10-K 1 v432767_10k.htm 10-K

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

 

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

For the fiscal year ended December 31, 2015

 

Commission file number: 000-31207

 

BANK MUTUAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Wisconsin 39-2004336
(State or other jurisdiction of incorporation or organization) (I.R.S.  Employer Identification No.)
   
4949 West Brown Deer Road, Milwaukee,  Wisconsin 53223
(Address of principal executive offices) (Zip Code)

 

Registrant's telephone number, including area code: (414) 354-1500

 

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

 

Common Stock, $0.01 Par Value The NASDAQ Stock Market LLC
(Title of each class) (Name of each exchange on which registered)

 

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

 

NONE

 

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

Yes  ¨    No  x

 

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

Yes  ¨    No  x

 

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

Yes  x    No  ¨

 

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

 

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

Yes  x    No  ¨

 

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

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

 

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

Yes  ¨    No  x

 

As of February 29, 2016, 45,575,567 shares of Common Stock were validly issued and outstanding. The aggregate market value of the Common Stock (based upon the $7.67 last sale price on The NASDAQ Global Select Market on June 30, 2015, the last trading date of the Company’s second fiscal quarter) held by non-affiliates (excluding outstanding shares reported as beneficially owned by directors and executive officers; does not constitute an admission as to affiliate status) was approximately $327.1 million.

 

    Part of Form 10-K Into Which
Documents Incorporated by Reference   Portions of Document are Incorporated
     
Proxy Statement for Annual Meeting of Shareholders on May 2, 2016   Part III

 

 

 

 

BANK MUTUAL CORPORATION

 

FORM 10-K ANNUAL REPORT TO

THE SECURITIES AND EXCHANGE COMMISSION

FOR THE YEAR ENDED DECEMBER 31, 2015

 

Table of Contents

 

Item     Page
       
Part I      
       
1 Business   3
       
1A Risk Factors   21
       
1B Unresolved Staff Comments   25
       
2 Properties   25
       
3 Legal Proceedings   25
       
4 Mine Safety Disclosures   25
       
Part II      
       
5 Market for Registrant's Common Equity, Related Stockholders Matters, and  Issuer Purchases of Equity Securities   26
       
6 Selected Financial Data   28
       
7 Management's Discussion and Analysis of Financial Condition and Results of Operations   30
       
7A Quantitative and Qualitative Disclosures About Market Risk   51
       
8 Financial Statements and Supplementary Data   55
       
9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   102
       
9A Controls and Procedures   102
       
9B Other Information   104
       
Part III      
       
10 Directors, Executive Officers, and Corporate Governance   105
       
11 Executive Compensation   106
       
12 Security Ownership of Certain Beneficial Owners, Management, and Related Stockholder Matters   106
       
13 Certain Relationships and Related Transactions and Director Independence   106
       
14 Principal Accountant Fees and Services   106
       
Part IV      
       
15 Exhibits, Financial Statement Schedules   107
       
SIGNATURES     108

 

2 

 

 

Part I

 

Cautionary Statement

 

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

 

Item 1. Business

 

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

 

General

 

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

 

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

 

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

 

Market Area

 

At December 31, 2015, the Company had 68 banking offices in Wisconsin and one in Minnesota. The Company is the third largest financial institution headquartered in Wisconsin based on total assets and the fourth largest based on deposit market share. At June 30, 2015, the Company had a 1.26% market share of all deposits held by FDIC-insured institutions in Wisconsin.

 

The largest concentration of the Company’s offices is in southeastern Wisconsin, consisting of the Milwaukee Metropolitan Statistical Area (“MSA”), and Racine and Kenosha Counties. The Company has 25 offices in these areas. The Company also has five offices in south central Wisconsin, consisting of the Madison MSA and the Janesville/Beloit MSA, as well as six other offices in communities in east central Wisconsin. The Company also operates 18 banking offices in northeastern Wisconsin, including the Green Bay MSA. Finally, the Company has 14 offices in northwestern Wisconsin, including the Eau Claire MSA, and one office in Woodbury, Minnesota, which is part of the Minneapolis-St. Paul MSA. A number of the Company’s banking offices are located near the northern Michigan and Illinois borders. Therefore, the Company may also draw customers from nearby regions in those states.

 

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

 

In March 2016 the Company expects to complete the consolidation of four banking offices into nearby offices, which will reduce the total number of its offices to 65. One of these offices is located in the Milwaukee MSA, one is located in the Eau Claire MSA, one is located in northeastern Wisconsin, and one is located in east central Wisconsin. The Company expects that it will continue to provide products and services to the affected customers through its other nearby locations, as well as its internet, mobile banking, remote deposit capture, and telephone channels. For additional discussion, refer to “Results of Operations—Non-Interest Expense” in “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.”

 

Competition

 

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

 

Lending Activities

 

General At December 31, 2015, the Company’s total loans receivable was $1.7 billion or 69.5% of total assets. The Company’s loan portfolio consists of loans to both commercial and retail borrowers. Loans to commercial borrowers include loans secured by real estate such as multi-family properties, non-residential commercial properties (referred to as “commercial real estate”), and construction and development projects secured by these same types of properties, as well as land. In addition, commercial loans include loans to businesses that are not secured by real estate (referred to as “commercial and industrial loans”). Loans to retail borrowers include loans to individuals that are secured by real estate such as one- to four-family first mortgages, home equity term loans, and home equity lines of credit. In addition, retail loans include student loans, automobile loans, and other loans not secured by real estate (collectively referred to as “other consumer loans”).

 

4 

 

 

The nature, type, and terms of loans originated or purchased by the Company are subject to federal and state laws and regulations. The Company has no significant concentrations of loans to particular borrowers or to borrowers engaged in similar activities. In addition, the Company limits its lending activities primarily to borrowers and related loan collateral located in its primary market areas, which consist of Wisconsin and contiguous regions of Illinois, Minnesota, and northern Michigan. However, from time-to-time the Company will make loans secured by properties outside of its primary market areas provided the borrowers are located within such areas and are well-known to the Company. For specific information related to the Company’s loans receivable for the periods covered by this report, refer to “Financial Condition—Loans Receivable” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Commercial and Industrial Loans At December 31, 2015, the Company’s portfolio of commercial and industrial loans was $235.3 million or 11.8% of its gross loans receivable. This portfolio consists of loans and lines of credit to businesses for equipment purchases, working capital, debt refinancing or restructuring, business acquisition or expansion, Small Business Administration (“SBA”) loans, and domestic standby letters of credit. The unfunded portion of approved commercial and industrial lines of credit and letters of credit was $175.0 million as of December 31, 2015. Typically, commercial and industrial loans are secured by general business security agreements and personal guarantees. The Company offers variable, adjustable, and fixed-rate commercial and industrial loans. The Company also has commercial and industrial loans that have an initial period where interest rates are fixed, generally for one to five years, and thereafter are adjustable based on various market indices. Fixed-rate loans are priced at either a margin over various market indices with maturities that correspond to the maturities of the notes or to match competitive conditions and yield requirements. Term loans are generally amortized over a three to seven year period. Commercial lines of credit generally have a term of one year and are subject to annual renewal thereafter. The Company performs an annual credit review of all commercial and industrial borrowers having an exposure to the Company of $500,000 or more.

 

Multi-family and Commercial Real Estate Loans At December 31, 2015, the Company’s aggregate portfolio of multi-family and commercial real estate loans was $709.2 million or 35.5% of its gross loans receivable. The Company’s multi-family and commercial real estate loan portfolios consist of fixed-rate and adjustable-rate loans originated at prevailing market rates usually tied to various market indices. This portfolio generally consists of loans secured by apartment buildings, office buildings, retail centers, warehouses, and industrial buildings. Loans in this portfolio may be secured by either owner or non-owner occupied properties. Loans in this portfolio typically do not exceed 80% of the lesser of the purchase price or an independent appraisal by an appraiser designated by the Company. Loans originated with balloon maturities are generally amortized on a 25 to 30 year basis with a typical balloon term of 3 to 5 years. However, if a multi-family or commercial real estate borrower desires a fixed-rate loan with a balloon maturity beyond five years, the Company generally requires the borrower to commit to an adjustable-rate loan that is converted back into a fixed-rate exposure through an interest rate swap agreement between the Company and the borrower. The Company then enters into an offsetting interest rate swap agreement with a third-party financial institution that converts the Company’s interest rate risk exposure back into a floating-rate exposure. The Company will generally record fee income related to the difference in the fair values of the respective interest rate swaps on the date of the transaction. Refer to “Financial Derivatives,” below, for additional discussion.

 

Loans secured by multi-family and commercial real estate are granted based on the income producing potential of the property, the financial strength and/or income producing potential of the borrower, and the appraised value of the property. In most cases, the Company also obtains personal guarantees from the principals involved, the assessment of which is also based on financial strength and/or income producing potential. The Company’s approval process includes a review of the other debt obligations and overall sources of cash flow available to the borrower and guarantors. The property’s expected net operating income must be sufficient to cover the payments relating to the outstanding debt. The Company generally requires an assignment of rents or leases to be assured that the cash flow from the property will be used to repay the debt. Appraisals on properties securing multi-family and larger commercial real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors. Title and hazard insurance are required as well as flood insurance, if applicable. Environmental assessments are performed on certain multi-family and commercial real estate loans in excess of $1.0 million, as well as all loans secured by certain properties that the Company considers to be “environmentally sensitive.” In addition, the Company performs an annual credit review of its multi-family and commercial real estate loans over $500,000.

 

5 

 

 

Loans secured by multi-family and commercial real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans. Such loans typically involve large balances to single borrowers or groups of related borrowers. The Bank has internal lending limits to single borrowers or a group of related borrowers that are adjusted from time-to-time, but are generally well below the Bank’s legal lending limit of approximately $41 million as of December 31, 2015. Because payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. Furthermore, borrowers’ problems in areas unrelated to the properties that secure the Company’s loans may have an adverse impact on such borrowers’ ability to comply with the terms of the Company’s loans.

 

Construction and Development Loans At December 31, 2015, the Company’s portfolio of construction and development loans was $330.7 million or 16.6% of its gross loans receivable. In addition, the unfunded portion of approved construction and development loans was $212.7 million as of that same date. Construction and development loans typically have terms of 18 to 24 months, are interest-only, and carry variable interest rates tied to a market index. Disbursements on these loans are based on draw requests supported by appropriate lien waivers. Construction loans typically convert to permanent loans at the completion of a project, but may or may not remain in the Company’s loan portfolio depending on the competitive environment for permanent financing at the end of the construction term. Development loans are typically repaid as the underlying lots or housing units are sold. Construction and development loans are generally considered to involve a higher degree of risk than mortgage loans on completed properties. The Company's risk of loss on a construction and development loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction, the estimated cost of construction, the appropriate application of loan proceeds to the work performed, the borrower's ability to advance additional construction funds if necessary, and the stabilization period for lease-up after the completion of construction. In addition, in the event a borrower defaults on the loan during its construction phase, the construction project often needs to be completed before the full value of the collateral can be realized by the Company. The Company performs an annual credit review of its construction and development loans over $500,000.

 

Residential Mortgage Loans At December 31, 2015, the Company’s portfolio of one- to four-family first mortgage loans was $504.2 million or 25.2% of its gross loans receivable. In addition, the unfunded portion of approved construction loans was $25.4 million as of that same date. Most of these loans are for owner-occupied residences; however, the Company also originates first mortgage loans secured by second homes, seasonal homes, and investment properties.

 

The Company originates primarily conventional fixed-rate residential mortgage loans and adjustable-rate residential mortgage (“ARM”) loans with maturity dates up to 30 years. Such loans generally are underwritten to the Federal National Mortgage Association (“Fannie Mae”) and other regulatory standards, including those specified in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). In general, ARM loans are retained by the Company in its loan portfolio. Conventional fixed-rate residential mortgage loans are generally sold in the secondary market without recourse, although the Company typically retains the servicing rights to such loans. When the Company sells residential mortgage loans in the secondary market, it makes representations and warranties to the purchasers about various characteristics of each loan, including the underwriting standards applied and the documentation being provided. Failure of the Company to comply with the requirements established by the purchaser of the loan may result in the Company being required to repurchase the loan. There have not been any material instances where the Company has been required to repurchase loans.

 

The Company also originates “jumbo” single family mortgage loans in excess of the Fannie Mae maximum loan amount, which was $417,000 for single family homes in its primary market areas. Fannie Mae has higher limits for two-, three- and four-family homes. The Company generally retains fixed-rate jumbo single family mortgage loans in its portfolio.

 

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

 

From time-to-time the Company also originates loans under programs administered by various government agencies such as the Wisconsin Housing and Economic Development Authority (“WHEDA”). Loans originated under these programs may or may not be held by the Company in its loan portfolio and the Company may or may not retain the servicing rights for such loans.

 

6 

 

 

 

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

 

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

 

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

 

In addition to servicing the loans in its own portfolio, the Company continues to service most of the loans that it sells to Fannie Mae and other third-party investors (“loans serviced for third-party investors”). Servicing mortgage loans, whether for its own portfolio or for third-party investors, includes such functions as collecting monthly principal and interest payments from borrowers, maintaining escrow accounts for real estate taxes and insurance, and making certain payments on behalf of borrowers. When necessary, servicing of mortgage loans also includes functions related to the collection of delinquent principal and interest payments, loan foreclosure proceedings, and disposition of foreclosed real estate. As of December 31, 2015, loans serviced for third-party investors amounted to $1.04 billion. These loans are not reflected in the Company’s Consolidated Statements of Financial Condition.

 

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

 

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

 

Home Equity Loans At December 31, 2015, the Company’s portfolio of home equity loans was $198.2 million or 9.9% of its gross loans receivable. Home equity loans include fixed term home equity loans and home equity lines of credit. The unfunded portion of approved home equity lines of credit was $115.9 million as of December 31, 2015. Home equity loans are typically secured by junior liens on owner-occupied one- to four-family residences, but in many instances are secured by first liens on such properties. Underwriting procedures for the home equity and home equity lines of credit loans include a comprehensive review of the loan application, an acceptable credit score, verification of the value of the equity in the home, and verification of the borrower’s income.

 

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

 

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

 

Other Consumer Loans At December 31, 2015, the Company’s portfolio of other consumer loans was $19.8 million or 1.0% of its gross loans receivable. Other consumer loans include student loans, automobile loans, recreational vehicle and boat loans, deposit account loans, overdraft protection lines of credit, and unsecured consumer loans, including loans through credit card programs that are administered by third parties. The Company no longer originates student loans through programs guaranteed by the federal government. Student loans that continue to be held by the Company are administered by a third party.

 

Other consumer loans generally have shorter terms and higher rates of interest than conventional mortgage loans, but typically involve more credit risk because of the nature of the collateral and, in some instances, the absence of collateral. In general, other consumer loans are more dependent upon the borrower's continuing financial stability, more likely to be affected by adverse personal circumstances, and often secured by rapidly depreciating personal property. In addition, various laws, including bankruptcy and insolvency laws, may limit the amount that may be recovered from a borrower. The Company believes that the higher yields earned on other consumer loans compensate for the increased risk associated with such loans and that consumer loans are important to the Company’s efforts to increase the interest rate sensitivity and shorten the average maturity of its loan portfolio.

 

Asset Quality

 

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

 

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Internal Risk Ratings and Classified Assets OCC regulations require thrift institutions to review and, if necessary, classify their assets on a regular basis. Accordingly, the Company has internal policies and procedures in place to evaluate and/or maintain risk ratings on all of its loans and certain other assets. In general, these internal risk ratings correspond with regulatory requirements to adversely classify problem loans and certain other assets as “substandard,” “doubtful,” or “loss.” A loan or other asset is adversely classified as substandard if it is determined to involve a distinct possibility that the Company could sustain some loss if deficiencies associated with the loan are not corrected. A loan or other asset is adversely classified as doubtful if full collection is highly questionable or improbable. A loan or other asset is adversely classified as loss if it is considered uncollectible, even if a partial recovery could be expected in the future. The regulations also provide for a “special mention” designation, described as loans or assets which do not currently expose the Company to a sufficient degree of risk to warrant adverse classification, but which demonstrate clear trends in credit deficiencies or potential weaknesses deserving management's close attention (refer to the following paragraph for additional discussion). As of December 31, 2015, $32.4 million or 1.9% the Company’s loans were classified as special mention and $37.1 million or 2.1% were classified as substandard. The latter includes all loans placed on non-accrual in accordance with the Company’s policies, as described below. In addition, as of December 31, 2015, $23.3 million of the Company’s mortgage-related securities, consisting of private-label collateralized mortgage obligations (“CMOs”) rated less than investment grade, were classified as substandard in accordance with regulatory guidelines. The Company had no loans or other assets classified as doubtful or loss at December 31, 2015.

 

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

 

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

 

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

 

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

 

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

 

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

 

Non-Accrual Policy With the exception of student loans that are guaranteed by the U.S. government, the Company generally stops accruing interest income on loans when interest or principal payments are 90 days or more in arrears or earlier when the future collectability of such interest or principal payments may no longer be certain. In such cases, borrowers have often been able to maintain a current payment status, but are experiencing financial difficulties and/or the properties that secure the loans are experiencing increased vacancies, declining lease rates, and/or delays in unit sales. In such instances, the Company generally stops accruing interest income on the loans even though the borrowers are current with respect to all contractual payments. Although the Company generally no longer accrues interest on these loans, the Company may continue to record periodic interest payments received on such loans as interest income provided the borrowers remain current on the loans and provided, in the judgment of management, the Company’s net recorded investment in the loans are deemed to be collectible. The Company designates loans on which it stops accruing interest income as non-accrual loans and establishes a reserve for outstanding interest that was previously credited to income. All loans on non-accrual are considered to be impaired. The Company returns a non-accrual loan to accrual status when factors indicating doubtful or uncertain collection no longer exist. In general, non-accrual loans are also classified as substandard, doubtful, or loss in accordance with the Company’s internal risk rating policy. As of December 31, 2015, $13.6 million or 0.78% of the Company’s loans were considered to be non-performing in accordance with the Company’s policies.

 

Foreclosed Properties and Repossessed Assets As of December 31, 2015, $3.3 million or 0.1% of the Company’s total assets consisted of foreclosed properties and repossessed assets. In the case of loans secured by real estate, foreclosure action generally starts when the loan is between the 90th and 120th day of delinquency following review by a senior officer and the executive loan committee of the board of directors. If, based on this review, the Company determines that repayment of a loan is solely dependent on the liquidation of the collateral, the Company will typically seek the shortest redemption period possible, thus waiving its right to collect any deficiency from the borrower. Depending on whether the Company has waived this right and a variety of other factors outside the Company’s control (including the legal actions of borrowers to protect their interests), an extended period of time could transpire between the commencement of a foreclosure action by the Company and its ultimate receipt of title to the property.

 

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

 

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

 

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

 

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

 

Allowance for Loan Losses As of December 31, 2015, the Company’s allowance for loan losses was $17.6 million or 1.01% of loans receivable and 129.51% of non-performing loans. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on factors such as the size and current risk characteristics of the portfolio, an assessment of individual problem loans and pools of homogenous loans within the portfolio, and actual loss, delinquency, and/or risk rating experience within the portfolio. The Company also considers current economic conditions and/or events in specific industries and geographical areas, including unemployment levels, trends in real estate values, peer comparisons, and other pertinent factors, including regulatory guidance. Finally, as appropriate, the Company also considers individual borrower circumstances and the condition and fair value of the loan collateral, if any. For additional information relating to the Company’s allowance for loan losses for the periods covered by this report, refer to “Results of Operations—Provision for Loan Losses” and “Financial Condition—Asset Quality” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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

 

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

 

The Company maintains general allowances for loan loss against certain homogenous pools of loans. These pools generally consist of smaller loans of all types that do not warrant individual review due to their size. In addition, pools may also consist of larger commercial loans that have not been individually identified as impaired by management. Certain of these pools are further segmented by management’s internal risk rating of the loans. Management has developed factors for each pool or segment based on the historical loss experience of each pool or segment, internal risk ratings, industry loss experience by type of loan, and consideration of current economic trends, in order to determine what it believes is an appropriate level for the general allowance. Given the significant amount of management judgment involved in this process there could be significant variation in the Company’s allowance for loan losses and provision for loan losses from period to period.

 

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

 

Management considers loans to be collateral dependent when, in its judgment, there is no source of repayment for the loan other than the ultimate sale or disposition of the underlying collateral and foreclosure is probable. Factors management considers in making this determination typically include, but are not limited to, the length of time a borrower has been delinquent with respect to loan payments, the nature and extent of the financial or operating difficulties experienced by the borrower, the performance of the underlying collateral, the availability of other sources of cash flow or net worth of the borrower and/or guarantor, and the borrower’s immediate prospects to return the loan to performing status. In some instances, because of the facts and circumstances surrounding a particular loan relationship, there could be an extended period of time between management’s identification of a problem loan and a determination that it is probable that such loan is collateral dependent.

 

Management generally measures impairment of impaired loans whether or not foreclosure is probable based on the estimated fair value of the underlying collateral. Such estimates are based on management’s judgment or, when considered appropriate, on an updated appraisal or similar evaluation. Updated appraisals are also typically obtained on impaired loans on at least an annual basis or when foreclosure or repossession of the underlying collateral is considered to be imminent. Prior to receipt of an updated appraisal, management has typically relied on the latest appraisal and knowledge of the condition of the collateral, as well as the current market for the collateral, to estimate the Company’s exposure to loss on impaired loans.

 

Investment Activities

 

At December 31, 2015, the Company’s portfolio of mortgage-related securities available-for-sale was $407.9 million or 16.3% of its total assets. As of the same date its portfolio of mortgage-related securities held-to-maturity was $120.9 million or 4.8% of total assets. Mortgage-related securities consist principally of mortgage-backed securities (“MBSs”) and CMOs. Most of the Company’s mortgage-related securities are directly or indirectly insured or guaranteed by Fannie Mae, the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or the Government National Mortgage Association (“Ginnie Mae”). The remaining securities are private-label CMOs. Private-label CMOs generally carry higher credit risks and higher yields than mortgage-related securities insured or guaranteed by the aforementioned agencies of the U.S. Government. Although the latter securities have less exposure to credit risk, like private-label CMOs they remain exposed to fluctuating interest rates and instability in real estate markets, which may alter the prepayment rate of underlying mortgage loans and thereby affect the fair value of the securities. For additional information related to the Company’s mortgage-related securities, refer to “Financial Condition—Mortgage-Related Securities Available-for-Sale” and “Financial Condition—Mortgage-Related Securities Held-to-Maturity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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

 

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

 

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

 

The Company’s investment policy prohibits the purchase of non-investment grade securities, although the Company may continue to hold investments that are reduced to less than investment grade after their purchase. Securities rated less than investment grade are adversely classified as substandard in accordance with federal guidelines (refer to Asset Quality—Internal Ratings and Classified Assets,” above).

 

Financial Derivatives

 

The Company’s policies permit the use of financial derivatives such as financial futures, forward commitments, and interest rate swaps, to manage its exposure to interest rate risk. At December 31, 2015, the Company was using forward commitments to manage interest rate risk related to its sale of residential loans in the secondary market and interest rate swaps to manage interest rate risk related to certain fixed-rate commercial loans and forecasted transaction cash flows. For additional information, refer to “Note 1. Summary of Significant Accounting Policies” and “Note 13. Financial Instruments with Off-Balance-Sheet Risk and Derivative Financial Instruments” in “Item 8. Financial Statements and Supplementary Data.”

 

Deposit Liabilities

 

At December 31, 2015, the Company’s deposit liabilities were $1.8 billion or 71.8% of its total liabilities and equity. The Company offers a variety of deposit accounts having a range of interest rates and terms for both retail and business customers. The Company currently offers regular savings accounts, interest-bearing demand accounts, non-interest-bearing demand accounts, money market accounts, and certificates of deposit. The Company also offers IRA time deposit accounts and health savings accounts. When the Company determines its deposit rates, it considers rates offered by local competitors, benchmark rates on U.S. Treasury securities, and rates on other sources of funds such as FHLB of Chicago advances. For additional information, refer to “Financial Condition—Deposit Liabilities” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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

 

Borrowings

 

At December 31, 2015, the Company’s borrowed funds were $372.4 million or 14.9% of its total liabilities and equity. The Company borrows funds to finance its lending, investing, operating, and, when active, stock repurchase activities. Substantially all of the Company’s borrowings have traditionally consisted of advances from the FHLB of Chicago on terms and conditions generally available to member institutions. The Company’s FHLB of Chicago borrowings typically carry fixed rates of interest, have stated maturities, and are generally subject to significant prepayment penalties if repaid prior to their stated maturity. The Company has pledged certain one- to four-family first and second mortgage loans, as well as certain multi-family mortgage loans, as blanket collateral for current and future advances. From time to time the Company may also pledge mortgage-related securities as collateral for advances.

 

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For additional information regarding the Company’s outstanding advances from the FHLB of Chicago as of December 31, 2015, refer to “Financial Condition—Borrowings” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Shareholders’ Equity

 

At December 31, 2015, the Company’s shareholders’ equity was $276.5 million or 11.17% of its total liabilities and equity. The Company and the Bank are both required to maintain specified amounts of regulatory capital pursuant to regulations promulgated by their respective federal regulators. Management’s objective is to maintain the Company and the Bank’s regulatory capital in an amount sufficient to be classified in the highest regulatory category (i.e., as a “well capitalized” institution). At December 31, 2015, the Company and the Bank exceeded all regulatory minimum requirements, as well as the amount required to be classified as a “well capitalized” institution. For additional discussion relating to regulatory capital standards refer to “Regulation and Supervision of the Company —Regulatory Capital Requirements” and “Regulation and Supervision of the Bank—Regulatory Capital Requirements,” below. For additional information related to the Company’s equity and the Company and Bank’s regulatory capital, refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data.”

 

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

 

From time to time, the Company has repurchased shares of its common stock which has had the effect of reducing the Company’s capital. However, as with the payment of dividends above, the repurchase of common stock is discretionary with the Company’s board of directors and depends on a variety of factors, including market conditions for the Company’s stock, the financial condition of the Company and the Bank, compliance with regulatory capital requirements, and other considerations. The Company currently has an active stock repurchase program in effect. However, because of the aforementioned considerations there can be no assurances the Company will repurchase shares of its common stock under the current stock repurchase program. For additional discussion relating to the Company’s current stock repurchase program, refer to “Financial Condition—Shareholders’ Equity,” in “Item 7. Management’s Discussion and Analysis.”

 

Subsidiaries

 

BancMutual Financial and Insurance Services, Inc. (“BMFIS”), a wholly-owned subsidiary of the Bank that does business as “Mutual Financial Group,” provides investment, wealth management, and insurance products and services to the Bank’s customers and the general public. These products and services include equity and debt securities, mutual fund investments, tax-deferred annuities, life, disability, and long-term care insurance, property and casualty insurance, financial advisory services, and other brokerage-related services. BMFIS also offers fee-based financial planning and third-party-administered trust services to customers. These products and services are provided through an operating agreement with a leading, third-party, registered broker-dealer.

 

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

 

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

 

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Employees

 

At December 31, 2015, the Company employed 563 full time and 100 part time associates. Management considers its relations with its associates to be good.

 

Regulation and Supervision

 

General

 

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

 

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

 

Financial Services Industry Legislation and Related Actions

 

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

 

Dodd-Frank Act

 

In 2010 Congress enacted the Dodd-FrankAct, which significantly changed the U.S. financial institution regulatory structure, as well as the lending, investment, trading, and operating activities of financial institutions and their holding companies. Many of the provisions of the Dodd-Frank Act have become effective since 2010 and management believes the Company and the Bank are in compliance with the new provisions, as applicable, and that the impacts of such provisions (if any) are fully reflected in the financial condition and/or results of operations of the Company and the Bank. However, portions of the Dodd-Frank Act remain subject to future rule-making procedures and studies. As such, the full impact of such future provisions cannot yet be determined at this time, although management does not expect them to have a material adverse impact on the Company or the Bank..

 

Regulation and Supervision of the Bank

 

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

 

The OCC regularly examines the Bank and issues a report on its examination findings to the Bank’s board of directors. The Bank’s relationships with its depositors and borrowers are also regulated by federal law, especially in such matters as the ownership of savings accounts and the form and content of the Bank’s loan documents. The Bank must file reports with the OCC and the FDIC concerning its activities and financial condition, and must obtain regulatory approvals prior to entering into transactions such as mergers or acquisitions.

 

Regulatory Capital Requirements In 2015 regulatory capital standards as specified by the Basel Committee of Banking Supervision (known as Basel III) became effective for financial institutions such as the Bank (although certain aspects of the new standards will continue to phase in through 2019). These regulatory capital standards, which superseded the standards in effect prior to 2015, require financial institutions such as the Bank to meet the following minimum regulatory capital standards to be classified as “adequately capitalized” under the regulations: (i) common equity Tier 1 (“CET1”) capital equal to at least 4.5% of total risk-weighted assets, (ii) Tier 1 capital equal to at least 4% of adjusted total assets (known as the “leverage ratio”), (iii) Tier 1 risk-based capital equal to at least 6% of total risk-weighted assets, and (iv) total risk-based capital equal to at least 8% of total risk-weighted assets. At December 31, 2015, the Bank’s regulatory capital ratios exceeded both the minimum requirements to be classified as “adequately capitalized,” as well as the higher requirements necessary to be classified as a “well capitalized” for regulatory capital purposes. For additional information related to the Bank’s regulatory capital ratios, refer to “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data.”

 

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

 

Dividend and Other Capital Distribution Limitations Federal regulations generally govern capital distributions by savings associations such as the Bank, which include cash dividends or other capital distributions. Currently, the Bank must file an application with the OCC for approval of a capital distribution because the total amount of its capital distributions for the most recent calendar year has exceeded the sum of its earnings for that period plus its earnings that have been retained in the preceding two years. In certain other circumstances, however, the Bank may only be required to give the OCC a minimum of 30 days’ notice before the board of directors declares a dividend or approves a capital distribution. The Bank is also required to notify the FRB of its intent to declare a dividend or approve a capital distribution.

 

The FRB or the OCC may disapprove or restrict dividends or other capital distributions if (i) the savings association would be undercapitalized, significantly undercapitalized or critically undercapitalized following the distribution; (ii) the proposed capital distribution raises safety and soundness concerns; or (iii) the capital distribution would violate any applicable statute, regulation, agreement or regulatory-imposed condition. The FRB and OCC have substantial discretion in making these decisions. Refer to “Regulation and Supervision of the Company—Dividend and Other Capital Distribution Limitations,” below, for the impact that regulatory restrictions on the Bank’s capital distributions could have on the Company.

 

Qualified Thrift Lender Test Federal savings associations must meet a qualified thrift lender (“QTL”) test or they become subject to operating restrictions. The Bank met the QTL test as of December 31, 2015, and anticipates that it will maintain an appropriate level of mortgage-related investments (which must be at least 65% of portfolio assets as defined in the regulations) and will otherwise continue to meet the QTL test requirements.

 

Federal Home Loan Bank System The Bank is a member of the FHLB of Chicago. The FHLB of Chicago makes loans (“advances”) to its members and provides certain other financial services to its members pursuant to policies and procedures established by its board of directors. The FHLB of Chicago imposes limits on advances made to member institutions, including limitations relating to the amount and type of collateral and the amount of advances.

 

As a member of the FHLB of Chicago, the Bank must meet certain eligibility requirements and must purchase and maintain common stock in the FHLB of Chicago in an amount equal to the greater of (i) $10,000, (ii) 0.40% of its mortgage-related assets at the most recent calendar year end, or (iii) 4.5% of its outstanding advances from the FHLB of Chicago. However, the FHLB of Chicago may occasionally require less than 4.5% for amounts borrowed under certain advance programs offered to member institutions. At December 31, 2015, the Bank owned $17.6 million in FHLB of Chicago common stock, which was in compliance with the minimum common stock ownership guidelines established by the FHLB of Chicago.

 

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

 

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

 

An institution’s assessment rate depends on the capital categorizations and supervisory sub-categorizations to which it is assigned. Under the risk-based assessment system, there are four assessment risk categories to which different assessment rates are applied. The assessment rates range from 2.5 to 45 basis points, depending on the institution’s capital category and supervisory sub-category. The assessment base used by the FDIC in determining deposit insurance premiums consists of an insured institution’s average consolidated total assets minus average tangible equity and certain other adjustments.

 

In June 2015 the FDIC issued a proposed rule that would change how insured financial institutions are assessed for deposit insurance. Under the proposed rule management estimates that the Bank’s federal deposit insurance premium rate could decline significantly from its current level. However, management anticipates that, even if the rule is adopted as currently proposed, it will not have an impact on the Bank’s premium rate until the second quarter 2016 or later. In addition, in October 2015 the FDIC issued another proposed rule that could result in the creation of insurance premium credits for insured institutions with less than $10 billion in assets, such as the Bank. Each insured institution’s credits would be determined by the FDIC at a future date in accordance with performance measures established for the insurance fund, as specified in the proposed rule. The credits could be used by insured institutions to offset future premium costs until the credits are exhausted. Management is unable to determine the amount or timing of credits that might be awarded, if any. In addition, there can be no assurances that the either of these proposed rules will be adopted as proposed or that they will not be significantly changed prior to their final adoption, which could materially change the deposit insurance premiums the Company might otherwise expect to pay in the future.

 

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

 

Transactions With Affiliates Sections 23A and 23B of the Federal Reserve Act and FRB Regulation W govern transactions between an insured federal savings association, such as the Bank, and any of its affiliates, such as the Company. An affiliate is any company or entity that controls, is controlled by or is under common control with it. Sections 23A and 23B limit the extent to which an institution or a subsidiary may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such savings association’s capital stock and surplus, and limit all such transactions with all affiliates to 20% of such stock and surplus. The term “covered transaction” includes the making of loans, purchase of assets, issuance of guarantees, derivatives transactions, securities borrowing, and lending transactions to the extent that they result in credit exposure to an affiliate. Further, most loans by a savings association to any of its affiliates must be secured by specified collateral amounts. All such transactions must be on terms that are consistent with safe and sound banking practices and must be on terms that are at least as favorable to the savings association as those that would be provided to a non-affiliate. At December 31, 2015, the Company and Bank did not have any covered transactions.

 

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

 

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

 

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

 

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

 

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

 

In 2013 the CFPB also issued final regulations to integrate certain single family residential loan disclosures under the Truth in Lending Act ( “TILA”) and Real Estate Settlement Procedures Act of 1974 (“RESPA”), which became effective on October 3, 2015. These new rules, which have become known as the TILA-RESPA Integrated Disclosure (“TRID”) rules. Among other things, the TRID rules consolidated certain existing loan disclosure documents and established strict delivery requirements related to such documents. The type of single family residential lending done by the Bank is subject to these new rules. Although the Bank has implemented the new TRID rules, many financial experts believe that such rules will increase the costs and difficulties that most consumers will experience to obtain a home loan and that such could have an adverse impact on residential lending as a whole. Management is unable to determine at this time whether and to what extent this may be true. Furthermore, it is unable to determine at this time the impact such may have on the Bank’s mortgage banking operations, if any.

 

In 2014 federal regulators issued a regulation relating to risk retention requirements on sales of single family residential mortgage loans. The risk retention requirements generally require institutions such as the Bank to retain no less than 5% of the credit risk in loans it sells into a securitization and prohibits such institutions from directly or indirectly hedging or otherwise transferring the credit risk that the institution is required to retain, subject to limited exceptions. One significant exception is for securities entirely collateralized by “qualified residential mortgages” (“QRMs”), which are defined the same as the “qualified mortgage” rule issued by the CFPB, as previously discussed. The new risk retention requirements apply to securitizations of residential loans issued after December 24, 2015. Management does not expect this new requirement to have a significant impact on the Bank’s single family mortgage lending or sales operations.

 

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

 

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

 

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

 

Loans to Insiders A savings association’s loans to its executive officers, directors, any owner of more than 10% of its stock (each, “an insider”) and certain entities affiliated with any such person (an insider’s “related interest”) are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the FRB’s Regulation O thereunder. Under these restrictions, the aggregate amount of the loans to any insider and related interests may not exceed the loans-to-one-borrower limit applicable to national banks. All loans by a savings association to all insiders and related interests in the aggregate may not exceed the savings association’s unimpaired capital and surplus. With certain exceptions, the Bank’s loans to an executive officer (other than certain education loans and residential mortgage loans) may not exceed $100,000. Regulation O also requires that any proposed loan to an insider or a related interest be approved in advance by a majority of the Bank’s board of directors, without the vote of any interested director, if such loan, when aggregated with any existing loans to that insider and related interests, would exceed $500,000. Generally, such loans must be made on substantially the same terms as, and follow credit underwriting procedures that are no less stringent than, those for comparable transactions with other persons and must not present more than a normal risk of collectability. There is an exception for extensions of credit pursuant to a benefit or compensation plan of a savings association that is widely available to employees that does not give preference to officers, directors, and other insiders. As of December 31, 2015, total loans to insiders were $787,000 (including $678,000 which relates to residential mortgages that have been sold in the secondary market).

 

Regulation and Supervision of the Company

 

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

 

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

 

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

 

Regulatory Capital Requirements On January 1, 2015, regulatory capital standards as specified in Basel III became effective for savings and loan holding companies such as the Company (although certain aspects of the new standards will continue to phase in through 2019). These capital requirements are substantially the same as those required for the Bank (refer to “Regulation and Supervision of the Bank—Regulatory Capital Requirements,” above). However, the requirements are separately applied to the Company on a consolidated basis. As of December 31, 2015, the Company’s regulatory capital ratios exceeded both the minimum requirements to be classified as “adequately capitalized,” as well as higher requirements necessary to be classified as “well capitalized” for regulatory capital purposes. For additional information related to the Company’s regulatory capital ratios, refer to “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data.”

 

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Dividend and Other Capital Distribution Limitations FRB regulations generally govern capital distributions by savings and loan holding companies such as the Company, which include cash dividends and stock repurchases. Currently, the Company is not required to give the FRB any notice or application before the board of directors declares a dividend or approves a stock repurchase. In certain other circumstances, however, the Bank would be required to give the FRB a notice or an application that meets certain filing requirements before the board of directors declares a dividend or stock repurchase.

 

The FRB may disapprove or restrict dividends or stock repurchases if (i) the savings and loan holding company would be undercapitalized, significantly undercapitalized or critically undercapitalized following the distribution; (ii) the proposed capital distribution raises safety and soundness concerns; or (iii) the capital distribution would violate any applicable statute, regulation, agreement or regulatory-imposed condition. The FRB has substantial discretion in making these decisions.

 

The Company is highly dependent on the ability of the Bank to pay dividends or otherwise distribute its capital to the Company. Neither the Company nor the Bank can provide any assurances that dividends will continue to be paid by the Bank to the Company or the amount of any such dividends. Furthermore, the Company cannot provide any assurances that dividends will continue to be paid to shareholders, the amount of any such dividends, or whether additional shares of common stock will be repurchased under its current stock repurchase plan. For additional discussion related to the Company’s dividends and common stock repurchases refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.”

 

Acquisition of Bank Mutual Corporation No person may acquire control of the Company without first obtaining the approval of such acquisition by the appropriate federal regulator. Currently, any person, including a company, or group acting in concert, seeking to acquire 10% or more of the outstanding shares of the Company (or otherwise gain the ability to control the Company) must, depending on the circumstances, obtain the approval of, and/or file a notice with the FRB.

 

Federal and State Taxation

 

Federal Taxation The Company and its subsidiaries file a calendar year consolidated federal income tax return, reporting income and expenses using the accrual method of accounting. The federal income tax returns for the Company and its subsidiaries have been examined or closed without examination by the Internal Revenue Service (“IRS”) for tax years prior to 2012.

 

State Taxation The Company and its subsidiaries are subject to combined reporting in the state of Wisconsin. The state income tax returns for the Company and its subsidiaries have been examined and closed by the Wisconsin Department of Revenue for tax years prior to 2011.

 

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Item 1A.   Risk Factors

 

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

 

The Company’s Loan Losses Could Be Significant in the Future and/or Could Exceed Established Allowances for Loan Losses, Which Could Have a Material Adverse Effect on the Company’s Results of Operations

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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The Bank’s Ability to Pay Dividends to the Company Is Subject to Limitations that May Affect the Company’s Ability to Pay Dividends to its Shareholders and/or Repurchase Its Stock

 

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

 

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

 

Global financial markets continue to be volatile from time to time, and economic performance has been inconsistent in various countries. Developments relating to the federal budget, federal borrowing authority, and/or other political issues could also negatively impact these markets, as could global developments such as a foreign sovereign debt crisis or in the war on terrorism. Volatility and/or instability in global financial markets could also affect the Company’s ability to sell investment securities and other financial assets, which in turn could adversely affect the Company’s liquidity and financial position. These factors could also affect the prices at which the Company could make any such sales, which could adversely affect its results of operations and financial condition. Conditions could also negatively affect the Company’s ability to secure funds or raise capital for acquisitions and other projects, which in turn, could cause the Company to use deposits or other funding sources for such projects.

 

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

 

Recent and Future Legislation and Rulemaking May Significantly Affect the Company’s Results of Operations and Financial Condition

 

Instability, volatility, and failures in the credit and financial institutions markets in recent years have led regulators and legislators to consider and/or adopt proposals that will significantly affect financial institutions and their holding companies, including the Company. Legislation such as the Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009, and the Dodd-Frank Act, were adopted. Although designed to address safety, soundness, and compliance issues in the banking system, there can be no assurance as to the ultimate impact of these actions on financial markets, which could have a material, adverse effect on the Company’s business, financial condition, results of operations, access to credit or the value of the Company’s securities. Further legislative and regulatory proposals to reform the U.S. financial system would also affect the Company and the Bank.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The Company’s success depends in large part on the continued service and availability of its management team, and on its ability to attract, retain and motivate qualified personnel, particularly customer relationship managers. The competition for these individuals can be significant, and the loss of key personnel could harm the Company’s business. The Company cannot provide assurances that it will be able to retain existing key personnel or attract additional qualified personnel.

 

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Item 1B.  Unresolved Staff Comments

 

None.

 

Item 2.   Properties

 

As of December 31, 2015, the Company and its subsidiaries conducted their business through an executive office and 69 banking offices. As of December 31, 2015, the Company owned the building and land for 62 of its property locations and leased the space for eight.

 

In March 2016 the Company expects to complete the consolidation of four banking offices into nearby offices. The Company owns the building and land for three of these locations and leases the space for one. However, the leased location had a free-standing ATM on land adjacent to the office that is owned by the Company. The Company intends to retain this land and continue to operate the ATM. For additional discussion, refer to “Results of Operations—Non-Interest Expense” in “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.”

 

The Company also owns 15 acres of developed land in a suburb of Milwaukee, Wisconsin, through its MC Development subsidiary, as well as approximately 300 acres of undeveloped land in another community located near Milwaukee through MC Development’s 50% ownership in Arrowood Development LLC. The Company’s interest in the net book value of these parcels of land was $2.2 million at December 31, 2015.

 

Item 3.   Legal Proceedings

 

The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Management believes that these routine legal proceedings, in the aggregate, are immaterial to the Company’s financial condition, results of operations, and cash flows.

 

Item 4.   Mine Safety Disclosures

 

Not applicable.

 

Executive Officers

 

Refer to “Item 10. Directors, Executive Officers, and Corporate Governance,” for information regarding the executive officers of the Company and the Bank.

 

25 

 

 

Part II

 

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

 

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

 

As of February 29, 2016, there were 45,575,567 shares of common stock outstanding and approximately 8,500 shareholders of record.

 

The Company paid a total cash dividend of $0.19 per share in 2015. A cash dividend of $0.05 per share was paid on February 26, 2016, to shareholders of record on February 12, 2016. For additional discussion relating to the Company’s dividends, refer to “Financial Condition—Shareholders’ Equity” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The payment of dividends in the future is discretionary with the Company’s board of directors and will depend on the Company’s operating results, financial condition, and other considerations. Refer also to “Item 1. Business—Regulation and Supervision” for information relating to regulatory limitations on the Company’s payment of dividends to shareholders, as well as the payment of dividends by the Bank to the Company, which in turn could affect the payment of dividends by the Company.

 

The quarterly high and low trading prices of the Company’s common stock from January 1, 2014, through December 31, 2015, and the dividends paid in each quarter, were as follows:

 

   2015 Stock Prices   2014 Stock Prices   Cash Dividends Paid 
   High   Low   High   Low   2015   2014 
1st Quarter  $7.39   $6.37   $7.34   $6.21   $0.04   $0.03 
2nd Quarter   7.75    7.02    6.46    5.80    0.05    0.04 
3rd Quarter   7.78    6.78    6.62    5.93    0.05    0.04 
4th Quarter   8.05    7.03    6.99    6.17    0.05    0.04 
                   Total     $0.19   $0.15 

 

From January 1, 2016, to February 29, 2016, the trading price of the Company's common stock ranged between $7.21 to $7.88 per share, and closed this period at $7.47 per share.

 

The Company’s board of directors announced a stock repurchase plan on February 2, 2015, that authorized the purchase of up to 2.3 million shares of the Company’s common stock. During 2015 the Company repurchased 1.5 million shares of stock under this plan at an average price of $7.18. The following table provides information about shares that were repurchased under this plan during the fourth quarter of 2015.

 

Month  Shares
Purchased
   Average
Price
Per
Share
   Total Number of
Shares Purchased as
Part of Publicly
Announced Plans
   Number of Shares
That May Yet Be
Purchased Under
the Plan
 
October 2015   102,160   $7.24    102,160    926,099 
November 2015   56,657    7.26    56,657    869,442 
December 2015               869,442 
Total/Average   158,817   $7.25    158,817      

 

From January 1, 2016, to February 2, 2016, 500 additional shares were purchased at an average price per share of $7.25 under the plan, which expired on February 2, 2016. However, on February 1, 2016, the Company’s board of directors announced a new stock repurchase plan that authorized the purchase of up to 1.0 million shares of the Company’s common stock. From February 1, 2016, to February 29, 2016, the Company repurchased 5,281 shares at an average price of $7.28 under the new plan. For additional information relating to the Company’s stock repurchase plans, refer to “Financial Condition—Shareholders’ Equity,” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” For additional discussion relating to the Company’s ability to repurchase of its common stock, refer to “Item 1. Business—Shareholders’ Equity” and “Item 1. Business—Regulation and Supervision.”

 

26 

 

 

Set forth below is a line graph comparing the cumulative total shareholder return on Company common stock, based on the market price of the common stock and assuming reinvestment of cash dividends, with the cumulative total return of companies on the NASDAQ Stock Market U.S. Index (“NASDAQ Composite Index”) and the NASDAQ Stock Market Bank Index. The graph assumes that $100 was invested on December 31, 2010, in Company common stock and each of those indices.

 

 

   Period Ending December 31 
Index  2010   2011   2012   2013   2014   2015 
Bank Mutual Corporation   100.00    67.58    92.53    153.34    153.60    179.23 
NASDAQ Composite Index   100.00    99.17    116.48    163.21    187.23    200.31 
NASDAQ Bank Index   100.00    74.57    100.48    137.27    153.50    156.89 

 

27 

 

 

Item 6. Selected Financial Data

 

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

 

   At December 31 
   2015   2014   2013   2012   2011 
   (Dollars in thousands, except number of shares and per share amounts) 
Selected financial condition data:                         
Total assets  $2,502,167   $2,328,446   $2,347,349   $2,418,264   $2,498,484 
Loans receivable, net   1,740,018    1,631,303    1,508,996    1,402,246    1,319,636 
Loans held-for-sale   3,350    3,837    1,798    10,739    19,192 
Mortgage-related securities available-for-sale   407,874    321,883    446,596    550,185    781,770 
Mortgage-related securities held-to-maturity   120,891    132,525    155,505    157,558     
Foreclosed properties and repossessed assets   3,306    4,668    6,736    13,961    24,724 
Mortgage servicing rights, net   7,205    7,867    8,737    6,821    7,401 
Deposit liabilities   1,795,591    1,718,756    1,762,682    1,867,899    2,021,663 
Borrowings   372,375    256,469    244,900    210,786    153,091 
Shareholders' equity   279,394    280,717    281,037    271,853    265,771 
Number of shares outstanding, net of treasury stock   45,443,548    46,568,284    46,438,284    46,326,484    46,228,984 
Book value per share  $6.15   $6.03   $6.05   $5.87   $5.75 

 

   For the Year Ended December 31 
   2015   2014   2013   2012   2011 
   (Dollars in thousands, except per share amounts) 
Selected operating data:                         
Total interest income  $77,901   $79,265   $79,456   $83,022   $89,345 
Total interest expense   9,566    9,416    13,112    21,641    26,756 
Net interest income   68,335    69,849    66,344    61,381    62,589 
Provision for loan losses   (3,665)   233    4,506    4,545    6,710 
Total non-interest income   23,239    22,349    26,116    29,259    23,158 
Total non-interest expense (1)   72,727    68,461    71,504    76,057    124,900 
Income (loss) before income taxes   22,512    23,504    16,450    10,038    (45,863)
Income tax expense   8,335    8,850    5,702    3,336    1,752 
Net income (loss) before non-controlling interest   14,177    14,654    10,748    6,702    (47,615)
Net loss attributable to non-controlling interest       11    48    52    50 
Net income (loss)  $14,177   $14,665   $10,796   $6,754   $(47,565)
Earnings (loss) per share-basic  $0.31   $0.32   $0.23   $0.15   $(1.03)
Earnings (loss) per share-diluted   0.31    0.31    0.23    0.15    (1.03)
Cash dividends paid per share   0.19    0.15    0.10    0.05    0.06 
                          

 

(1)Total non-interest expense in 2011 includes a goodwill impairment of $52.6 million.

 

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   At or For the Year Ended December 31 
   2015   2014   2013   2012   2011 
Selected financial ratios:                         
Net interest margin (2)   3.11%   3.32%   3.11%   2.67%   2.76%
Net interest rate spread   3.02    3.24    3.02    2.57    2.64 
Return on average assets   0.59    0.63    0.46    0.27    (1.87)
Return on average shareholders' equity   5.07    5.14    3.93    2.50    (16.37)
Efficiency ratio (3)   79.61    74.34    77.34    84.04    85.07 
Non-interest expense as a percent of adjusted average assets (4)   3.00    2.94    3.03    3.03    2.84 
Shareholders' equity to total assets   11.17    12.06    11.97    11.24    10.64 
                          
Selected asset quality ratios:                         
Non-performing loans to loans receivable, net   0.78%   0.74%   0.86%   1.84%   5.69%
Non-performing assets to total assets   0.68    0.72    0.84    1.64    4.00 
Allowance for loan losses to non-performing loans   129.51    185.68    181.62    83.64    37.17 
Allowance for loan losses to total loans receivable, net   1.01    1.37    1.56    1.54    2.12 
Charge-offs to average loans   0.06    0.10    0.18    0.78    1.96 

 

(2)Net interest margin is calculated by dividing net interest income by average earnings assets.
(3)Efficiency ratio is calculated by dividing non-interest expense (excluding goodwill impairment) by the sum of net interest income and non-interest income (excluding gains and losses on investments and real estate).
(4)The ratio in 2011 excludes the impact of the goodwill impairment.

 

29 

 

 

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

 

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

 

Results of Operations

 

Overview The Company’s net income for the years ended December 31, 2015, 2014, and 2013, was $14.2 million, $14.7 million, and $10.8 million, respectively. Diluted earnings per share during these periods were $$0.31, $0.31, and $0.23, respectively. The Company’s net income during these periods represented a return on average assets (“ROA”) of 0.59%, 0.63%, and 0.46%, respectively, and a return on average equity (“ROE”) of 5.07%, 5.14%, and 3.93%, respectively.

 

The Company’s net income in 2015 was impacted by the following unfavorable developments compared to 2014:

 

a $3.5 million or 8.5% increase in compensation-related expenses;

 

a $1.5 million or 2.2% decrease in net interest income;

 

a $1.5 million or 22.8% increase in occupancy, equipment, and data processing costs; and

 

a $920,000 or 33.0% decrease in income form bank-owned life insurance.

 

These unfavorable developments were partially offset by the following favorable developments in 2015 compared to 2014:

 

a $3.9 million decrease in provision for (recovery of) loan losses;

 

a $1.0 million or 39.0% increase in brokerage and insurance commissions;

 

a $713,000 or 7.1% decrease in other non-interest expense;

 

a $676,000 or 41.6% increase in loan-related fees; and

 

a $518,000 non-recurring charge in 2014 related to state income taxes, net of federal benefit.

 

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

 

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

 

a $4.3 million or 94.8% decrease in provision for (recovery of) loan losses;

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The following paragraphs discuss these developments in greater detail, as well as other changes in the components of net income during the years ended December 31, 2015, 2014, and 2013.

 

30 

 

 

Net Interest Income The Company’s net interest income declined by $1.5 million or 2.2% during the twelve months ended December 31, 2015, compared to the same period in 2014. This decline was primarily attributable to a decrease in the Company’s net interest margin that was only partially offset by an increase in earning assets and an increase in funding from non-interest-bearing checking accounts. The Company’s net interest margin was 3.11% in 2015 compared to 3.32% in 2014. In 2015 the average yield on the Company’s earning assets declined by 23 basis points compared to 2014, but the average cost of funds declined by only one basis point. The decline in the average yield on earning assets was largely due to the continued repricing of the Company’s loan portfolio to lower rates in the current interest rate environment, as well as its continued emphasis on the origination of variable-rate loans, which generally have lower initial yields than fixed-rate loans. Also contributing to the decline in yield on earning assets was the purchase of mortgage-related securities in 2015 at yields that were generally less than the prevailing yields in the securities portfolio.

 

The one basis point decline in the Company’s average cost of funds in 2015 compared to 2014 was due principally to a decrease in its average cost of borrowed funds. This decrease was caused by an increase in overnight borrowings from FHLB of Chicago, which were drawn to fund growth in earning assets in 2015. Overnight borrowings from the FHLB of Chicago generally have a lower initial interest cost than the Company’s certificates of deposit. The benefit of this lower interest cost more than offset an increase in the average cost of the Company’s certificates of deposits in 2015. In that year the Company increased the rates and lengthened the maturity terms on certain of the certificates of deposit it offers customers in an effort to fund growth in earning assets and to manage exposure to future changes in interest rates.

 

The Company’s average earning assets increased by $97.7 million or 4.6% during the twelve months ended December 31, 2015, compared to the same period in 2014. This increase was primarily attributable to a $99.7 million or 6.5% increase in average loans receivable in 2015. This development was partially offset by a small decrease in average mortgage-related securities in 2015 compared to 2014. Although the full-year average of mortgage-related securities declined between these years, the average balance of such securities actually increased during the last half of 2015 due to an increase in purchases of such securities.

 

Also contributing favorably to the Company’s net interest income in 2015, as well as its net interest margin in that year, was an increase in funding from non-interest-bearing checking accounts. The average balance in these accounts increased by $22.9 million or 12.4% in 2015 compared to 2014.

 

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

 

With respect to the Company’s funding mix in 2014, its average non-interest-bearing checking accounts increased by $61.8 million or over 50% in that year compared to 2013. In contrast, its average certificates of deposit declined by $148.5 million or 20.8% in 2014 compared to 2013. Also contributing to the improvement in funding mix in 2014 was a $44.7 million or 21.6% increase in average borrowings from the FHLB of Chicago. This increase, which funded loan growth and net deposit outflows in 2014, had a marginal average interest cost in that year that was lower than the average cost of the Company’s certificates of deposit.

 

Also contributing to the improvement in net interest margin in 2014 was a 38 basis point decline in the average cost of the Company’s certificates of deposit compared to the prior year. During most of 2014 the Company’s pricing strategy was to price certificates of deposits lower in order to reduce its overall funding cost and improve its funding mix, as noted in the previous paragraph.

 

The favorable impact of the aforementioned developments on net interest income in 2014 were partially offset by a $30.8 million or 1.4% decrease in average earning assets in 2014 compared to 2013. The Company’s earning assets declined in 2014 as it utilized available cash flow in that year to fund a net decrease in deposit liabilities, particularly certificates of deposit, as previously described.

 

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Finally, included in net interest income in 2015 and 2014 were call premiums of $219,000 and $512,000, respectively, that the Company received on mortgage-related securities called by their issuer in those periods. These call premiums increased the Company’s reported net interest margin by one and two basis points in 2015 and 2014, respectively.

 

The following table presents certain details regarding the Company's average balance sheet and net interest income for the periods indicated. The tables present the average yield on interest-earning assets and the average cost of interest-bearing liabilities. The yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods shown. The average balances are derived from daily balances over the periods indicated. Interest income includes prepayment fees, accretion or amortization of deferred fees and costs, and accretion or amortization of purchase discounts and premiums, all of which are considered adjustments to the yield of the related assets. Net interest spread is the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin is derived by dividing net interest income by average interest-earning assets. The Company’s tax exempt investments are insignificant, so no tax equivalent adjustments have been made.

 

   Year Ended December 31 
   2015   2014   2013 
       Interest   Avg.       Interest   Avg.       Interest   Avg. 
   Average   Earned/   Yield/   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Cost   Balance   Paid   Cost   Balance   Paid   Cost 
   (Dollars in thousands) 
Assets:   
Interest-earning assets:                                             
Loans receivable, net  (1)  $1,641,567   $65,954    4.02%  $1,541,879   $66,261    4.30%  $1,432,606   $64,638    4.51%
Mortgage-related securities   525,222    11,684    2.22    533,902    12,850    2.41    626,084    14,666    2.34 
Investment securities (2)   16,362    244    1.49    13,633    139    1.02    12,168    54    0.44 
Interest-earning deposits   17,333    19    0.11    13,339    15    0.11    62,742    98    0.16 
Total interest-earning assets   2,200,484    77,901    3.54    2,102,753    79,265    3.77    2,133,600    79,456    3.72 
Non-interest-earning assets   221,267              225,444              228,010           
Total average assets  $2,421,751             $2,328,197             $2,361,610           
                                              
Liabilities and equity:                                             
Interest-bearing liabilities:                                             
Savings deposits  $220,038    46    0.02   $222,930    55    0.02   $226,307    62    0.03 
Money market accounts   511,793    702    0.14    503,090    735    0.15    478,938    694    0.14 
Interest-bearing demand accounts   246,711    30    0.01    228,578    30    0.01    220,381    32    0.01 
Certificates of deposit   536,457    3,993    0.74    564,505    3,834    0.68    713,043    7,537    1.06 
Total deposit liabilities   1,514,999    4,771    0.31    1,519,103    4,684    0.31    1,638,669    8,325    0.51 
Advance payment by borrowers for taxes and insurance   20,107    1    0.00    20,949    1    0.00    21,881    2    0.01 
Borrowings   313,655    4,794    1.53    252,128    4,731    1.88    207,404    4,785    2.31 
Total interest-bearing liabilities   1,848,761    9,566    0.52    1,792,180    9,416    0.53    1,867,954    13,112    0.70 
Non-interest-bearing liabilities:                                             
Non-interest-bearing deposits   207,372              184,479              122,677           
Other non-interest-bearing liabilities   85,928              66,067              96,215           
Total non-interest-bearing liabilities   293,300              250,546              218,892           
Total liabilities   2,142,061              2,042,726              2,086,846           
Total equity   279,690              285,471              274,764           
Total average liabilities and equity  $2,421,751             $2,328,197             $2,361,610           
Net interest income and net interest rate spread       $68,335    3.02%       $69,849    3.24%       $66,344    3.02%
Net interest margin             3.11%             3.32%             3.11%
Average interest-earning assets to interest-bearing liabilities   1.19x             1.17x             1.14x          

 

(1)For the purposes of these computations, non-accruing loans and loans held-for-sale are included in the average loans outstanding.
(2)Investment securities consist of FHLB of Chicago common stock, which is owned as a condition of membership in that organization.

 

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

 

   Year Ended December 31, 2015,
Compared to Year Ended December 31, 2014
 
   Increase (Decrease) 
   Volume   Rate   Net 
  (Dollars in thousands) 
Interest-earning assets:    
Loans receivable  $4,150   $(4,457)  $(307)
Mortgage-related securities   (165)   (1,001)   (1,166)
Investment securities   32    73    105 
Interest-earning deposits   4        4 
Total interest-earning assets   4,021    (5,385)   (1,364)
Interest-bearing liabilities:               
Savings deposits   (7)   (2)   (9)
Money market deposits   13    (46)   (33)
Interest-bearing demand deposits   2    (2)    
Certificates of deposit   (197)   326    129 
Advance payment by borrowers for taxes and insurance            
Borrowings   1,035    (972)   63 
Total interest-bearing liabilities   846    (696)   150 
Net change in net interest income  $3,175   $(4,689)  $(1,514)

 

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

 

Provision for Loan Losses The Company’s provision for (recovery of) loan losses was $(3.7) million, $233,000, and $4.5 million during the years ended December 31, 2015, 2014, and 2013, respectively. The Company’s provision for (recovery of) loan losses in 2015 and 2014 benefited from a continued decline in Company’s actual loan charge-off experience in those periods, which had a favorable impact on the methodology the Company uses to compute general valuation allowances for most of its loan types. Also contributing was a general decline in non-performing and classified loans in both years, although non-performing loans increased in the fourth quarter of 2015. As described later in this report, non-performing loans increased in the fourth quarter of 2015 because of a $4.8 million loan to an industrial manufacturing company. This loan was downgraded to non-performing status due to a general deterioration in operating performance, coupled with difficulties the borrower has experienced integrating an acquired business. The Company established a loss allowance in the fourth quarter of 2015 related to this loan, which management believes is appropriate given the estimated fair value of the collateral that secures the loan. The borrower has a plan to improve its operating results, the execution of which will occur over the next several quarters, but results of which cannot be assured. Management will closely monitor the borrower's progress in implementing this plan. Excluding this loan, total non-performing loans would have declined in 2015. Refer to “Financial Condition—Asset Quality,” below, for additional discussion.

 

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Despite the recent increase in the Company’s non-performing loans, which related to a single commercial loan as noted in the previous paragraph, management believes that general economic, employment, and real estate conditions continue to be stable in the Company’s markets. If such conditions persist in the near term and Company continues to experience stable or reduced levels of non-performing loans, classified loans, and/or loan charge-offs, management anticipates that the provision for (recovery of) loan losses may consist of net recoveries in the first and possibly the second quarter of 2016. However, there can be no assurances that these trends will continue or that classified loans, non-performing loans, and/or loan charge-off experience will not increase in future periods. Accordingly, there can be no assurances that the Company’s provision for (recovery of) loan losses will not fluctuate considerably from period to period.

 

Non-Interest Income Total non-interest income for the years ended December 31, 2015, 2014, and 2013, was $23.2 million, $22.3 million, and $26.1 million, respectively. The following paragraphs discuss the principal components of non-interest income and primary reasons for its change from 2014 to 2015, as well as 2013 to 2014.

 

Deposit-related fees and charges were $11.6 million, $12.0 million, and $12.2 million in 2015, 2014, and 2013, respectively. Deposit-related fees and charges consist of overdraft fees, ATM and debit card fees, merchant processing fees, account service charges, and other revenue items related to services performed by the Company for its retail and commercial deposit customers. Management attributes the declines in deposit-related fees and charges in recent years to changes in customer spending behavior that has resulted in reduced revenue from overdraft charges and from check printing commissions. These developments have been partially offset by increased revenue from treasury management and merchant card processing services that the Company offers to commercial depositors. In the fourth quarter of 2015 the Company introduced a new checking account product line. Management believes that this new product line, combined with an increased advertising and marketing effort to support its retail deposit business, could result in an increase in deposit-related fees and charges in 2016. However, there can be no assurances.

 

Brokerage and insurance commissions were $3.6 million, $2.6 million, and $3.1 million, for the years ended December 31, 2015, 2014, and 2013, respectively. This revenue item typically consists of commissions earned on sales of tax-deferred annuities, mutual funds, and certain other securities, as well as personal and business insurance products. The increase in this revenue item in 2015 was due to non-refundable incentive payments that the Company received both to enter into a new relationship with a third-party financial service provider and to assist in recruiting additional qualified financial advisors. These payments will not recur in future periods. The new financial service provider has enabled the Company to expand the investment products and services that it provides to its brokerage and investment advisory customers, as well as attract additional financial advisors because of such expanded products and services. Management also believes that such developments may enable the Company to increase this revenue item in 2016 at a pace similar to the fourth quarter of 2015, which increased by $88,000 or 13.1% compared to the same quarter in 2014. However, it is unlikely this source of revenue in the full-year 2016 will exceed the amount recorded in 2015 because the previously described incentive payments will not recur. The decrease in brokerage and insurance commissions in 2014 compared to 2013 was primarily due to a decline in customer demand for tax-deferred annuities. This development was offset somewhat by an increase in commission revenue from the sale of mutual funds and other securities.

 

Mortgage banking revenue, net, was $3.5 million, $3.0 million, and $6.9 million in 2015, 2014, and 2013, respectively. The following table presents the components of mortgage banking revenue, net, for the periods indicated:

 

   Year Ended December 31 
   2015   2014   2013 
   (Dollars in thousands) 
Gross loan servicing fees  $2,661   $2,796   $2,885 
MSR amortization   (1,906)   (1,772)   (2,809)
MSR valuation recovery       1    2,395 
Loan servicing revenue, net   755    1,025    2,471 
Gain on sales of loan activities, net   2,707    1,965    4,405 
Mortgage banking revenue, net  $3,462   $2,990   $6,876 

 

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Gross loan servicing fees were $2.7 million, $2.8 million, and $2.9 million in 2015, 2014, and 2013, respectively. Gross loan servicing fees are highly correlated with loans serviced for third-party investors. As of December 31, 2015, 2014, and 2013, loans serviced for third-party investors were $1.04 billion, $1.09 billion, and $1.15 billion, respectively. In recent years the Company’s origination of fixed-rate, one- to four-family mortgage loans that it sells and services for third-party investors has not kept pace with repayments of such loans. Management attributes this to increased competition from non-bank sources, such as on-line mortgage banks. The Company has implemented new processing systems and improved management and staffing in its mortgage banking line of business in recent periods. Management is optimistic that these changes, combined with a planned increase in loan originators in 2016, as described below, could result in increases in gross servicing revenue in future periods. However, there can be no assurances.

 

Amortization of MSRs increased in 2015 compared to 2014. Generally lower market interest rates for one- to four-family residential loans in 2015 caused higher levels of actual and expected loan prepayment activity in 2015, which resulted in higher MSR amortization compared to 2014. Amortization of MSRs decreased in 2014 compared to 2013 for the opposite reason. Generally higher market interest rates for residential loans in 2014 caused lower levels of actual and expected prepayment activity in that year, which resulted in lower MSR amortization in 2014 compared to 2013.

 

The change in the valuation allowance that the Company maintains against its MSRs is recorded as a recovery or loss, as the case may be, in the period in which the change occurs. MSR valuation allowances typically increase in lower interest rate environments and decrease in higher interest rate environments. In lower rate environments, loan refinance activity and expectations for future loan prepayments generally increase, which typically reduces the fair value of MSRs and results in an increase in the MSR valuation allowance. The opposite situation generally occurs in higher rate environments. Lower market interest rates for one- to four-family residential loans in 2013 resulted in the recovery of substantially all of the Company’s MSR valuation allowance in that year. Subsequent to 2013 interest rates for residential loans have not been low enough to generate a requirement for an MSR valuation allowance in 2014 or 2015. However, if market interest rates for one- to four-family residential loans decrease and/or actual or expected loan prepayment expectations increase in future periods, the Company could record significant charges to earnings related to increases in the valuation allowance on its MSRs, as well as record increased levels of MSR amortization expense.

 

Net gains on loan sales activities were $2.7 million, $2.0 million, and $4.4 million, during the years ended December 31, 2015, 2014, and 2013, respectively. The Company’s policy is to sell substantially all of its fixed-rate, one- to four-family mortgage loan originations in the secondary market. During 2015, 2014, and 2013, sales of one- to four-family residential loans were $111.5 million, $77.8 million, and $252.3 million, respectively. Lower market interest rates for one- to four-family residential loans in 2013 resulted in significantly higher sales of loans in that year compared to 2014 and 2015. Market interest rates for residential loans were generally lower in 2015 compared to 2014, which resulted in increased sales of such loans in the latest year.

 

Management is optimistic that environment for home sales may continue to improve in 2016 and believes that fixed-rate, one- to four-family mortgage loans should continue to be affordable to borrowers. This optimism, combined with a planned increase of 20% to 30% in the number of loan originators the Company has on staff in 2016, could result in an increase in gains on sales of loans in 2016 compared to 2015. However, the origination and sale of residential loans are subject to variations in market interest rates, overall economic conditions, and other factors outside of management’s control. In addition, management cannot be certain it will be able to attract or retain loan originators as anticipated. Accordingly, there can be no assurances that originations and sales of loans will increase in the future or will not vary considerably from period to period.

 

Loan-related fees were $2.3 million, $1.6 million, and $976,000 in 2015, 2014, and 2013, respectively. In previous periods, loan-related fees were reported as a component of other non-interest income. Loan-related fees consist of periodic income from lending activities that are not deferred as yield adjustments under the applicable accounting rules. The largest source of fees in this revenue category are those realized from interest rate swaps related to commercial loan relationships. The Company mitigates the interest rate risk associated with certain of its loan relationships by executing interest rate swaps, the accounting for which results in the recognition of a certain amount of fee income at the time the swap contracts are executed. Management believes this source of revenue will vary considerably from period to period depending on borrower preference for the types of loan relationships that generate the interest rate swaps.

 

Income from BOLI was $1.9 million, $2.8 million, and $2.4 million during the years ended December 31, 2015, 2014, and 2013, respectively. Results in 2015 included no payouts related to excess death benefits under the terms of the insurance contracts. In contrast, results in 2014 and 2013 included payouts of $948,000 and $639,000 related to excess death benefits, respectively. Income from BOLI is also not subject to income taxes.

 

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In 2015 the Company recorded $218,000 in gains on the disposition of real estate properties that it held for investment purposes. No such gains were recorded in 2014 or 2013. Management continues to actively sell certain properties that the Company holds for investment purposes, but does not expect to record material gains or losses on the future disposition of such properties, if any.

 

In 2014 the Company recorded a $102,000 gain on the sale of mortgage-related securities that management felt no longer met the yield objectives of that portfolio. The Company did not sell any securities in 2015 or 2013.

 

Other non-interest income was $240,000, $284,000, and $565,000 for the years ended December 31, 2015, 2014, and 2013, respectively. The decreases in this revenue item in recent years have been caused by a decline in the fair value of assets held in trust for certain non-qualifying employee benefit plans.

 

Non-Interest Expense Total non-interest expense for the years ended December 31, 2015, 2014, and 2013 was $72.7 million, $68.5 million, and $71.5 million, respectively. The following paragraphs discuss the principal components of non-interest expense and the primary reasons for its change from 2014 to 2015, as well as 2013 to 2014.

 

Compensation and related expenses were $44.8 million, $41.3 million, and $43.9 million, during the years ended December 31, 2015, 2014, and 2013, respectively. The increase in 2015 was partly the result of increased cost related to the Company’s defined benefit pension plan, which was caused in large part by a decrease in the discount rate used to determine the present value of the pension obligation, as well as changes in certain other actuarial assumptions. In 2015 pension-related expense was $1.3 million higher than it was in 2014 for these reasons. Also contributing to the increase in compensation-related expenses in 2015 was a change in 2014 in the manner in which employees earned benefits for compensated absences. This change reduced the Company’s expense for compensated absences in 2014, which caused such expense to be $1.5 million higher in 2015 than it was in 2014. Compensation-related expenses in the 2015 were also higher because of normal annual merit increases granted to most employees at the beginning of the year, as well as higher stock-based compensation expense. Finally, compensation-related expenses in 2015 included $80,000 for employee severance costs related to the Company’s consolidation of eleven retail branch offices, as discussed later in this report.

 

In December 2015 the Company announced that, effective December 31, 2015, it froze the benefits of its remaining employees that were still earning benefits in its defined benefit pension plan. The benefits of all other employees had been frozen in 2013. As a result of this most recent change, as well as changes in other actuarial assumptions related to the plan, management anticipates that pension-related expenses in 2016 could be $2.8 million lower than they were in 2015, although there can be no assurances.

 

The decrease compensation and related expenses in 2014 compared to 2013 was caused in part by lower costs related to the Company’s defined benefit pension plan due to an increase in the discount rate used to determine the present value of the pension obligation in 2014. Also contributing to the decrease in compensation-related expenses in 2014 was a change in the way employees earned benefits for compensated absences, as previously described. These favorable developments were partially offset by an increase in employer contributions to the Company’s defined contribution savings plan in 2014, which were intended to partially offset the impact of the freezing of the plan for most employees in 2013. Also offsetting the favorable developments in 2014 was the impact of normal annual merit increases granted to most employees during the year, as well as an increase in costs related to certain non-qualified employee benefit plans.

 

As of December 31, 2015, the Company had 563 full-time employees and 100 part-time employees. This compared to 616 full-time and 99 part-time at December 31, 2014, and 637 full-time and 85 part-time at December 31, 2013. The number of employees has declined in recent years as the Company has consolidated retail branch offices and has improved efficiencies in other areas of its operations.

 

Occupancy, equipment, and data processing costs during the years ended December 31, 2015, 2014, and 2013 was $14.3 million, $12.8 million, and $11.9 million, respectively. The increase in 2015 was due in part to $715,000 in asset disposition costs associated with the Company’s consolidation of retail branch offices, as noted later in this report. Also contributing to the increase in 2015, as well as the increase in 2014, were increases in data processing costs related to the installation of new systems, certain repairs and maintenance on the Company’s facilities, and in 2014, snow removal and utility costs due to harsh winter conditions.

 

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Advertising and marketing expenses were $1.9 million, $1.8 million, and $1.8 million in 2015, 2014, and 2013, respectively. In 2016 management anticipates that the Company may increase advertising and marketing-related expense by 20% to 25% in an effort to increase sales and expand the Company’s overall brand awareness, especially as such relates to the retail deposit business. However, this increase will depend on future management decisions and there can be no assurances.

 

Federal insurance premiums were $1.5 million, $1.5 million, and $1.9 million in 2015, 2014, and 2013, respectively. The decrease in premiums from 2013 to 2014 was caused by an improvement in the Bank’s financial condition and operating results that, under the FDIC’s risk-based premium assessment system, resulted in lower insurance assessment rates. In June 2015 the FDIC issued a proposed rule that would change how insured financial institutions are assessed for deposit insurance. Under the proposed rule management estimates that the Bank’s federal deposit insurance premiums could decline beginning as early as the second quarter of 2016 and that its premium expense in all of 2016 could be up to 20% lower than it was in 2015. In addition, in October 2015 the FDIC issued another proposed rule that could result in the creation of insurance premium credits for insured institutions with less than $10 billion in assets, such as the Bank. Each insured institution’s credits would be determined by the FDIC at a future date in accordance with performance measures established for the insurance fund, as specified in the proposed rule. The credits could be used by insured institutions to offset future premium costs until the credits are exhausted. Management is unable to determine the amount or timing of credits that might be awarded, if any. In addition, there can be no assurances that the either of these proposed rules will be adopted as proposed or that they will not be significantly changed prior to their final adoption, which could materially change the deposit insurance premiums the Bank might otherwise expect to pay in the future. For additional information, refer to “Regulation and Supervision of the Bank—Deposit Insurance” in “Item 1. Business—Regulation and Supervision,” above.

 

Net losses and expenses on foreclosed properties were $801,000, $1.0 million, and $2.3 million in 2015, 2014, and 2013, respectively. The Company has experienced lower losses and expenses on foreclosed real estate in recent periods due to reduced levels of foreclosed properties and improved market conditions.

 

Other non-interest expense was $9.4 million, $10.1 million, and $9.8 million during the years ended December 31, 2015, 2014, and 2013, respectively. In 2015 and 2014 the Company prepaid $10.0 million and $20.0 million in fixed-rate, term FHLB of Chicago advances, respectively. These advances had been drawn in prior years to fund the purchase of mortgage-related securities that were called by the issuer in 2015 and 2014, as previously described. Management elected to prepay these advances concurrent with the calls of the securities. As a result, the Company recorded prepayment penalties of $102,000 and $242,000 in 2015 and 2014, respectively. Also contributing to the decrease in other non-interest expense in 2015 compared to 2014 was lower spending on legal, consulting, and other professional services.

 

In May 2015 the Company consolidated seven retail branch offices in connection with an efficiency and expense reduction effort. In December 2015 the Company announced the consolidation of four additional offices that it expects will be completed in March 2016. Management estimates these actions may result in annual net cost savings of approximately $1.5 million and $1.0 million, respectively. In connection with the branch consolidations the Company recorded certain one-time costs in non-interest expense in 2015, as previously noted in this report. For additional discussion, refer to “Item 1. Business—Market Area.”

 

Income Tax Expense Income tax expense was $8.3 million, $8.9 million, and $5.7 million in 2015, 2014, and 2013, respectively. The year ended December 31, 2014, included a non-recurring charge of $518,000 (net of federal income tax benefit) related to a payment by the Company to the Wisconsin Department of Revenue to settle a tax matter. Excluding the impact of this non-recurring charge, the Company’s effective tax rate (“ETR”) in 2015, 2014, and 2013 was 37.0%, 35.4%, and 34.7%, respectively. The Company’s ETR will vary from period to period depending primarily on the impact of non-taxable revenue, such as earnings from BOLI and tax-exempt interest income. The ETR will generally be higher in periods in which non-taxable revenue comprises a smaller portion of pre-tax income, such as it did in 2015.

 

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Financial Condition

 

Overview The Company’s total assets increased by $173.7 million or 7.5% during the twelve months ended December 31, 2015. During this period the Company’s loans receivable increased by $108.7 million and its aggregate mortgage-related securities increased by $74.4 million. These increases were funded by a $115.9 million increase in borrowings from the FHLB of Chicago and a $76.8 million increase in deposit liabilities. The Company’s total shareholders’ equity was $279.4 million at December 31, 2015, compared to $280.7 million at December 31, 2014. The following paragraphs describe these changes in greater detail, as well as other changes in the Company’s financial condition during the twelve months ended December 31, 2015.

 

Mortgage-Related Securities Available-for-Sale The Company’s portfolio of mortgage-related securities available-for-sale increased by $86.0 million or 26.7% during the year ended December 31, 2015. This increase was the result of $203.7 million in security purchases that were only partially offset by periodic repayments. The purpose of the security purchases was to maintain the portfolio at a level management considers sufficient to sustain the Company’s balance sheet liquidity.

 

The following table presents the carrying value of the Company’s mortgage-related securities available-for-sale at the dates indicated:

 

   December 31 
   2015   2014   2013 
   (Dollars in thousands) 
Freddie Mac  $216,278   $169,168   $228,873 
Fannie Mae   169,771    123,209    179,021 
Ginnie Mae   24    29    33 
Private-label CMOs   21,801    29,477    38,669 
Total  $407,874   $321,883   $446,596 

 

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

 

   Year Ended December 31 
   2015   2014   2013 
   (Dollars in thousands) 
Carrying value at beginning of period  $321,883   $446,596   $550,185 
Purchases   203,729        88,094 
Sales       (17,692)    
Principal repayments   (111,640)   (104,430)   (186,674)
Premium amortization, net   (1,725)   (1,213)   (1,460)
Other-than-temporary impairment reductions   148         
Increase (decrease) in net unrealized gain or loss   (4,521)   (1,378)   (3,549)
Net increase (decrease)   85,991    (124,713)   (103,589)
Carrying value at end of period  $407,874   $321,883   $446,596 

 

The table below presents information regarding the carrying values, weighted-average yields, and contractual maturities of the Company’s mortgage-related securities available-for-sale at December 31, 2015:

 

   One Year or Less   More Than One Year
to Five Years
   More Than Five
Years to Ten Years
   More Than Ten Years   Total 
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
 
   (Dollars in thousands) 
Securities by issuer and type:                                                  
Freddie Mac, Fannie Mae, and Ginnie Mae MBSs          $4,198    2.81%  $87,664    2.07%  $45,078    2.07%  $139,940    2.09%
Freddie Mac and Fannie Mae CMOs           9,255    2.05    110,233    2.71    129,646    1.85    249,134    2.23 
Private-label CMOs           4,451    5.08            17,349    2.89    21,800    3.33 
Total          $17,904    2.98%  $197,897    2.42%  $192,073    1.99%  $407,874    2.24%
Securities by coupon:                                                  
Adjustable-rate coupon                  $342    1.64%  $16,532    2.74%  $16,874    2.72%
Fixed-rate coupon          $17,904    2.98%   197,555    2.42    175,541    1.92    391,000    2.22 
Total          $17,904    2.98%  $197,897    2.42%  $192,073    1.99%  $407,874    2.24%

 

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Changes in the fair value of mortgage-related securities available-for-sale are recorded through accumulated other comprehensive loss, net of related income tax effect, which is a component of shareholders’ equity. The fair value adjustment on the Company’s mortgage-related securities available-for-sale was a net unrealized gain of $1.2 million at December 31, 2015, compared to a net unrealized gain of $5.7 million at December 31, 2014. The net unrealized gain declined in 2015 because of an increase in market interest rates at the end of 2015.

 

The Company maintains an investment in private-label CMOs that were purchased from 2004 to 2006 and are secured by prime residential mortgage loans. The securities were all rated “triple-A” by various credit rating agencies at the time of their purchase. However, all of the securities in the portfolio have been downgraded since their purchase. Securities rated less than investment grade are adversely classified as substandard in accordance with regulatory guidelines (refer to “Item 1. Business—Asset Quality”). As of December 31, 2015 and 2014, the carrying value of the Company’s investment in private-label CMOs was $21.8 million and $29.5 million, respectively. The net unrealized gain on the securities as of such dates was $200,000 and $479,000, respectively. As of December 31, 2015, $15.7 million of the Company’s private-label CMOs were rated less than investment grade by at least one credit rating agency. These securities had a net unrealized gain of $237,000 as of that date. As of December 31, 2014, $23.3 million of the Company’s private-label CMOs were rated less than investment grade and had a net unrealized gain of $480,000.

 

As of December 31, 2015 and 2014, management determined that none of the Company’s private-label CMOs had incurred OTTI as of those dates. The Company does not intend to sell these securities and it is unlikely it would be required to sell them before recovery of their amortized cost. However, collection is subject to numerous factors outside of the Company’s control and a future determination of OTTI could result in significant losses being recorded through earnings in future periods. For additional discussion refer to “Critical Accounting Policies—Other-Than-Temporary Impairment,” below, and “Item 1. Business—Investment Activities,” above.

 

Mortgage-Related Securities Held-to-Maturity The Company’s mortgage-related securities held-to-maturity consist of fixed-rate mortgage-backed securities issued and guaranteed by Fannie Mae and backed by multi-family residential loans. The Company classified these securities as held-to-maturity because it has the ability and intent to hold them until they mature.

 

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

 

   Year Ended December 31 
   2015   2014   2013 
   (Dollars in thousands) 
Carrying value at beginning of period  $132,525   $155,505   $157,558 
Principal repayments   (10,985)   (21,977)   (1,354)
Premium amortization   (649)   (1,003)   (699)
Net decrease   (11,634)   (22,980)   (2,053)
Carrying value at end of period  $120,891   $132,525   $155,505 

  

In 2015 and 2014 mortgage-related securities held-to-maturity with carrying values of $8.9 million and $20.4 million, respectively, were called by the issuers. The Company recorded call premiums in interest income of $219,000 and $512,000 in 2015 and 2014, respectively, in connection with these calls.

 

The table below presents information regarding the carrying values, weighted-average yields, and contractual maturities of the Company’s mortgage-related securities held-to-maturity at December 31, 2015, all of which are fixed rate:

 

   One Year or Less   More Than One Year
to Five Years
   More Than Five
Years to Ten Years
   More Than Ten Years   Total 
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
   Carrying
Value
   Weighted
Average
Yield
 
   (Dollars in thousands) 
Securities by issuer and type:                                                  
Fannie Mae DUS          $60,131    2.09%  $60,760    2.49%          $120,891    2.29%

 

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

 

   Year Ended December 31 
   2015   2014   2013 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $3,837   $1,798   $10,739 
Origination of loans held-for-sale (1)   111,012    79,714    243,669 
Principal balance of loans sold   (111,456)   (77,776)   (252,348)
Change in net unrealized gains or losses (2)   (43)   101    (262)
Total loans held-for-sale  $3,350   $3,837   $1,798 

 

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

 

The origination of one- to four-family mortgage loans intended for sale and the corresponding sales of such loans are lower than they were in 2013 because of generally higher market interest rates since that time, which resulted in fewer borrowers refinancing higher-rate loans into lower rate loans since that time. For additional discussion, refer to “Results of Operations—Non-Interest Income,” above.

 

Loans Receivable The Company’s loans receivable increased by $108.7 million or 6.7% during the twelve months ended December 31, 2015. During this period increases in multi-family, commercial real estate, and construction loans (net of the undisbursed portion), as well as commercial and industrial (C&I) loans, were partially offset by declines in one- to four-family permanent mortgages, home equity loans, and other consumer loans. Management believes that the overall loan growth experienced in recent periods is sustainable in the near term. However, the loan portfolio is subject to economic, market, and competitive factors outside of the Company’s control and there can be no assurances that expected loan growth will continue or that total loans will not decrease in future periods.

 

Construction loans, net of the undisbursed portion, increased by $14.8 million during the twelve months ended December 31, 2015, despite a substantially larger increase in the origination of such loans during the period, which was $263.0 million in 2015 compared to $154.9 million 2014. This development was due mostly to a large amount of construction loans that refinanced to permanent financing away from the Company after the completion of the construction phase. In many cases the Company chooses to not compete aggressively for the permanent financing on these loans because of pricing, terms, and/or other conditions that management considers to be unfavorable. It should be noted, however, that the significant increase in the origination of construction loans in 2015 caused the undisbursed portion of such loans to increase significantly, from $162.5 million at December 31, 2014, to $238.1 million at December 31, 2015. Management expects that these loans will be fully disbursed over the next few quarters, which should contribute to continued growth in total loans outstanding, although there can be no assurances.

 

Declines in the one- to four-family permanent and home equity loan portfolios during the twelve months ended December 31, 2015, were largely the result of a relatively low interest rate environment. These loan portfolios consist largely of adjustable-rate loans. The current rate environment favors the refinancing of such loans by borrowers into new fixed-rate, one- to four-family mortgage loans, which the Company typically sells in the secondary market, as previously described. Also contributing to the decreases, however, was low customer demand in recent years for adjustable-rate mortgage loans, which the Company generally retains in its loan portfolio, as well as low customer demand for home equity loans. Management does not expect these trends to change in the near term.

 

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

 

   December 31 
   2015   2014   2013   2012   2011 
   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent 
   (Dollars in thousands) 
Commercial loans:                                                  
Commercial and industrial  $235,313    11.78%  $226,537    12.47%  $166,788    10.10%  $132,436    8.82%  $87,715    6.31%
Commercial real estate   299,550    14.99    263,512    14.50    276,547    16.75    263,775    17.57    226,195    16.27 
Multi-family   409,674    20.51    322,413    17.74    265,841    16.10    264,013    17.58    247,040    17.77 
Construction and development:                                                  
Commercial real estate   28,156    1.41    42,405    2.33    27,815    1.68    11,116    0.74    19,907    1.43 
Multi-family   291,380    14.59    211,239    11.62    164,685    9.97    86,904    5.79    29,409    2.12 
Land and land development   11,143    0.56    5,069    0.28    6,962    0.42    6,445    0.43    8,078    0.60 
Total construction and development loans   330,679    16.56    258,713    14.24    199,462    12.08    104,465    6.96    57,394    4.15 
Total commercial loans   1,275,216    63.84    1,071,175    58.94    908,638    55.03    764,689    50.93    618,344    44.50 
Retail loans:                                                  
One- to four-family first mortgages:                                                  
Permanent   461,797    23.12    480,102    26.42    449,230    27.21    471,551    31.40    516,854    37.17 
Construction   42,357    2.12    23,905    1.32    40,968    2.48    18,502    1.23    16,263    1.17 
Total first mortgages   504,154    25.24    504,007    27.73    490,198    29.69    490,053    32.63    533,117    38.34 
Home equity loans:                                                  
Fixed term home equity   122,985    6.16    139,046    7.65    148,688    9.01    141,898    9.45    126,798    9.12 
Home equity lines of credit   75,261    3.77    80,692    4.44    79,470    4.81    81,898    5.45    86,540    6.23 
Total home equity   198,246    9.93    219,738    12.09    228,158    13.82    223,796    14.90    213,338    15.35 
Other consumer loans:                                                  
Student   8,129    0.41    9,692    0.53    11,177    0.68    12,915    0.86    15,711    1.13 
Other   11,678    0.58    12,681    0.70    12,942    0.78    10,202    0.68    9,405    0.68 
Total other consumer   19,807    0.99    22,373    1.23    24,119    1.46    23,117    1.54    25,116    1.81 
Total retail loans   722,207    36.16    746,118    41.06    742,475    44.97    736,966    49.07    771,571    55.50 
Gross loans receivable   1,997,423    100.00%   1,817,293    100.00%   1,651,113    100.00%   1,501,655    100.00%   1,389,915    100.00%
Undisbursed loan proceeds   (238,124)        (162,471)        (117,439)        (76,703)        (41,859)     
Allowance for loan losses   (17,641)        (22,289)        (23,565)        (21,577)        (27,928)     
Deferred fees and costs, net   (1,640)        (1,230)        (1,113)        (1,129)        (492)     
Total loans receivable, net  $1,740,018        $1,631,303        $1,508,996        $1,402,246        $1,319,636      

 

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

 

   Year Ended December 31 
   2015   2014   2013 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $1,631,303   $1,508,996   $1,402,246 
Loan originations:                   
Commercial loans:               
Commercial and industrial   90,265    73,630    52,701 
Commercial real estate   101,198    37,444    80,157 
Multi-family   87,328    101,260    50,323 
Construction and development   263,030    154,940    164,028 
Total commercial loans   541,821    367,274    347,209 
Retail loans:               
One- to four-family first mortgages (1)   100,876    75,402    84,822 
Home equity   33,291    33,850    52,827 
Other consumer   1,594    1,427    3,775 
Total retail loans   135,761    110,679    141,424 
Total loan originations   677,582    477,953    488,633 
Principal payments and repayments:               
Commercial loans   (337,601)   (204,737)   (199,507)
Retail loans   (157,515)   (104,782)   (134,225)
Total principal payments and repayments   (495,116)   (309,519)   (333,732)
Transfers to foreclosed properties, real estate owned, and repossessed assets   (2,336)   (2,254)   (5,443)
Net change in undisbursed loan proceeds, allowance for loan losses, and deferred fees and costs   (71,415)   (43,873)   (42,708)
Total loans receivable, net  $1,740,018   $1,631,303   $1,508,996 

 

(1)Amounts do not include one- to four-family mortgage loans originated for sale.

 

The following table presents the contractual maturity of the Company’s commercial and industrial loans and construction and development loans at December 31, 2015. The table does not include the effect of prepayments or scheduled principal amortization.

 

   Commercial
and Industrial
   Construction and
Development
   Total 
   (Dollars in thousands) 
Amounts due:                 
Within one year or less  $99,454   $36,406   $135,860 
After one year through five years   126,036    258,281    384,317 
After five years   9,823    78,349    88,172 
Total due after one year   135,859    336,630    472,489 
Total commercial and construction loans  $235,313   $373,036   $608,349 

 

The following table presents, as of December 31, 2015, the dollar amount of the Company’s commercial and industrial loans and construction and development loans due after one year and whether these loans have fixed interest rates or adjustable interest rates.

 

   Due After One Year 
   Fixed Rate   Adjustable
Rate
   Total 
   (Dollars in thousands) 
Commercial and industrial  $51,687   $84,172   $135,859 
Construction and development   11,453    325,177    336,630 
Total loans due after one year  $63,140   $409,349   $472,489 

 

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Mortgage Servicing Rights The carrying value of the Company’s MSRs was $7.2 million at December 31, 2015, compared to $7.9 million at December 31, 2014, net of valuation allowances of zero at both dates. As of December 31, 2015 and 2014, the Company serviced $1.04 billion and $1.09 billion in loans for third-party investors, respectively. For additional information refer to “Results of Operations—Non-Interest Income” and “Item 1. Business—Lending Activities,” above.

 

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

 

   December 31 
   2015   2014 
   (Dollars in thousands) 
Accrued interest receivable:          
 Loans receivable  $4,894   $4,748 
 Mortgage-related securities   1,141    1,027 
 Total accrued interest receivable   6,035    5,775 
Foreclosed properties and repossessed assets:          
 Commercial real estate   1,685    2,566 
 Land and land development   747    1,693 
 One- to four- family first mortgages   874    409 
 Total foreclosed and repossessed assets   3,306    4,668 
Bank-owned life insurance   61,656    59,830 
Premises and equipment   49,218    52,594 
Deferred tax asset, net   16,485    25,595 
Federal Home Loan Bank stock, at cost   17,591    14,209 
Other assets   24,037    22,183 
Total other assets  $178,328   $184,854 

 

The Company’s foreclosed properties and repossessed assets were $3.3 million and $4.7 million at December 31, 2015 and 2014, respectively. The Company does not expect significant changes in the level of its foreclosed properties and repossessed in the near term. However, there can be no assurances.

 

BOLI is long-term life insurance on the lives of certain current and past employees where the insurance policy benefits and ownership are retained by the Company. The cash surrender value of the related policies is an asset that the Company uses to partially offset the future cost of employee benefits. The cash value accumulation on BOLI is permanently tax deferred if the policy is held to the insured person’s death and certain other conditions are met. The increase in BOLI in 2015 was a result of the increase in the accumulated cash value of the insurance policies during the period.

 

As of December 31, 2015, the Company and its subsidiaries conducted their business through an executive office and 69 banking offices. The Company owned the building and land for 62 of its office locations and leased the space for seven. However, refer to “Results of Operations—Non-Interest Expense,” above, for discussion related to the Company’s consolidation of certain banking office locations in March 2016.

 

The Company’s net deferred tax asset decreased by $9.1 million or 35.6% during the year ended December 31, 2015, due primarily to the utilization of net operating loss carryforwards during the period. Management evaluates this asset on an on-going basis to determine if a valuation allowance is required. Management determined that no valuation allowance was required as of December 31, 2015. The evaluation of the net deferred tax asset requires significant management judgment based on positive and negative evidence. Such evidence includes the Company’s recent trend in earnings, expectations for the Company’s future earnings, the duration of federal and state net operating loss carryforward periods, and other factors. There can be no assurance that future events, such as adverse operating results, court decisions, regulatory actions or interpretations, changes in tax rates and laws, or changes in positions of federal and state taxing authorities will not differ from management’s current assessments. The impact of these matters could be significant to the consolidated financial conditions, results of operations, and capital of the Company.

 

The FHLB of Chicago requires its members to own its common stock as a condition of membership, which is redeemable at par. As of December 31, 2015, the Company’s ownership of FHLB of Chicago common stock exceeded the amount required under the FHLB of Chicago’s minimum guidelines. For additional discussion refer to the section entitled “Federal Home Loan Bank System” in “Item 1. Business—Regulation and Supervision.”

 

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Deposit Liabilities The Company’s deposit liabilities increased by $76.8 million or 4.5% during the twelve months ended December 31, 2015. Transaction deposits, which consist of checking, savings, and money market accounts, increased by $56.3 million or 4.7% during the period and certificates of deposit increased by $20.5 million or 3.9%. As noted earlier in this release, the Company increased rates and lengthened maturity terms on certain of the certificates of deposit it offers customers in 2015. Accordingly, management believes that the average cost of the Company’s certificates of deposit may continue to increase modestly for the foreseeable future, which would have an adverse impact on its net interest margin. Management further believes that the low interest rate environment that has persisted for the past few years has encouraged some customers to switch to transaction deposits in an effort to retain flexibility in the event interest rates increase in the future. If interest rates increase in the future, customer preference may shift from transaction deposits back to certificates of deposit, which typically have a higher interest cost to the Company. This development could also increase the Company’s cost of funds in the future, which would also have an adverse impact on its net interest margin.

 

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

 

   December 31 
   2015   2014   2013 
       Percent   Weighted-       Percent   Weighted-       Percent   Weighted- 
       of Total   Average       of Total   Average       of Total   Average 
       Deposit   Nominal       Deposit   Nominal       Deposit   Nominal 
   Amount   Liabilities   Rate   Amount   Liabilities   Rate   Amount   Liabilities   Rate 
   (Dollars in thousands) 
Non-interest-bearing demand  $213,761    11.90%   0.00%  $187,852    10.93%   0.00%  $161,639    9.20%   0.00%
Interest-bearing demand   277,606    15.46    0.01    253,595    14.76    0.01    245,923    13.95    0.01 
Money market savings   542,020    30.19    0.12    532,705    30.99    0.14    501,020    28.40    0.14 
Savings accounts   217,6331    12.12    0.01    220,557    12.83    0.03    220,236    12.50    0.03 
Total transaction accounts   1,251,020    69.67    0.06    1,194,709    69.51    0.07    1,128,818    64.05    0.07 
Certificates of deposit:                                             
With original maturities of:                                             
Three months or less   4,559    0.25