Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method. Fair value adjustments on impaired loans were $51,089 for the nine months ended September 30, 2011, $3,304 for the three months ended September 30, 2011, and $16,040 for the year ended December 31, 2010.
Schedule 6
PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For the nine month periods ended September 30, 2011 and 2010
The following discussion and analysis provides information about Princeton National Bancorp, Inc.'s (“PNBC” or the “Corporation”) financial condition and results of operations for the nine month periods ended September 30, 2011 and 2010. This discussion and analysis should be read in conjunction with the Corporation’s Condensed Consolidated Financial Statements and Notes thereto included in this report. This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as discussions of the Corporation’s pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Corporation, are identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the state of the United States economy, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Further information concerning the Corporation and its business, including a discussion of these and additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s 2010 Annual Report on Form 10-K under the heading “Item 1. Business.”
CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES
The Corporation has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Corporation’s financial statements. The significant accounting policies of the Corporation are described in the Notes to the Condensed Consolidated Financial Statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation.
Allowance for Loan Losses
The Corporation believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its Condensed Consolidated Financial Statements. We determine probable incurred losses inherent in our loan portfolio and establish an allowance for those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, we use organizational history and experience with credit decisions and related outcomes. The allowance for loan losses represents our best estimate of losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. We evaluate our allowance for loan losses quarterly. If our underlying assumptions later prove to be inaccurate based on subsequent loss evaluations, the allowance for loan losses is adjusted.
We estimate the appropriate level of allowance for loan losses by separately evaluating impaired and non-impaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a non-impaired loan is more subjective. Generally, the allowance assigned to non-impaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics, adjusted for qualitative factors including the volume and severity of identified classified loans, changes in economic conditions, changes in credit policies or underwriting standards and changes in the level of credit risk associated with specific industries and markets. Because the economic and business climate in any given industry or market and its impact on any given borrower can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that our assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required.
Other Real Estate Owned
Other real estate owned acquired through loan foreclosure is initially recorded at fair value less estimated selling costs when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to non-interest expense.
Deferred Income Tax Assets/Liabilities
A net deferred income tax asset arises from differences in the dates that items of income and expense enter into reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. From an accounting standpoint, deferred tax assets are reviewed to determine if they are realizable based on the historical level of taxable income, estimates of future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on future profitability. Under generally accepted accounting principles, income tax benefits and the related tax assets are only allowed to be recognized if they will “more likely than not” be fully realized.
The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies and assessments of the current and future economic and business conditions. The Corporation considers both positive and negative evidence regarding the ultimate realizability of the deferred tax assets, which is largely dependent upon the ability to derive benefits based on future taxable income.
The Corporation did not record a valuation allowance in quarters previous to the third quarter of 2011 due to the weight of all positive evidence overcoming the negative evidence. However, during the third quarter of 2011, due to the negative evidence of a cumulative loss in the most recent three year period and earnings forecasts revised downward from previous quarters forecasts due to acceleration of provision for loan losses, loan collection and other real estate owned expenses, the Corporation has determined that a valuation allowance against deferred tax assets should be recorded as of September 30, 2011. As a result, as of September 30, 2011, the carrying value of the Corporation’s deferred tax assets has been reduced to zero through the recognition of a $14,584,000 valuation allowance.
In each future accounting period, the Corporation will reevaluate whether the current conditions in conjunction with positive and negative evidence support a change in the valuation allowance against deferred tax assets. Any such subsequent reduction in the estimated valuation allowance would lower the amount of income tax expense recognized in the Corporation’s Consolidated Statements of Income in future periods.
Additionally, the Corporation reviews its uncertain tax positions annually under ASC 740-10,
“Accounting for Uncertainty in Income Taxes.”
An uncertain tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount actually recognized is the largest amount of tax benefit that is greater than 50% likely to be recognized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. A significant amount of judgment is applied to determine both whether the tax position meets the “more likely than not” test as well as to determine the largest amount of tax benefit that is greater than 50% likely to be recognized. Differences between the position taken by management and that of taxing authorities could result in a reduction of a tax benefit or increase to tax liability, which could adversely affect future income tax expense.
Impairment of Intangible Assets
Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets with finite lives will be tested for impairment when changes in events or circumstances indicate that its carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2011, and no impairment was recognized.
Mortgaging Service Rights (“MSRs”)
MSR fair values are very sensitive to movements in interest rates as expected future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease when mortgage interest rates rise. For discussion regarding the impairment of MSRs, see Note 4 – “Originated Mortgage Servicing Rights” in the Notes to Condensed Consolidated Financial Statements.
Fair Value Measurements
The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Corporation estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. When observable market prices do not exist, the Corporation estimates fair value. The Corporation’s valuation methods consider factors such as liquidity and concentration concerns. Other factors, such as model assumptions, market dislocations and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded.
ASC 820,
“Fair Value Measurements,”
defines the fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
ASC 820 establishes a framework for measuring the fair value of financial instruments that considers the attributes specific to particular assets or liabilities and establishes a three-level hierarchy for determining fair value based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:
Level 1 - quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2 - inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 - inputs that are unobservable and significant to the fair value measurement.
At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 9 - “Fair Value of Assets and Liabilities” in the Notes to Condensed Consolidated Financial Statements.
RECENT DEVELOPMENTS
Formal Written Agreement with the Comptroller of the Currency
Effective as of March 15, 2010, Citizens First National Bank entered into a formal written agreement (the “Agreement”) with the Office of the Comptroller of the Currency (the “OCC”) that contains provisions to lower nonperforming loan levels and foster improvement in the Bank’s policies and procedures with respect to the Bank’s allowance for loan losses and loan credit risk rating system. The Bank has addressed all of these requirements.
Pursuant to the Agreement, the Bank’s Board of Directors is required to review the adequacy of the Bank’s allowance for loan losses and to establish a program for the maintenance of an adequate allowance. A copy of the Board’s program is required to be submitted to the OCC for review. The program has been completed and is reviewed quarterly by the Board of Directors in order to verify management is maintaining an adequate allowance.
The Bank is also required to take immediate action to protect its interest in criticized assets identified in the Bank’s most recent Report of Examination with the OCC and to adopt individual written workout plans with respect to such assets. A copy of the workout plans is required to be submitted quarterly to the OCC with respect to any criticized asset equal to or exceeding $100,000. Additionally, the Bank is prohibited from extending any additional credit to any borrower whose loan is criticized, unless a majority of the Bank’s Board of Directors (or appropriate committee) has determined that the extension is necessary to promote the best interests of the Bank and such determination is properly recorded.
Under the Agreement, the Board must also ensure that the Bank’s internal ratings of credit relationships are timely, accurate and consistent with the regulatory credit classification criteria set forth in the OCC Handbook and related authority. The board must also ensure that any loan relationship with a high probability of payment default or other well-defined weakness is rated no better than “substandard,” regardless of the existence of certain other mitigating factors that could reduce credit risk.
In 2010, the internal loan review staff, and the scope of their reviews, was expanded. Considerable progress was achieved in meeting the expanded loan review scope and evaluating and verifying internal loan ratings on a timely basis consistent with credit classification criteria set forth in the OCC's Handbook. Loan review grading methodology was refined to ensure that loans with a probability of payment default or well-defined weaknesses are graded “substandard,” regardless of mitigating controls which might reduce credit risk. The Directors’ Loan Committee monitored this process with bi-monthly meetings and reviewed loan review reports to ensure compliance with the terms of the Agreement.
In March of 2011, the risk management department’s loan review function was restructured, and the majority of the loan review responsibilities were outsourced to a loan review risk advisory firm. The external loan review services began in April of 2011 and are structured to cover 75% of the loan portfolio (excluding residential and consumer loans). The external loan review services are managed by the Loan Review Officer, or another designee deemed independent and appropriate within the risk management department, with reports made independently to the Directors’ Loan Committee. The Directors’ Loan Committee then reports results to the Bank’s Board of Directors. The outsourcing of the loan review function has assisted management in ensuring that the Bank’s internal ratings of commercial credit relationships are timely, accurate and consistent with regulatory credit classification criteria. In addition, this process has contributed in the identification of trends and the assessment of the overall quality of the loan portfolio.
In the fourth quarter of 2010, the Corporation filled a newly created role of Chief Credit Officer and established a credit administration division to oversee the development, maintenance and monitoring of loan policies and procedures. Responsibilities of the credit administration division that were created in the fourth quarter of 2010 and the first quarter of 2011 include credit analysis, credit risk management, loan servicing and administration, loan collections and the special assets group, as well as loan portfolio analytics and the maintenance of the allowance for loan losses. The functions of the special assets group include loss mitigation and workout of non-performing loans, liquidation of non-performing assets and other responsibilities to accelerate and maximize loan recoveries. As part of establishing the new credit administration division and improving internal controls, the Bank’s Chief Credit Officer has identified and engaged experienced personnel to fill key roles within credit administration.
In addition to the special assets group, credit risk analytics was created and staffed to facilitate allowance for loan losses calculations, loan portfolio monitoring, migration analysis, concentration analysis and other credit risk analysis. In conjunction with the special assets group, the credit risk analytics position is responsible for ensuring that loan level detail is appropriately maintained relative to problem loan reporting, including current appraisal documentation and the identification of non-accrual loans and loans subject to classification as troubled debt restructurings.
Consent Order with the Comptroller of the Currency
On September 20, 2011, the Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Order”) with the Office of the Comptroller of the Currency (the “OCC”). The Consent Order replaced the previously disclosed formal written agreement entered into by the Bank with the OCC on March 15, 2010. Pursuant to the Consent Order, the Bank has agreed to take certain actions and operate in compliance with the Consent Order’s provisions during its term.
Under the terms of the Consent Order, the Bank is required to, among other things: (i) adopt and adhere to a three-year written strategic plan that establishes objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in non-performing assets and its product development; (ii) adopt and maintain a capital plan; (iii) by December 19, 2011, achieve and thereafter maintain a Tier 1 capital ratio of at least 8% and a total risk-based capital ratio of at least 12%; (iv) seek approval of the OCC prior to paying dividends on its capital stock; (v) develop a program to reduce the Bank’s credit risk; (vi) take certain actions related to credit and collateral exceptions; (vii) reaffirm the Bank’s liquidity risk management program; and (viii) appoint a compliance committee of the Board of Directors to help ensure the Bank’s compliance with the Consent Order. The Bank is also required to submit certain regular reports to the OCC with respect to the foregoing requirements.
The Bank has taken steps to address the issues raised in the Consent Order and intends to fully comply with the requirements set forth.
Written Agreement with the Federal Reserve Bank
On October 27, 2011, the Corporation entered into a Written Agreement with the Federal Reserve Bank (the “FRB”). Pursuant to the Written Agreement, the Corporation has agreed to take certain actions and operate in compliance with the Written Agreement’s provisions during its term.
Under the terms of the Written Agreement, the Corporation is required to, among other things: (i) serve as a source of strength to the Bank, including taking steps to ensure that the Bank complies with the Consent Order entered into with the OCC on September 20, 2011, and any other supervisory action taken by the Bank’s federal regulator; (ii) refrain from declaring or paying any dividend, or taking dividends or other payments representing a reduction in the Bank’s capital, each without the prior written consent of the FRB and the Director of the Division of Banking Supervision and Regulation (the “Director”) of the Board of Governors of the Federal Reserve System; (iii) refrain from making any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior approval of the FRB and the Director; (iv) refrain from incurring, increasing or guaranteeing any debt, and from purchasing or redeeming any shares of its capital stock, each without the prior approval of the FRB; (v) provide the FRB with a written plan to maintain sufficient capital at the Corporation on a consolidated basis; (vi) provide the FRB with a projection of the Corporation’s planned sources and uses of cash; (vii) comply with certain regulatory notice provisions pertaining to the appointment of any new director or senior executive officer, or the changing of responsibilities of any senior executive officer; and (viii) comply with certain regulatory restrictions on indemnification and severance payments. The Corporation is also required to submit certain reports to the FRB with respect to the foregoing requirements.
The Corporation has taken steps to address the issues raised in the Written Agreement and intends to fully comply with the requirements set forth.
Other Developments
On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of September 30, 2011, “dividends in arrears” on the preferred stock, which must be paid prior to the payment of dividends on common shares, total approximately $941,000.
In April 2011, the Corporation received a Sale Agreement concerning an industrial development property located in the Corporation’s northern region, the carrying value of which represents over 45% of the balance of other real estate owned as of September 30, 2011. The closing of this other real estate owned sale is expected to occur in the fourth quarter of 2011.
RESULTS OF OPERATIONS
Net loss available to common stockholders was $19,146,000 for the third quarter of 2011 compared to net loss available to common stockholders of $2,232,000 for the third quarter of 2010. Basic and diluted loss per common share available to common stockholders for the third quarter of 2011 were $5.75 compared to basic and diluted loss per share of $0.67 for the third quarter of 2010. This represents a decrease of $16,914,000 (757.7%) or $5.08 per basic and diluted common share. The net loss is caused by the recording of a valuation allowance of $14,584,000 for net deferred tax assets, provision for loan losses of $7,975,000 required due to continued collateral de-valuation in troubled real estate markets, increasing costs to carry and manage other real estate owned properties of $853,000, and recognition of impairment on originated mortgage servicing rights of $817,000 created due to the historically low rate environment. The annualized loss on average assets and loss on average equity were 7.06% and 135.49%, respectively, for the third quarter of 2011 compared with 0.79% and 11.28% for the third quarter of 2010.
Net loss available to common stockholders for the first nine months of 2011 was $20,978,000 compared to net loss available to common stockholders of $2,194,000 for the first nine months of 2010. Basic and diluted loss per common share available to common stockholders for the first nine months of 2011 were $6.30 compared to basic and diluted loss per share of $0.66 for the first nine months of 2010. The increase in net loss for the first nine months of 2011 as compared to the first nine months of 2010 is attributed to a $14,584,000 valuation allowance recorded for net deferred tax assets, a $4,600,000 increase in provision for loan losses, a result of continued collateral de-valuation in troubled real estate markets and a $1,300,000 increase in other real estate expenses, net of a $1,971,000 increase in gains on sales of available-for-sale securities. The annualized loss on average assets and loss on average equity were 2.58% and 49.04%, respectively, for the first nine months of 2011 compared with 0.25% and 3.80% for the first nine months of 2010.
Net interest income before the provision for loan losses was $8,365,000 for the third quarter of 2011, compared to $9,245,000 for the third quarter of 2010 (a decrease of $880,000 or 9.5%). The net yield on interest-earning assets (on a fully taxable equivalent basis) decreased by 0.22% to 3.92% in the third quarter of 2011 from 4.14% in the third quarter of 2010, from the impact of a high level of non-accrual loans, a decrease in loans from the lack of sufficient quality loan demand and the historically low rate environment.
Net interest income before the provision for loan losses was $26,478,000 for the first nine months of 2011, compared to $27,913,000 for the first nine months of 2010 (a decrease of $1,435,000 or 5.1%). The net yield on interest-earning assets (on a fully taxable equivalent basis) increased by 0.15% to 4.15% in the first nine months of 2011 from 4.00% for the first nine months of 2010. This increase in the net yield on average interest-earning assets was created from the impact of a high level of non-accrual loans combined with a reduction in the cost of interest-bearing liabilities, primarily time deposits, which decreased from 1.87% for the first nine months of 2010 to 1.22% for the first nine months of 2011.
The Corporation’s provision for loan loss expense recorded each quarter is determined by management’s evaluation of the risk characteristics of the loan portfolio. Net charge-offs increased during the third quarter of 2011 to $10,593,000, compared to net charge-offs of $4,147,000 for the third quarter of 2010. The Corporation recorded a provision for loan loss of $7,975,000 in the third quarter of 2011 compared to a provision of $6,725,000 in the third quarter of 2010. The allowance for loan losses is discussed more fully below.
Net charge-offs increased during the first nine months of 2011 to $31,115,000, compared to net charge-offs of $6,822,000 for the first nine months of 2010. The Corporation recorded a provision for loan loss of $17,900,000 in the first nine months of 2011 compared to a provision of $13,300,000 in the first nine months of 2010.
Non-interest income totaled $2,089,000 in the third quarter of 2011, compared to $2,474,000 in the third quarter of 2010, a decrease of 385,000 or 15.6%. This decrease was primarily due to the recognition of impairment on originated mortgage servicing rights of $817,000 in the third quarter of 2011. Annualized non-interest income as a percentage of total average assets decreased to 0.77% for the third quarter of 2011, from 0.87% for the same period in 2010.
Non-interest income totaled $9,716,000 for the first nine months of 2011, compared to $7,695,000 in the first nine months of 2010, an increase of $2,021,000 or 26.3%. The increase from the prior period is the result of an increase in realization of gains on sales of available-for-sale securities. Securities were sold from the investment portfolio to reduce municipal bond concentration, lower the generation of tax-exempt income, improve the credit position of the municipal portfolio and enhance the efficiency of the overall portfolio via strategic swap opportunities, thereby improving the portfolio’s interest rate risk management structure. There were $2,693,000 in gains on securities sold in 2011, compared to $722,000 during the same period in 2010. In addition, service charges on deposits increased to $3,032,000 in the first nine months of 2011 compared to $2,853,000 during the first nine months of 2010, an increase of $179,000 or 6.3% due primarily to an increase in checking account overdraft fees of $113,000. Annualized non-interest income as a percentage of total average assets increased to 1.20% for the first nine months of 2011, from .92% for the same period in 2010.
Total non-interest expense for the third quarter of 2011 was $10,089,000, an increase of $1,042,000 (or 11.5%) from $9,047,000 in the third quarter of 2010. The primary difference between the two quarters was an increase in expenses related to other real estate owned of $407,000 (or 91.3%) due to updated property valuations and an increase in loan collection expenses of $459,000 (or 441.3%). Annualized non-interest expense as a percentage of total average assets increased to 3.72% for the third quarter of 2011, compared to 3.19% for the same period in 2010.
Total non-interest expense for the first nine months of 2011 was $29,757,000, an increase of $2,608,000 (or 9.6%) from $27,149,000 in the first nine months of 2010. The primary difference between the two periods was an increase in expenses related to other real estate owned of $1,301,000 (or 83.0%) and an increase in loan collection expenses of $605,000 (or 123.0%). Annualized non-interest expense as a percentage of total average assets increased to 3.66% for the first nine months of 2011, compared to 3.11% for the same period in 2010.
INCOME TAXES
The Corporation recorded income tax expense of $8,552,000 for the first nine months of 2011, as compared to an income tax benefit of $3,609,000 for the first nine months of 2010, due primarily to the establishment of a valuation allowance against the Corporation’s deferred tax assets as of September 30, 2011. Under generally accepted accounting principles, income tax benefits and the related tax assets are only allowed to be recognized if they will “more likely than not” be realized.
The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies and assessments of the current and future economic and business conditions. The Corporation considered both positive and negative evidence regarding the ultimate realizability of the deferred tax assets, which is largely dependent upon the ability to derive benefits based on future taxable income.
The Corporation did not record a valuation allowance in quarters previous to the third quarter of 2011due to the weight of all positive evidence overcoming the negative evidence. However, during the third quarter of 2011, due to the negative evidence of a cumulative loss in the most recent three year period and earnings forecasts revised downward from previous quarters forecasts due to acceleration of provision for loan losses, loan collection and other real estate owned expenses, the Corporation has determined that a valuation allowance against deferred tax assets should be recorded as of September 30, 2011. As a result, as of September 30, 2011, the carrying value of the Corporation’s deferred tax assets has been reduced to zero through the recognition of a $14,584,000 valuation allowance.
In each future accounting period, the Corporation will reevaluate whether the current conditions in conjunction with positive and negative evidence support a change in the valuation allowance against deferred tax assets. Any such subsequent reduction in the estimated valuation allowance would lower the amount of income tax expense recognized in the Corporation’s Consolidated Statements of Income in future periods.
The effective tax rate was 74.6% for the nine-month period ended September 30, 2011 and (74.6%) for the nine-month period ended September 30, 2010. For more information on the Corporation’s income taxes see Note 10 – “Income Taxes” in the Notes to Condensed Consolidated Financial Statements.
FDIC
On September 29, 2009, the Board of Directors of the FDIC adopted a Notice of Proposed Rulemaking (NPR) that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC estimated that the total prepaid assessments collected would be approximately $45 billion. The FDIC Board also voted to adopt a uniform three-basis point increase in assessment rates effective on January 1, 2011, and extend the restoration period from seven to eight years.
Under GAAP accounting rules, unlike special assessments, prepaid assessments do not immediately affect bank earnings. Each institution recorded the entire amount of its assessment related to future periods as a prepaid expense (an asset) as of December 31, 2009, the date the payment was made. The Corporation paid an assessment of $6,763,000 for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.
Beginning January 1, 2010, and each quarter thereafter, each institution would record an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted. At September 30, 2011, the Corporation had a remaining prepaid assessment of $2,809,000. This amount is reflected in the category of Other Assets in the Condensed Consolidated Balance Sheets. The Corporation recorded $597,000 of federal insurance assessment expense for the third quarter of 2011 and $522,000 for the third quarter of 2010. Federal insurance assessment expense of $1,500,000 was recorded for the first nine months of 2011, compared to $1,617,000 for the first nine months of 2010.
ANALYSIS OF FINANCIAL CONDITION
Total assets at September 30, 2011 decreased to $1,069,783,000 from $1,096,471,000 at December 31, 2010 (a decrease of $26.7 million or 2.4%). Total loan balances decreased by $65.5 million during the nine month period to $638.6 million, due to the effects of aggressive loan collection and workout efforts relative to problem loans and general decline in the overall demand for new low-risk credit. Investment balances totaled $265,611,000 at September 30, 2011, compared to $260,939,000 at December 31, 2010 (an increase of $4.7 million, or 1.8%). Investment balances have increased slightly as a portion of the Bank’s excess liquidity has been utilized in conservative investments due to the lack of sufficient quality loan demand. Total deposits decreased to $939,225,000 at September 30, 2011 from $962,961,000 at December 31, 2010 (a decrease of $23.7 million or 2.5%). Comparing categories of deposits at September 30, 2011 to December 31, 2010, time deposits decreased $42.5 million (or 11.6%), interest-bearing demand deposits increased $3.2 million (or 0.8%), savings deposits increased $4.8 million (or 6.4%) and demand deposits increased $10.7 million (or 7.7%). Borrowings, consisting of customer repurchase agreements, treasury, tax, and loan (“TT&L”) deposits and Federal Home Loan Bank (“FHLB”) advances, increased from $71,559,000 at December 31, 2010 to $85,800,000 at September 30, 2011 (an increase of $14.2 million or 19.9%). This increase was primarily due to growth in repurchase agreement balances partially offset by the maturity and repayment of a $4,000,000 FHLB advance in the first quarter of 2011.
CAPITAL PURCHASE PROGRAM
On January 23, 2009, the Corporation received $25,083,000 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation’s 5.00% Series B Non-voting Cumulative Preferred Stock, par value $0.01 per share with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation’s common stock, par value $5.00 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and additional paid-in capital based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation’s Condensed Consolidated Statements of Income as “Accretion of preferred stock discount,” resulting in additional dilution to the Corporation’s earnings per share. The warrants are exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation’s diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation’s regulatory Tier 1 and total capital.
The Series B Preferred Stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. The Corporation can redeem the preferred securities at any time with Federal Reserve approval. The Series B Preferred Stock ranks on equal priority with the Corporation’s currently authorized Series A Preferred Stock.
A company that participates must adopt certain standards for executive compensation, including (a) prohibiting “golden parachute” payments as defined in the Emergency Economic Stabilization Act of 2008 (EESA) to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution; and (d) accepting restrictions on the payment of dividends and the repurchase of common stock.
On January 24, 2011, the Corporation notified the U.S. Treasury that it will defer regularly scheduled payments on the Corporation’s 25,083 shares in Series B Preferred Stock. As of September 30, 2011, dividends in arrears on preferred shares, which must be paid prior to the payment of dividends on common shares, total approximately $941,000.
LOANS
The Corporation’s loan portfolio largely reflects the profile of the communities in which it operates. The Corporation essentially offers four types of loans: commercial, agricultural, real estate and consumer installment. The Corporation has no foreign loans. The following table summarizes the Corporation’s loan portfolio:
|
|
September 30,
|
|
|
December 31,
|
|
|
September 30,
|
|
|
|
2011
|
|
|
2010
|
|
|
2010
|
|
|
|
|
|
|
% of
|
|
|
|
|
|
% of
|
|
|
|
|
|
% of
|
|
|
|
Amount
|
|
|
Total
|
|
|
Amount
|
|
|
Total
|
|
|
Amount
|
|
|
Total
|
|
Commercial
|
|
$
|
61,394
|
|
|
|
9.6
|
%
|
|
$
|
138,325
|
|
|
|
19.6
|
%
|
|
$
|
139,876
|
|
|
|
19.2
|
%
|
Agricultural
|
|
|
59,881
|
|
|
|
9.4
|
|
|
|
78,086
|
|
|
|
11.1
|
|
|
|
71,738
|
|
|
|
9.9
|
|
Agricultural real estate
|
|
|
60,133
|
|
|
|
9.4
|
|
|
|
46,361
|
|
|
|
6.6
|
|
|
|
45,825
|
|
|
|
6.3
|
|
Commercial real estate
|
|
|
235,833
|
|
|
|
36.9
|
|
|
|
205,301
|
|
|
|
29.2
|
|
|
|
206,316
|
|
|
|
28.3
|
|
Commercial real estate development
|
|
|
70,944
|
|
|
|
11.1
|
|
|
|
88,402
|
|
|
|
12.6
|
|
|
|
105,830
|
|
|
|
14.5
|
|
Residential real estate
|
|
|
100,552
|
|
|
|
15.7
|
|
|
|
90,869
|
|
|
|
12.9
|
|
|
|
95,936
|
|
|
|
13.2
|
|
Total Real Estate
|
|
|
467,462
|
|
|
|
73.2
|
|
|
|
430,933
|
|
|
|
61.2
|
|
|
|
453,907
|
|
|
|
62.3
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consumer
|
|
|
49,816
|
|
|
|
7.8
|
|
|
|
56,730
|
|
|
|
8.1
|
|
|
|
62,253
|
|
|
|
8.6
|
|
Total loans
|
|
$
|
638,553
|
|
|
|
100.0
|
%
|
|
$
|
704,074
|
|
|
|
100.0
|
%
|
|
$
|
727,774
|
|
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total assets
|
|
$
|
1,069,783
|
|
|
|
|
|
|
$
|
1,096,471
|
|
|
|
|
|
|
$
|
1,111,227
|
|
|
|
|
|
Loans to total assets
|
|
|
59.7
|
%
|
|
|
|
|
|
|
64.2
|
%
|
|
|
|
|
|
|
65.5
|
%
|
|
|
|
|
In the third quarter of 2011, the Corporation implemented a loan reporting reclassification in which the segregation of reported loan categories was changed to a collateral focus based on regulatory reporting guidelines from a segregation based on product focus. The primary result of this reclassification in the reported composition of the loan portfolio was a shift of commercial loans that are secured by commercial real estate to be reported as commercial real estate loans rather than commercial loans. Of the $76.9 million decrease in reported commercial loans from December 31, 2010 to September 30, 2011, $53.3 million represented this reclassification to commercial real estate loans, $2.8 million to agricultural real estate loans, and $6.6 million to residential real estate loans. Also impacting this decline in the nine months ended September 30, 2011 was $3.0 million in commercial loan charge-offs and normal loan paydowns. The third quarter 2011 reclassification did not impact the calculation of the allowance for loans losses during the nine months ended September 30, 2011 as the allowance calculation was already based on a collateral focused segregation of the loan portfolio.
Total loans decreased $65,521 (or 9.3%) in the first nine months of 2011. There were no acquisitions in the first nine months of 2011 or in 2010. The decrease reflects the Corporation’s 2011 capital management objectives, as well as the continued dual effects of the present economic environment in which business and consumer borrowers have reduced demand and capacity for new indebtedness and borrower financial deterioration resulting in a higher level of loans charged off and transferred to other real estate owned.
Loans to agricultural operations decreased $18,205 (or 23.3%) in the first nine months of 2011. Short-term agricultural loans are seasonal in nature with paydown from grain sales occurring near the beginning and end of each year. Rapid growth in the bio-fuels industry (primarily ethanol) and rising worldwide food demand continue to influence corn prices. Rising corn prices have influenced soybean prices as the two commodities compete for planted acreage. Corn and soybeans are the two primary crops of the Corporation’s market area. As in 2010, selling prices remain historically strong in 2011, resulting in another year of high profitability for most of the Corporation’s agricultural customers. The balance sheet of local agriculture remains strong, both in terms of equity and liquidity. Agriculture remains the largest single loan industry concentration of the Corporation. The highly experienced agricultural staff continues to effectively manage risk and seek opportunities in this portfolio. Agricultural loans as a percentage of total loans were 9.4% at September 30, 2011, compared to 11.1% at year-end 2010.
Total real estate loans increased $36,529 (or 8.5%) in the first nine months of 2011. Residential real estate loans with fixed rates of more than 7 years are generally sold into the secondary market. The Corporation retains the servicing of sold loans, maintaining the local relationship with customers and generating servicing fee income. With home mortgage rates in 2010 and through the third quarter of 2011 at or near their lowest level in almost 50 years, many borrowers refinanced adjustable rate loans into fixed rate loans that were sold. Total home mortgage closings approximated $57,000 during the first nine months of 2011 and $130,000 in 2010, $45,000 below the record level of $175,000 in 2009.
Consumer installment loans decreased $6,914 (or 12.2%) in the first nine months of 2011. Home equity lending, which continues to reflect reduced consumer demand, comprises over two-thirds of the installment portfolio.
Although the risk of non-payment for any reason exists with respect to all loans, certain other more specific risks are associated with each type of loan. The primary risks associated with commercial loans are quality of the borrower’s management and the impact of national economic factors. Development and construction loans have primary risks associated with demand for housing and other construction projects. As these businesses are capital intensive, when demand for product weakens, revenues are reduced while fixed costs such as debt service remain. With respect to agricultural loans, the primary risks are weather and, like commercial loans, the quality of the borrower’s management. Risks associated with real estate loans include concentrations of loans in a loan type, such as commercial or agricultural, and fluctuating land values. Non-owner occupied commercial real estate loans have risks related to occupancy and lease rates during economic downturns. Consumer loans also have risks associated with concentrations of loans in a single type of loan. Consumer loans additionally carry the risk of a borrower’s unemployment as a result of deteriorating economic conditions. With the exception of agricultural lending, the current economic environment has increased the risk level in the subsidiary bank’s loan portfolio.
The Corporation’s strategy with respect to addressing and managing these types of risks, whether loan demand is weak or strong, is for the subsidiary bank to follow its loan policies and sound underwriting practices, which include: (i) granting loans on a sound and collectible basis; (ii) investing funds profitably for the benefit of the stockholders and the protection of depositors; (iii) serving the legitimate needs of the community and the subsidiary bank’s general market area while obtaining a balance between maximum yield and minimum risk; (iv) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan; (v) administering loan policies through a Directors Loan Committee, an Executive Loan Committee, Chief Credit Officer and officer approvals; (vi) developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each loan category and (vii) ensuring that each loan is properly documented and, if appropriate, secured or guaranteed by government agencies, and that insurance coverage is adequate, especially with respect to certain agricultural loans because of the risk of poor weather. In the present difficult economic environment, bank officers and staff actively work with borrowers to achieve the best resolutions possible.
NON-PERFORMING LOANS AND OTHER REAL ESTATE OWNED
Non-performing loans consist of non-accrual loans, loans past due 90 days on which interest is still accruing and loans modified in troubled debt restructurings. Non-performing loans amounted to 14.7% of total loans at September 30, 2011 compared to 13.83% at December 31, 2010. The increase reflects continued stress on the commercial real estate market, primarily from persistent economic issues and their impact on consumer spending and the housing industry. The majority of non-performing loans are in two industries: commercial real estate development and commercial real estate. The Corporation’s exposure to the commercial real estate development industry is primarily in the northern and eastern market areas. Non-performing commercial real estate development loans comprise approximately 37.1% of the Corporation’s total non-performing loans as of September 30, 2011, which is down from 41.3% as of June 30, 2011 and 46.4% as of December 31, 2010. Due to the severe downturn in the housing industry, certain builders and developers have encountered difficulty in servicing their debt, eventually leading to non-performing status. Commercial real estate loans comprise approximately 44.1% of the non-performing total as of September 30, 2011, up from 32.7% and 31.9% as of June 30, 2011 and December 31, 2010, respectively. These loans are generally secured by owner-occupied and leased properties and are located throughout the Corporation’s market area. The Corporation continues to closely monitor these loan relationships for opportunities to accelerate acquisition of property ownership and thereby accelerate eventual resolution. The balance of non-performing loans is comprised primarily of residential real estate and home equity credits. The Corporation has been proactive in obtaining updated appraisals for non-performing loans secured by real estate. As discussed further below, as of September 30, 2011, 91.5% of impaired loans had current third party appraisals. The continued downward pressure on real estate values, particularly development properties, has prompted charge-offs and the recording of specific reserves for potential loss on loans secured by real estate.
Troubled debt restructurings at September 30, 2011 were $22,030 compared to $23,386 at December 31, 2010. These are loans to borrowers that are experiencing varying levels of financial stress but are expected to recover. To assist the borrowers, the Corporation has provided some concession in loan terms, most commonly extending the loan amortization or adjusting the interest rate. In the present economic environment, the vast majority of non-performing loans are secured by real estate. At the time a loan is restructured, the Corporation considers the repayment history of the loan and the value of the collateral. If the principal or interest is due and has remained unpaid for 90 days or more and the loan is not well-secured, the loan is placed on nonaccrual status. If the principal and interest payments are current and the loan is well-secured, the troubled debt restructuring loan continues to accrue interest. Once a loan is placed on nonaccrual status, the borrower is required to make current principal and interest payments based on the modified terms for a period of at least six months before returning the loan to accrual status.
As of September 30, 2011 and December 31, 2010, $8,884 and $14,368, respectively, in troubled debt restructuring loans were on accrual status. When the loan is restructured, the loan officer is required to document the basis for the restructure, obtain current and complete credit and cash flow information and identify a specific repayment plan that would retire the debt. This information is provided to the Credit Analysis department which prepares a thorough credit presentation. The credit presentation includes the modified terms of the loan, a collateral analysis and a cash flow analysis based on the modified terms of the loan. The credit presentation is presented to the Directors’ Loan Committee for approval.
Problem credits are closely monitored by the lending staff, credit administration division and special assets group, which was newly formed in 2010. In addition, beginning in April 2011, external loan review performed by representatives of a loan review risk advisory firm has provided further assistance in identifying problem situations. Loans over 90 days past due are normally either charged off or placed on a non-accrual status. Problem credits have a life cycle in which they either improve or they move through a workout/liquidation process. The workout process often includes reclassification to non-accrual status, unless the loan is well secured and in the process of collection. Collateral securing non-accrual real estate loans that are not resolved by borrowers becomes other real estate owned via foreclosure or receipt of a deed in lieu of foreclosure. The Corporation actively markets other real estate owned properties for sale.
The Corporation formed a special assets group in 2010 to focus on the management of the other real estate owned workout process. Total other real estate owned as of September 30, 2011 was $18,502, down from $20,652 as of December 31, 2010. Over 45% of the September 30, 2011 total is one industrial development property located in the Corporation’s northern region. The Corporation is actively marketing the property by parcel or as a bulk sale. Most of all improvements are complete on the property. Two distribution centers are presently located in the industrial park. Additional roadways may be built depending on how end users choose parcel configuration. Construction of a third distribution center was completed as of June 30, 2011 on a portion of the parcel that was sold in 2010. The selling price per acre was significantly above the Corporation’s carrying value of the property. In April 2011, the Corporation received a Sale Agreement concerning the remaining acres for this industrial development property. The closing of this particular other real estate owned sale is expected to occur in the fourth quarter of 2011.
As with non-performing loans, the Corporation is proactive in obtaining appraisals to support the carrying value of other real estate owned property on the Condensed Consolidated Balance Sheets. The following table provides information on the Corporation’s non-performing loans and other real estate owned as of the periods indicated:
|
|
September 30,
|
|
|
December 31,
|
|
|
September 30,
|
|
|
|
2011
|
|
|
2010
|
|
|
2010
|
|
Non-accrual
|
|
$
|
68,925
|
|
|
$
|
72,404
|
|
|
$
|
73,699
|
|
90 days past due and accruing
|
|
|
1,705
|
|
|
|
1,561
|
|
|
|
1,438
|
|
Troubled debt restructurings
|
|
|
22,030
|
|
|
|
23,386
|
|
|
|
7,518
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total non-performing loans
|
|
$
|
92,660
|
|
|
$
|
97,351
|
|
|
$
|
82,655
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other real estate owned
|
|
|
18,502
|
|
|
|
20,652
|
|
|
|
18,372
|
|
Total non-performing assets
|
|
$
|
111,162
|
|
|
$
|
118,003
|
|
|
$
|
101,027
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-performing loans to total loans
(net of unearned interest)
|
|
|
14.51
|
%
|
|
|
13.83
|
%
|
|
|
11.36
|
%
|
Non-performing assets to total assets
|
|
|
10.39
|
%
|
|
|
10.76
|
%
|
|
|
9.09
|
%
|
Non-performing loans consist of non-accrual loans, loans past due 90 days on which interest is still accruing and troubled debt restructurings. Impaired loans of $93,584, included in the impaired loans table in Note 8 – “Loans and the Allowance for Loan Losses” in the Notes to Condensed Consolidated Financial Statements, include $1,052 in impaired loans which are performing as of September 30, 2011, and therefore are not included in non-performing loans. Performing impaired loans consist of loans for which management has concern regarding the ultimate collectability of full principal and interest under the original terms of the loan agreement due to issues such as borrower payment capacity or collateral coverage. There were no performing impaired loans as of December 31, 2010.
Of the $93,584 in impaired loans at September 30, 2011, the Corporation relied on third party appraisals for $90,790 of the impaired loans. Approximately $85,602 or 91.5% of the impaired loans had current third party appraisals which were relied upon. These appraisals were completed within 12 months of September 30, 2011. The appraisals for the remaining $5,188 in impaired loans in which third party appraisals were obtained had not been updated as the fair value in the last appraisal received and the current estimated value were in significant excess of the outstanding debt for $590 of these loans.
The weighted average loan to fair value for the $5,188 was approximately 75%. Collateral values which are not based on current appraisals are discounted 10% to 20% in the collateral evaluation in addition to the already required 12% discount. The initial 12% discount, which was increased in the third quarter from a 10% discount, is due to the anticipated selling costs of the collateral. The additional discount is based on several factors. These factors include the Loan Officer’s review of the collateral and its current condition, the Corporation’s knowledge of the current economic environment in the collateral markets, and the Corporation’s past experience with real estate in the area. The date of the appraisal is also considered in conjunction with the economic environment and the decline in the real estate market since the appraisal was obtained.
The following table provides a loan-to-value ratio distribution for the $5,188 in impaired loans with appraisals over twelve months old as of September 30, 2011:
Loan-to-Value
Amount
0 - 50% $ 45
50 - 60% $ 545
60 - 70% $ 261
70 - 80% $ 1,671
80 - 90% $ 2,666
90% + $ -0-
Once a loan is deemed an impaired loan, the Loan Officer or Special Assets officer in conjunction with the credit analysis department in credit administration, completes a Problem Asset Workout Summary, which includes a detailed review of the collateral. Problem Asset Workout Summaries are prepared by the Credit Analysts and Loan Officers, then reviewed by Credit Administration management and utilized in the preparation of the allowance for loan losses calculation. Summaries include a collateral analysis detailing a description of the collateral, the date of the appraisal and the discounts on the collateral. If the discounted collateral is sufficient to cover the outstanding loan balance, no specific valuation allowance is placed on the loan. If the estimated current collateral value is in significant excess of the outstanding debt or the appraisal is less than twelve months old, a new appraisal is not ordered. If the collateral value is not in significant excess of the outstanding debt or the appraisal is over twelve months old, the Loan Officer or Special Assets officer with concurrence of the Chief Credit Officer will determine if a new appraisal should be ordered based on their knowledge of the current market in the collateral’s area. If the Corporation determines that full collection of the principal of the debt owed is not likely, a new appraisal is ordered. If the estimated fair value presented in the new appraisal is less than the outstanding debt, a specific reserve or charge-off is recorded, as appropriate, equal to the difference between the discounted collateral value and the outstanding debt.
The determination of a specific allowance or charge-off is reviewed by the Corporation on a monthly basis. During the nine months ended September 30, 2011, the Corporation recorded partial charge-offs totaling $25,243 on the impaired loans with an outstanding balance of $49,976. The charge-offs were considered warranted as the loans were considered collateral dependent and the discounted collateral value was not sufficient to cover the outstanding debt.
The Corporation requires appraisals on real estate if the loan is over $250,000 or if the collateral is commercial real estate at the time of origination of the loan. If the appraisal is not within one year of the reporting period, the loan officer provides an additional discount on the collateral based on the loan officer’s review of the collateral and its current condition, the Corporation’s knowledge of the current economic environment in the collateral’s market and the Corporation’s past experience with real estate in the area. The date of the appraisal is also considered in conjunction with the economic environment and the decline in the real estate market since the appraisal was obtained. This additional discount is usually 10% to 35%, depending on the type of property and market area. If the loan is below $250,000 and is not commercial real estate, an internal valuation of the collateral may be used, but must be completed by a staff member who has no involvement in the credit decision. Underlying collateral consisting of vehicles, equipment or other assets is valued using information provided by the borrower. The loan officer must confirm the existence of the assets and provide adequate discounts on the value of the collateral when determining its adequacy to cover the loan.
ALLOWANCE FOR POSSIBLE LOAN LOSSES
The allowance shown in the following table represents the allowance available to absorb losses within the entire portfolio
:
|
|
September 30,
|
|
|
December 31,
|
|
|
September 30,
|
|
|
|
2011
|
|
|
2010
|
|
|
2010
|
|
Amount of loans outstanding at end of
period (net of unearned interest)
|
|
$
|
638,553
|
|
|
$
|
704,074
|
|
|
$
|
727,774
|
|
Average amount of loans outstanding for
the period (net of unearned interest)
|
|
$
|
677,687
|
|
|
$
|
687,177
|
|
|
$
|
756,301
|
|
Allowance for loan losses
at beginning of period
|
|
$
|
29,726
|
|
|
$
|
12,075
|
|
|
$
|
12,075
|
|
Charge-offs:
|
|
|
|
|
|
|
|
|
|
|
|
|
Agricultural
|
|
|
403
|
|
|
|
68
|
|
|
|
68
|
|
Commercial
|
|
|
26,960
|
|
|
|
19,525
|
|
|
|
5,988
|
|
Real estate-mortgage
|
|
|
3,100
|
|
|
|
2,266
|
|
|
|
616
|
|
Installment
|
|
|
1,113
|
|
|
|
1,307
|
|
|
|
310
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total charge-offs
|
|
|
31,576
|
|
|
|
23,166
|
|
|
|
6,982
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Recoveries:
|
|
|
|
|
|
|
|
|
|
|
|
|
Agricultural
|
|
|
15
|
|
|
|
-0-
|
|
|
|
-0-
|
|
Commercial
|
|
|
282
|
|
|
|
45
|
|
|
|
40
|
|
Real estate-mortgage
|
|
|
8
|
|
|
|
-0-
|
|
|
|
-0-
|
|
Installment
|
|
|
156
|
|
|
|
222
|
|
|
|
120
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total recoveries
|
|
|
461
|
|
|
|
267
|
|
|
|
160
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loans charged off
|
|
|
31,115
|
|
|
|
22,899
|
|
|
|
6,822
|
|
Provision for loan losses
|
|
|
17,900
|
|
|
|
40,550
|
|
|
|
13,300
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for loan losses
at end of period
|
|
$
|
16,511
|
|
|
$
|
29,726
|
|
|
$
|
18,553
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loans charged off
to average loans (annualized)
|
|
|
6.12
|
%
|
|
|
3.33
|
%
|
|
|
1.20
|
%
|
Allowance for loan losses
to non-performing loans
|
|
|
17.82
|
%
|
|
|
30.53
|
%
|
|
|
22.44
|
%
|
Allowance for loan losses to total loans at
end of period (net of unearned interest)
|
|
|
2.59
|
%
|
|
|
4.22
|
%
|
|
|
2.55
|
%
|
The allowance for loan losses is considered by management to be a critical accounting policy. The allowance for loan losses is increased by provisions charged to operating expense and decreased by charge-offs, net of recoveries. The allowance is based on factors that include the overall composition of the loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful loans and such other factors that, in management’s best judgment, deserve evaluation in estimating possible loan losses. The adequacy of the allowance for loan losses is monitored monthly during the ongoing, systematic review of the loan portfolio by the Credit Risk Analytics staff in Credit Administration, Senior Lending Officers, Chief Credit Officer, Chief Operating Officer, Chief Financial Officer and Chief Executive Officer of the subsidiary bank. The results of these reviews are reported to the Board of Directors of the subsidiary bank on a monthly basis. Monitoring and addressing problem loan situations are primarily the responsibility of the subsidiary bank’s staff, management and its Board of Directors.
More specifically, the Corporation calculates the appropriate level of the allowance for loan losses on a monthly basis using base charge-offs for each loan type, substandard loans and potential losses with respect to specific loans. In addition to management’s assessment of the portfolio, the Corporation and the subsidiary bank are examined periodically by regulatory agencies. Although the regulatory agencies do not determine whether the subsidiary bank’s allowance for loan losses is adequate, such agencies do review the procedures and policies followed by management of the subsidiary bank in establishing the allowance.
Given the current state of the economy, management has assessed the impact of the recession on each category of loans and adjusted historical loss factors for recent economic trends. Management utilizes a twelve quarter history as one component in assessing the probability of inherent future losses, while including additional weighting of the most recent historical data. Given the decline in economic conditions over the past year, management has also increased its allocation to various loan categories for economic factors. Some of the economic factors include the potential for reduced cash flow for commercial operating loans from reduction in sales or increased operating costs, decreased occupancy rates for commercial buildings, reduced levels of home sales for commercial and land developments, reduced values in real estate or other collateral, the decline in and uncertainty regarding grain prices and increased operating costs for farmers, and increased levels of unemployment and bankruptcy impacting consumers’ ability to pay. Each of these economic uncertainties is taken into consideration in developing the appropriate level of reserve.
The Corporation’s allowance for loan losses has two components. The first component is based upon individual review of nonperforming, substandard or other loans identified as a risk for loss and deemed impaired. This includes nonperforming loans, which consist of nonaccrual loans, loans past due over 90 days and troubled debt restructurings, loans designated as impaired as defined by accounting and regulatory guidance and loans evaluated for potential loss on an individual basis.
The second component is based upon expected, but unidentified, losses inherent in our loan portfolio. The second component is determined utilizing the Corporation’s most recent twelve quarter net charge-off history which is then adjusted for qualitative and quantitative factors. These loss reserve factors are reviewed on a quarterly basis by an Allowance Review Committee which is comprised of members of management, including lending, accounting and credit administration. The qualitative and quantitative factors considered include economic conditions, changes in underwriting practices, changes in the value of collateral, changes in the portfolio volume, staff experience, past due and nonaccrual loans, loan review oversight, concentrations of loans and competition.
The allowance for loan losses of $16,511 and $29,726, respectively, was 2.59% and 4.22% of total loans as of September 30, 2011 and December 31, 2010. The Corporation’s net charge-offs as a percentage of loans were 6.12% and 3.33% for the nine months ended September 30, 2011 and year ended December 31, 2010, respectively. The Corporation’s net charge-offs have remained high due to the continued deterioration in the economic environment, especially relative to commercial real estate and commercial real estate development loans in the northern and eastern markets in Grundy, Kane and DuPage counties, but the growth trends in losses and provision are expected to begin to diminish due to the Corporation’s aggressive efforts to identify and resolve problem loans and as signs of economic stabilization begin to appear in the commercial real estate market.
Reduction in the allowance for loan losses recorded for loans collectively evaluated for impairment as reflected in the allowance for loan losses roll-forward table in Note 8 to the Condensed Consolidated Financial Statements ($9,783 and $12,245 as of September 30, 2011 and December 31, 2010, respectively) as a ratio of the ending balance of loans collectively evaluated for impairment ($544,970 and $660,918 as of September 30, 2011 and December 31, 2010, respectively) to 1.80% at September 30, 2011 from 2.65% at December 30, 2010 is primarily the result of the acceleration of loan charge-offs into the third quarter of 2011. This was facilitated by the continued aggressive loan collection and workout efforts of the credit administration department. These ongoing efforts have created acceleration in the identification of troubled loans and recognition of appropriate charge-offs, resulting in the reduction of recorded loan balances to their appropriate carrying value. The Corporation continues to aggressively pursue all practical and legal methods of collection, repossession, disposal and recovery in relation to troubled loans.
During the first nine months of 2011, $31,115 in net loan charge-offs were recorded due to these aggressive loan collection and workout efforts and the receipt of updated appraisals reflecting current deterioration in the collateral value of commercial real estate and commercial real estate development properties primarily in the northern and eastern markets. In estimating the adequacy of the allowance for loan losses, management consistently utilizes a twelve-quarter loan loss history as one component in assessing the probability of inherent future losses, while including higher weighting of the most recent four quarters of data.
The allowance for loan losses as a percentage of non-performing loans has decreased to 17.8% as of September 30, 2011 from 30.5% as of December 31, 2010. The reserve for specifically impaired loans decreased by $2.1 million from the second quarter of 2011. The resulting decrease in the specifically reserved loans is primarily due to the charge-off of $10.9 million in loans that were previously reserved and adding over $5.7 million in new specific provisions, largely due to two commercial real estate development relationships. Also increasing the provision in the third quarter 2011 was an increase in the selling cost discount from 10% to 12%. Charge-offs were taken on credits that were impaired and also collateral dependent and were based on current appraisals. At the end of the current period, the Corporation has an updated appraisal (within twelve months) on the collateral for over 91% of all impaired loans. The Corporation continues to aggressively monitor the collateral values of its impaired loan classifications to assess the need for specific reserves. The allowance for loan losses calculation takes into consideration continuing economic declines and resulting increases in non-performing loans in the quantitative and qualitative factors used to adjust the reserve percentages on loans not specifically reserved for in the calculation.
There were $6,728
in specific loan loss reserves for non-performing loans as of September 30, 2011, compared to $12,245 as of December 31, 2010. Although non-performing loans are trending downward, they remain elevated, and the balance is comprised of loans that management believes will not result in significant additional losses not reserved in the allowance for loan losses as of September 30, 2011. Management considers the allowance for loan losses adequate to meet probable losses as of September 30, 2011.
CAPITAL RESOURCES
Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the levels of risk inherent in different assets. At September 30, 2011, total risk-based capital of the Corporation was 7.64%, compared to 9.68% at December 31, 2010. The Tier 1 capital ratio decreased to 4.26% at September 30, 2011 from 5.93% at December 31, 2010. Total stockholders' equity to total assets at September 30, 2011 decreased to 3.66% from 5.19% at December 31, 2010.
As reflected in the following table, the Corporation and Bank were considered adequately capitalized under regulatory requirements for the tier one leverage capital ratio and the tier one risk-based capital ratio as of September 30, 2011 and December 31, 2010. The Corporation and the Bank were considered adequately capitalized for the total risk-based capital ratio at December 31, 2010. At September 30, 2011 the Bank was considered adequately capitalized while the Corporation was considered undercapitalized for the total risk-based capital ratio.
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Princeton National Bancorp, Inc.
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Citizens First National Bank
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Adequately-
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September 30, 2011
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December 31, 2010
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September 30, 2011
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December 31, 2010
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Capitalized Thresholds
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Carrying Amounts:
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Total risk-based capital
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$
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54,788
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|
|
$
|
76,618
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|
|
$
|
65,713
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|
|
$
|
81,447
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|
|
|
|
Tier 1 risk-based capital
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|
$
|
45,729
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|
|
$
|
66,476
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|
|
$
|
56,658
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|
|
$
|
71,307
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|
|
|
|
Tier 1 leverage capital
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|
$
|
45,729
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|
|
$
|
66,476
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|
|
$
|
56,658
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|
|
$
|
71,307
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Capital Ratios:
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|
|
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Total risk-based capital
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7.64
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%
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|
|
9.68
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%
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|
|
9.17
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%
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|
|
10.29
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%
|
|
|
8.00
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%
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Tier 1 risk-based capital
|
|
|
6.38
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%
|
|
|
8.40
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%
|
|
|
7.90
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%
|
|
|
9.01
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%
|
|
|
4.00
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%
|
Tier 1 leverage ratio
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|
|
4.26
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%
|
|
|
5.93
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%
|
|
|
5.29
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%
|
|
|
6.36
|
%
|
|
|
4.00
|
%
|
Total capital and corresponding capital ratios decreased during the third quarter 2011 due to net operating losses caused by increased provision for loan losses, loan collection and other real estate costs and recognition of a valuation allowance for net deferred tax assets.
LIQUIDITY
Due to internal stress and uncertainty in the financial markets, the Corporation continues conservative liquidity maintenance strategies. The Corporation remains in a stable liquidity position by maintaining minimal reliance on wholesale funding sources combined with strong excess Federal reserves. Interest-bearing deposits with financial institutions, comprised primarily of excess reserve balances held at the Federal Reserve Bank, increased to $66.0 million at September 30, 2011 from $30.9 million at December 31, 2010, an increase of 113.6%. Wholesale funding, consisting of brokered deposits, Federal Home Loan Bank advances and other borrowings, decreased $13.2 million or 49.1% from December 31, 2010 to September 30, 2011 as borrowings from the Federal Home Loan Bank were repaid and brokered deposits were reduced.
Liquidity is measured by a financial institution's ability to raise funds through deposits, borrowed funds, capital or the sale of assets. The Corporation manages its liquidity position with the objective of maintaining sufficient funds to respond to the needs of depositors and borrowers and to take advantage of earnings enhancement opportunities. In addition to the normal inflow of funds from core-deposit growth together with repayments and maturities of loans and investments, the Corporation utilizes other short-term funding sources such as securities sold under agreements to repurchase and the acceptance of short-term deposits from public entities.
The Corporation classifies a significant majority of its securities as available-for-sale, thereby enhancing liquidity. In managing its investment portfolio, the Corporation provides for staggered maturities so that cash flows are a consistent source of liquidity over an appropriate time frame. The Corporation’s liquidity position is further enhanced by loan portfolio principal reduction and interest payments and by the steady stream of loan payment from the Corporation’s retail credit and residential mortgage loan portfolios.
The Corporation is a member of the Federal Home Loan Bank of Chicago (FHLB) and as such has advances from FHLB secured generally by residential mortgage loans with a remaining borrowing capacity of $13.0 million at September 30, 2011.
Cash flows provided by investing and operating activities, offset by those used in financing activities, resulted in a net increase in cash and cash equivalents of $40.5 million from December 31, 2010 to September 30, 2011. This increase was primarily the result of a net decrease in loans. For more detailed information, see the Corporation's Condensed Consolidated Statements of Cash Flows.
FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Corporation generates agricultural, commercial, real estate and consumer loans to customers located primarily in North Central Illinois. The Corporation’s loans are generally secured by specific items of collateral including real property, consumer assets and business assets. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon economic conditions in the agricultural industry.
In the normal course of business to meet the financing needs of its customers, the subsidiary bank is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Condensed Consolidated Balance Sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.
The subsidiary bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At September 30, 2011, commitments to extend credit and standby letters of credit were approximately $121.2 million and $1.6 million, respectively.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment and income-producing properties.
Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan. The maximum amount of credit that would be extended under standby letters of credit is equal to the off-balance sheet contract amount.
The standby letters of credit have terms that expire in one year or less.
LAND HELD FOR SALE
The Corporation owns separate lots in Elburn, Aurora and Somonauk, Illinois that have been removed from the land balance and are now shown on the Corporation’s balance sheet as land held-for-sale, at the lower of cost or market. The land in Elburn, approximately two acres, was purchased in 2003 in anticipation of the construction of a branch facility and has a cost basis of $820,000 at September 30, 2011. The land in Aurora, consisting of two lots remaining from the original purchase of fourteen acres in 2004 which was used to construct a branch facility, has a cost basis of $1,344,000. The land in Somonauk, acquired in 2005 during the acquisition of FSB Bancorp, Inc., consists of approximately two acres with a cost basis of $80,000.
LEGAL PROCEEDINGS
There are various claims pending against the Corporation's subsidiary bank, arising in the normal course of business. Management believes, based upon consultation with counsel, that liabilities arising from these proceedings, if any, will not be material to the Corporation’s financial position or results of operation.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a smaller reporting company under the U.S. Securities and Exchange Commission’s scaled reporting requirements, the Corporation is not required to include the information required by this item. Accordingly, the information is omitted from this Form 10-Q filing.
EFFECTS OF INFLATION
The Condensed Consolidated Financial Statements and related condensed consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation.