, or $0.21 per common share, in the comparable 2011 period.  For the nine months ended September 30, 2012, net loss to common shareholders was $2,701, or $1.63 per common share.  This compares to a net loss to common shareholders of $1,228, or $0.74 per common share, for the nine months ended September 30, 2011.


Key financial data includes:


·

The Company’s results for the nine months ended September 30, 2012 were negatively impacted by the establishment of a full valuation allowance against its remaining net deferred tax asset which resulted in an


22


additional write-off of $1,152 recognized in income tax expense during the second quarter.  At December 31, 2011, management had determined that a valuation allowance relating to a portion of the Company's net deferred tax asset was necessary and accordingly, a partial valuation allowance of $3,081 was recognized. Continuing losses and general uncertainty surrounding future economic and business conditions contributed to management’s determination to establish the additional valuation allowance in the second quarter of 2012.   


·

The provision for loan losses was $3,680 for the first nine months of 2012 compared to $3,850 for the same period in 2011.  The provision for the first nine months of 2012 was negatively impacted by changes to the historical loss rates and changes made in the values assigned to qualitative factors utilized by management in the calculation of the ALL during the second quarter.  The provision for loan losses was $750 for the third quarter of 2012, compared with $900 for same period in 2011.  


·

Net charge-offs were $2,967 in the first nine months of 2012, compared to $4,039 for the comparable period in 2011.  Net charge-offs for the third quarter of 2012 totaled $1,163, compared to $842 for the third quarter of 2012.  The Bank’s ratio of the ALL to total loans at September 30, 2012 was 3.42% compared to 2.98% at December 31, 2011 and 2.74% at September 30, 2011.  


·

Net interest income of $11,165 for the nine months ended September 30, 2012, decreased by 3% from the same period in 2011.  The net interest margin for the nine months ended September 30, 2012 was 3.33% unchanged from the same period in 2011.  However, this trend may not continue as assets mature, as the current reinvestment rates are substantially lower than the previous rates, and there is less opportunity to offset the future impact of the decline in income earned on assets as rates paid on liabilities approach 0%.  The average yield on earning assets was 4.42% at September 30, 2012 compared to 4.76% for the nine months ended September 30, 2011.  The cost of interest-bearing liabilities was 1.34% for the nine months ended September 30, 2012 compared to 1.72% for the nine months ended September 30, 2011.  


·

Loans of $307,589 at September 30, 2012, decreased $22,274 from December 31, 2011.   Much of this decrease was the result of a continued lack of demand for loans in our market areas coupled with the regular pay downs and pay-offs of existing loans.  Increased competition for creditworthy borrowers continues to adversely impact profits and the Bank’s ability to attract and retain creditworthy borrowers.


·

Total deposits were $364,404 at September 30, 2012, down $17,216 from December 31, 2011, primarily due to seasonal fluctuations in noninterest-bearing demand deposits, decreased time deposits and the Company’s strategy to continue to reduce noncore funding sources.  

 

·

Noninterest income for the nine months ended September 30, 2012 was $2,911.  Excluding a legal settlement of $500 and a $55 loss on sale of investments, noninterest income was $2,824 for the nine months ended September 30, 2011.  The increase in the “core” noninterest income was due to increased mortgage banking income from the sales of residential real estate loans into the secondary market and an increase in other income from the recovery of loan fees from charged-off loans.  These increases were offset in part by a decline in service fees of $98 primarily due to a general decrease in the amount of NSF/overdraft fees resulting from regulatory changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act.  


·

For the nine months ended September 30, 2012, noninterest expense, excluding foreclosure/OREO expense and legal and professional fees, decreased $1,276, or 11%, to $10,122, compared to the same period in 2011, primarily due to decreased salaries and employee benefits, occupancy expenses, data processing costs, FDIC expense and marketing expenses.  The Company will continue to focus on expense control for the remainder of 2012.  Foreclosure/OREO expense was $668 for the first nine months of 2012 compared to $432 for the same period in 2011, primarily due to valuation adjustments on OREO properties and net losses on the sales of various foreclosed OREO properties.  


·

As of September 30, 2012, the Bank’s Tier One Capital Leverage ratio was 8.8% and Total Risk-Based Capital ratio was 14.9%, compared to 8.7% and 14.2%, respectively, at December 31, 2011.  The Company’s Tier One Capital Leverage ratio was 9.7% and Total Risk-Based Capital ratio was 16.2%, compared to 9.6% and 15.6%, respectively, at December 31, 2011.  All ratios are above the regulatory guidelines stipulated in the Bank’s and Company’s agreements with their primary regulators.


23


Net Interest Income


Our earnings are substantially dependent on net interest income, which is the difference between interest earned on investments and loans and the interest paid on deposits and other interest-bearing liabilities. Net interest income is directly impacted by the sensitivity of the balance sheet to changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities, and repricing frequencies.


Comparison of nine months ended September 30, 2012 versus September 30, 2011


The following table sets forth information regarding average balances, interest income, or interest expense, and the average rates earned or paid for each of the Company’s major asset, liability and stockholders’ equity categories for the nine-month periods ended September 30, 2012and 2011. Effective for 2012, interest income on tax-exempt securities has not been adjusted to reflect the tax equivalent basis, since the Company does not expect to realize all of the tax benefits associated with these securities.


Table 1:  Year-To-Date Net Interest Income Analysis


 

Nine months ended September 30, 2012

Nine months ended September 30, 2011

 

Average

Interest

Average

Average

Interest

Average

 

Balance

Income/Expense

Yield/Rate

Balance

Income/Expense

Yield/Rate

ASSETS

 

 

 

 

 

 

Earning Assets

 

 

 

 

 

 

Loans (1) (2) (3)

$

323,509 

$

12,964

5.35%

$

339,460 

$

14,154

5.57%

Investment securities:

 

 

 

 

 

 

  Taxable

94,522 

1,539

2.17%

92,804 

1,980

2.85%

  Tax-exempt (2)

11,814 

273

3.09%

12,278 

448

4.88%

Interest-bearing deposits in other financial institutions

13,520 

26

0.26%

0

0.00%

Federal funds sold

1,732 

2

0.15%

11,491 

11

0.13%

Securities purchased under agreements to sell

0

0.00%

10,783 

108

1.34%

Other interest-earning assets

2,948 

32

1.45%

3,515 

29

1.10%

Total earning assets

$

448,045 

$

14,836

4.42%

$

470,340 

$

16,730

4.76%

Cash and due from banks

$

12,793 

 

 

$

7,781 

 

 

Other assets

23,309 

 

 

26,914 

 

 

Allowance for loan losses

(10,297)

 

 

(9,144)

 

 

Total assets

$

473,850 

 

 

$

495,891 

 

 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

 

  Interest-bearing demand

$

38,488 

$

91

0.32%

$

36,308 

$

127

0.47%

  Savings deposits

123,199 

502

0.54%

115,935 

671

0.77%

  Time deposits

141,584 

1,731

1.63%

174,326 

2,775

2.13%

Short-term borrowings

14,526 

68

0.63%

11,543 

87

1.01%

Long-term borrowings

37,316 

1,129

4.04%

41,682 

1,223

3.92%

Subordinated debentures

10,310 

150

1.94%

10,310 

135

1.75%

Total interest-bearing liabilities

$

365,423 

$

3,671

1.34%

$

390,104 

$

5,018

1.72%

Noninterest-bearing demand deposits

66,752 

 

 

60,029 

 

 

Other liabilities

3,089 

 

 

2,706 

 

 

Stockholders' equity

38,586 

 

 

43,052 

 

 

Total liabilities and stockholders' equity

$

473,850 

 

 

$

495,891 

 

 

 

 

 

 

 

 

 

Net interest income and rate spread

 

$

11,165

3.08%

 

$

11,712

3.04%

Net interest margin

 

 

3.33%

 

 

3.33%

(1)  Nonaccrual loans are included in the daily average loan balances outstanding.

(2) The yield on tax-exempt loans and investment securities is computed on a tax-equivalent basis using a federal

       tax rate of 34% and adjusted for the disallowance of interest expense for the 2011 period.

(3)   Interest income includes loan fees of $246 in 2012 and $242 in 2011.


24


Net interest income for the nine months ended September 30, 2012, was $11,165, down from taxable-equivalent net interest income of $11,712 in the related 2011 period. The decrease in net interest income was primarily attributable to unfavorable rate variances (as the impact of changes in the interest rate environment and product pricing reduced  net interest income by $357) and unfavorable volume variances (as changes in the balances and mix of earning assets and interest-bearing liabilities decreased net interest income by $190).


The net interest margin for the first nine months of 2012 was 3.33%, unchanged from the taxable-equivalent net interest margin in the related 2011 period.  Yields on earning assets have declined year-over-year as elevated levels of liquidity have been reinvested in lower-yielding investment securities and interest-bearing deposits at other financial institutions and levels of nonaccrual loans remain above historical averages.  The decline in yields was offset by the decline in the cost of interest-bearing deposits due to the decline in interest rates in the current low rate environment.  


For the nine-month period ended September 30, 2012, the yield on earning assets of 4.42% was 34 basis points (“bps”) lower than the comparable period in 2011.  Loan yields decreased 22 bps, to 5.35%, impacted by levels of nonaccrual loans, lower loan yields given the repricing of adjustable rate loans, soft loan demand, and competitive pricing pressures to retain and/or obtain creditworthy borrowers.  The weighted-average yield on other earning assets decreased 62 bps to 2.01%, impacted by the Company’s excess liquidity position as a result of soft loan demand being invested in lower-yielding assets.  


The cost of interest-bearing liabilities of 1.34% for the first nine months of 2012 was 38 bps lower than the related 2011 period.  The weighted-average cost of interest-bearing deposits was 1.02%, down 44 bps from the prior-year period, while the weighted-average cost of wholesale funding (comprised of short-term borrowings and long-term borrowings) decreased 21 bps to 3.08% for the nine months ended September 30, 2012.  The Company’s outstanding $10,310 of subordinated debentures have a floating rate equal to the three-month LIBOR plus 1.43%, adjusted quarterly.  The interest rate at September 30, 2012 was 1.82%.  


Average earning assets of $448,045 for the first nine months of 2012 was $22,295 lower than the comparable period last year.   Average investment securities increased $1,254 to $106,336, reflecting the Company’s excess liquidity position invested in lower-yielding assets rather than loans.  Overnight liquidity (comprised of interest-bearing deposits in other financial institutions, federal funds sold, and securities purchased under agreements to sell) decreased $7,031 to $15,252, due to the decrease in total average interest-bearing deposits and long-term borrowings.  Due to the reduced liquidity needs, long-term borrowings have not been renewed as they mature.  Year to date interest income in 2012 decreased $1,894 relative to the comparable 2011 period to $14,836, of which $767 of such decrease was due to unfavorable volume changes and $1,127 was due to unfavorable rate changes.


Average interest-bearing liabilities of $365,423 for the first nine months of 2012 were down $24,681 compared to the comparable 2011 period. Average interest-bearing deposits decreased $23,298 while noninterest-bearing deposits increased $6,723.  Total average borrowings decreased $1,383 to $51,842.


For the first nine months of 2012, interest expense decreased $1,347.  $770 of such decrease was due to favorable rate changes and $577 was due to favorable volume changes.  Management continues to manage the liability side of the net interest margin by adjusting short-term deposit rates to market.


25


Table 2:  Volume/Rate Variance


Comparison of nine months ended September 30, 2012 versus 2011

 

Volume

Due to Rate  (1)

Net

 

($ in thousands)

  Loans (2)

($665)

($525)

($1,190)

  Taxable investments

37 

(478)

(441)

  Tax-exempt investments (2)

(17)

(158)

(175)

  Interest-bearing deposits in other financial institutions

26 

26 

  Federal funds sold

(9)

(9)

  Securities purchased under agreements to sell

(108)

(108)

  Other interest-earning assets

(5)

Total earning assets

(767)

(1,127)

(1,894)

  Interest-bearing demand

(44)

(36)

  Savings deposits

42 

(211)

(169)

  Time deposits

(522)

(522)

(1,044)

  Short-term borrowings

23 

(42)

(19)

  Long-term borrowings

(128)

34 

(94)

  Subordinated debenture

15 

15 

Total interest-bearing liabilities

(577)

(770)

(1,347)

Net interest income

($190)

($357)

($547)

(1)  The change in interest due to both rate and volume has been allocated to rate.

 

(2)  The yield on tax-exempt loans and tax-exempt investment securities is computed on a tax-equivalent

        basis using a federal tax rate of 34% and adjusted for the disallowance of interest expense for the 2011

        period.


26


Comparison of three months ended September 30, 2012 versus September 30, 2011


Table 3:  Quarterly Net Interest Income Analysis


 

Three months ended September 30, 2012

Three months ended September 30, 2011

 

Average

Interest

Average

Average

Interest

Average

 

Balance

Income/Expense

Yield/Rate

Balance

Income/Expense

Yield/Rate

ASSETS

 

 

 

 

 

 

Earning Assets

 

 

 

 

 

 

Loans (1) (2) (3)

$

316,791 

$

4,160

5.22%

$

342,285 

$

4,614

5.35%

Investment securities:

 

 

 

 

 

 

  Taxable

94,560 

491

2.07%

93,429 

652

2.77%

  Tax-exempt (2)

11,565 

89

3.06%

12,443 

151

4.81%

Interest-bearing deposits in other financial institutions

18,719 

12

0.26%

0

0.00%

Federal funds sold

420 

0

0.00%

15,823 

5

0.13%

Securities purchased under agreements to sell

0

0.00%

859 

2

0.92%

Other interest-earning assets

2,668 

11

1.64%

3,467 

9

1.03%

Total earning assets

$

444,723 

$

4,763

4.26%

$

468,315 

$

5,433

4.60%

Cash and due from banks

$

13,429 

 

 

$

8,277 

 

 

Other assets

22,351 

 

 

27,784 

 

 

Allowance for loan losses

(10,854)

 

 

(9,106)

 

 

Total assets

$

469,649 

 

 

$

495,270 

 

 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

 

  Interest-bearing demand

$

38,680 

$

16

0.16%

$

33,833 

$

38

0.44%

  Savings deposits

121,400 

100

0.33%

117,395 

231

0.78%

  Time deposits

137,541 

520

1.50%

168,914 

835

1.96%

Short-term borrowings

15,242 

10

0.26%

14,078 

35

0.99%

Long-term borrowings

36,061 

372

4.10%

40,061 

410

4.06%

Subordinated debentures

10,310 

49

1.89%

10,310 

45

1.73%

Total interest-bearing liabilities

$

359,234 

$

1,067

1.18%

$

384,591 

$

1,594

1.64%

Noninterest-bearing demand deposits

70,031 

 

 

64,895 

 

 

Other liabilities

3,423 

 

 

2,775 

 

 

Stockholders' equity

36,962 

 

 

43,010 

 

 

Total liabilities and stockholders' equity

$

469,649 

 

 

$

495,270 

 

 

Net interest income and rate spread

 

$

3,696

3.08%

 

$

3,839

2.96%

Net interest margin

 

 

3.31%

 

 

3.25%

(1)  Nonaccrual loans are included in the daily average loan balances outstanding.

(2) The yield on tax-exempt loans and investment securities is computed on a tax-equivalent basis using a federal

       tax rate of 34% and adjusted for the disallowance of interest expense for the 2011 period.

(3)   Interest income includes loan fees of $82 in 2012 and $79 in 2011.



Net interest income for the third quarter of 2012 was $3,696, $143 lower than third quarter of 2011.  Unfavorable volume variances decreased net interest income by $175, offset by favorable rate variances which increased net interest income by $32.  The net interest margin for the quarter ended September 30, 2012 was 3.31%, up from 3.25% in the comparable 2011 period.


Average earnings assets of $444,723 for the third quarter of 2012 were $23,592 lower than the comparable quarter of 2011.  Average investment securities increased $253 to $106,125, while average loans decreased $25,494 to $316,791.  Overnight liquidity increased $2,448 to $19,139, due to the decrease in average loans.  On the funding side, average interest-bearing deposits of $297,621 were down $22,521, while average noninterest-bearing deposits increased $5,136 to $70,031 compared to$64,895 for the comparable 2011 period.  Total average borrowings decreased $2,836 to $51,303.


27


Table 4:  Volume/Rate Variance


Comparison of three months ended September 30, 2012 versus 2011

 

 

Due to

 

Volume

Rate

Net

 

($ in thousands)

  Loans (1)(2)

($343)

($111)

($454)

  Taxable investments

(169)

(161)

  Tax-exempt investments (2)

(11)

(51)

(62)

  Interest-bearing deposits in other financial institutions

12 

12 

  Federal funds sold

(5)

(5)

  Securities purchased under agreements to sell

(2)

(2)

  Other interest-earning assets

(2)

Total earning assets

(355)

(315)

(670)

  Interest-bearing demand

(27)

(22)

  Savings deposits

(139)

(131)

  Time deposits

(155)

(160)

(315)

  Short-term borrowings

(28)

(25)

  Long-term borrowings

(41)

(38)

  Subordinated debenture

Total interest-bearing liabilities

(180)

(347)

(527)

Net interest income

($175)

$

32 

($143)

(1)  Non-accrual loans are included in the daily average loan balances outstanding.

 

(2)  The yield on tax-exempt loans and investment securities is computed on a tax-equivalent basis using

        a federal tax rate of 34% and adjusted for the disallowance of interest expense for the 2011 period.


Provision for Loan Losses


The provision for loan losses for the first nine months of 2012 was $3,680, compared to $3,850 for the same period in 2011.  In consultation with banking regulators, during the second quarter of 2012, management changed various factors in the ALL allocation methodology including changes to the historical loss rates and values assigned to qualitative factors utilized in the calculation of the ALL which increased the amount of provision taken year to date in 2012.  The provision for loan losses for the third quarter of 2012 was $750, compared to $900 for the same period in 2011.  


Net charge-offs were $2,967 for the first nine months of 2012, compared to $4,039 for the same period of 2011.  Net charge-offs for the third quarter of 2012 totaled $1,163, compared to $842 for the third quarter of 2011.  The level of charge-offs in 2012 were primarily due to management’s decision, made in consultation with the banking regulators, to charge-off certain impaired loans that were covered by specific reserve allocations identified in the ALL.  At September 30, 2012, the ALL was $10,529, an increase of $713 from December 31, 2011.  The ratio of the ALL to total loans was 3.42% and 2.98% at September 30, 2012 and December 31, 2011, respectively. Nonperforming loans at September 30, 2012, were, $13,157, compared to $11,215 at December 31, 2011, representing 4.28% and 3.40% of total loans, respectively.


The provision for loan losses is predominantly a function of the Company’s methodology and judgment as to qualitative and quantitative factors used to determine the adequacy of the ALL.  The adequacy of the ALL is affected by changes in the size and character of the loan portfolio, changes in levels of impaired and other nonperforming loans, historical losses and delinquencies on each portfolio category, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing and future economic conditions, the fair value of underlying collateral, and other factors which could affect potential credit losses.  We believe the provision and level of our ALL conforms to our policies and was adequate to cover anticipated and unexpected loan losses inherent in our loan portfolio as of September 30, 2012.  However, we may need to increase our provisions for loan losses in the future should the quality of the loan portfolio decline or other factors used to determine the ALL worsen.  Please refer to the discussion under “Allowance for Loan Losses” also included under Item 2.  “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for further information.


28


Noninterest Income


Table 5:  Noninterest Income


 

            Three months ended

 

 

 

         Nine months ended

 

 

 

September 30, 2012

September 30, 2011

$ Change

% Change

 

September 30, 2012

September 30, 2011

$ Change

% Change

($ in thousands)

 

 

 

 

 

 

 

 

 

Service fees

$

235

$

226

$

9

4%

 

$

633

$

731 

($98)

(13%) 

Trust service fees

270

270

0

0%

 

823

803 

20 

2%

Investment product commissions

55

47

8

17%

 

131

160 

(29)

(18%) 

Mortgage banking

104

94

10

11%

 

376

327 

49 

15%

Loss on sale of investments

0

0

0

0%

 

0

(55)

55 

(100%) 

Other

313

278

35

13%

 

948

1,303 

(355)

(27%) 

Total noninterest income

$

977

$

915

$

62

7%

 

$

2,911

$

3,269 

($358)

(11%) 


Comparison of nine months ended September 30, 2012 versus September 30, 2011


Noninterest income for the first nine months of 2012 was $2,911, down $358, or 11%, from the same period in 2011.  Excluding a legal settlement of $500, which is included in “Other” and a $55 loss on the sale of investments during the nine months ended September 30, 2011, noninterest income increased $87 between related periods.


Service fees on deposit accounts for the first nine months of 2012 were $633, down $98, or 13%, from the comparable 2011 period.  The year to date decline in service fees was primarily due to a general decrease in the amount of NSF/overdraft fees resulting from regulatory changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Core fee-based revenues for the remainder of 2012 and beyond are expected to be lower than historical amounts due to regulatory changes.  


The Wealth Management Services Group generates trust service fees and investment product commissions. Wealth Management income was $954 for the first nine months of 2012, down $9, or 1%, from the same period in 2011, primarily due to the level of assets under management, on which trust service fees are based, remaining relatively flat while the volume of investment product sales decreased.


Mortgage banking income represents income received from the sale of residential real estate loans into the secondary market.  Mortgage banking income for the first nine months of 2012 was $376, compared to $327 for the same period in 2011.  This increase between the nine months ended September 30, 2012 and 2011was primarily attributable to higher volume of loans sold to the secondary market.  Secondary mortgage production was $26,770 for the nine months ended September 30, 2012, compared to $23,899 for the same period in 2011.  


For the first nine months of 2011, the Company recognized a $55 loss on the sale of investments.  The security sales were executed in an effort to increase the credit quality of the Company’s investment portfolio.  There were no investment sales in the first nine months of 2012.


In the first quarter of 2011, the Company received a $500 legal settlement, the details of which are subject to a confidentiality agreement.  Excluding this legal settlement, other noninterest income increased $145, or 18%, to $948 for the first nine months of 2012 compared to $803 in the same period in 2011, primarily due to $55 of loan fees recovered from charged-off loans, $22 of loan prepayment penalties and $27 of ATM transaction fees and debit card interchange income earned in the first nine months of 2012.


Comparison of three months ended September 30, 2012 versus September 30, 2011


Total noninterest income for the quarter ended September 30, 2012 was $977 compared to $915 during the September 30, 2011 quarter, an increase of $62, or 7%.  Third quarter 2012 noninterest income increased primarily due to increased service fees, investment product commissions, mortgage banking income, loan prepayment penalties and ATM transaction fees and debit card interchange income.  Trust service fees remained unchanged compared to the same period last year.


29


Noninterest Expense


Table 6:  Noninterest Expense


 

Three months ended

 

Nine months ended

 

September 30, 2012

September 30, 2011

$ Change

% Change

 

September 30, 2012

September 30, 2011

$ Change

% Change

 ($ in thousands)

 

 

 

 

 

 

 

 

 

Salaries and employee benefits

$

1,815

$

2,133

($318)

(15%) 

 

$

5,669

$

6,360

($691)

(11%) 

Occupancy

391

432

(41)

(9%) 

 

1,238

1,342

(104)

(8%) 

Data processing

161

167

(6)

(4%) 

 

477

501

(24)

(5%) 

Foreclosure/OREO expense

119

261

(142)

(54%) 

 

668

432

236 

55%

Legal and professional fees

227

219

4%

 

668

610

58 

10%

FDIC expense

253

263

(10)

(4%) 

 

767

862

(95)

(11%) 

Other

573

709

(136)

(19%) 

 

1,971

2,333

(362)

(16%) 

Total noninterest expense

$

3,539

$

4,184

(645)

(15%) 

 

$

11,458

$

12,440

(982)

(8%) 


Comparison of nine months ended September 30, 2012 versus September 30, 2011


Total noninterest expense was $11,458 for the first nine months of 2012, a decrease of $982, or 8%, compared to the first nine months of 2011.  Excluding foreclosure/OREO expense and legal and professional fees, total noninterest expense decreased $1,276, or 11%.  The majority of the noninterest expense decrease was due to decreased salaries and employee benefits and marketing expenses.  The decreases were offset by increases in foreclosure/OREO expense and legal and professional fees related to continued heightened levels of nonperforming assets and expenses relating to such nonperforming assets.


Salaries and employee benefits of $5,669 for the first nine months of 2012 decreased $691, or 11%, from the same period in 2011, primarily due to the decrease of full-time equivalent employees from 152 at September 30, 2011 to 134 at September 30, 2012.  Occupancy expense decreased $104, or 8%, in the first nine months of 2012, due to decreased building maintenance, utility costs, depreciation and automobile expense, due in part to the February 1, 2011 closing of the Bank’s branch located in Lake Tomahawk, Wisconsin as well as certain renegotiated contracts. Effective October 19, 2012, the Bank’s branch located in Weston, Wisconsin, which was leased from a third party, was also closed.  Data processing costs decreased $24, or 5%, due to decreased data processing maintenance costs.  


Foreclosure/OREO expense consists of OREO carrying costs (maintenance, utilities, real estate taxes), valuation adjustments against the OREO carrying value, and gains or losses from the sale of OREO.  Foreclosure/OREO expense increased $236 between the comparable nine-month periods.  Foreclosure/OREO expense for the first nine months of 2012 included $354 of valuation adjustments against the carrying costs of various foreclosed properties based on appraisals obtained during the period, compared to $318 in such valuation adjustments in the same period in 2011.  Net losses on the sale of foreclosed properties were $2 for the nine months ended September 30, 2012 compared to net gains on the sale of foreclosed properties of $135 for the nine months ended September 30, 2011.


Legal and professional fees of $668 increased $58, or 10%, primarily due to costs associated with problem loans, credit reviews, properties held in foreclosure and consultant fees.  The decrease in FDIC expense of $95 was primarily due to the decrease in the Bank’s average assets, which is the basis of the FDIC assessment calculation. Other operating expenses decreased $362 compared to the first nine months of 2011, primarily due to a $264 decrease in marketing costs, which had been elevated in the 2011 period due to the introduction of a new deposit program at that time.  


Comparison of three months ended September 30, 2012 versus September 30, 2011


Noninterest expense for the third quarter of 2012 decreased $645, or 15%, compared to the third quarter of 2011.  Excluding foreclosure/OREO expense and legal and professional fees, total noninterest expense decreased $511, or 14%.  Foreclosure/OREO expense of $119 decreased $142, primarily due to $210 of valuation adjustments against the carrying cost of one foreclosed property recorded in the third quarter 2011.  Legal and professional fees increased $8, primarily due to costs associated with problem loans, credit reviews or properties held in foreclosure.  


30


Income Taxes and Deferred Tax Asset

The Company recorded income tax expense of $3 for the third quarter of 2012, compared to a benefit of $209 for the third quarter of 2011. For the first nine months of 2012, income tax expense totaled $1,152 compared with a benefit of $761 for the same period of 2011. The increase in tax expense for the three months ended September 30, 2012 was due to increased taxable income relative to the 2011 period, and the increase in tax expense for the nine months ended September 30, 2012 was primarily the result of establishing a full valuation allowance against our deferred tax asset which resulted in an additional write-off of $1,149 recognized in income tax expense in the second quarter of 2012.

Under U.S. GAAP, the Company must periodically analyze its deferred tax asset to determine if a valuation allowance is required. A valuation allowance is required to be recognized if it is “more likely than not” that such deferred tax assets will not be realized. In making that determination, management is required to evaluate both positive and negative evidence, including recent historical financial performance, forecasts of future income, tax planning strategies and assessments of the current and future economic and business conditions. Based upon consideration of the available evidence, including historical losses, which must be treated as substantial negative evidence, and the potential of future taxable income, a $3,081 valuation allowance was determined to be necessary at December 31, 2011. During the second quarter of 2012, the Company determined an additional $1,149 valuation allowance was necessary due to continuing losses and general uncertainty surrounding future economic and business conditions. Consequently, the Company now has a full valuation allowance against its existing net deferred tax assets. The valuation allowance includes $1,095 recorded in accumulated other comprehensive loss, fully offsetting deferred taxes which were established for investment securities available-for-sale.


FINANCIAL CONDITION


Investment Securities Portfolio


The investment securities portfolio is intended to provide the Bank with adequate liquidity, flexible asset/liability management and a source of stable income.  The portfolio is structured with minimum credit exposure to the Bank. All securities are classified as available-for-sale and are carried at fair market value.  Unrealized gains and losses are excluded from earnings, but are reported as other comprehensive income in a separate component of stockholders’ equity, net of income tax.   Premium amortization and discount accretion are recognized as adjustments to interest income using the interest method.  Realized gains or losses on sales are based on the net proceeds and the adjusted carrying value amount of the securities sold using the specific identification method.


At September 30, 2012, the total carrying value of investment securities was $110,335, a decrease of $41 compared to December 31, 2011, representing 24% and 23% of total assets at September 30, 2012 and December 31, 2011, respectively.  Primarily due to continued soft loan demand and the general decrease in overall loans, the Company’s excess liquidity has continued to be invested in securities.


31


Table 7:  Investments


 

 

As of

 

As of

 

Investment Category

Rating

September 30, 2012

December 31, 2011

 

 

Amount

%

Amount

%

 

 

($ in thousands)

U.S. Treasury & Government Agencies Debt

 

 

 

 

 

 

AAA

$

12,281

100%

$

18,808

100%

 

Total

$

12,281

100%

$

18,808

100%

U.S. Treasury & Government Agencies Debt as % of Total Investment Portfolio

 

 

11%

 

17%

Mortgage-Backed Securities

 

 

 

 

 

 

AAA

$

73,610

100%

$

67,588

100%

 

AA3

0

0%

53

0%

 

A1

36

0%

0

0%

 

A+

12

0%

12

0%

 

Total

$

73,658

100%

$

67,653

100%

Mortgage-Backed Securities as % of Total Investment Portfolio

 

 

67%

 

61%

Obligations of State and Political Subdivisions

 

 

 

 

 

 

AAA

$

502

2%

$

0

0%

 

Aa1

4,364

19%

3,457

15%

 

Aa2

5,378

23%

5,704

25%

 

AA3

2,769

12%

3,363

15%

 

A1

1,524

6%

990

4%

 

A2

135

1%

0

0%

 

Baa2

330

1%

337

1%

 

NR

8,409

36%

9,081

40%

 

Total

$

23,411

100%

$

22,932

100%

Obligations of State and Political Subdivisions as % of Total Investment Portfolio

 

 

21%

 

21%

Corporate Debt and Equity Securities

 

 

 

 

 

 

NR

$

985

100%

$

983

100%

 

Total

$

985

100%

$

983

100%

Corporate Debt and Equity Securities as % of Total Investment Portfolio

 

 

1%

 

1%

Total Market Value of Securities Available-For-Sale

 

$

110,335

100%

$

110,376

100%


Obligations of States and Political Subdivisions (“municipal securities”):  At September 30, 2012 and December 31, 2011, municipal securities were $23,411 and $22,932, respectively, and represented 21% of total investment securities based on fair value.  The majority of municipal securities held are general obligations or essential service bonds.  Municipal bond insurance company downgrades have resulted in credit downgrades in certain municipal securities; however, it has been determined that due to the large number of small investments in these obligations, the Bank’s loss exposure on any particular obligation is minimal.  The municipal portfolio is evaluated periodically for credit risk by a third party.  As of September 30, 2012, the total fair value of municipal securities reflected a net unrealized gain of $1,302.


Mortgage-Backed Securities:  At September 30, 2012 and December 31, 2011, mortgage-related securities (which include predominantly mortgage-backed securities and collateralized mortgage obligations) were $73,658 and $67,653, respectively, and represented 67% and 61%, respectively, of total investment securities based on fair value.  The fair value of mortgage-related securities is subject to inherent risks based upon the future performance of the underlying collateral (mortgage loans) for these securities. Future performance may be impacted by prepayment risk and interest rate changes.  


Corporate Debt and Equity Securities:  At September 30, 2012 and December 31, 2011, corporate debt securities were $985 and $983, respectively, and represented 1% of total investment securities based on fair value.  Corporate debt and equity securities include trust preferred debt securities, corporate bonds, and common equity securities.  Corporate debt and equity securities included two trust preferred securities totaling $800, and other securities of $185 and $183 at September 30, 2012 and December 31, 2011, respectively.  As of September 30, 2012, the interest payments on the two trust preferred securities were current.


32


FHLB Stock:  The Company had $1,303 and $2,306 of FHLB stock at September 30, 2012 and December 31, 2011, respectively.  On April 18, 2012 the FHLB announced that the consensual cease and desist order with its regulator was terminated immediately.  The FHLB can now declare quarterly dividends without the consent of its regulator, provided that: (i) the dividend payment is be at or below the average three-month LIBOR for that quarter; and (ii) the dividend will not result in the FHLB’s retained earnings to fall below their level at the previous year-end.  The FHLB also has the option to seek regulatory approval to pay a higher dividend, if warranted.  The Company redeemed $1,003 of its excess FHLB capital stock in the first nine months of 2012 and has been informed that the FHLB will continue to repurchase excess stock on a quarterly basis.  


Loans


The Company serves a diverse customer base throughout North Central Wisconsin, including the following industries: agriculture (primarily dairy), retail, manufacturing, service, resort properties, timber and businesses supporting the general building industry.  We continue to concentrate our efforts on originating loans in our local markets and assisting our current loan customers.  We are actively utilizing government loan programs such as those provided by the U.S. Small Business Administration, U.S. Department of Agriculture, and USDA Farm Service Agency to help these customers through current economic conditions and position their businesses for the future.


Total loans were $307,589 at September 30, 2012, a decrease of $22,274, or 7%, from December 31, 2011.  This decrease was primarily the result of loan pay-offs, charge-offs, increased competition in our market areas for credit-worthy borrowers and the regular pay downs of existing loans.


Table 8:  Loan Composition


 

 

 

 

 

As of,

 

 

 

 

 

 

September 30, 2012

 

June 30, 2012

 

March 31, 2012

 

December 31, 2011

 

September 30, 2011

 

 

 

% of

 

% of

 

% of

 

% of

 

% of

 

Amount

Total

Amount

Total

Amount

Total

Amount

Total

Amount

Total

 

($ in thousands)

Commercial business

$

38,149

12%

$

40,926

13%

$

44,927

14%

$

41,347

12%

$

41,756

12%

Commercial real estate

120,153

39%

122,483

39%

123,792

38%

123,868

37%

128,929

37%

Real estate construction

20,679

7%

23,094

8%

24,828

8%

28,708

9%

28,842

9%

Agricultural

44,833

15%

45,462

14%

43,851

13%

45,351

14%

47,010

14%

Real estate residential

79,474

26%

80,487

25%

84,215

26%

85,614

26%

86,479

26%

Installment

4,301

1%

4,512

1%

4,388

1%

4,975

2%

5,134

2%

Total loans

$

307,589

100%

$

316,964

100%

$

326,001

100%

$

329,863

100%

$

338,150

100%

Owner occupied

$

70,197

58%

$

70,166

57%

$

69,970

57%

$

70,412

57%

$

71,407

55%

Non-owner occupied

49,956

42%

52,317

43%

53,822

43%

53,456

43%

57,522

45%

  Commercial real estate

$

120,153

100%

$

122,483

100%

$

123,792

100%

$

123,868

100%

$

128,929

100%

1-4 family construction

$

773

4%

$

1,118

5%

$

1,495

6%

$

1,837

6%

$

1,396

5%

All other construction

19,906

96%

21,976

95%

23,333

94%

26,871

94%

27,446

95%

  Real estate construction

$

20,679

100%

$

23,094

100%

$

24,828

100%

$

28,708

100%

$

28,842

100%


Commercial business, commercial real estate, real estate construction and agricultural loans comprise 73% of our loan portfolio at September 30, 2012.  Such loans are considered to have more inherent risk of default than residential mortgage or installment loans.  The commercial balance per borrower is typically larger than that for residential loans, implying higher potential losses on an individual customer basis.  Commercial loan growth throughout 2011 and 2012 has been negatively impacted by increased competition for credit-worthy borrowers, the Company’s aggressive approach to recognizing risks associated with specific borrowers and the recognition of charge-offs on nonperforming loans in a timely manner.


Commercial business loans were $38,149 at September 30, 2012, a decrease of $3,198, or 8%, since year-end 2011, and comprised 12% of total loans.  The commercial business loan classification primarily consists of commercial loans to small businesses, multi-family residential income-producing real estate, and loans to municipalities. Loans of this type include a diverse range of industries. The credit risk related to commercial business loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations, or on the value of underlying collateral, if any.


33


The commercial real estate classification primarily includes commercial-based mortgage loans that are secured by nonfarm/nonresidential real estate properties. Commercial real estate loans totaled $120,153 at September 30, 2012, a decrease of $3,715, or 3%, from December 31, 2011, primarily due to the amount of gross charge-offs taken in 2012 and participation loan pay-offs received.  Since 2011, lending in this segment has focused on loans that are secured by commercial income-producing properties as opposed to speculative real estate development.  Credit risk is managed by employing sound underwriting guidelines, lending primarily to borrowers in local markets, periodically evaluating the underlying collateral, and formally reviewing the borrower’s financial soundness and overall relationship on an ongoing basis.


Real estate construction loans declined $8,029, or 28%, from December 31, 2011to $20,679, representing 7% of the total loan portfolio at September 30, 2012, primarily due to loan pay-offs and pay downs received from borrowers.  Loans in this classification provide financing for the acquisition or development of commercial income properties, multi-family residential development, and single-family consumer construction. The Company controls the credit risk on these types of loans by making loans in familiar markets, underwriting the loans to meet the requirements of institutional investors in the secondary market, reviewing the merits of individual projects, controlling loan structure, and monitoring the progress of projects through the analysis of construction advances.


Agricultural loans totaled $44,833 at September 30, 2012 relatively unchanged from December 31, 2011, and represented 15% of the loan portfolio.  Loans in this classification include loans secured by farmland and financing for agricultural production.  Credit risk is managed by employing sound underwriting guidelines, periodically evaluating the underlying collateral, and formally reviewing the borrower’s financial soundness and relationship on an ongoing basis.


Real estate residential loans totaled $79,474 at September 30, 2012, down $6,140, or 7%, from December 31, 2011. Residential mortgage loans include conventional first lien home mortgages and home equity loans.  Home equity loans consist of home equity lines, and term loans, some of which are first lien positions.  If the declines in market values that have occurred in the residential real estate markets in recent years worsen, particularly in our market area, the value of collateral securing our real estate loans could decline further, which could cause an increase in our provision for loan losses.  In light of the uncertainty that exists in the economy and credit markets, there can be no guarantee that we will not experience additional deterioration resulting from a downturn in credit performance by our residential real estate loan customers.   As part of its management of originating residential mortgage loans, nearly all of the Company’s long-term, fixed-rate residential real estate mortgage loans are sold in the secondary market without retaining the servicing rights. At September 30, 2012, $2,287 of residential mortgages were being held for resale in the secondary market, compared to $2,163 at December 31, 2011.


Installment loans totaled $4,301 at September 30, 2012, down $674, or 14%, compared to December 31, 2011, and represented 1% of the loan portfolio.  The decline in aggregate installment loan balances is largely a result of the fact that the Company experiences extensive competition from local credit unions offering low rates on installment loans and therefore has directed resources toward more profitable lending segments.  Loans in this classification include short-term and other personal installment loans not secured by real estate. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.  


Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early problem loan identification and remedial action to minimize losses, an adequate ALL, and sound nonaccrual and charge-off policies. An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. The credit management process is regularly reviewed and the process has been modified over the past several years to further strengthen the controls and enhance the direct participation by the Bank’s Board Loan Committee in the credit process.


The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to multiple numbers of borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. The Bank has also developed guidelines to manage its exposure to various types of concentration risks.

At September 30, 2012, the commercial real estate industry concentration exceeded 30% of total loans in the Company’s portfolio.  


34


Allowance for Loan Losses


Credit risks within the loan portfolio are inherently different for each loan type. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and on-going review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problems, aids in the management of credit risk and minimization of loan losses.


At September 30, 2012, the ALL was $10,529, compared to $9,816 at December 31, 2011.  The ALL as a percentage of total loans was 3.42% and 2.98% at September 30, 2012 and December 31, 2011, respectively.  The provision for loan losses for the first nine months of 2012 was $3,680, compared to $3,850 for the first nine months of 2011.  Net charge-offs were $2,967 for the nine months ended September 30, 2012, compared to $4,039 for the comparable period in 2011.  The ALL for individually evaluated impaired loans was $4,768 and $3,300 at September 30, 2012 and December 31, 2011, respectively, or 11.3% and 19.1% of the respective impaired loan balances.  In consultation with banking regulators, during the second quarter of 2012, management changed various factors in the ALL allocation methodology including changes to the historical loss rates and values assigned to qualitative factors utilized in the calculation of the ALL.  Effective June 30, 2012, all substandard and doubtful loans are classified as impaired in the ALL calculation and are evaluated individually for impairment based on collateral values.  This change in methodology was a large reason for the increase in impaired loans experienced in the second quarter of 2012, as previously only substandard and doubtful loans with collateral shortfalls were classified as impaired.   The allowance for loan losses applicable to loans evaluated collectively was $5,761, or 2.2% of the loans, at September 30, 2012 compared to $6,516, or 2.1% of the loans, at December 31, 2011.


The allocation methodology used by the Company includes specific allocations for impaired loans evaluated individually for impairment with the remaining loan portfolio collectively evaluated for impairment primarily based on historical loss rates and other qualitative factors.  A specific reserve for the estimated collateral shortfall is established for all impaired loans if necessary based on underlying collateral values.  Impaired loans now include all troubled debt-restructurings, and loans risk-rated as substandard and doubtful.  Management allocates the remaining loan portfolio into portfolio segments of similar risk profile and the risk of loss is based on the Bank’s historical loss specific to each loan portfolio segment.  The historic loss ratio is now calculated by dividing the portfolio segment’s 36-month average annual charge-offs for each portfolio segment by the 36-month average balance.  Qualitative factors used to allocate each specific loan segment include, but are not limited to, the following: (i) changes in lending policy and procedures; (ii) changes in economic and business conditions; (iii) changes in nature and volume of the loan portfolio; (iv) loan management; (v) volume of past due loans; (vi) changes in the value of underlying collateral; and (vii) loan concentrations.


The ALL was 80% and 88% of nonperforming loans at September 30, 2012 and December 31, 2011, respectively. Gross charge-offs were $3,257 for the first nine months of 2012 compared to $4,406 for the first nine months of 2011, while recoveries for the corresponding periods were $290 and $367, respectively. As a result, net charge-offs at September 30, 2012 were 0.37% of average loans, compared to 0.25% of average loans at September 30, 2011.  The decrease in net charge-offs of $1,072 was comprised of a $1,471 decrease in the commercial real estate, real estate construction, agricultural, and installment segments, offset in part by a $399 increase in commercial business, real estate residential, and installment loans.  Issues impacting asset quality included historically depressed economic factors, such as heightened unemployment, depressed commercial and residential real estate markets, volatile energy prices, and depressed consumer confidence. Declining collateral values have significantly contributed to our historically elevated levels of nonperforming loans, net charge-offs, and ALL.  The Company has been focused on implementing enhancements to the credit management process to address and enhance underwriting and risk-based pricing guidelines for commercial real estate and real estate construction lending, as well as on new home equity and residential mortgage loans, to reduce potential exposure within these portfolio segments.  


The largest portion of the ALL at September 30, 2012 was allocated to commercial real estate loans and was $5,146, representing 48.8% of the ALL, an increase from 39.6% at year-end 2011. The increase in the amount allocated to commercial real estate was attributable to the increase in the level of nonaccrual and impaired loans in this category and the $943 increase in the related specific valuation allowance assigned to these loans.  The ALL allocated to commercial business loans was $946 at September 30, 2012, a decrease of $58 from year-end 2011, and represented 9.0% of the ALL at September 30, 2012, compared to 10.2% at year-end 2011. The decrease in the commercial business allocation was due to the $3,198 decrease in the balance of loans in the segment from December 31, 2011.  At September 30, 2012, the ALL allocated to real estate construction was $1,397, compared to $1,320 at December 31, 2011, representing 13.3% and 13.4% of the ALL at September 30, 2012 and December 31, 2011, respectively.  The allocation to real estate construction increased as the level of impaired loans in the category increased $1,081 from December 31, 2011.  The ALL allocation to agricultural loans decreased to 4.9% at September 30, 2012 from 11.6% at December 31, 2011.  Agricultural loans risk rated acceptable or better have improved since December 31,


35


2011.  The ALL allocation to real estate residential loans decreased to 23.0% at September 30, 2012, compared to 25.8% at December 31, 2011.  Real estate residential loans as a percent of the total loan portfolio was 26% at September 30, 2012 unchanged from year-end 2011.  The ALL allocation to installment loans was 1.0% at September 30, 2012 compared to 1.4% at December 31, 2011.  Management (i) performs ongoing intensive analyses of its loan portfolios to allow for early identification of customers experiencing financial difficulties, (ii) maintains prudent underwriting standards, (iii) understands the economy in its markets, and (iv) considers the trend of deterioration in loan quality in establishing the level of the ALL.


The Company believes that at September 30, 2012 the ALL was appropriate to absorb probable incurred losses on existing loans that may become uncollectible; however, given the conditions in the real estate markets and economy in general, there can be no assurance that the allowance will prove sufficient to cover actual loan losses in the future.  Consolidated net income and stockholders’ equity could be affected if management’s estimate of the ALL necessary to cover expected losses is subsequently materially different, requiring a change in the level of provision for loan losses to be recorded.  While management uses currently available information to recognize losses on loans, future adjustments to the ALL may be necessary based on newly received appraisals, updated commercial customer financial statements, rapidly deteriorating customer cash flow, and changes in economic conditions that affect our customers.  Additionally, larger credit relationships do not necessarily create more allowance directly, but can create wider fluctuations in net charge-offs and asset quality measures compared to the Company’s longer historical trends.  As an integral part of their examination process, various federal and state regulatory agencies also review the ALL. Such agencies may require additions to the ALL or may require that certain loan balances be charged-off or downgraded into criticized loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examination.


36


Table 9:  Loan Loss Experience


 

 

For the Three Months Ended

 

 

September 30, 2012

June 30,

2012

March 31,

2012

December 31, 2011

September 30, 2011

 

($ in thousands)

Allowance for loan losses:

 

 

 

 

 

Balance at beginning of period

$

10,943  

$

10,068  

$

9,816  

$

9,282  

$

9,224  

Loans charged-off:

 

 

 

 

 

Commercial business

144  

25  

165  

73  

62  

Commercial real estate

622  

715  

280  

149  

479  

Real estate construction

85  

106  

28  

146  

28  

Agricultural

8  

3  

10  

1  

123  

  Total commercial

859  

849  

483  

369  

692  

Real estate residential

391  

491  

155  

212  

244  

Installment

4  

11  

14  

1  

30  

  Total loans charged-off

1,254  

1,351  

652  

582  

966  

Recoveries of loans previously charged-off:

 

 

 

 

 

Commercial business

37  

3  

6  

3  

19  

Commercial real estate

1  

23  

62  

3  

53  

Real estate construction

2  

0  

5  

120  

5  

Agricultural

15  

3  

67  

(17) 

34  

  Total commercial

55  

29  

140  

109  

111  

Real estate residential

30  

7  

9  

60  

6  

Installment

5  

10  

5  

47  

7  

  Total recoveries

90  

46  

154  

216  

124  

Total net charge-offs

1,164  

1,305  

498  

366  

842  

Provision for loan losses

750  

2,180  

750  

900  

900  

Balance at end of period

$

10,529  

$

10,943  

$

10,068  

$

9,816  

$

9,282  

Ratios at end of period:

 

 

 

 

 

Allowance for loan losses to total loans

3.42%

3.45%

3.09%

2.98%

2.74%

Allowance for loan losses to net charge-offs

     9.0x

    8.4x

   20.2x

   26.8x

   11.0x

Net charge-offs to average loans

0.37%

0.40%

0.15%

0.11%

0.25%

Net loan charge-offs (recoveries):

 

 

 

 

 

Commercial business

$

107  

$

22  

$

159  

$

70  

$

43  

Commercial real estate

621  

692  

218  

146  

426  

Real estate construction

83  

106  

23  

26  

23  

Agricultural

(7) 

0  

(57) 

18  

89  

  Total commercial

804  

820  

343  

260  

581  

Real estate residential

361  

484  

146  

152  

238  

Installment

(1) 

1  

9  

(46) 

23  

  Total net charge-offs

$

1,164  

$

1,305  

$

498  

$

366  

$

842  

Commercial Real Estate and Construction net charge-off detail:

 

 

 

 

 

Owner occupied

$

297  

$

374  

$

216  

$

146  

$

411  

Non-owner occupied

324  

318  

2  

0  

15  

  Commercial real estate

$

621  

$

692  

$

218  

$

146  

$

426  

1-4 family construction

$

0  

$

0  

$

0  

$

0  

$

0  

All other construction

83  

106  

23  

26  

23  

  Real estate construction

$

83  

$

106  

$

23  

$

26  

$

23  



The allocation of the ALL is based on our estimate of loss exposure by category of loans shown in Table 10.


37


Table 10: Allocation of the ALL


($ in thousands)

September 30, 2012

% of Loan Type to Total Loans

June 30, 2012

% of Loan Type to Total Loans

March 31, 2012

% of Loan Type to Total Loans

December 31, 2011

% of Loan Type to Total Loans

September 30, 2011

% of Loan Type to Total Loans

ALL allocation:

 

 

 

 

 

 

 

 

 

 

Commercial business

$

946  

12%

$

1,056  

13%

$

834  

14%

$

1,004  

12%

$

935  

12%

Commercial real estate

5,146  

39%

5,184  

39%

3,984  

38%

3,685  

37%

3,368  

37%

Real estate construction

1,397  

7%

1,602  

8%

1,073  

8%

1,320  

9%

1,309  

9%

Agricultural

516  

15%

513  

14%

1,069  

13%

1,139  

14%

1,251  

14%

  Total commercial

8,005  

73%

8,355  

74%

6,960  

73%

7,148  

72%

6,863  

72%

Real estate residential

2,417  

26%

2,477  

25%

3,009  

26%

2,530  

26%

2,299  

26%

Installment

107  

1%

111  

1%

99  

1%

138  

2%

120  

2%

Total allowance for loan losses

$

10,529  

100%

$

10,943  

100%

$

10,068  

100%

$

9,816  

100%

$

9,282  

100%

ALL category as a percent of total ALL:

 

 

 

 

 

 

 

 

 

 

Commercial business

9.0%

 

9.7%

 

8.3%

 

10.2%

 

10.1%

 

Commercial real estate

48.8%

 

47.4%

 

39.6%

 

37.6%

 

36.2%

 

Real estate construction

13.3%

 

14.6%

 

10.7%

 

13.4%

 

14.1%

 

Agricultural

4.9%

 

4.7%

 

10.6%

 

11.6%

 

13.5%

 

  Total commercial

76.0%

 

76.4%

 

69.2%

 

72.8%

 

73.9%

 

Real estate residential

23.0%

 

22.6%

 

29.8%

 

25.8%

 

24.8%

 

Installment

1.0%

 

1.0%

 

1.0%

 

1.4%

 

1.3%

 

Total allowance for loan losses

100.0%

 

100.0%

 

100.0%

 

100.0%

 

100.0%

 


Impaired Loans and Nonperforming Assets


As part of its overall credit risk management process, management has been committed to an aggressive problem loan identification philosophy. This philosophy has been implemented through the ongoing monitoring and review of all pools of risk in the loan portfolio to ensure that problem loans are identified early and the risk of loss is minimized.


Nonperforming loans are considered one indicator of potential future loan losses. Nonperforming loans are defined as nonaccrual loans, including those defined as impaired under current accounting standards, loans 90 days or more past due but still accruing interest, and nonaccrual restructured loans.  Loans are generally placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on nonaccrual status immediately. Previously accrued and uncollected interest on such loans is reversed, amortization of related loan fees is suspended, and income is recorded only to the extent that interest payments are subsequently received in cash after a determination has been made that the principal balance of the loan is collectible. If collectability of the principal is in doubt, payments received are applied to loan principal.


Nonperforming loans were $13,157 at September 30, 2012, compared to $11215 at year-end 2011.  Total nonperforming loans have increased $1,942, or 17%, since year-end 2011.  During the third quarter of 2012, one loan relationship totaling $1.4 million which was previously classified as a restructured accruing loan was moved to nonaccrual status.


At September 30, 2012, the Company had total restructured loans of $13,854, which consisted of $8,549  performing in accordance with their modified terms and $5,305 classified as nonaccrual, compared to total restructured loans of $12,887 which consisted of $5,346 performing in accordance with their modified terms and $7,775 classified as nonaccrual at December 31, 2011.  


The level of potential problem loans is another predominant factor in determining the relative level of risk in the loan portfolio and in determining the adequacy of the ALL. Potential problem loans are generally defined by management to include performing loans rated as substandard by management, but having circumstances present which might adversely affect the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that the Company expects losses to occur, but that management recognizes a higher degree of risk associated with these loans. Potential problem loans are predominantly commercial loans covering a diverse range of businesses and real estate property types. Effective June 30, 2012, management classifies all potential problem loans as impaired loans in the


38


ALL calculation.  At December 31, 2011 potential problem loans totaled $23,124.  Identifying potential problem loans requires a heightened management review of the pace at which a credit may deteriorate, the duration of asset quality stress, and uncertainty around the magnitude and scope of economic stress that may be felt by the Company’s customers and on underlying real estate values.  


Table 11:  Nonperforming Loans and OREO


 

 

 

As of,

 

 

 

September 30,

2012

June 30,

2012

March 31,

2012

December 31, 2011

September 30,

2011

 

 

 

($ in thousands)

 

Nonaccrual loans:

 

 

 

 

Commercial

$

8,302  

$

6,528  

$

5,721  

$

7,329  

$

10,898  

Agricultural

294  

310  

322  

134  

407  

Real estate residential

4,557  

4,806  

3,751  

3,726  

3,296  

Installment

4  

0  

10  

5  

6  

Total nonaccrual loans

13,157  

11,644  

9,804  

11,194  

14,607  

Accruing loans past due 90 days or more

0  

36  

13  

21  

0  

Total nonperforming loans

13,157  

11,680  

9,817  

11,215  

14,607  

OREO

4,472  

4,707  

4,164  

4,404  

5,108  

Other repossessed assets

0  

0  

0  

60  

0  

Total nonperforming assets (1)

$

17,629  

$

16,387  

$

13,981  

$

15,679  

$

19,715  

Restructured loans accruing

 

 

 

 

 

Commercial

$

7,483  

$

9,120  

$

9,164  

$

5,908  

$

0  

Agricultural

366  

371  

194  

201  

0  

Real estate residential

683  

687  

1,991  

1,411  

0  

Installment

17  

18  

19  

21  

0  

Total restructured loans accruing

$

8,549  

$

10,196  

$

11,368  

$

7,541  

$

0  

RATIOS

 

 

 

 

 

Nonperforming loans to total loans

4.28%

3.68%

3.01%

3.40%

4.32%

Nonperforming assets to total loans plus OREO

5.65%

5.09%

4.23%

4.69%

5.74%

Nonperforming assets to total assets

3.80%

3.53%

2.89%

3.21%

3.99%

ALL to nonperforming loans

80.03%

93.69%

102.56%

87.53%

63.54%

ALL to total loans at end of period

3.42%

3.45%

3.09%

2.98%

2.74%

Nonperforming loans by type:

 

 

 

 

 

Commercial business

$

1,168  

$

193  

$

375  

$

734  

$

765  

Commercial real estate (CRE)

6,777  

5,442  

4,208  

4,076  

6,904  

Real estate construction

357  

917  

1,142  

2,519  

3,229  

Total commercial

8,302  

6,552  

5,725  

7,329  

10,898  

Agricultural

294  

310  

322  

134  

407  

Real estate residential

4,557  

4,806  

3,751  

3,726  

3,296  

Installment

4  

12  

19  

26  

6  

Total nonperforming loans

13,157  

11,680  

9,817  

11,215  

14,607  

Commercial real estate owned

3,715  

4,092  

4,011  

4,116  

4,861  

Residential real estate owned

757  

615  

153  

288  

247  

Total OREO

4,472  

4,707  

4,164  

4,404  

5,108  

Other repossessed assets

0  

0  

0  

60  

0  

Total nonperforming assets

$

17,629  

$

16,387  

$

13,981  

$

15,679  

$

19,715  

CRE and Construction nonperforming loan detail:

 

 

 

 

 

Owner occupied

$

2,917  

$

2,483  

$

2,607  

$

2,697  

$

2,848  

Non-owner occupied

3,860  

2,959  

1,601  

1,379  

4,056  

Commercial real estate

$

6,777  

$

5,442  

$

4,208  

$

4,076  

$

6,904  

1-4 family construction

$

0  

$

0  

$

0  

$

0  

$

0  

All other construction

357  

917  

1,142  

2,519  

3,229  

Real estate construction

$

357  

$

917  

$

1,142  

$

2,519  

$

3,229  


 (1) Beginning in 2012, the Company excluded restructured loans accruing interest from its definition of nonperforming loans.  The definition of nonperforming assets now consists of  nonaccrual loans, loans past due 90 days or more and still accruing interest, other real estate owned and other repossessed assets.  As a result, certain prior period reclassifications and disclosures have been made to conform to the new definition.


39


Deposits


Deposits represent the Company’s largest source of funds.  The Company competes with other bank and nonbank institutions for deposits, as well as with a growing number of non-deposit investment alternatives available to depositors, such as mutual funds, money market funds, annuities, and other brokerage investment products. Competition for deposits remains high. Challenges to deposit growth include price changes on deposit products given movements in the rate environment, and customer preferences regarding higher-costing deposit products or non-deposit investment alternatives.  A stipulation of the Bank’s Agreement with the Federal Deposit Insurance Corporation (the “FDIC”) and Wisconsin Department of Financial Institutions (the “WDFI”) limits the rates of interest it may set on its deposit products.  As a result, the Bank’s ability to attract deposits based on rate competition is limited to a certain degree and its focus remains on expanding existing customer relationships.


At September 30, 2012, total deposits were $364,404, down $17,216, or 5%, from year-end 2011, primarily due to seasonal fluctuations in noninterest-bearing demand deposits, decreased time deposits, and the Company’s strategy to continue to reduce noncore funding sources.  


Time deposits were $123,540 at September 30, 2012, down $12,600 from December 31, 2011, as the Company has not been as aggressive in bidding for municipal funds and customers have moved time deposits into liquid, short-term, non-maturing deposits as time deposit rates have decreased to levels relative to certain non-maturity deposit accounts.


Due to the reduced liquidity needs brokered certificate of deposits have not been renewed as they mature.  


Table 12:  Deposit Distribution


 

September 30,

% of

December 31,

% of

 

2012

Total

2011

Total

 

($ in thousands)

Noninterest-bearing demand deposits

$

71,071

19%

$

70,790

19%

Interest-bearing demand deposits

42,062

12%

39,160

10%

Savings deposits

117,860

32%

120,513

32%

Time deposits

123,540

34%

136,140

35%

Brokered certificates of deposit

9,871

3%

15,017

4%

Total

$

364,404

100%

$

381,620

100%


Contractual Obligations  


We are party to various contractual obligations requiring the use of funds as part of our normal operations.  The table below outlines the principal amounts and timing of these obligations, excluding amounts due for interest, if applicable.  Most of these obligations are routinely refinanced into similar replacement obligations.  However, renewal of these obligations is dependent on our ability to offer competitive interest rates, liquidity needs, or availability of collateral for pledging purposes.  


Table 13:  Contractual Obligations


 

Payments due by period

 

Total

< 1year

1-3 years

3-5 years

> 5 years

 

 

 

($ in thousands)

 

Subordinated debentures

$

10,310

$

0

$

0

$

0

$

10,310

Other long-term borrowings

10,000

0

10,000

0

0

FHLB borrowings

26,061

2,000

21,061

3,000

0

Total long-term borrowing obligations

$

46,371

$

2,000

$

31,061

$

3,000

$

10,310



40


Liquidity


Liquidity management refers to the ability to ensure that cash is available in a timely and cost-effective manner to meet cash flow requirements of depositors and borrowers and to meet other commitments as they fall due, including the ability to pay dividends to shareholders, service debt, invest in subsidiaries, repurchase common stock, and satisfy other operating requirements.


Funds are available from a number of basic banking activity sources, primarily from the core deposit base and from the repayment and maturity of loans and investment securities. Additionally, liquidity is available from the sale of investment securities and brokered deposits.  Volatility or disruptions in the capital markets may impact the Company’s ability to access certain liquidity sources.


While dividends and service fees from the Bank and proceeds from the issuance of capital have historically been the primary funding sources for the Company, these sources could be limited or costly (such as by regulation increasing the capital needs of the Bank, or by limited appetite for new sales of Company stock).  No dividends have been received in cash from the Bank since 2006.  Also, as discussed in the “Capital” section, the Company’s written agreement with the Federal Reserve Bank of Minneapolis (the “Federal Reserve Bank”) and the Bank’s written agreement with the FDIC and WDFI place restrictions on the payment of dividends from the Bank to the Company without prior approval from our regulators.  The Company’s written agreement with the Federal Reserve Bank also requires the written consent of the Federal Reserve Bank to pay dividends to the Company’s stockholders.  We are also prohibited from paying dividends on our common stock if we fail to make distributions or required payments on the Company’s junior subordinated debentures or on the TARP Preferred Stock (as defined under “Capital” below). In consultation with the Federal Reserve, on May 12, 2011, the Company exercised its rights to suspend dividends on the outstanding TARP Preferred Stock and has also elected to defer interest on the junior subordinated debentures.  


Investment securities are an important tool to the Company’s liquidity objective.  All investment securities are classified as available-for-sale and are reported at fair value on the consolidated balance sheet.  Approximately $67,201 of the $110,335 investment securities portfolio on hand at September 30, 2012, were pledged to secure public deposits, short-term borrowings, and for other purposes as required by law.  The majority of the remaining securities could be sold to enhance liquidity, if necessary.  


The scheduled maturity of loans could also provide a source of additional liquidity.  Factors affecting liquidity relative to loans are loan renewals, origination volumes, prepayment rates, and maturity of the existing loan portfolio.  The Bank’s liquidity position is influenced by changes in interest rates, economic conditions, and competition.  Conversely, loan demand may cause us to acquire other sources of funding which could be more costly than deposits.


Deposits are another source of liquidity for the Bank.  Deposit liquidity is affected by core deposit growth levels, certificates of deposit maturity structure, and retention and diversification of wholesale funding sources.  Deposit outflows would require the Bank to access alternative funding sources which may not be as liquid and may be more costly than deposits.


Other funding sources for the Bank are in the form of short-term borrowings (corporate repurchase agreements and federal funds purchased) and long-term borrowings.  Short-term borrowings can be renewed and do not represent an immediate need to repay cash.  Long-term borrowings are used for asset/liability matching purposes and to access more favorable interest rates than deposits.  The Bank's liquidity resources were sufficient as of September 30, 2012 to fund our loans and to meet other cash needs when necessary.


At September 30, 2012 and December 31, 2011, the Company held $2,603 and $2,743, respectively, in total cash and due from banks on an unconsolidated basis.  The Bank Holding Company Act of 1956, as amended, requires that “a bank holding company shall serve as a source of financial and managerial strength to its subsidiary banks and shall not conduct its operations in an unsafe or unsound manner.”  Pursuant to this mandate, the Company has continued to monitor the capital strength and liquidity of the Bank.

 

41



Capital


The Company regularly reviews the adequacy of its capital to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. Management actively reviews capital strategies for the Company and the Bank in light of perceived business risks associated with current and prospective earning levels, liquidity, asset quality, economic conditions in the markets served, and the level of dividends available to shareholders.  


As of September 30, 2012 and December 31, 2011, the Tier 1 Risk-Based Capital ratio, Total Risk-Based Capital (Tier 1 and Tier 2) ratio, and Tier 1 Leverage ratio for the Company and Bank were in excess of regulatory minimum requirements, as well as the heightened requirements as set forth in the Bank’s Agreement with the FDIC and WDFI.  In the second quarter of 2012, the federal bank regulatory agencies issued joint proposed rules that would implement an international capital accord called “Basel III,” developed by the Basel Committee on Banking Supervision, a committee of central banks and bank supervisors.  The proposed rules would apply to all depository organizations in the United States and most of their parent companies and would increase minimum capital ratios, add a new minimum common equity ratio, add a new capital conservation buffer, and would change the risk-weightings of certain assets for the purposes of calculating certain capital ratios.  The proposed changes, if implemented, would be phased in from 2013 through 2019.  The comment period on the proposed rules expired on October 22, 2012.  Various banking associations and industry groups have provided comments on the proposed rules to the regulators and it is unclear when the final rules will be adopted and what changes, if any, may be made to the proposed rules.  Management continues to assess the effect of the proposed rules on the Company and the Bank's capital position and will continue to monitor new developments with respect to the proposed rules.


On November 9, 2010, the Bank entered into a formal written agreement with the FDIC and the WDFI.  Under the terms of the agreement, the Bank is required to: (i) maintain ratios of Tier 1 capital to each of total assets and total risk-weighted assets of at least 8.5% and 12%, respectively; (ii) refrain from declaring or paying any dividend without the written consent of the FDIC and WDFI; and (iii) refrain from increasing its total assets by more than 5% during any three-month period without first submitting a growth plan to the FDIC and WDFI.  Additionally, on May 10, 2011, the Company entered into a formal written agreement with the Federal Reserve Bank.  Pursuant to the Company’s agreement, the Company needs the written consent of the Federal Reserve Bank to pay dividends to our stockholders.  We are also prohibited from paying dividends on our common stock if we fail to make distributions or required payments on our junior subordinated debentures or on our TARP Preferred Stock.  


On October 14, 2008, the U.S. Department of the Treasury (“Treasury”) announced details of the Capital Purchase Plan (“CPP”) whereby the Treasury made direct equity investments into qualifying financial institutions in the form of preferred stock, providing an immediate influx of Tier 1 capital into the banking system.   Participants also adopted the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under this program.


On February 20, 2009, under the CPP, the Company issued 10,000 shares of Series A Preferred Stock and a warrant to purchase 500 shares of Series B Preferred Stock (together with the Series A Preferred stock, the “TARP Preferred Stock”), which was immediately exercised, to the Treasury.  Total proceeds received were $10,000.  The proceeds received were allocated between the Series A Preferred Stock and the Series B Preferred Stock based upon their relative fair values, which resulted in the recording of a discount on the Series A Preferred Stock and a premium on the Series B Preferred Stock.  The discount and premium will be amortized over five years.  The allocated carrying value of the Series A Preferred Stock and Series B Preferred Stock on the date of issuance (based on their relative fair values) was $9,442 and $558, respectively.  Cumulative dividends on the Series A Preferred Stock accrue and are payable quarterly at a rate of 5% per annum for five years.  The rate will increase to 9% per annum thereafter if the shares are not redeemed by the Company.  The Series B Preferred Stock dividends accrue and are payable quarterly at 9%.  All $10,000 of the TARP Preferred Stock qualify as Tier 1 Capital for regulatory purposes at the Company.  


In the second quarter of 2012, the Treasury announced its intention to exit the remaining banking investments made through the CPP by (i) repayments, (ii) restructurings, or (iii) sales to third parties through individual sales or pooling smaller investments into auction pools.  On September 27, 2012 the Company was notified that Treasury had accepted the Company’s request to opt out of the pooled sale process.  The Company was informed that it would be contacted in the coming weeks regarding Treasury’s plans to dispose of the TARP Preferred Stock.


A summary of the Company’s and the Bank’s regulatory capital ratios as of September 30, 2012 and December 31, 2011 are as follows:

 

42



Table14:  Capital Ratios


 

 

 

 

 

To Be Well Capitalized

 

 

 

For Capital Adequacy

 

Under Prompt Corrective

 

Actual

 

Purposes (1)

 

Action Provisions (2)

 

Amount

Ratio

 

Amount

Ratio

 

Amount

Ratio

 

 

 

 

($ in thousands)

 

 

 

September 30, 2012

 

 

 

 

 

 

 

 

Mid-Wisconsin Financial Services, Inc.

 

 

 

 

 

 

 

 

Tier 1 to average assets

$

45,285

9.7%

 

$

18,716

4.0%

 

 

 

Tier 1 risk-based capital ratio

45,285

14.9%

 

12,197

4.0%

 

 

 

Total risk-based capital ratios

49,179

16.1%

 

24,393

8.0%

 

 

 

Mid-Wisconsin Bank

 

 

 

 

 

 

 

 

Tier 1 to average assets

$

41,076

8.8%

 

$

18,584

4.0%

 

$

39,492

8.5%

Tier 1 risk-based capital ratio

41,076

13.6%

 

12,077

4.0%

 

18,115

6.0%

Total risk-based capital ratios

44,933

14.9%

 

24,154

8.0%

 

36,231

12.0%

 

 

 

 

 

 

 

 

 

December 31, 2011

 

 

 

 

 

 

 

 

Mid-Wisconsin Financial Services, Inc.

 

 

 

 

 

 

 

 

Tier 1 to average assets

$

46,729

9.6%

 

$

19,396

4.0%

 

 

 

Tier 1 risk-based capital ratio

46,729

14.3%

 

13,071

4.0%

 

 

 

Total risk-based capital ratios

50,884