10-K 1 v460394_10k.htm FORM 10-K

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10 - K

 

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

 

For the fiscal year ended December 31, 2016

 

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 28, 2017, 45,887,719 shares of Common Stock were validly issued and outstanding. The aggregate market value of the Common Stock (based upon the $7.68 last sale price on The NASDAQ Global Select Market on June 30, 2016, 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 $288.9 million.

 

    Part of Form 10-K Into Which
Documents Incorporated by Reference   Portions of Document are Incorporated
     
Proxy Statement for Annual Meeting of Shareholders on May 1, 2017   Part III

 

 

 

 

BANK MUTUAL CORPORATION

 

FORM 10-K ANNUAL REPORT TO

THE SECURITIES AND EXCHANGE COMMISSION

FOR THE YEAR ENDED DECEMBER 31, 2016

 

Table of Contents

 

Item   Page
     
Part I    
     
1 Business 3
     
1A Risk Factors 20
     
1B Unresolved Staff Comments 24
     
2 Properties 24
     
3 Legal Proceedings 24
     
4 Mine Safety Disclosures 24
     
Part II    
     
5 Market for Registrant's Common Equity, Related Stockholders Matters, and Issuer Purchases of Equity Securities 25
     
6 Selected Financial Data 27
     
7 Management's Discussion and Analysis of Financial Condition and Results of Operations 29
     
7A Quantitative and Qualitative Disclosures About Market Risk 49
     
8 Financial Statements and Supplementary Data 52
     
9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 98
     
9A Controls and Procedures 98
     
9B Other Information 100
     
Part III    
     
10 Directors, Executive Officers, and Corporate Governance 101
     
11 Executive Compensation 102
     
12 Security Ownership of Certain Beneficial Owners, Management, and Related Stockholder Matters 102
     
13 Certain Relationships and Related Transactions and Director Independence 102
     
14 Principal Accountant Fees and Services 102
     
Part IV    
     
15 Exhibits, Financial Statement Schedules 103
     
16 Form 10-K Summary 103
     
SIGNATURES   104

 

 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 various federal regulatory agencies that could affect the Company or the Bank, particularly as such relates to guidelines concerning certain types of lending; 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 System (“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.

 

 3 

 

 

The Company’s principal executive office is located at 4949 West 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, 2016, the Company had 64 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, 2016, the Company had a 1.30% 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 24 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 five other offices in communities in east central Wisconsin. The Company also operates 17 banking offices in northeastern Wisconsin, including the Green Bay MSA. Finally, the Company has 13 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 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.

 

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 advancements in information technology and increases in internet-based commerce in recent years, the Company also competes with financial service providers outside of Wisconsin, as well as non-bank financial technology firms that offer products and services that compete with those offered by the Company.

 

Lending Activities

 

General At December 31, 2016, the Company’s total loans receivable was $1.9 billion or 73.4% of total assets. The Company’s loan portfolio consists of loans to both commercial and retail borrowers. Loans to commercial borrowers include loans secured by real estate such as multi-family properties, non-residential commercial properties (referred to as “commercial real estate”), and construction and development projects secured by these same types of properties, as well as land. In addition, commercial loans include loans to businesses that are not secured by real estate (referred to as “commercial and industrial loans”). Loans to retail borrowers include loans to individuals that are secured by real estate such as one- to four-family first mortgages, home equity term loans, and home equity lines of credit. In addition, retail loans include student loans, automobile loans, and other loans not secured by real estate (collectively referred to as “other consumer loans”).

 

The nature, type, and terms of loans originated or purchased by the Company are subject to federal and state laws and regulations. The Company has no significant concentrations of loans to particular borrowers or to borrowers engaged in similar activities. In addition, the Company limits its lending activities primarily to borrowers and related loan collateral located in its primary market areas, which consist of Wisconsin and contiguous regions of Illinois, Iowa, 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.”

 

 4 

 

 

Commercial and Industrial Loans At December 31, 2016, the Company’s portfolio of commercial and industrial loans was $241.7 million or 11.0% 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 $185.5 million as of December 31, 2016. 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, 2016, the Company’s aggregate portfolio of multi-family and commercial real estate loans was $881.6 million or 40.2% of its gross loans receivable. The Company’s multi-family and commercial real estate loan portfolios consist of fixed-rate and adjustable-rate loans originated at prevailing market rates usually tied to various market indices. This portfolio generally consists of loans secured by apartment buildings, office buildings, retail centers, warehouses, and industrial buildings. Loans in this portfolio may be secured by either owner or non-owner occupied properties. Loans in this portfolio typically do not exceed 80% of the lesser of the purchase price or an independent appraisal by an appraiser designated by the Company. Loans originated with balloon maturities are generally amortized on a 20 to 30 year basis with a typical balloon term of 3 to 10 years. 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 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.

 

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 $42.8 million as of December 31, 2016. 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.

 

 5 

 

 

Construction and Development Loans At December 31, 2016, the Company’s portfolio of construction and development loans was $374.8 million or 17.1% of its gross loans receivable. This amount included the unfunded portion of approved construction and development loans of $200.8 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, 2016, the Company’s portfolio of one- to four-family first mortgage loans was $500.0 million or 22.8% of its gross loans receivable. This amount included the unfunded portion of approved construction loans of $26.8 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. 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.

 

ARM loans pose credit risks different from the risks inherent in fixed-rate loans, primarily because as interest rates rise, the underlying payments from the borrowers increase, which increases the potential for payment default. At the same time, the marketability and/or value of the underlying property may be adversely affected by higher interest rates. ARM loans generally have an initial fixed-rate term of 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.

 

 6 

 

 

The Company requires an appraisal of the real estate that secures a residential mortgage loan, which must be performed by an independent state certified or licensed 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, 2016, loans serviced for third-party investors amounted to $997.0 million. 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.

 

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.

 

 7 

 

 

Home Equity Loans At December 31, 2016, the Company’s portfolio of home equity loans was $175.6 million or 8.0% 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 $111.0 million as of December 31, 2016. 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, 2016, the Company’s portfolio of other consumer loans was $18.2 million or 0.8% 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. The unfunded portion of customers’ approved credit card lines was $49.9 million as of December 31, 2016.

 

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.”

 

 8 

 

 

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, 2016, $54.4 million or 2.8% the Company’s loans were classified as special mention and $22.5 million or 1.2% 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, 2016, $11.6 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, 2016.

 

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.

 

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 material amounts of loss under accounting rules. In most cases the Company continues to report restructured or modified troubled loans as non-performing loans unless the borrower has clearly demonstrated the ability to service the loan in accordance with the new terms.

 

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

 

Non-Accrual Policy With the exception of student loans that are guaranteed by the U.S. government, the Company generally stops accruing interest income on loans when interest or principal payments are 90 days or more in arrears or earlier when the future collectability of such interest or principal payments may no longer be certain. In such cases, borrowers have often been able to maintain a current payment status, but are experiencing financial difficulties and/or the properties that secure the loans are experiencing increased vacancies, declining lease rates, and/or delays in unit sales. In such instances, the Company generally stops accruing interest income on the loans even though the borrowers are current with respect to all contractual payments. Although the Company generally no longer accrues interest on these loans, the Company may continue to record periodic interest payments received on such loans as interest income provided the borrowers remain current on the loans and provided, in the judgment of management, the Company’s net recorded investment in the loans are deemed to be collectible. The Company designates loans on which it stops accruing interest income as non-accrual loans and establishes a reserve for outstanding interest that was previously credited to income. All loans on non-accrual are considered to be impaired. The Company returns a non-accrual loan to accrual status when factors indicating doubtful or uncertain collection no longer exist. In general, non-accrual loans are also classified as substandard, doubtful, or loss in accordance with the Company’s internal risk rating policy. As of December 31, 2016, $8.2 million or 0.42% 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, 2016, $2.9 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 non-consumer borrower has surrendered control of the property to the Company or has otherwise abandoned the property, the Company may transfer the property to foreclosed properties as an “in substance foreclosure” prior to actual receipt of title. Foreclosed properties and repossessed assets are adversely classified in accordance with the Company’s internal risk rating policy.

 

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

 

In the case of loans secured by assets other than real estate, action to repossess the underlying collateral generally starts when the loan is between the 90th and 120th day of delinquency. 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.

 

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Allowance for Loan Losses As of December 31, 2016, the Company’s allowance for loan losses was $19.9 million or 1.03% of loans receivable and 242.5% 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 loss factors for each pool or segment based on the historical loss experience of each pool or segment and internal risk ratings. In addition, management has developed loss factors for each pool or segment that are intended to capture management’s judgments relating to changes in economic and business conditions, underlying collateral values, underwriting and credit management policies and procedures, experience and ability of lending managers, legal and regulatory requirements, etc. 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, 2016, the Company’s portfolio of mortgage-related securities available-for-sale was $371.9 million or 14.0% of its total assets. As of the same date its portfolio of mortgage-related securities held-to-maturity was $93.2 million or 3.5% 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.

 

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.

 

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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, 2016, 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, 2016, the Company’s deposit liabilities were $1.9 billion or 70.4% 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. The Company had no such deposits as of December 31, 2016.

 

Borrowings

 

At December 31, 2016, the Company’s borrowed funds were $439.2 million or 16.6% of its total liabilities and equity. The Company borrows funds to finance its lending, investing, and operating 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.

 

For additional information regarding the Company’s outstanding advances from the FHLB of Chicago as of December 31, 2016, 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, 2016, the Company’s shareholders’ equity was $286.6 million or 10.8% 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, 2016, 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.”

 

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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. It also owns 50% of Arrowood Development LLC, which was formed to develop approximately 300 acres for residential purposes in Oconomowoc, Wisconsin. Neither MC Development nor Arrowood Development LLC is currently engaged in significant efforts to develop its respective parcels of land.

 

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

 

Employees

 

At December 31, 2016, the Company employed 548 full time and 74 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.

 

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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.

 

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 The Bank is subject to various regulatory capital standards administered by the federal banking agencies and as defined in the applicable regulations. These regulatory capital standards, 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, 2016, 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.”

 

In addition to the requirements described in the previous paragraph, 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 phases-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 the minimums described in the preceding paragraph, plus 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.

 

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Loan Concentration Guidelines As part of their ongoing supervisory monitoring processes, federal regulatory agencies have established certain criteria to identify financial institutions such as the Bank that are potentially exposed to significant multi-family, non-owner occupied commercial real estate, and construction loan concentration risks. An institution that has experienced rapid growth in these types of loans or has notable exposure to such loans may be identified for further supervisory analysis to assess the nature and risk posed by such concentrations. Specifically, the federal regulatory agencies use the following criteria to identify concentrations in these types of loans:

 

·Total reported loans for construction, land development, and other land loans represent 100% or more of the institution's total risk-based capital; or

 

·Total multi-family, non-owner occupied commercial real estate, construction, land development, and other land loans, represent 300 percent or more of the institution's total risk-based capital, and the total outstanding balance of such loans has increased by 50% or more during the past three years.

 

As of December 31, 2016, the Bank’s holdings of and growth in multi-family, non-owner occupied commercial real estate, construction, land development, and other land loans exceeded the guidelines noted in the second bullet, above. As such, regulators have subjected the Bank’s lending operations and risk management controls to increased scrutiny. In response, management has taken steps to implement certain enhancements in its lending operations and controls that it believes will be satisfactory to its regulator. However, there can be no assurances that these enhancements will be considered adequate by the Bank’s regulator, that additional enhancements will not be required by its regulator, and/or that the Bank’s ability to originate or retain these types of loans will not be restricted by its regulator in the future. Such action could have an adverse impact on the Bank’s ability to grow its loan portfolio and its future results of operations.

 

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, 2016, 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. The FHLB of Chicago may require less than 4.5% for amounts borrowed under certain advance programs offered to member institutions. At December 31, 2016, the Bank owned $20.3 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.

 

The FDIC establishes deposit insurance premiums for individual banks or savings associations based upon the risks a particular institution poses to its deposit insurance fund. Under its assessment system for relatively smaller institutions such as the Bank, the FDIC assigns an institution to one of four categories based on the composite assessment of the institution by its primary regulator, which along with certain financial ratios, determines its initial base assessment rate. The initial base assessment rate may be adjusted higher or lower depending on the amount of unsecured debt held by an institution, which results in a total assessment rate for an institution. Depending on these factors an institution’s total assessment rate could range from 1.5 to 30 basis points. 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.

 

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In 2016 the FDIC issued a new 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 new rule. The credits could be used by insured institutions to offset future premium costs until the credits are exhausted. At this time, management is unable to determine the amount or timing of credits that might be awarded, if any.

 

Consumer Financial Protection Bureau The Consumer Financial Protection Bureau (“CFPB”) has broad rule-making and enforcement authority related to a wide range of consumer protection laws. This authority extends 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, 2016, the Company and Bank did not have any covered transactions.

 

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

 

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

 

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

 

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

 

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

 

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

 

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, 2016, total loans to insiders were $768,000 (including $659,000 which relates to residential mortgages that have been sold in the secondary market).

 

Regulation and Supervision of the Company

 

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

 

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

 

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

 

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Regulatory Capital Requirements The Company is subject to various regulatory capital standards administered by the federal banking agencies and as defined in the applicable regulations. 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, 2016, 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.”

 

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 2013.

 

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 2012.

 

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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.

 

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Regulators Could Restrict or Limit Future Growth in the Bank’s Loans

 

In recent periods banking regulatory agencies have publicly expressed increased concern about financial institutions whose holdings of non-owner occupied commercial real estate and construction loans and growth in such loans exceed guidelines issued in certain regulatory pronouncements. Specifically, financial institutions whose holdings of such loans exceed 300% of total risk-based capital and whose growth in such loans exceeds 50% over the past three years can expect increased scrutiny from their primary regulator. As of December 31, 2016, the Bank’s holdings of, and three-year growth in, these types of loans exceeded these guidelines. As such, the Bank’s regulator has subjected its lending operations and risk management controls to increased scrutiny in recent months. In response, management has taken steps to implement certain enhancements in its lending operations and controls that it believes will be satisfactory to its regulator. However, there can be no assurances that these enhancements will be considered adequate by the Bank’s regulator, that additional enhancements will not be required by its regulator, and/or that the Bank’s ability to originate or retain these types of loans will not be restricted by its regulator in the future. Such action could have an adverse impact on the Bank’s ability to grow its loan portfolio and its future results of operations.

 

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, especially with regards to matters related to consumer compliance and customer information security. As a consequence, regulatory activities affecting financial institutions relating to a wide variety of matters 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.

 

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, challenges in the European Union, 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.

 

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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 from time-to-time to consider and/or adopt proposals that will significantly affect financial institutions and their holding companies, including the Company. Although designed to address safety, soundness, and compliance issues in the banking system, these actions, if any, could have a material adverse impact on financial markets, and/or the Company’s business, financial condition, results of operations, and access to credit.

 

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, 2016, the Company and its subsidiaries conducted their business through an executive office and 65 banking offices. As of December 31, 2016, the Company owned the building and land for 57 of its property locations and leased the space for eight.

 

The Company also owns 15 acres of developed land in a suburb of Milwaukee, Wisconsin, through its MC Development subsidiary, as well as approximately 300 acres of undeveloped land in another community located near Milwaukee through MC Development’s 50% ownership in Arrowood Development LLC. The Company’s interest in the net book value of these parcels of land was $2.2 million at December 31, 2016.

 

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.

 

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Part II

 

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

 

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

 

As of February 28, 2017, there were 45,887,719 shares of common stock outstanding and approximately 8,100 shareholders of record.

 

The Company paid a total cash dividend of $0.215 per share in 2016. A cash dividend of $0.055 per share was paid on February 27, 2017, to shareholders of record on February 17, 2017. 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, 2015, through December 31, 2016, and the dividends paid in each quarter, were as follows:

 

   2016 Stock Prices   2015 Stock Prices   Cash Dividends Paid 
   High   Low   High   Low   2016   2015 
1st Quarter  $7.88   $7.21   $7.39   $6.37   $0.050   $0.040 
2nd Quarter   8.30    7.24    7.75    7.02    0.055    0.050 
3rd Quarter   7.99    7.51    7.78    6.78    0.055    0.050 
4th Quarter   9.65    7.69    8.05    7.03    0.055    0.050 
                   Total    $0.215   $0.190 

 

From January 1, 2017, to February 28, 2017, the trading price of the Company's common stock ranged between $9.25 to $10.15 per share, and closed this period at $9.70 per share.

 

The Company’s board of directors announced a stock repurchase plan on February 1, 2016, that authorized the purchase of up to 1.0 million shares of the Company’s common stock. In 2016 the Company repurchased 30,168 shares of stock under this plan at an average price of $7.35. No shares were repurchased under this plan during the fourth quarter of 2016 and no shares were repurchased from January 1, 2017, to January 31, 2017, on which date the plan expired. On February 6, 2017, the Company’s board of directors announced a new stock repurchase plan that authorized the purchase of up to 500,000 shares of the Company’s common stock. From February 6, 2017, to February 28, 2017, no shares were repurchased under this 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.”

 

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Set forth below is a line graph comparing the cumulative total shareholder return on Company common stock, based on the market price of the common stock and assuming reinvestment of cash dividends, with the cumulative total return of companies on the NASDAQ Stock Market U.S. Index (“NASDAQ Composite Index”) and the NASDAQ Stock Market Bank Index. The graph assumes that $100 was invested on December 31, 2011, in Company common stock and each of those indices.

 

 

 

   Period Ending December 31 
Index  2011   2012   2013   2014   2015   2016 
Bank Mutual Corporation   100.00    136.93    226.90    227.29    265.21    348.14 
NASDAQ Composite Index   100.00    117.45    164.57    188.84    201.98    219.89 
NASDAQ Bank Index   100.00    134.74    184.08    205.85    210.40    266.24 

 

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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 
   2016   2015   2014   2013   2012 
Selected financial condition data:  (Dollars in thousands, except number of shares and per share amounts) 
Total assets  $2,648,524   $2,502,167   $2,328,446   $2,347,349   $2,418,264 
Loans receivable, net   1,942,907    1,740,018    1,631,303    1,508,996    1,402,246 
Loans held-for-sale   5,952    3,350    3,837    1,798    10,739 
Mortgage-related securities available-for-sale   371,880    407,874    321,883    446,596    550,185 
Mortgage-related securities held-to-maturity   93,234    120,891    132,525    155,505    157,558 
Mortgage servicing rights, net   6,569    7,205    7,867    8,737    6,821 
Deposit liabilities   1,864,730    1,795,591    1,718,756    1,762,682    1,867,899 
Borrowings   439,150    372,375    256,469    244,900    210,786 
Shareholders' equity   286,641    279,394    280,717    281,037    271,853 
Number of shares outstanding, net of treasury stock   45,691,790    45,443,548    46,568,284    46,438,284    46,326,484 
Book value per share  $6.27   $6.15   $6.03   $6.05   $5.87 

 

   For the Year Ended December 31 
   2016   2015   2014   2013   2012 
Selected operating data:  (Dollars in thousands, except per share amounts) 
Total interest income  $83,148   $77,901   $79,265   $79,456   $83,022 
Total interest expense   10,801    9,566    9,416    13,112    21,641 
Net interest income   72,347    68,335    69,849    66,344    61,381 
Provision for (recovery of) loan losses   2,998    (3,665)   233    4,506    4,545 
Total non-interest income   26,844    23,239    22,349    26,116    29,259 
Total non-interest expense   69,127    72,727    68,461    71,504    76,057 
Income before income taxes   27,066    22,512    23,504    16,450    10,038 
Income tax expense   10,112    8,335    8,850    5,702    3,336 
Net income before non- controlling interest   16,954    14,177    14,654    10,748    6,702 
Net loss attributable to non-controlling interest           11    48    52 
Net income  $16,954   $14,177   $14,665   $10,796   $6,754 
Earnings per share-basic  $0.37   $0.31   $0.32   $0.23   $0.15 
Earnings per share-diluted  $0.37    0.31    0.31    0.23    0.15 
Cash dividends paid per share   0.215    0.19    0.15    0.10    0.05 

 

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   At or For the Year Ended December 31 
   2016   2015   2014   2013   2012 
Selected financial ratios:                         
Net interest margin (1)   3.03%   3.11%   3.32%   3.11%   2.67%
Net interest rate spread   2.94    3.02    3.24    3.02    2.57 
Return on average assets   0.66    0.59    0.63    0.46    0.27 
Return on average shareholders' equity   5.93    5.07    5.14    3.93    2.50 
Efficiency ratio (2)   69.70    79.61    74.34    77.34    84.04 
Non-interest expense as a percent of adjusted average assets   2.67    3.00    2.94    3.03    3.03 
Shareholders' equity to total assets   10.82    11.17    12.06    11.97    11.24 
                          
Selected asset quality ratios:                         
Non-performing loans to loans receivable, net   0.42%   0.78%   0.74%   0.86%   1.84%
Non-performing assets to total assets   0.42    0.68    0.72    0.84    1.64 
Allowance for loan losses to
non-performing loans
   242.46    129.51    185.68    181.62    83.64 
Allowance for loan losses to total loans receivable, net   1.03    1.01    1.37    1.56    1.54 
Charge-offs to average loans   0.04    0.06    0.10    0.18    0.78 

 

(1)Net interest margin is calculated by dividing net interest income by average earnings assets.
(2)Efficiency ratio is calculated by dividing non-interest expense by the sum of net interest income and non-interest income (excluding gains and losses on investments and real estate).

 

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

 

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

 

Results of Operations

 

Overview The Company’s net income for the years ended December 31, 2016, 2015, and 2014, was $17.0 million, $14.2 million, and $14.7 million, respectively. Diluted earnings per share during these periods were $0.37, $0.31, and $0.31, respectively. The Company’s net income during these periods represented a return on average assets (“ROA”) of 0.66%, 0.59%, and 0.63%, respectively, and a return on average equity (“ROE”) of 5.93%, 5.07%, and 5.14%, respectively.

 

The Company’s net income in 2016 was impacted by the following favorable developments compared to 2015:

 

a $4.0 million or 5.9% increase in net interest income;

 

a $3.5 million or over 150% increase in loan-related fees;

 

a $3.0 million or 6.7% decrease in compensation-related expenses;

 

a $786,000 or 22.7% increase in mortgage banking revenue;

 

a $606,000 or 4.2% decrease in occupancy, equipment, and data processing costs; and

 

a $579,000 or 72.3% decrease in net losses and expenses on foreclosed real estate.

 

These favorable developments were partially offset by the following unfavorable developments in 2016 compared to 2015:

 

a $6.7 million adverse change in provision for (recovery of) loan losses;

 

a $482,000 or 25.2% increase in advertising and marketing expense;

 

a $402,000 or 11.2% decrease in brokerage and insurance commissions; and

 

a $1.8 million or 21.3% increase in income tax expense.

 

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 from bank-owned life insurance.

 

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

 

a $3.9 million favorable change 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.

 

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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, 2016, 2015, and 2014.

 

Net Interest Income The Company’s net interest income increased by $4.0 million or 5.9% during the twelve months ended December 31, 2016, compared to the same period in 2015. This increase was due in part to an increase in the Company’s average earning assets in 2016 compared to 2015, as well as an increase in funding from non-interest bearing checking accounts between the periods. Also contributing to the increase was an increase in call premiums received on mortgage-related securities that were called during the periods. These favorable developments were partially offset by a decrease in the Company’s net interest margin in the 2016 periods compared to the same periods in 2015.

 

The Company’s average earning assets increased by $185.0 million or 8.4% in 2016 compared to 2015. This increase was primarily attributable to a $205.1 million or 12.5% increase in average loans receivable was only partially offset by a $22.1 million or 4.2% decrease in average mortgage-related securities between these years.

 

Also contributing favorably to the Company’s net interest income in 2016, as well as its net interest margin, was an increase in funding from non-interest-bearing checking accounts. The average balance in these accounts increased by $45.5 million or 21.9% in 2016 compared to 2015.

 

The Company’s net interest margin was 3.03% in 2016 compared to 3.11% in 2015. In 2016 the average yield on the Company’s earning assets declined by 11 basis points (excluding the impact of call premiums) and its average cost of funds increased by three basis points compared to 2015. The decline in the average yield on earning assets was largely due to the continued repricing of the Company’s loan portfolio to lower yields 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. However, management believes that the negative impact these developments have had on the Company’s loan portfolio yield may have run their course and that the loan portfolio yield may stabilize or even improve slightly in the near term. However, future results will depend in large part on developments affecting interest rates throughout the U.S. economy, so there can be no assurances. Also contributing to the decline in yield on earning assets in the 2016 was the purchase of mortgage-related securities at yields that were less than the prevailing rates in the investment portfolio.

 

The increase in the Company’s average cost of funds in 2016 was primarily due to a six basis point increase in its average cost of deposits compared to 2015. The impact of this increase was offset slightly by a decline in the average cost of borrowings from the FHLB of Chicago. This decline was caused by an increase in overnight borrowings, which were drawn to fund growth in earning assets in 2016. Overnight borrowings generally have a lower interest cost than the rates the Company offers on its certificates of deposit.

 

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, as well as an 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 in 2015 was the purchase of mortgage-related securities 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. 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.

 

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The Company’s average earning assets increased by $97.7 million or 4.6% in 2015 compared to 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.

 

Finally, included in net interest income in 2016, 2015, and 2014, were call premiums of $1.3 million, $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 five, one, and two basis points in these periods, 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 
   2016   2015   2014 
       Interest   Avg.       Interest   Avg.       Interest   Avg. 
   Average   Earned/   Yield/   Average   Earned/   Yield/   Average   Earned/   Yield/ 
   Balance   Paid   Cost   Balance   Paid   Cost   Balance   Paid   Cost 
Assets:  (Dollars in thousands) 
Interest-earning assets:                                             
Loans receivable, net (1)  $1,846,665   $70,782    3.83%  $1,641,567   $65,954    4.02%  $1,541,879   $66,261    4.30%
Mortgage-related securities   503,139    11,867    2.36    525,222    11,684    2.22    533,902    12,850    2.41 
Investment securities (2)   18,646    467    2.50    16,362    244    1.49    13,633    139    1.02 
Interest-earning deposits   17,029    32    0.19    17,333    19    0.11    13,339    15    0.11 
Total interest-earning assets   2,385,479    83,148    3.49    2,200,484    77,901    3.54    2,102,753    79,265    3.77 
Non-interest-earning assets   199,775              221,267              225,444           
Total average assets  $2,585,254             $2,421,751             $2,328,197           
                                              
Liabilities and equity:                                             
Interest-bearing liabilities:                                             
Interest-bearing demand accounts  $256,865    45    0.02   $246,711    30    0.01   $228,578    30    0.01 
Money market accounts   533,954    839    0.16    511,793    702    0.14    503,090    735    0.15 
Savings deposits   227,573    30    0.01    220,038    46    0.02    222,930    55    0.02 
Certificates of deposit   541,605    4,847    0.89    536,457    3,993    0.74    564,505    3,834    0.68 
Total deposit liabilities   1,559,997    5,761    0.37    1,514,999    4,771    0.31    1,519,103    4,684    0.31 
Borrowings   389,891    5,039    1.29    313,655    4,794    1.53    252,128    4,731    1.88 
Advance payment by borrowers for taxes and insurance   19,514    1    0.01    20,107    1    0.00    20,949    1    0.00 
Total interest-bearing liabilities   1,969,402    10,801    0.55    1,848,761    9,566    0.52    1,792,180    9,416    0.53 
Non-interest-bearing liabilities:                                             
Non-interest-bearing deposits   252,861              207,372              184,479           
Other non-interest-bearing liabilities   77,240              85,928              66,067           
Total non-interest-bearing liabilities   330,101              293,300              250,546           
Total liabilities   2,299,503              2,142,061              2,042,726           
Total equity   285,751              279,690              285,471           
Total average liabilities and equity  $2,585,254             $2,421,751             $2,328,197           
Net interest income and net interest rate spread       $72,347    2.94%       $68,335    3.02%       $69,849    3.24%
Net interest margin             3.03%             3.11%             3.32%
Average interest-earning assets to interest-bearing liabilities   1.21x             1.19x             1.17x          

  

(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, 2016,
Compared to Year Ended December 31, 2015
 
   Increase (Decrease) 
   Volume   Rate   Net 
Interest-earning assets:   (Dollars in thousands) 
Loans receivable  $8,054   $(3,226)  $4,828 
Mortgage-related securities   (533)   716    183 
Investment securities   38    185    223 
Interest-earning deposits       13    13 
Total interest-earning assets   7,559    (2,312)   5,247 
Interest-bearing liabilities:               
Interest-bearing demand deposits   1    14    15 
Money market deposits   32    105    137 
Savings deposits   7    (23)   (16)
Certificates of deposit   38    816    854 
Borrowings   1,055    (810)   245 
Advance payment by borrowers for taxes and  insurance            
Total interest-bearing liabilities   1,133    102    1,235 
Net change in net interest income  $6,426   $(2,414)  $4,012 

 

   Year Ended December 31, 2015,
Compared to Year Ended December 31, 2014
 
   Increase (Decrease) 
   Volume   Rate   Net 
Interest-earning assets:  (Dollars in thousands) 
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:               
Interest-bearing demand deposits   2    (2)    
Money market deposits   13    (46)   (33)
Savings deposits   (7)   (2)   (9)
Certificates of deposit   (197)   326    129 
Borrowings   1,035    (972)   63 
Advance payment by borrowers for taxes and  insurance            
Total interest-bearing liabilities   846    (696)   150 
Net change in net interest income  $3,175   $(4,689)  $(1,514)

 

Provision for Loan Losses The Company’s provision for (recovery of) loan losses was $3.0 million, $(3.7) million, and $233,000 during the years ended December 31, 2016, 2015, and 2014, respectively. Management believes that general economic, employment, and real estate conditions continue to be relatively stable in the Company’s local markets. In addition, the Company’s level of non-performing loans, as well as its actual loan charge-offs, have continued to trend lower in recent periods, as noted in “Financial Condition—Asset Quality,” below. However, the Company has experienced a modest increase in classified loans in recent periods, as also noted below. Management believes that this development could be an early indication of emerging difficulties in the lending environment for Company. This consideration, along with growth in the Company’s loan portfolio, contributed to management’s conclusion in 2016 that an increase in the allowance for loan losses was appropriate. As such, the Company’s allowance for loan losses increased from $17.6 million at December 31, 2015, to $19.9 million at December 31, 2016. Management anticipates that the Company’s provision for loan losses will continue to consist of provisions rather than recoveries for the foreseeable future, particularly if the Company’s loan portfolio continues to grow.

 

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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 used to compute general valuation allowances for most of its loan types. Also contributing was a general decline in non-performing and classified loans during those years. Refer to “Financial Condition—Asset Quality,” below, for additional discussion.

 

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

 

Non-Interest Income Total non-interest income for the years ended December 31, 2016, 2015, and 2014, was $26.8 million, $23.2 million, and $22.3 million, respectively. The following paragraphs discuss the principal components of non-interest income and primary reasons for its change from 2015 to 2016, as well as 2014 to 2015.

 

Deposit-related fees and charges were $11.5 million, $11.6 million, and $12.0 million in 2016, 2015, and 2014, 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 fluctuations in deposit-related fees and charges to changes in retail customer spending behavior in recent years which has generally resulted in lower revenue from overdraft charges and from check printing commissions. Benefiting this revenue line item in recent periods, however, has been increased revenue from treasury management and merchant card processing services that the Company offers to commercial depositors.

 

Loan-related fees were $5.8 million, $2.3 million, and $1.6 million in 2016, 2015, and 2014, respectively. 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 is interest rate swap fees 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. The increases in loan-related fees in the 2016 and 2015 were the result of increased loan production in those periods, as well as a generally lower interest rate environment that increased borrower preference for the types of loan transactions that generate interest rate swap fees. Management believes this source of revenue will vary considerably from period to period depending on the rate environment and on borrower preference for the types of transactions that generate interest rate swaps. Furthermore, a likely future decline in the origination of multi-family and construction loans, which are the types of loans that generate most of the Company’s interest rate swap fees, could have a negative impact on such fee income in the future (refer to “Financial Condition—Loans Receivable,” below, for additional discussion).

 

Brokerage and insurance commissions were $3.2 million, $3.6 million, and $2.6 million, for the years ended December 31, 2016, 2015, and 2014, respectively. This revenue item generally consists of commissions earned on sales of tax-deferred annuities, mutual funds, and certain other securities, as well as personal and business insurance products. However, results in 2015 included certain non-recurring incentive payments. Excluding these payments, this revenue item would have been $2.7 million in 2015. Management attributes the increase in this revenue item in recent years (excluding consideration of the non-recurring incentive payments) to new products, services, systems, and investment advisors that the Company has added in recent years.

 

Mortgage banking revenue, net, was $4.2 million, $3.5 million, and $3.0 million in 2016, 2015, and 2014, respectively. The following table presents the components of mortgage banking revenue, net, for the periods indicated:

 

   Year Ended December 31 
   2016   2015   2014 
   (Dollars in thousands) 
Gross loan servicing fees  $2,540   $2,661   $2,796 
MSR amortization   (2,158)   (1,907)   (1,772)
MSR valuation recovery           1 
Loan servicing revenue, net   382    754    1,025 
Gain on sales of loan activities, net   3,866    2,708    1,965 
Mortgage banking revenue, net  $4,248   $3,462   $2,990 

 

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Gross loan servicing fees were $2.5 million, $2.7 million, and $2.8 million in 2016, 2015, and 2014, respectively. Gross loan servicing fees are highly correlated with loans serviced for third-party investors. As of December 31, 2016, 2015, and 2014, loans serviced for third-party investors were $997.0 million, $1.04 billion, and $1.09 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.

 

Amortization of MSRs has increased in recent years. Generally lower market interest rates for one- to four-family residential loans has caused higher levels of actual and expected loan prepayment activity, which has resulted in higher MSR amortization in recent periods. In recent months market interest rates for one- to four-family residential loans have increased. As such, management anticipates that that amortization of MSRs will decline in the near term in response to reduced levels of loan refinance activity. However, this development cannot be assured, particularly if market interest rates for one- to four-family residential loans decline in the future.

 

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. Although market interest rates for one- to four-family mortgage loans were generally lower in 2016 and 2015, they were not low enough to generate an MSR valuation allowance during those periods. However, there can be no assurances that an increase in the MSR valuation allowance will not be required in the future, particularly if market interest rates for one- to four-family residential loans decline in the future.

 

Net gains on loan sales activities were $3.9 million, $2.7 million, and $2.0 million, during the years ended December 31, 2016, 2015, and 2014, 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 2016, 2015, and 2014, sales of one- to four-family residential loans were $151.2 million, $111.5 million, and $77.8 million, respectively. Generally lower market interest rates for one- to four-family residential loans since 2014 have resulted in increased sales of loans in 2015 and 2016. Although interest rates for one- to four-family residential loans have increased in recent months, management believes that origination and sales of such loans may not be adversely impacted due to continued strength in housing markets in Wisconsin, increases in the number and quality of the Company’s loan production personnel, and continued improvements in the Company’s loan origination systems and procedures. However, the origination and sale of residential loans are subject to variations in market interest rates and other factors outside of management’s control. Accordingly, there can be no assurances that such originations and sales will increase or will not fluctuate considerably from period to period.

 

Income from BOLI was $1.8 million, $1.9 million, and $2.8 million during the years ended December 31, 2016, 2015, and 2014, respectively. Results in 2016 and 2015 included no payouts related to excess death benefits under the terms of the insurance contracts. In contrast, results in 2014 included payouts of $948,000 related to excess death benefits. Income from BOLI is also not subject to income taxes.

 

In 2016 and 2015 the Company recorded $12,000 and $218,000 in gains on the disposition of real estate properties that it held for investment purposes. No such gains were recorded in 2014. The Company continues to actively market certain properties that it holds for investment purposes. There can be no assurances that the Company will be able to sell such properties or that gains or losses on sales, if any, will not fluctuate considerably from period to period.

 

In 2014 the Company recorded a $102,000 gain on the sale of mortgage-related securities that management believed no longer met the yield objectives of that portfolio. The Company did not sell any securities in 2016 or 2015.

 

Non-Interest Expense Total non-interest expense for the years ended December 31, 2016, 2015, and 2014, was $69.1 million, $72.7 million, and $68.5 million, respectively. The following paragraphs discuss the principal components of non-interest expense and the primary reasons for its change from 2015 to 2016, as well as 2014 to 2015.

 

 34 

 

 

Compensation and related expenses were $41.8 million, $44.8 million, and $41.3 million, during the years ended December 31, 2016, 2015, and 2014, respectively. The decrease in 2016 was mostly due to lower costs associated with the Company’s defined benefit pension plan, which was due in part to an increase in the discount rate used to determine the present value of the pension obligation, but also to a freeze of the plan’s benefits at the end of 2015. This latter change also resulted in a lengthening of the amortization period for unrealized losses in the pension plan, which further contributed to lower pension costs in 2016. Also contributing to the decrease in compensation-related expenses in 2016 compared to 2015 was a decline in the number of employees at the Company. This decline was primarily due to the consolidation of seven retail banking offices in the second quarter of 2015 and an additional four in the first quarter of 2016. These developments were partially offset by normal annual merit increases granted to most employees at the beginning of 2016, as well as higher stock-based compensation and employee commission expense compared to 2015.

 

The increase in compensation-related expenses in 2015 compared to 2014 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. Also contributing was a change in 2014 in the manner in which employees earned benefits for compensated absences. The one-time impact of this change reduced the Company’s expense for compensated absences in 2014. Compensation-related expenses in the 2015 were also higher because of normal annual merit increases granted to most employees, as well as higher stock-based compensation expense. Finally, compensation-related expenses in 2015 included employee severance-related costs associated with the Company’s 2015 announcements that it intended to consolidate a total of eleven retail branch offices, as noted in the previous paragraph.

 

As of December 31, 2016, the Company had 548 full-time employees and 74 part-time employees. This compared to 563 full-time and 100 part-time at December 31, 2015, and 616 full-time and 99 part-time at December 31, 2014. 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, 2016, 2015, and 2014, were $13.7 million, $14.3 million, and $12.8 million, respectively. The 2015 amount included $715,000 in one-time costs associated with the Company’s announcements in that year that it was consolidating a total of eleven retail branch offices, as previously described. These consolidations resulted in a decline in on-going occupancy-related costs of $364,000 during the year ended December 31, 2016, compared to 2015. However, the impact of these cost declines were partially offset in 2016 by increased data processing, software, and equipment costs associated with other initiatives undertaken by Company in recent periods. The cost of similar initiatives also contributed to the increase in occupancy, equipment, and data processing costs in 2015 compared to 2014.

 

Advertising and marketing expenses were $2.4 million, $1.9 million, and $1.8 million in 2016, 2015, and 2014, respectively. The Company increased its spending on advertising and marketing in 2016 in an effort to increase sales and expand the Company’s overall brand awareness, especially as such relates to the retail deposit business. Management anticipates that spending on advertising and marketing-related expenses in 2017 may be slightly lower than what it was in 2016. However, this outcome depends on future management decisions and there can be no assurances.

 

Federal insurance premiums were $1.4 million, $1.5 million, and $1.5 million in 2016, 2015, and 2014, respectively. In 2016 the FDIC issued a final rule that changed how insured financial institutions less than $10 billion in assets, such as the Company, are assessed for deposit insurance. The new rule, which was effective for the last half of 2016, resulted in a lower deposit insurance assessment rate for the Company. 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 $222,000, $801,000, and $1.0 million in 2016, 2015, and 2014, respectively. The Company has experienced lower losses and expenses on foreclosed real estate in recent years due to reduced levels of foreclosed properties and improved market conditions.

 

Other non-interest expense was $9.6 million, $9.4 million, and $10.1 million during the years ended December 31, 2016, 2015, and 2014, respectively. In these years the Company prepaid $31.9 million, $10.0 million, and $20.0 million in fixed-rate, term FHLB of Chicago advances, respectively. Most of these advances had been drawn in prior years to fund the purchase of mortgage-related securities that were called by the issuer in those years, as previously described. However, in 2016 the Company also prepaid certain other fixed-rate, term advances in an effort to manage its overall exposure to interest rate risk. Management elected to prepay these advances concurrent with the calls of the securities. As a result, the Company recorded prepayment penalties of $758,000, $102,000, and $242,000 in 2016, 2015, and 2014, respectively. In 2016 the Company also incurred lower processing costs related to its ATM network, lower deposit account fraud losses, and lower amortization expense related to certain intangible assets. Other non-interest expense in 2015 also included a one-time cost to terminate a contract with a third-party vendor, as well as lower on legal, consulting, and other professional services relative to 2014.

 

 35 

 

 

Income Tax Expense Income tax expense was $10.1 million, $8.3 million, and $8.9 million in 2016, 2015, and 2014, 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 2016, 2015, and 2014, was 37.4%, 37.0%, and 35.4%, 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 also vary because of certain tax deductions related to stock-based compensation.

 

Financial Condition

 

Overview The Company’s total assets increased by $146.5 million or 5.8% during the twelve months ended December 31, 2016, due principally to an increase in total loans receivable. This increase was primarily funded by increases in deposit liabilities and other borrowings. Also providing funds for the increase in loans receivable was a decrease in mortgage-related securities during the year. The Company’s total shareholders’ equity was $286.6 million at December 31, 2016, compared to $279.4 million at December 31, 2016. 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, 2016.

 

Mortgage-Related Securities Available-for-Sale The Company’s portfolio of mortgage-related securities available-for-sale decreased by $36.0 million or 8.8% during the year ended December 31, 2016. This decrease was the result of periodic repayments that exceeded the Company’s purchase of new securities during the period.

 

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

 

   December 31 
   2016   2015   2014 
   (Dollars in thousands) 
Freddie Mac  $187,838   $216,278   $169,168 
Fannie Mae   162,610    169,771    123,209 
Ginnie Mae   5,202    24    29 
Private-label CMOs   16,230    21,801    29,477 
Total  $371,880   $407,874   $321,883 

 

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 
   2016   2015   2014 
   (Dollars in thousands) 
Carrying value at beginning of period  $407,874   $321,883   $446,596 
Purchases   85,040    203,729     
Sales           (17,692)
Principal repayments   (117,460)   (111,640)   (104,430)
Premium amortization, net   (1,974)   (1,725)   (1,213)
Other-than-temporary impairment reductions   132    148     
Change in net unrealized gain or loss   (1,732)   (4,521)   (1,378)
Carrying value at end of period  $371,880   $407,874   $321,883 

 

 36 

 

 

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, 2016:

 

   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
 
Securities by issuer and type:   (Dollars in thousands) 
Freddie Mac, Fannie Mae, and Ginnie Mae MBSs  $3    6.58%  $6,761    2.75%  $74,567    2.06%  $32,918    2.20%  $114,249    2.14%
Freddie Mac and Fannie Mae CMOs           5,366    2.12    86,177    2.56    149,858    2.00    241,401    2.20 
Private-label CMOs           2,606    5.09            13,624    3.32    16,230    3.61 
Total  $3    6.58%  $14,733    2.94%  $160,744    2.33%  $196,400    2.13%  $371,880    2.24%
Securities by coupon:                                                  
Adjustable-rate coupon                  $268    1.76%  $12,969    3.20%  $13,237    3.17%
Fixed-rate coupon  $3    6.58%  $14,733    2.94%   160,476    2.33    183,431    2.05    358,643    2.21 
Total  $3    6.58%  $14,733    2.94%  $160,744    2.33%  $196,400    2.13%  $371,880    2.24%

 

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 loss of $526,000 at December 31, 2016, compared to a net unrealized gain of $1.2 million at December 31, 2015. The net unrealized loss at the end of 2016 was the result of an increase in market interest rates at the end of that year.

 

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, 2016 and 2015, the carrying value of the Company’s investment in private-label CMOs was $16.2 million and $21.8 million, respectively. The net unrealized gain (loss) on the securities as of such dates was $(3,000) and $201,000, respectively. As of December 31, 2016, $11.6 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 $37,000 as of that date. As of December 31, 2015, $15.7 million of the Company’s private-label CMOs were rated less than investment grade and had a net unrealized gain of $237,000.

 

As of December 31, 2016 and 2015, 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 
   2016   2015   2014 
   (Dollars in thousands) 
Carrying value at beginning of period  $120,891   $132,525   $155,505 
Principal repayments   (27,066)   (10,985)   (21,977)
Net premium amortization   (591)   (649)   (1,003)
Carrying value at end of period  $93,234   $120,891   $132,525 

 

In 2016, 2015, and 2014, mortgage-related securities held-to-maturity with carrying values of $25.2 million, $8.9 million, and $20.4 million, respectively, were called by the issuers. In connection with these calls the Company recorded premiums in interest income of $1.3 million, $219,000, and $512,000 in these years, respectively.

 

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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, 2016, 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
 
Securities by issuer and type:  (Dollars in thousands) 
Fannie Mae DUS          $49,567    2.10%  $43,667    2.52%          $93,234    2.30%

 

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 
   2016   2015   2014 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $3,350   $3,837   $1,798 
Origination of loans held-for-sale (1)   153,863    111,012    79,714 
Principal balance of loans sold   (151,185)   (111,456)   (77,776)
Change in net unrealized gain or loss (2)   (76)   (43)   101 
Total loans held-for-sale  $5,952   $3,350   $3,837 

 

(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 have increased in recent years because of generally lower market interest rates, which resulted in more borrowers refinancing higher-rate loans into lower rate loans. In addition, the Company has increased the number and quality of its residential loan officers in recent years. For additional discussion, refer to “Results of Operations—Non-Interest Income,” above.

 

Loans Receivable The Company’s loans receivable increased by $202.9 million or 11.7% during the twelve months ended December 31, 2016. During this period increases in multi-family, commercial real estate, and construction loans (net of the undisbursed portion) and commercial and industrial loans were partially offset by declines in the Company’s other loan categories. Management attributes the increases in part to a low interest rate environment that encouraged loan growth in the Company’s local markets, particularly for loans secured by multi-family and commercial real estate. This rate environment also improved the competitiveness of the Company’s loan offerings linked to its interest rate swap loan program, as noted earlier in this release. Because of this improvement, the Company was able to increase new loan production, as well as retain in its loan portfolio a larger portion of construction loans transitioning to permanent financing than it typically has in prior periods. However, management is not certain that the loan growth experienced in recent periods can be sustained in the future. The loan portfolio is subject to economic, market, competitive, and regulatory 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.

 

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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 
   2016   2015   2014   2013   2012 
   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent 
Commercial loans:   (Dollars in thousands) 
Commercial and industrial  $241,689    11.03%  $235,313    11.78%  $226,537    12.47%  $166,788    10.10%  $132,436    8.82%
Commercial real estate   375,459    17.13    299,550    14.99    263,512    14.50    276,547    16.75    263,775    17.57 
Multi-family   506,136    23.09    409,674    20.51    322,413    17.74    265,841    16.10    264,013    17.58 
Construction and development:                                                  
Commercial real estate   34,125    1.56    28,156    1.41    42,405    2.33    27,815    1.68    11,116    0.74 
Multi-family   328,186    14.97    291,380    14.59    211,239    11.62    164,685    9.97    86,904    5.79 
Land and land development   12,484    0.57    11,143    0.56    5,069    0.28    6,962    0.42    6,445    0.43 
Total construction and development loans   374,795    17.10    330,679    16.56    258,713    14.24    199,462    12.08    104,465    6.96 
Total commercial loans   1,498,079    68.35    1,275,216    63.84    1,071,175    58.94    908,638    55.03    764,689    50.93 
Retail loans:                                                  
One- to four-family first mortgages:                                                  
Permanent   457,014    20.85    461,797    23.12    480,102    26.42    449,230    27.21    471,551    31.40 
Construction   42,961    1.96    42,357    2.12    23,905    1.32    40,968    2.48    18,502    1.23 
Total first mortgages   499,975    22.81    504,154    25.24    504,007    27.73    490,198    29.69    490,053    32.63 
Home equity loans:                                                  
Fixed term home equity   105,544    4.81    122,985    6.16    139,046    7.65    148,688    9.01    141,898    9.45 
Home equity lines of credit   70,043    3.20    75,261    3.77    80,692    4.44    79,470    4.81    81,898    5.45 
Total home equity   175,587    8.01    198,246    9.93    219,738    12.09    228,158    13.82    223,796    14.90 
Other consumer loans:                                                  
Student   6,810    0.31    8,129    0.41    9,692    0.53    11,177    0.68    12,915    0.86 
Other   11,373    0.52    11,678    0.58    12,681    0.70    12,942    0.78    10,202    0.68 
Total other consumer   18,183    0.83    19,807    0.99    22,373    1.23    24,119    1.46    23,117    1.54 
Total retail loans   693,745    31.65    722,207    36.16    746,118    41.06    742,475    44.97    736,966    49.07 
Gross loans receivable   2,191,824    100.00%   1,997,423    100.00%   1,817,293    100.00%   1,651,113    100.00%   1,501,655    100.00%
Undisbursed loan proceeds   (227,537)        (238,124)        (162,471)        (117,439)        (76,703)     
Allowance for loan losses   (19,940)        (17,641)        (22,289)        (23,565)        (21,577)     
Deferred fees and costs, net   (1,440)        (1,640)        (1,230)        (1,113)        (1,129)     
Total loans receivable, net  $1,942,907        $1,740,018        $1,631,303        $1,508,996        $1,402,246      

 

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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 
   2016   2015   2014 
   (Dollars in thousands) 
Balance outstanding at beginning of period  $1,740,018   $1,631,303   $1,508,996 
Loan originations:               
Commercial loans:               
Commercial and industrial   69,271    90,265    73,630 
Commercial real estate   102,014    101,198    37,444 
Multi-family   133,216    87,328    101,260 
Construction and development   232,071    263,030    154,940 
Total commercial loans   536,572    541,821    367,274 
Retail loans:               
One- to four-family first mortgages (1)   108,630    100,876    75,402 
Home equity   32,429    33,291    33,850 
Other consumer   1,993    1,594    1,427 
Total retail loans   143,052    135,761    110,679 
Total loan originations   679,624    677,582    477,953 
Principal payments and repayments:               
Commercial loans   (313,147)   (337,601)   (204,737)
Retail loans   (169,836)   (157,515)   (104,782)
Total principal payments and repayments   (482,983)   (495,116)   (309,519)
Transfers to foreclosed properties, real estate owned, and repossessed assets   (2,240)   (2,336)   (2,254)
Net change in undisbursed loan proceeds, allowance for loan losses, and deferred fees and costs   8,488    (71,415)   (43,873)
Total loans receivable, net  $1,942,907   $1,740,018   $1,631,303 

 

(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, 2016. The table does not include the effect of prepayments or scheduled principal amortization.

 

   Commercial
and Industrial
   Construction and
 Development
   Total 
Amounts due:  (Dollars in thousands) 
Within one year or less  $93,957   $14,211   $108,168 
After one year through five years   140,418    264,679    405,097 
After five years   7,314    138,866    146,180 
Total due after one year   147,732    403,545    551,277 
Total commercial and construction loans  $241,689   $417,756   $659,445 

 

The following table presents, as of December 31, 2016, 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  $58,062   $89,670   $147,732 
Construction and development   1,134    402,411    403,545 
Total loans due after one year  $59,196   $492,081   $551,277 

 

 40 

 

  

In recent periods banking regulatory agencies have publicly expressed increased concern about financial institutions whose holdings of non-owner-occupied commercial real estate and construction loans and whose growth in such loans exceed guidelines established in certain regulatory pronouncements. Specifically, these guidelines indicate that financial institutions whose holdings of such loans exceed 300% of total risk-based capital and whose growth in such loans exceeds 50% over the past three years will receive increased scrutiny from their primary regulator. As of December 31, 2016, the Bank’s holdings of and three-year growth in these types of loans exceeded these guidelines. As such, the Bank’s regulator has subjected its lending operations and credit risk management controls to increased scrutiny in recent months. In response, management has taken steps to implement certain enhancements in its lending operations and controls that it believes will be satisfactory to its regulator. However, there can be no assurances. Regardless of these enhancements, given the regulatory scrutiny and other factors management believes that growth in multi-family and construction loans will be slower in the future than it has been in recent periods. Specifically, management expects that the aggregate future growth rate for these loan types will be managed in the future to more closely approximate growth in the total risk-based capital of the Bank.

 

Mortgage Servicing Rights The carrying value of the Company’s MSRs was $6.6 million at December 31, 2016, compared to $7.2 million at December 31, 2015, net of valuation allowances of zero at both dates. As of December 31, 2016 and 2015, the Company serviced $997.0 million and $1.04 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 
   2016   2015   2014 
Accrued interest receivable:  (Dollars in thousands) 
Loans receivable  $5,357   $4,894   $4,748 
Mortgage-related securities   1,015    1,141    1,027 
Total accrued interest receivable   6,372    6,035    5,775 
Foreclosed properties and repossessed assets:               
Commercial real estate   1,559    1,685    2,566 
Land and land development   598    747    1,693 
One- to four- family first mortgages   787    874    409 
Total foreclosed and repossessed assets   2,944    3,306    4,668 
Bank-owned life insurance   63,494    61,656    59,830 
Premises and equipment   47,343    49,218    52,594 
Federal Home Loan Bank stock, at cost   20,261    17,591    14,209 
Deferred tax asset, net   14,543    16,485    25,595 
Other assets   22,938    24,037    22,183 
Total other assets  $177,895   $178,328   $184,854 

 

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.

 

As of December 31, 2016, the Company and its subsidiaries conducted their business through an executive office and 65 banking offices. The Company owned the building and land for 57 of its office locations and leased the space for eight. However, refer to “Results of Operations—Non-Interest Expense,” above, for discussion related to the Company’s consolidation of certain banking office locations in March 2016.

 

The Company’s net deferred tax asset has decreased in recent years due primarily to the utilization of net operating loss carryforwards and alternative minimum tax (“AMT”) credits. 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, 2016. 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, 2016, 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.”

 

 41 

 

 

Deposit Liabilities The Company’s deposit liabilities increased by $69.1 million or 3.9% during the twelve months ended December 31, 2016. Transaction deposits, which consist of checking, savings, and money market accounts, increased by $89.2 million or 7.1% during the period and certificates of deposit decreased by $20.1 million or 3.7%. Management believes that the increase in transaction deposits in recent periods, particularly the increase in non-interest-bearing checking accounts, is due in part to improved marketing and sales efforts. However, management also 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 continue to increase in the future, customer preference may shift from transaction deposits back to certificates of deposit, which typically have a higher interest cost to the Company. This development could increase the Company’s cost of funds in the future, which would 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 
   2016   2015   2014 
       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  $309,137    16.58%   0.00%  $213,761    11.90%   0.00%  $187,852    10.93%   0.00%
Interest-bearing demand   238,142    12.77    0.01    277,606    15.46    0.01    253,595    14.76    0.01 
Money market savings   558,905    29.97    0.16    542,020    30.19    0.12    532,705    30.99    0.14 
Savings accounts   234,038    12.55    0.02    217,6331    12.12    0.01    220,557    12.83    0.03 
Total transaction accounts   1,340,222    71.87    0.07    1,251,020    69.67    0.06    1,194,709    69.51    0.07 
Certificates of deposit:                                             
With original maturities of:                                             
Three months or less   3,632    0.19    0.38    4,559    0.25    0.32    6,081    0.35    0.25 
Over three to 12 months   107,341    5.77    0.39    136,547    7.60    0.36    177,748    10.34    0.44 
Over 12 to 24 months   255,910    13.72    0.96    260,143    14.50    0.93    204,499    11.90    0.53 
Over 24 to 36 months   120,117    6.44    1.48    101,571    5.66    1.09    84,507    4.92    0.58 
Over 36 to 48 months   3,729    0.20    1.35    2,388    0.13    1.44             
Over 48 to 60 months   33,779    1.81    1.07    39,363    2.19    1.14    51,212    2.98    1.37 
Total certificates of deposit   524,508    28.13    0.96    544,571    30.33    0.82    524,047    30.49    0.58 
Total deposit liabilities  $1,864,730    100.00%   0.32%  $1,795,591    100.00%   0.29%  $1,718,756    100.00%   0.23%

 

At December 31, 2016, the Company had certificates of deposit with balances of $100,000 and over maturing as follows:

 

   Amount 
Maturing in:  (In thousands) 
Three months or less  $33,658 
Over three months through six months   25,969 
Over six months through 12 months   43,176 
Over 12 months through 24 months   53,260 
Over 24 months through 36 months   11,120 
Over 36 months   2,109 
Total certificates of deposit greater than $100,000  $169,292 

 

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

 

   Year Ended December 31 
   2016   2015   2014 
   (Dollars in thousands) 
Total deposit liabilities at beginning of period  $1,795,591   $1,718,756   $1,762,682 
Net deposits (withdrawals)   63,759    72,746    (48,358)
Interest credited, net of penalties   5,380    4,090    4,432 
Total deposit liabilities at end of period  $1,864,730   $1,795,591   $1,718,756 

 

 42 

 

 

Borrowings Borrowings, which consist of advances from the FHLB of Chicago, increased by $66.8 million or 17.9% during the twelve months ended December 31, 2016. This increase was used to fund growth in loans receivable, as previously described.

 

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

 

   At or For the Year Ended December 31 
   2016   2015   2014   2013   2012 
Balance outstanding at end of year:  (Dollars in thousands) 
FHLB term advances  $154,150   $242,375   $213,669   $204,900   $210,786 
Overnight borrowings from FHLB   285,000    130,000    42,800    40,000     
Weighted-average interest rate at end of year:                         
FHLB term advances   2.24%   1.86%   2.01%   2.26%   2.34%
Overnight borrowings from FHLB   0.70%   0.16%   0.13%   0.13%    
Maximum amount outstanding during the year:                         
FHLB term advances  $242,375   $252,920   $234,085   $210,786   $311,419 
Overnight borrowings from FHLB   295,000    130,000    80,000    40,000    5,000 
Average amount outstanding during the year:                         
FHLB term advances  $203,711   $228,346   $213,566   $206,828   $227,573 
Overnight borrowings from FHLB   186,180    85,309    38,562    207    14 
Weighted-average interest rate during the year:                         
FHLB term advances   2.11%   2.01%   2.19%   2.31%   3.07%
Overnight borrowings from FHLB   0.39%   0.13%   0.13%   0.13%   0.30%

 

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

 

Shareholders’ Equity The Company’s shareholders’ equity was $286.6 million at December 31, 2016, compared to $279.4 million at December 31, 2015. This increase was primarily due to $17.0 million in net income that was only partially offset by $9.8 million in regular cash dividends. Bank Mutual did not repurchase a significant amount of its common stock during the year ended December 31, 2016. The book value of the Company’s common stock was $6.27 at December 31, 2016, compared to $6.15 at December 31, 2015.

 

The Company’s ratio of shareholders’ equity to total assets was 10.82% at December 31, 2016, compared to 11.17% at December 31, 2015. The Company is required to maintain specified amounts of regulatory capital pursuant to regulations promulgated by the FRB. The Company is “well capitalized” for regulatory capital purposes. As of December 31, 2016, the Company had a total risk-based capital ratio of 15.50% and a Tier 1 leverage capital ratio of 11.11%. The minimum ratios to be considered “well capitalized” under current supervisory regulations are 10% for total risk-based capital and 5% for Tier 1 capital. The minimum ratios to be considered “adequately capitalized” are 8% and 4%, respectively. For additional discussion refer to “Note 8. Shareholders’ Equity” in “Item 8. Financial Statements and Supplementary Data.”

 

On February 6, 2017, the Company’s board of directors declared a $0.055 per share dividend payable on February 27, 2017, to shareholders of record on February 17, 2017. On February 6, 2017, the Company’s board of directors also approved a plan to repurchase up to 500,000 shares of its common stock. This plan replaced a previous plan that was approved in February 2016, but expired on January 31, 2017. The Company did not purchase any shares of its common stock from January 1, 2017, to February 28, 2017.

 

The payment of dividends and/or the repurchase of common stock by the Company is highly dependent on the ability of the Bank to pay dividends or otherwise distribute capital to the Company. Such payments are subject to requirements imposed by law or regulations and to the application and interpretation thereof by the OCC and FRB. The Company cannot provide any assurances that dividends will continue to be paid, the amount of any such dividends, or whether additional shares of common stock will be repurchased under its current stock repurchase plan. For further information regarding the factors which could affect the Company’s payment of dividends and/or the repurchase of its common stock, refer to “Item 1. Business—Regulation and Supervision,” as well as “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchase of Equity Securities,” above.

 

 43 

 

 

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

 

   December 31 
   2016   2015   2014   2013   2012 
Non-accrual commercial loans:  (Dollars in thousands) 
Commercial and industrial  $989   $4,915   $201   $284   $693 
Commercial real estate   2,839    3,968    4,309    4,401    6,994 
Multi-family   274        1,402    1,783    6,824 
Construction and development   148    766    803    728    865 
Total commercial loans   4,250    9,649    6,715    7,196    15,376 
Non-accrual retail loans:                         
One- to four-family first mortgages   3,191    2,703    4,148    4,556    8,264 
Home equity   442    703    493    676    1,514 
Other consumer   46    82    108    104    59 
Total non-accrual retail loans   3,679    3,488    4,749    5,336    9,837 
Total non-accrual loans   7,929    13,137    11,464    12,532    25,213 
Accruing loans delinquent 90 days or more (1)   295    484    540    443    584 
Total non-performing loans   8,224    13,621    12,004    12,975    25,797 
Foreclosed real estate and repossessed assets   2,943    3,306    4,668    6,736    13,961 
Total non-performing assets  $11,167   $16,927   $16,672   $19,711   $39,758 
                          
Non-performing loans to total loans   0.42%   0.78%   0.74%   0.86%   1.84%
Non-performing assets to total assets   0.42%   0.68%   0.72%   0.84%   1.64%
Interest income that would have been recognized if non-accrual loans had been current  $498   $637   $634   $1,265   $1,998 

 

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

 

The Company’s non-performing loans were $8.2 million or 0.42% of loans receivable as of December 31, 2016, compared to $13.6 million or 0.78% of loans receivable as of December 31, 2015. Non-performing assets, which include non-performing loans, were $11.2 million or 0.42% of total assets and $16.9 million or 0.68% of total assets as of these same dates, respectively. The general decline in non-performing loans and non-performing assets in recent years has been caused by repayments of the related loans or disposition of the foreclosed properties. Also contributing are upgrades of loans to performing status due to improvements in the financial condition or performance of the borrowers and/or the underlying collateral, as permitted by the Company’s credit policies.

 

Non-performing assets are classified as “substandard” in accordance with the Company’s internal risk rating policy. In addition to these non-performing assets, at December 31, 2016, management was closely monitoring $68.6 million in additional loans that were classified as either “special mention” or “substandard” in accordance with the Company’s internal risk rating policy. This amount compared to $55.9 million at December 31, 2015. As of December 31, 2016, most of these additional classified loans were secured by commercial real estate, multi-family real estate, land, and certain commercial business assets. Management does not believe any of these loans were impaired as of December 31, 2016, although there can be no assurances that the loans will not become impaired in future periods. The increase in additional classified loans during the year ended December 31, 2016, was primarily the result of management’s assessment that the credit condition of a number of commercial loan relationships, most of which were manufacturing related, had deteriorated in recent months.

 

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

 

Loans considered to be impaired by the Company at December 31, 2016, were $10.7 million compared to $13.6 million at December 31, 2015, $12.0 million at December 31, 2014, $13.0 million at December 31, 2013, and $25.8 million at December 31, 2012. The average annual balance of loans impaired as of December 31, 2016, was $9.8 million and the interest received and recognized on these loans while they were impaired was $370,000.

 

 44 

 

 

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

 

   At or For the Year Ended December 31 
   2016   2015   2014   2013   2012 
   (Dollars in thousands) 
Balance at beginning of period  $17,641   $22,289   $23,565   $21,577   $27,928 
Provision for loan losses   2,998    (3,655)   233    4,506    4,545 
Charge-offs:                         
Commercial and industrial   (107)   (74)   (59)   (199)   (136)
Commercial real estate   (179)   (149)   (561)   (514)   (4,894)
Multi-family           (241)   (536)   (857)
Construction and development           (34)   (148)   (2,693)
One- to four-family first mortgages   (133)   (346)   (871)   (1,205)   (3,182)
Home equity   (101)   (147)   (103)   (1,000)   (327)
Other consumer   (396)   (544)   (431)   (389)   (485)
Total charge-offs   (916)   (1,260)   (2,300)   (3,991)   (12,574)
Recoveries:                         
Commercial and industrial   6    7    64    5    26 
Commercial real estate   33    120    169    666    956 
Multi-family   30        15    102    568 
Construction and development           142    109    1 
One- to four-family first mortgages   47    73    344    492    86 
Home equity   35    29    27    68    1 
Other consumer   66    48    30    31    40 
Total recoveries   217    277    791    1,473    1,678 
Net charge-offs   (699)   (983)   (1,509)   (2,518)   (10,896)
Balance at end of period  $19,940   $17,641   $22,289   $23,565   $21,577 
                          
Net charge-offs to average loans   0.04%   0.06%   0.10%   0.18%   0.78%
Allowance for loan losses to total loans   1.03%   1.01%   1.37%   1.56%   1.54%
Allowance for loan losses to non-performing loans   242.46%   129.51%   185.68%   181.62%   83.64%

 

The reasons for the increase in the dollar amount of the Company’s allowance for loan losses during the year ended December 31, 2016, were described earlier in this report (refer to “Operating Results—Provision for Loan Losses,” above). Prior to 2016 the changes in the Company’s allowance for loan losses was generally consistent with overall changes in the Company’s level of non-performing loans and changes in loan charge-off activity. The changes in all periods are also consistent with changes in management’s assessment of overall economic conditions, unemployment, real estate values, and industry trends during the periods.

 

The Company’s ratio of allowance for loan losses as a percent of non-performing loans increased from 83.64% at December 31, 2012, to 242.46% at December 31, 2016. The general increase in this ratio over this period was primarily caused by a substantial decline in non-performing loans relative to the allowance for loan losses. Such increase is to be expected when non-performing loans (which are generally evaluated for impairment on an individual basis) decline and, as a result, a larger portion of the allowance for loan losses relates to loans that are evaluated for impairment on a collective basis (refer to “Note 3. Loans Receivable” in “Item 8. Financial Statements and Supplementary Data”).

 

Although management believes the Company’s allowance for loan losses at December 31, 2016, was adequate, there can be no assurances that future adjustments to the allowance will not be necessary, which could adversely affect the Company’s results of operations. For additional discussion, refer to “Item 1. Business—Asset Quality,” above, and “Critical Accounting Policies—Allowance for Loan Losses,” below.

 

 45 

 

 

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

 

   December 31 
   2016   2015   2014   2013   2012 
   Amount   Percent
to Total
   Amount   Percent
to Total
   Amount   Percent
to Total
   Amount   Percent
to Total
   Amount   Percent
to Total
 
Loan category:   (Dollars in thousands) 
Commercial and industrial  $3,840    19.26%  $3,658    20.73%  $2,349    10.54%  $2,603    11.05%  $1,686    7.81%
Commercial real estate   4,630    23.22    4,796    27.19    6,880    30.86    6,377    27.06    7,354    34.08 
Multi-family   5,307    26.61    3,337    18.92    6,078    27.27    5,931    25.17    5,195    24.08 
Construction and development   2,680    13.44    2,835    16.07    2,801    12.57    4,160    17.65    2,617    12.13 
One- to four-family first mortgages   2,518    12.63    1,835    10.40    3,004    13.48    3,220    13.66    3,267    15.14 
Home equity and other consumer   965    4.84    1,180    6.69    1,177    5.28    1,274    5.41    1,458    6.76 
Total allowance for loan losses  $19,940    100.00%  $17,641    100.00%  $22,289    100.00%  $23,565    100.00%  $21,577    100.00%

 

Critical Accounting Policies

 

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

 

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

 

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

 

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

 

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

 

 46 

 

 

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

 

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

 

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

 

The following table presents, as of December 31, 2016, significant fixed and determinable contractual obligations to third parties by payment date. All amounts in the table exclude interest costs to be paid in the periods indicated, if applicable.

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Deposit liabilities without a stated maturity  $1,340,222               $1,340,222 
Certificates of deposit   325,408   $194,076   $5,024        524,508 
Borrowed funds   328,397    59,385    39,012   $12,356    439,150 
Purchase obligations   2,640    4,620            7,260 
Operating leases   983    1,527    1,211    2,803    6,524 
Deferred retirement plans and deferred compensation plans   797    1,632    1,113    4,248    7,790 

 

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

 

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

 

The following table details the amounts and expected maturities of significant off-balance sheet commitments to extend credit as of December 31, 2016.

 

   Payments Due In 
       One to   Three to   Over     
   One Year   Three   Five   Five     
   Or Less   Years   Years   Years   Total 
   (Dollars in thousands) 
Commercial lines of credit  $177,672               $177,672 
Commercial loans   3,659   $50            3,709 
Standby letters of credit   7,261    278   $282        7,821 
Multi-family and commercial real estate   303,239                303,239 
Residential real estate   34,381                34,381 
Revolving home equity and credit card lines   160,898                160,898 
Net commitments to sell residential loans   11,861                11,861 

 

 

 47 

 

 

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

 

Quarterly Financial Information

 

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

 

   2016 Quarter Ended 
   March 31   June 30   September 30   December 31 
   (Dollars in thousands, except per share amounts) 
Interest income  $20,307   $20,211   $21,470   $21,160 
Interest expense   2,659    2,693    2,758    2,691 
Net interest income   17,648    17,518    18,712    18,469 
Provision for (recovery of) loan losses   (573)   1,164    1,395    1,012 
Total non-interest income   6,245    7,009    6,867    6,723 
Total non-interest expense   17,417    17,069    17,246    17,395 
Income before taxes   7,049    6,294    6,938    6,785 
Income tax expense   2,576    2,345    2,484    2,707 
Net income  $4,473   $3,949   $4,454   $4,078 
                     
Earnings per share-basic  $0.10   $0.09   $0.10   $0.09 
Earnings per share-diluted   0.10    0.09    0.10    0.09 
Cash dividend paid per share   0.050    0.055    0.055    0.055 

 

   2015 Quarter Ended 
   March 31   June 30   September 30   December 31 
   (Dollars in thousands, except per share amounts) 
Interest income  $19,410   $19,271   $19,441   $19,778 
Interest expense   2,246    2,309    2,449    2,561 
Net interest income   17,164    16,962    16,992    17,217 
Provision for (recovery of) loan losses   (964)   (752)   (930)   (1,019)
Total non-interest income   5,546    5,907    5,996    5,789 
Total non-interest expense   18,057    17,942    18,470    18,258 
Income before taxes   5,617    5,679    5,448    5,767 
Income tax expense   2,064    2,090    2,103    2,077 
Net income  $3,553   $3,589   $3,345   $3,690 
                     
Earnings per share-basic  $0.08   $0.08   $0.07   $0.08 
Earnings per share-diluted   0.08    0.08    0.07    0.08 
Cash dividend paid per share   0.04    0.05    0.05    0.05 

 

 48 

 

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

·managing deposits and borrowings to provide stable funding.

 

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

 

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

 

 49 

 

 

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

 

The following table presents the amounts of the Company’s interest-earning assets and interest-bearing liabilities outstanding at December 31, 2016, which management anticipates to reprice or mature in each of the future time periods shown. The information presented in the following table is based on the following assumptions:

 

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

 

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

 

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

 

·Borrowings—based upon final maturity.

 

   December 31, 2016 
   Within   Three to   More than   More than         
   Three   Twelve   1 Year to   3 Years -   Over 5     
   Months   Months   3 Years   5 Years   Years   Total 
Loans receivable:  (Dollars in thousands) 
Commercial loans:                              
Fixed  $22,143   $78,168   $144,167   $84,705   $16,060   $345,243 
Adjustable   819,282    47,694    79,539    17,097    109    963,721 
Retail loans:                              
Fixed   20,464    37,001    70,380    41,920    55,400    225,165 
Adjustable   101,549    125,954    85,189    70,731    45,977    429,400 
Interest-earning deposits   18,798                    18,798 
Mortgage-related securities:                              
Fixed   22,310    67,294    172,864    81,416    108,338    452,222 
Adjustable   13,418                    13,418 
Other interest-earning assets   20,261                    20,261 
Total interest-earning assets   1,038,225    356,111    552,139    295,869    225,884    2,468,228 
                               
Deposit liabilities:                              
Non-interest-bearing demand accounts                   309,231    309,231 
Interest-bearing demand accounts                   237,758    237,758 
Money market accounts   559,194                    559,194 
Savings accounts                   234,038    234,038 
Certificates of deposit   106,731    221,182    191,572    5,024        524,509 
Borrowings   285,292    44,292    61,307    37,789    10,470    439,150 
Advance payments by borrowers for taxes and insurance   4,770                    4,770 
Total non-interest- and interest-bearing liabilities   955,987    265,474    252,879    42,813    791,497    2,308,650 
Interest rate sensitivity gap  $82,238   $90,637   $299,260   $253,056   $(565,613)  $159,578 
Cumulative interest rate sensitivity gap  $82,238   $172,875   $472,135   $725,191   $159,578      
Cumulative interest rate sensitivity gap as a percent of total assets   3.11%   6.53%   17.83%   27.38%   6.03%     
Cumulative interest-earning assets as a percentage of non-interest- and interest-bearing liabilities   108.60%   114.15%   132.02%   147.80%   106.91%     

 

 50 

 

 

Based on the above gap analysis, at December 31, 2016, the Company’s interest-bearing assets maturing or repricing within one year exceeds its interest-earning liabilities maturing or repricing within the same period. Based on this information, over the course of the next year net interest income could be favorably impacted by an increase in market interest rates. Alternatively, net interest income could be unfavorably impacted by a decrease in market interest rates. However, it should be noted that the Company’s future net interest income is affected by more than just future market interest rates. Net interest income is also affected by absolute and relative levels of earning assets and interest-bearing liabilities, the level of non-performing loans and other investments, and by other factors outlined in “Item 1. Business—Cautionary Statement,” “Item 1A. Risk Factors,” and “Item 7. Management Discussion of Financial Condition and Results of Operations.”

 

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

 

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

 

The following table presents the estimated PVE over a range of interest rate change scenarios at December 31, 2016. The present value ratio shown in the table is the PVE as a percent of the present value of total assets in each of the different rate environments. For purposes of this table, management has made assumptions such as prepayment rates and decay rates similar to those used for the gap analysis table.

 

       Present Value of Equity 
       as a Percent of the 
Change in  Present Value of Equity   Present Value of Assets 
Interest Rates  Dollar   Dollar   Percent   Present Value   Percent 
(Basis Points)  Amount   Change   Change   Ratio   Change 
   (Dollars in thousands)             
+400  $352,690   $19,480    5.8%   14.08%   12.4%
+300   350,913    17,703    5.3    13.81    10.2 
+200   347,287    14,077    4.2    13.46    7.4 
+100   337,303    4,093    1.2    12.88    2.8 
  0   333,210            12.53     
-100   329,476    (3,734)   (1.1)   12.19    (2.8)

 

Based on the above analysis, the Company’s PVE is not expected to be materially impacted by changes in interest rates. However, it should be noted that the Company’s PVE is impacted by more than changes in market interest rates. Future PVE is also affected by management’s decisions relating to reinvestment of future cash flows, decisions relating to funding sources, and by other factors outlined in “Item 1. Business—Cautionary Statement,” “Item 1A. Risk Factors,” and “Item 7. Management Discussion of Financial Condition and Results of Operations.”

 

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

 

 51 

 

 

Item 8. Financial Statements and Supplementary Data

 

 

Report of Independent Registered Public Accounting Firm

 

 

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

 

We have audited the accompanying consolidated statements of financial condition of Bank Mutual Corporation and subsidiaries (the "Company") as of December 31, 2016 and 2015, and the related consolidated statements of income, total comprehensive income, equity, and cash flows for each of the three years in the period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

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

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Bank Mutual Corporation and subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 6, 2017, expressed an unqualified opinion on the Company's internal control over financial reporting.

  

 

/s/ Deloitte & Touche LLP

 

Milwaukee, Wisconsin
March 6, 2017

 

 52 

 

 

Bank Mutual Corporation and Subsidiaries

 

Consolidated Statements of Financial Condition

 

   December 31 
   2016   2015 
   (Dollars in thousands) 
Assets    
         
Cash and due from banks  $31,284   $27,971 
Interest-earning deposits in banks   18,803    16,530 
Cash and cash equivalents   50,087    44,501 
Mortgage-related securities available-for-sale, at fair value   371,880    407,874 
Mortgage-related securities held-to-maturity, at amortized cost (fair value of $94,266 in 2016 and $121,641 in 2015)   93,234    120,891 
Loans held-for-sale   5,952    3,350 
Loans receivable (net of allowance for loan losses of $19,940 in 2016 and $17,641 in 2015)   1,942,907    1,740,018 
Mortgage servicing rights, net   6,569    7,205 
Other assets   177,895    178,328 
           
Total assets  $2,648,524   $2,502,167 
           
Liabilities and equity          
           
Liabilities:          
Deposit liabilities  $1,864,730   $1,795,591 
Borrowings   439,150    372,375 
Advance payments by borrowers for taxes and insurance   4,770    3,382 
Other liabilities   53,233    51,425 
Total liabilities   2,361,883    2,222,773 
Equity:          
Preferred stock–$0.01 par value:          
Authorized–20,000,000 shares in 2016 and 2015          
Issued and outstanding–none in 2016 and 2015        
Common stock–$0.01 par value:          
Authorized–200,000,000 shares in 2016 and 2015          
Issued–78,783,849 shares in 2016 and 2015          
Outstanding–45,691,790 shares in 2016 and 45,443,548 in 2015   788    788 
Additional paid-in capital   484,940    486,273 
Retained earnings   171,633    164,482 
Accumulated other comprehensive loss   (11,139)   (9,365)
Treasury stock–33,092,059 shares in 2016 and 33,340,301 in 2015   (359,581)   (362,784)
Total shareholders' equity   286,641    279,394 
           
Total liabilities and equity  $2,648,524   $2,502,167 

 

Refer to Notes to Consolidated Financial Statements

 

 53 

 

 

Bank Mutual Corporation and Subsidiaries

 

Consolidated Statements of Income

 

   Year Ended December 31 
   2016   2015   2014 
   (Dollars in thousands, except per share data) 
Interest income:               
Loans  $70,782   $65,954   $66,261 
Mortgage-related securities   11,867    11,684    12,850 
Investment securities   467    244    139 
Interest-earning deposits   32    19    15 
Total interest income   83,148    77,901    79,265 
Interest expense:               
Deposit liabilities   5,761    4,771    4,684 
Borrowings   5,039    4,794    4,731 
Advance payments by borrowers for taxes and insurance   1    1    1 
Total interest expense   10,801    9,566    9,416 
Net interest income   72,347    68,335    69,849 
Provision for (recovery of) loan losses   2,998    (3,665)   233 
Net interest income after provision for loan losses   69,349    72,000    69,616 
Non-interest income:               
Deposit-related fees and charges   11,525    11,572    11,985 
Brokerage and insurance commissions   3,175    3,577    2,574