UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2018
OR
For the transition period from ____________ to ____________
Commission file number: 001-38676
BANK FIRST NATIONAL CORPORATION
(Exact name of registrant as specified in its charter)
(920) 652-3100
(Registrant’s telephone number, including area code)
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 o
Indicate by check mark whether the registrant has submitted electronically, if any, every Interactive Data File required to be submitted 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 o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The number of shares of the issuer’s common stock, par value $0.01, outstanding as of December 5, 2018 was 6,644,759 shares.
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS:
Consolidated Balance Sheets(In thousands, except share and per share data)
See accompanying notes to unaudited consolidated financial statements.
ITEM 1. Financial Statements Continued:
Consolidated Statements of Income
(In thousands, except share and per share data) (Unaudited)
See accompanying notes to unaudited consolidated financial statements
Consolidated Statements of Comprehensive Income
(In thousands) (Unaudited)
Consolidated Statement of Changes in Stockholders’ Equity
(In thousands, except per share data) (Unaudited)
Consolidated Statements of Cash Flows
Consolidated Statements of Cash Flows (Continued)
See accompanying notes to consolidated financial statements.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)
NOTE 1 – BASIS OF PRESENTATION
Bank First National Corporation (the “Company”) provides a variety of financial services to individual and corporate customers through its wholly owned subsidiary, Bank First, N.A. (the “Bank”). The Bank operates as a full-service financial institution with a primary market area including, but not limited to, the counties in which the Bank’s branches are located. The Bank has eighteen locations located in Manitowoc, Outagamie, Brown, Winnebago, Sheboygan, Waupaca and Barron counties in Wisconsin. The Company is subject to the regulations of certain federal agencies and undergoes periodic examinations by those regulatory authorities.
These interim unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information and with the instructions to Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures required by (GAAP) have been omitted or abbreviated. These unaudited consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and footnotes included in the Company’s Registration Statement on Form 10 Amendment No.1 (Registration No. 001-38676) filed with the Securities and Exchange Commission (“SEC”) on October 17, 2018 (the “Registration Statement”).
The unaudited consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the results for the interim periods. The results for interim periods are not necessarily indicative of results for a full year.
Subsequent Events
The Company has evaluated, for consideration of recognition or disclosure, subsequent events that occurred through the date of issuance of these financial statements. The Company has determined that there were no subsequent events other than that which is described below that occurred after September 30, 2018, but prior to the issuance of these financial statements that would have a material impact on the Company’s consolidated financial statements.
On October 16, 2018, the Company declared a regular quarterly dividend of $0.20 per share to be paid on January 7, 2019, to stockholders of record as of December 21, 2018, totaling approximately $1.3 million.
Critical Accounting Policies and Estimates
Preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, the allowance for loan losses (ALL), valuation of loans in acquisition transactions, useful lives for depreciation and amortization, fair value of financial instruments, other-than-temporary impairment calculations, valuation of deferred tax assets, uncertain income tax positions and contingencies. Estimates that are particularly susceptible to significant change for the Company include the determination of the ALL, the determination and assessment of deferred tax assets and liabilities, and the valuation of loans acquired in acquisition transactions; therefore, these are critical accounting policies. Factors that may cause sensitivity to the aforementioned estimates include but are not limited to: external market factors such as market interest rates and employment rates, changes to operating policies and procedures, changes in applicable banking or tax regulations, and changes to deferred tax estimates. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the consolidated financial statements in any individual reporting period presented.
There have been no material changes or developments with respect to the assumptions or methodologies that the Company uses when applying what management believes are critical accounting policies and developing critical accounting estimates as previously disclosed in the Company’s Registration Statement.
Recent Accounting Developments Adopted
In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-09, Compensation — Stock Compensation (Topic 718). ASU 2017-09 applies to entities that change the terms or conditions of a share-based payment award to provide clarity and reduce diversity in practice as well as cost and complexity when applying the guidance in Topic 718 to the modification to the terms and conditions of a share-based payment award. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2017. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, to clarify the definition of a business to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets versus businesses. The update narrows the definition of a business by adding three principal clarifications: (1) if substantially all the fair value of the gross assets in the asset group is concentrated in either a single identifiable asset or group of similar identifiable assets the transaction does not involve a business, (2) if the asset group does not include a minimum of an input and a substantive process, it does not represent a business, and (3) if the integrated set of activities (including its inputs and processes) does not create, or have the ability to create, goods or services to customers, investment income (e.g., dividends or interest) or other revenue, it is not a business. The overall intention is to provide consistency in applying the guidance and make the definition of a business more operable. This update is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years and should be applied prospectively. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash to provide guidance on the presentation of restricted cash or restricted cash equivalents in the statement of cash flows to reduce diversity in practice. The amendment requires that a statement of cash flow explain the change during the period in the total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash or restricted cash equivalents should be included in cash and cash equivalents when reconciling the beginning and end of period total amounts shown on the statement of cash flow. This amendment is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years and should be applied retrospectively to each period presented. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts to address diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments provide guidance on specific cash flow issues, including: debt prepayment or debt extinguishment costs, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of Corporate-Owned Life Insurance Policies, including Bank-Owned Life Insurance Policies, and distributions received from equity method investees. The amendments are effective for public business entities for fiscal years beginning after December 31, 2017, and interim periods within those fiscal years. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This amendment supersedes the guidance to classify equity securities with readily determinable fair values into different categories, requires equity securities to be measured at fair value with changes in the fair value recognized through net income, and simplifies the impairment assessment of equity investments without readily determinable fair values. The amendment also requires public business entities that are required to disclose the fair value of financial instruments measured at amortized cost on the balance sheet to measure that fair value using the exit price notion. The amendment requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or in the accompanying notes to the financial statements. This amendment is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Entities are required to apply the amendment by means of a cumulative-effect adjustment as of the beginning of the fiscal year of adoption, with the exception of the amendment related to equity securities without readily determinable fair values, which should be applied prospectively to equity investments that exist as of the date of adoption. The Company adopted the updated guidance effective January 1, 2018 with no material impact on its consolidated financial statements.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), with several subsequent updates. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Topic 606 provides a five-step model to apply to revenue recognition, consisting of the following: (1) identify the contract; (2) identify the performance obligation in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations; and (5) recognize revenue when or as the performance obligation is satisfied. The guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The Company adopted the updated guidance using the modified retrospective approach effective January 1, 2018, with no material impact on its consolidated financial statements.
Recently Issued Not Yet Effective Accounting Standards
In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842).” The update will require lessees to recognize right-of-use assets and lease liabilities for all leases not considered short term leases. The provisions of the update also include (a) defining direct costs to only include those incremental costs that would not have been incurred if the lease had not been entered into, (b) circumstances under which the transfer contract in a sale-leaseback transaction should be accounted for as the sale of an asset by the seller-lessee and the purchase of an asset by the buyer-lessor, and (c) additional disclosure requirements. The provisions of this update become effective for interim and annual periods beginning after December 15, 2018. The Company’s assets and liabilities will increase based on the present value of the remaining leases in place at the adoption date; however, this is not expected to be material to the Company’s consolidated financial statements.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts and requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as, the credit quality and underwriting standards of an organization’s portfolio. In addition, ASU 2016-13 amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 will become effective for interim and annual periods beginning after December 15, 2019. Management is currently evaluating the potential impact of this update, although the general expectation in the banking industry is that the implementation of this standard will result in higher required balances in the ALL.
In March 2017, the FASB issued ASU 2017-08, “Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities.” The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount, which continue to be amortized to maturity. Public business entities must prospectively apply the amendments in this ASU to annual periods beginning after December 15, 2018, including interim periods. The adoption of this update will not have a material impact on the Company’s consolidated financial statements.
NOTE 2 – ACQUISITIONS
On October 27, 2017, the Company completed a merger with Waupaca Bancorporation, Inc. (“Waupaca”), a bank holding company headquartered in Waupaca, Wisconsin, pursuant to the Agreement and Plan of Bank Merger, dated as of May 11, 2017 and as amended on July 20, 2017, by and among the Company, BFNC Merger Sub, LLC, a wholly-owned subsidiary of the Company, and Waupaca, whereby Waupaca merged with and into the Company, and First National Bank, Waupaca’s wholly-owned banking subsidiary, was merged with and into the Bank. Waupaca’s principal activity was the ownership and operation of First National Bank, a national banking institution that operated eight (8) branches in Wisconsin at the time of closing. The merger consideration totaled approximately $78,060,000, 70% of which was distributed in cash and 30% of which was distributed in the form of Company common stock.
For more information concerning this acquisition, see “Note 2 – Acquisition” in the Company’s audited consolidated financial statements included in the Company’s Registration Statement.
NOTE 3 – EARNINGS PER SHARE
Basic earnings per share are computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share are computed by dividing net income by the sum of the weighted average number of shares of common stock outstanding and potential common shares using the treasury stock method. There were no potential common shares during the periods presented.
A reconciliation of the numerators and denominators of the earnings per common share, which equals earnings per common share assuming dilution, for the three and nine months ended September 30, 2018 and 2017, are presented below:
NOTE 4 – SECURITIES
The Company’s securities available for sale as of September 30, 2018 and December 31, 2017 is summarized as follows:
The Company’s securities held to maturity as of September 30, 2018 and December 31, 2017 is summarized as follows:
The following table shows the fair value and gross unrealized losses of securities with unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
As of September 30, 2018, the Company does not consider its securities with unrealized losses to be other-than-temporarily impaired, as the unrealized losses in each category have occurred as a result of changes in interest rates, market spreads and market conditions subsequent to purchase, not credit deterioration. The Company has the intent and ability to hold its securities to maturity. There were no other-than-temporary impairments charged to earnings during the nine months ended September 30, 2018 or 2017.
The following is a summary of amortized cost and estimated fair value of securities by contractual maturity as of September 30, 2018. Contractual maturities will differ from expected maturities for mortgage-backed securities because borrowers may have the right to call or prepay obligations without penalties.
The following is a summary of the proceeds from sales of securities available for sale, as well as gross gains and losses for the nine months ended September 30, 2018 and 2017:
NOTE 5 – LOANS, ALL AND CREDIT QUALITY
The following table presents total loans by portfolio segment and class of loan as of September 30, 2018 and December 31, 2017:
The ALL by loan type as of September 30, 2018 and December 31, 2017 is summarized as follows:
The Company’s past due loans as of September 30, 2018 is summarized as follows:
The Company’s past due loans as of December 31, 2017 is summarized as follows:
We utilize a numerical risk rating system for commercial relationships. All other types of relationships (ex: residential, consumer, other) are assigned a “Pass” rating, unless they have fallen 90 days past due or more, at which time they receive a rating of 7. The Company uses split ratings for government guaranties on loans. The portion of a loan that is supported by a government guaranty is included with other Pass credits.
The determination of a commercial loan risk rating begins with completion of a matrix, which assigns scores based on the strength of the borrower’s debt service coverage, collateral coverage, balance sheet leverage, industry outlook, and customer concentration. A weighted average is taken of these individual scores to arrive at the overall rating. This rating is subject to adjustment by the loan officer based on facts and circumstances pertaining to the borrower. Risk ratings are subject to independent review.
Commercial borrowers with ratings between 1 and 5 are considered Pass credits, with 1 being most acceptable and 5 being just above the minimum level of acceptance.
Commercial borrowers rated 6 have potential weaknesses which may jeopardize repayment ability.
Borrowers rated 7 have a well-defined weakness or weaknesses such as the inability to demonstrate significant cash flow for debt service based on analysis of the company’s financial information. These loans remain on accrual status provided full collection of principal and interest is reasonably expected. Otherwise they are deemed impaired and placed on nonaccrual status. Borrowers rated 8 are the same as 7 rated credits with one exception: collection or liquidation in full is not probable.
The breakdown of loans by risk rating as of September 30, 2018 is as follows:
The breakdown of loans by risk rating as of December 31, 2017 is as follows:
The ALL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALL requires the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on the consolidated balance sheets. Loan losses are charged off against the ALL, while recoveries of amounts previously charged off are credited to the ALL. A provision for loan losses (PFLL) is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.
The ALL consists of specific reserves for certain individually evaluated impaired loans and general reserves for collectively evaluated non-impaired loans. Specific reserves reflect estimated losses on impaired loans from management’s analyses developed through specific credit allocations. The specific reserves are based on regular analyses of impaired, non-homogenous loans greater than $250,000. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based in part on the Bank’s historical loss experience which is updated quarterly. The general reserve portion of the ALL also includes consideration of certain qualitative factors such as 1) changes in lending policies and/or underwriting practices, 2) national and local economic conditions, 3) changes in portfolio volume and nature, 4) experience, ability and depth of lending management and other relevant staff, 5) levels of and trends in past-due and nonaccrual loans and quality, 6) changes in loan review and oversight, 7) impact and effects of concentrations and 8) other issues deemed relevant.
There are many factors affecting ALL; some are quantitative while others require qualitative judgment. The process for determining the ALL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses could be required that could adversely affect the Company’s earnings or financial position in future periods. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized. As an integral part of their examination process, various regulatory agencies review the ALL as well. Such agencies may require that changes in the ALL be recognized when such regulators’ credit evaluations differ from those of management based on information available to the regulators at the time of their examinations.
A summary of impaired loans individually evaluated as of September 30, 2018 is as follows:
A summary of impaired loans individually evaluated as of December 31, 2017 is as follows:
The following table presents loans acquired with deteriorated credit quality as of September 30, 2018 and December 31, 2017. No loans in this table had a related allowance at either date, and therefore, the below disclosures were not expanded to include loans with and without a related allowance.
Due to the nature of these loan relationships, prepayment expectations have not been considered in the determination of future cash flows. Management regularly monitors these loan relationships, and if information becomes available that indicates expected cash flows will differ from initial expectations, it may necessitate reclassification between accretable and non-accretable components of the original discount calculation.
The following table represents the change in the accretable and non-accretable components of discounts on loans acquired with deteriorated credit quality for the period ended September 30, 2018:
A troubled debt restructuring (TDR) includes a loan modification where a borrower is experiencing financial difficulty and we grant a concession to that borrower that we would not otherwise consider except for the borrower’s financial difficulties. A TDR may be either on accrual or nonaccrual status based upon the performance of the borrower and management’s assessment of collectability. If a TDR is placed on nonaccrual status, it remains there until a sufficient period of performance under the restructured terms has occurred at which time it is returned to accrual status, generally six months. The Company did not have any specific reserves for TDR’s as of September 30, 2018 or December 31, 2017, and none of them have subsequently defaulted.
NOTE 6 – MORTGAGE SERVICING RIGHTS
Loans serviced for others are not included in the accompanying consolidated balance sheets. Mortgage servicing rights (MSRs) are recognized as separate assets when loans sold in the secondary market are sold with servicing retained. The Company utilizes a third-party consulting firm to determine an accurate assessment of the mortgage servicing rights fair value. The third-party firm collects relevant data points from numerous sources. Some of these data points relate directly to the pricing level or relative value of the mortgage servicing while other data points relate to the assumptions used to derive fair value. In addition, the valuation evaluates specific collateral types, and current and historical performance of the collateral in question. The valuation process focuses on the non-distressed secondary servicing market, common industry practices and current regulatory standards. The primary determinants of the fair value of mortgage servicing rights are servicing fee percentage, ancillary income, expected loan life or prepayment speeds, discount rates, costs to service, delinquency rates, foreclosure losses and recourse obligations. The valuation data also contains interest rate shock analyses for monitoring fair value changes in differing interest rate environments.
Following is an analysis of activity in the mortgage servicing rights asset:
The primary economic assumptions utilized by the Company in measuring the value of MSRs were constant prepayment speeds of 8.6 and 9.5 months as of September 30, 2018 and December 31, 2017, respectively, and discount rates of 10% as of both period ends.
NOTE 7 – NOTES PAYABLE
From time to time the Company utilizes short-term Federal Home Loan Bank (FHLB) advances to fund liquidity. As of September 30, 2018, outstanding balances in overnight borrowings from the FHLB totaled $46 million. There were no advances outstanding from the FHLB as of December 31, 2017.
The Company maintains a $5 million line of credit with a commercial bank. At September 30, 2018 and December 31, 2017, the Company had outstanding balances on this note of $2 million and $5 million, respectively. The note requires monthly payments of interest at a variable rate, and is due in full on May 25, 2019.
The Company maintains a $5 million line of credit with another commercial bank. There were no outstanding balances on this note at September 30, 2018 or December 31, 2017.
During September 2017 the Company entered into a term-loan agreement with a commercial bank under which it borrowed $3.5 million which was outstanding as of December 31, 2017. The borrowings bore interest at a variable rate. This note was paid in full during July, 2018.
NOTE 8 – SUBORDINATED NOTES
During September 2017, the Company entered into subordinated note agreements with three separate commercial banks. The Company borrowed $11.5 million under these agreements as of September 30, 2018 and December 31, 2017. These notes were all issued with 10-year maturities, carry interest at a variable rate payable quarterly, are callable on or after the sixth anniversary of the issuance dates, and qualify for Tier 2 capital for regulatory purposes.
NOTE 9 – REGULATORY MATTERS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
Under regulatory guidance for non-advanced approaches institutions, the Bank is required to maintain minimum amounts and ratios of common equity Tier I capital to risk-weighted assets. Additionally, under Basel III rules, the decision was made to opt-out of including accumulated other comprehensive income in regulatory capital. As of September 30, 2018 and December 31, 2017, the Bank and Company met all capital adequacy requirements to which they are subject.
Beginning in 2016, an additional conservation buffer was added to the minimum requirements for capital adequacy purposes, subject to a three year phase-in period. As of September 30, 2018 and December 31, 2017, the buffer was 1.88% and 1.25%, respectively. The capital conservative buffer will be fully phased in January 1, 2019 at 2.50%.
Actual and required capital amounts and ratios are presented below at period-end:
NOTE 10 – COMMITMENTS
The Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate-lock commitments). Rate-lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Accordingly, such commitments, along with any related fees received from potential borrowers, are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of mortgage loans. Fair value is based on fees currently charged to enter into similar agreements and for fixed rate commitments also considers the difference between current levels of interest rates and committed rates. The notional amount of rate-lock commitments at September 30, 2018 and December 31, 2017, respectively, was $7,031,000 and $3,186,000.
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.
The Company’s exposure to credit loss is represented by the contractual or notional amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance-sheet instruments. Since some of the commitments are expected to expire without being drawn upon and some of the commitments may not be drawn upon to the total extent of the commitment, the notional amount of these commitments does not necessarily represent future cash requirements.
The following commitments were outstanding:
NOTE 11 – FAIR VALUE MEASUREMENTS
Accounting guidance establishes a fair value hierarchy to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.
Information regarding the fair value of assets measured at fair value on a recurring basis is as follows:
Fair value of assets measured on a recurring basis using significant unobservable inputs (Level 3) are as follows:
Information regarding the fair value of assets measured at fair value on a non-recurring basis is as follows:
The following is a description of the valuation methodologies used by the Company for the items noted in the table above, including the general classification of such instruments in the fair value hierarchy. For individually evaluated impaired loans, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate, the estimated fair value of the underlying collateral for collateral-dependent loans, or the estimated liquidity of the note. For OREO, the fair value is based upon the estimated fair value of the underlying collateral adjusted for the expected costs to sell. The following table shows significant unobservable inputs used in the fair value measurement of Level 3 assets:
The following methods and assumptions were used by the Company to estimate fair value of financial instruments.
Cash and cash equivalents — Fair value approximates the carrying amount.
Securities — The fair value measurement is obtained from an independent pricing service and is based on recent sales of similar securities and other observable market data.
Loans held for sale — Fair value is based on commitments on hand from investors or prevailing market prices.
Loans — Fair value of variable rate loans that reprice frequently are based on carrying value. Fair value of other loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings. Fair value of impaired and other nonperforming loans are estimated using discounted expected future cash flows or the fair value of the underlying collateral, if applicable.
Other investments — The carrying amount reported in the consolidated balance sheets for other investments approximates the fair value of these assets.
Mortgage servicing rights — Fair values were determined using the present value of future cash flows.
Cash value of life insurance — The carrying amount approximates its fair value.
Deposits — Fair value of deposits with no stated maturity, such as demand deposits, savings, and money market accounts, by definition, is the amount payable on demand on the reporting date. Fair value of fixed-rate time deposits is estimated using discounted cash flows applying interest rates currently offered on similar time deposits.
Securities sold under repurchase agreements — The fair value of securities sold under repurchase agreements with variable rates or due on demand is the amount payable at the reporting date. The fair value of securities sold under repurchase agreements with fixed terms is estimated using discounted cash flows with discount rates at interest rates currently offered for securities sold under repurchase agreements of similar remaining values.
Notes payable and Subordinated notes — Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. Fair value of borrowings is estimated by discounting future cash flows using the current rates at which similar borrowings would be made. Fair value of borrowed funds due on demand is the amount payable at the reporting date.
Off-balance-sheet instruments — Fair value is based on quoted market prices of similar financial instruments where available. If a quoted market price is not available, fair value is based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the company’s credit standing. Since this amount is immaterial, no amounts for fair value are presented.
The carrying value and estimated fair value of financial instruments at September 30, 2018 and December 31, 2017 follows:
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Consequently, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.
Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters that could affect the estimates. Fair value estimates are based on existing on- and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.
Deposits with no stated maturities are defined as having a fair value equivalent to the amount payable on demand. This prohibits adjusting fair value derived from retaining those deposits for an expected future period of time. This component, commonly referred to as a deposit base intangible, is neither considered in the above amounts nor is it recorded as an intangible asset on the consolidated balance sheet. Significant assets and liabilities that are not considered financial assets and liabilities include premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
NOTE 12 – STOCK-BASED COMPENSATION
The Company has made restricted share grants pursuant to the Bank First National Corporation 2011 Equity Plan (Plan). The purpose of the Plan is to provide financial incentives for selected employees and for the non-employee Directors of the Company, thereby promoting the long-term growth and financial success of the Company. The Company stock to be offered under the Plan pursuant to Stock Appreciation Rights (SAR), performance unit awards, and restricted stock and unrestricted Company stock awards must be Company stock previously issued and outstanding and reacquired by the Company. The number of shares of Company stock that may be issued pursuant to awards under the Plan shall not exceed, in the aggregate, 659,250. As of September 30, 2018 and December 31, 2017, 160,362 and 142,465 shares of Company stock have been awarded under the Plan, respectively. Compensation expense for restricted stock is based on the fair value of the awards of Bank First National Corporation common stock at the time of grant. The value of restricted stock grants that are expected to vest is amortized into expense over the vesting periods. For the nine months ended September 30, 2018 and 2017, compensation expense of $410,000 and $338,000, respectively, was recognized related to restricted stock awards.
As of September 30, 2018, there was $1,461,000 of unrecognized compensation cost related to non-vested restricted stock awards granted under the plan. That cost is expected to be recognized over a weighted average period of 2.75 years. The aggregate grant date fair value of restricted stock awards that vested during the nine months ended September 30, 2018, was approximately $483,000.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2017 set forth in our Registration Statement on Form 10 Amendment No. 1 (Registration No. 001-38676) and filed with the SEC on October 17, 2018 (the “Registration Statement”) and with our unaudited condensed accompanying notes set forth in this Quarterly Report on Form 10-Q for the quarterly period September 30, 2018.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this report are forward-looking statements within the meaning of and subject to the safe harbor protections of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, statements relating to the Company’s assets, business, cash flows, condition (financial or otherwise), credit quality, financial performance, liquidity, short and long-term performance goals, prospects, results of operations, strategic initiatives, potential future acquisitions, disposition and other growth opportunities. These statements, which are based upon certain assumptions and estimates and describe the Company’s future plans, results, strategies and expectations, can generally be identified by the use of the words and phrases “may,” “will,” “should,” “could,” “would,” “goal,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target,” “aim,” “predict,” “continue,” “seek,” “projection” and other variations of such words and phrases and similar expressions. These forward-looking statements are not historical facts, and are based upon current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond the Company’s control. The inclusion of these forward-looking statements should not be regarded as a representation by the Company or any other person that such expectations, estimates and projections will be achieved. Accordingly, the Company cautions investors that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict and that are beyond the Company’s control. Although the Company believes that the expectations reflected in these forward-looking statements are reasonable as of the date of this report, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements. A number of factors could cause actual results to differ materially from those contemplated by the forward-looking statement in this report including, without limitation, the risks and other factors set forth in the Company’s Registration Statements under the captions “Cautionary Note Regarding Forward-Looking Statements” and “Risk factors.” Many of these factors are beyond the Company’s ability to control or predict. If one or more events related to these or other risks or uncertainties materialize, or if the Company’s underlying assumptions prove to be incorrect, actual results may differ materially from the forward-looking statements. Accordingly, investors should not place undue reliance on any such forward-looking statements. Any forward-looking statements speaks only as of the date of this report, and the Company does not undertake any obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by law. New risks and uncertainties may emerge from time to time, and it is not possible for the Company to predict their occurrence or how they will affect the Company.
We qualify all of our forward-looking statements by these cautionary statements.
CRITICAL ACCOUNTING POLICIES
Our financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and general practices within the banking industry. Within our financial statements, certain financial information contains approximate measurements of financial effects of transactions and impacts at the consolidated balance sheet dates and our results of operations for the reporting periods. As certain accounting policies require significant estimates and assumptions that have a material impact on the carrying value of assets and liabilities, we have established critical accounting policies to facilitate making the judgments necessary to prepare our financial statements. Our critical accounting policies are described in our previously filed Registration Statement
OVERVIEW
Bank First National Corporation is a Wisconsin corporation that was organized primarily to serve as the holding company for Bank First, N.A. Bank First, N.A., which was incorporated in 1894, is a nationally-chartered bank headquartered in Manitowoc, Wisconsin. It is a member of the Board of Governors of the Federal Reserve System (“Federal Reserve”), and is regulated by the Office of the Comptroller of the Currency (“OCC”). Including its headquarters in Manitowoc, Wisconsin, the Bank has 18 banking locations in Manitowoc, Outagamie, Brown, Winnebago, Sheboygan, Waupaca and Barron counties in Wisconsin. The Bank offers loan, deposit and treasury management products at each of its banking locations.
As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interest-bearing and noninterest-bearing. In order to maximize the Bank’s net interest income, or the difference between the income on interest-earning assets and the expense of interest-bearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an ALL to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section.
The Bank is a 49.8% member of a data processing subsidiary, UFS, LLC which provides core data processing, endpoint management cloud services, cyber security and digital banking solutions for over 50 Midwest banks. The Bank, through its 100% owned subsidiary TVG Holdings, Inc., also holds a 30% ownership interest in Ansay & Associates, LLC, an insurance agency providing clients throughout the Midwest with insurance and risk management solutions. These unconsolidated subsidiary interests contribute noninterest income to the Bank through their underlying annual earnings.
On October 27, 2017, the Company consummated its merger with Waupaca pursuant to the Agreement and Plan of Bank Merger, dated as of May 11, 2017 and as amended on July 20, 2017, by and among the Company, BFNC Merger Sub, LLC, a wholly-owned subsidiary of the Company, and Waupaca, whereby Waupaca was merged with and into the Company, and First National Bank, Waupaca’s wholly owned banking subsidiary, was merged with and into the Bank. The system integration was completed, and six branches of First National Bank opened on October 30, 2017 as branches of the Bank, expanding the Bank’s presence into Barron and Waupaca counties.
SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA
The following tables present certain selected historical consolidated financial data as of the dates or for the period indicated:
GAAP RECONCILIATION AND MANAGEMENT EXPLANATION OF NON-GAAP FINANCIAL MEASURES
We identify certain financial measures discussed in the Report as being “non-GAAP financial measures.” The non-GAAP financial measures presented in this Report are tangible book value per common share and tangible equity to tangible assets.
In accordance with the SEC’s rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP as in effect from time to time in the United States in our statements of income, balance sheets or statements of cash flows.
The non-GAAP financial measures that we discuss in this Report should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate the non-GAAP financial measures that we discuss in our selected historical consolidated financial data may differ from that of other companies reporting measures with similar names. You should understand how such other banking organizations calculate their financial measures similar or with names similar to the non-GAAP financial measures we have presented in our selected historical consolidated financial data when comparing such non-GAAP financial measures. The following discussion and reconciliations provide a more detailed analysis of these non-GAAP financial measures.
Tangible book value per common share and tangible equity to tangible assets are non-GAAP measures that exclude the impact of goodwill and other intangibles used by the Company’s management to evaluate capital adequacy. Because intangible assets such as goodwill and other intangibles vary extensively from company to company, we believe that the presentation of this information allows investors to more easily compare the Company’s capital position to other companies. The most directly comparable financial measures calculated in accordance with GAAP are book value per common share, return on average common equity and stockholders’ equity to total assets.
The following table presents, as of the dates set forth below, reconciliations of our tangible common equity to our total stockholders’ equity, our tangible assets to total assets, our tangible book value per share to our book value per share, and our tangible common equity to tangible assets to our stockholders’ equity to total assets:
PUBLIC COMPANY COSTS
On September 24, 2018, the Company filed a Registration Statement on Form 10 with the SEC, and filed the Amendment No.1 to the Registration Statement on Form 10 on October 17, 2018. That Registration Statement was declared effective by the SEC on October 23, 2018. The Company qualifies as an “emerging growth company” as defined by the Jumpstart Our Business Startups Act (JOBS Act).
There are additional costs associated with operating as a public company including hiring additional personnel, enhancing technology and expanding our capabilities. We expect that these costs will include legal, regulatory, accounting, investor relations and other expenses that we did not incur as a private company. Sarbanes-Oxley, as well as rules adopted by the U.S. Securities and Exchange Commission, or SEC, the Federal Deposit Insurance Corporation (FDIC) and national securities exchanges also requires public companies to implement specified corporate governance practices. In addition, due to regulatory changes in the banking industry and the implementation of new laws, rules and regulations, we are now subject to higher regulatory compliance costs. These additional rules and regulations also increase our legal, regulatory, accounting and financial compliance costs and make some activities more time-consuming.
RESULTS OF OPERATIONS
Results of Operations for the Three Months Ended September 30, 2018 and September 30, 2017
General. Net income increased $2.1 million to $5.9 million for three months ended September 30, 2018, compared to $3.8 million for the same period in 2017. This increase was primarily due to the increased scale of the Bank’s operations as a result of the Waupaca acquisition during the fourth quarter of 2017 as well as the lower corporate tax rates enacted by the Tax Cuts and Jobs Act. The results of operations for the three months ended September 30, 2018 are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2018.
Net Interest Income. Net interest and dividend income increased by $4.9 million to $15.5 million for the three months ended September 30, 2018, compared to $10.6 million for three months ended September 30, 2017. The increase in net interest income was primarily due to the increased scale of the Bank’s loan portfolio as a result of the Waupaca acquisition during the fourth quarter of 2017, and to a lesser extent the result of an increasing interest rate environment. Interest income on loans increased by $6.6 million, or 57.7%, during the same period. Total average interest-earning assets increased to $1.7 billion for the three months ended September 30, 2018, up from $1.3 billion for the same period in 2017. Our tax equivalent net interest margin increased 46 basis points to 3.81% for the three-months ended September 30, 2018, up from 3.35% for the same period in 2017. Net interest margin and net interest income are influenced by internal and external factors. Internal factors include balance sheet changes on both volume and mix and pricing decisions, and external factors include changes in market interest rates, competition and the shape of the interest rate yield curve.
Interest Income. Total interest income increased $6.9 million, or 54.5%, to $19.5 million for the three months ended September 30, 2018 compared to $12.6 million for the same period in 2017. The increase in total interest income was primarily due to the increased scale of the Bank’s loan portfolio as a result of the Waupaca acquisition during the fourth quarter of 2017, and to a lesser extent the result of an increasing interest rate environment. The average balance of loans increased by $352.0 million during the three months ended September 30, 2018 compared to the same period in 2017.
Interest Expense. Interest expense increased $2.0 million, or 98.9%, to $4.0 million for the three months ended September 30, 2018 compared to $2.0 million for the same period in 2017. The increase in net interest expense was due in part to the increased scale of the Bank’s core deposit base as a result of the acquisition of Waupaca during the fourth quarter of 2017 as well as the result of an increasing interest rate environment.
Interest expense on interest-bearing deposits increased by $1.7 million to $3.4 million for the three months ended September 30, 2018, from $1.7 million for the same period in 2017. This increase was primarily due to the increased scale of the Bank’s deposit portfolio as a result of the Waupaca acquisition during the fourth quarter of 2017, as well as the result of an increasing interest rate environment. The average cost of interest-bearing deposits was 1.23% for the three months ended September 30, 2018, compared to 0.82% for the same period in 2017.
Provision for Loan Losses. Credit risk is inherent in the business of making loans. We establish an ALL through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of our ALL and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in our market area. The determination of the amount is complex and involves a high degree of judgment and subjectivity.
We recorded a provision for loan losses of $0.8 million for the three months ended September 30, 2018, compared to $0.3 million for the same period in 2017. We recorded net charge-offs of $2.3 million for the three months ended September 30, 2018, compared to net charge offs of $76,000 for the same period in 2017. The ALL was $11.6 million, or 0.80% of total loans, at September 30, 2018 compared to $11.2 million, or 1.02% of total loans at September 30, 2017. The increase in provision for loan losses was due primarily to establishing an ALL on loans that were a part of the Waupaca acquisition and were initially recorded at fair value under purchase accounting rules which were renewing during the eleven months since that transaction. The reduction in the ALL to total loans ratio was a result of loans acquired from Waupaca being recorded at fair value at the time of acquisition, with no related allowance recorded.
Noninterest Income. Noninterest income is an important component of our total revenues. A significant portion of our noninterest income is associated with service charges and income from the Bank’s subsidiaries, Ansay & Associates, LLC and UFS, LLC. Other sources of noninterest income include loan servicing fees, gains on sales of mortgage loans, and other income from strategic alliances.
Noninterest income increased $0.3 million to $2.5 million for the three months ended September 30, 2018 compared to $2.2 million for the same period in 2017. The primary reason for the increase in noninterest income was stronger fees from service charges during 2018 as a result of the Bank’s added scale from the acquisition of Waupaca during the fourth quarter of 2017. Secondarily, other noninterest income increased due to rent received on three OREO properties which were acquired as part of that same transaction. These increases were partially offset by reduced gains on sales of mortgage loans as we experienced a slowdown in mortgage originations during 2018. The major components of our noninterest income are listed below:
Noninterest Expense. Noninterest expense increased $2.7 million to $9.7 million for the three months ended September 30, 2018 compared to $7.0 million for the same period in 2017. The significant increase in noninterest expense was nearly entirely attributable to the added scale as a result of the Bank’s acquisition of Waupaca during the fourth quarter of 2017. Salaries, commissions and employee benefits expense for the three months ended September 30, 2018 was $5.2 million compared to $3.6 million for the three months ended September 30, 2017, an increase of $1.6 million, or 45.5%. This increase was attributable to an increase in the overall number of employees due to the Waupaca acquisition and also to support our continued growth, annual salary adjustments, increased bonus and incentives and increased benefit costs. Data processing expense also increased due to the added scale as a result of the Waupaca acquisition. Net losses from sales and valuations of OREO increased in the three months ended September 30, 2018 compared to the same period in 2017 due to the higher level of OREO which was a part of our acquisition of Waupaca in the fourth quarter of 2017. The increase in amortization of intangibles from the three months ended September 30, 2017 to the same period in 2018 is the result of amortization of the core deposit intangible which resulted from the same acquisition of Waupaca. The category of other expense contains all other noninterest expenses which occur from operating the Bank. Significant increases from the third quarter of 2017 to the same period in 2018 occurred in the areas of costs related to foreclosure and maintenance on OREO, collection activities on loans which have deteriorated credit quality, and the costs of added scale of six branches acquired in the Waupaca transaction.
The major components of our noninterest expense are listed below:
Income Tax Expense. We recorded a provision for income taxes of $1.6 million for the three months ended September 30, 2018 compared to a provision of $1.8 million for the same period during 2017, reflecting effective tax rates of 21.3% and 32.2%, respectively. The effective tax rates were reduced from the statutory federal and state income tax rates largely as a result of tax-exempt interest income produced by certain qualifying loans and investments in the Bank’s portfolios. The effective tax rate for the three months ended September 30, 2018 as compared to the effective tax rate for the three months ended September 30, 2017 was reduced primarily as a result of lower corporate tax rates which were enacted by the Tax Cuts and Jobs Act.
Results of Operations for the Nine Months Ended September 30, 2018 and September 30, 2017
General. Net income increased $7.4 million, or 61.2% to $19.4 million for the nine months ended September 30, 2018, from $12.0 million for the nine months ended September 30, 2017. This increase was primarily due to the increased scale of the Bank’s operations as a result of the Waupaca acquisition during the fourth quarter of 2017 as well as the lower corporate tax rates enacted by the Tax Cuts and Jobs Act.
Net Interest Income. Net interest income increased by $17.0 million to $47.6 million for the nine months ended September 30, 2018, from $30.6 million for the same period in 2017. The increase in net interest income was due to loan growth primarily from the acquisition of loans from Waupaca. Interest income on loans increased by $20.9 million, or 63.9%, for the first nine months of 2018 compared to the first nine months of 2017. Total average interest-earning assets increased to $1.7 billion for the nine months ended September 30, 2018 from $1.3 billion for the same period in 2017. The Bank’s net interest margin increased 62 basis points to 3.90% for the nine months ended September 30, 2018, up from 3.28% for the same period in 2017.
Interest Income. Total interest income increased $22.2 million, or 61.5%, to $58.2 million for the nine months ended September 30, 2018, up from $36.0 million for the same period in 2017. As noted above, the increase was primarily due to loan growth from the acquisition of Waupaca. The average balance of loans increased by $361.1 million during the first nine months of 2018 compared to the same period in 2017.
Interest Expense. Interest expense increased $5.2 million, or 95.2%, to $10.6 million for the nine months ended September 30, 2018, up from $5.4 million for the nine months ended September 30, 2017. The increase was driven by a $272.6 million increase in the average balance of interest-bearing liabilities as well as an increase in the average cost of interest bearing liabilities, rising 40 basis points from 0.78% to 1.18%. Interest expense from sweep repurchase agreements and borrowed funds increased by $1.2 million for the first nine months of 2018 compared to the same period in the prior year, primarily impacted by the borrowings required to fund the acquisition of Waupaca during the fourth quarter of 2017. Interest expense on interest-bearing deposits increased by $4.0 million to $8.6 million for the nine months ended September 30, 2018, from $4.6 million for the same period in 2017. This increase was primarily due to a higher interest rate environment along with elevated levels of interest-bearing deposits as a result of the acquisition of Waupaca. The average cost of interest-bearing deposits was 1.07% for the nine months ended September 30, 2018, compared to 0.75% for the same period in 2017. The average cost of certificates of deposits decreased during the first nine months of 2018 as compared to the same period in 2017 due to a significant change in duration mix of the certificates acquired in the Waupaca acquisition, leading to a shorter overall duration of lower bearing deposits. We experienced an increase in the average cost of checking, savings and money market accounts for the nine months ended September 30, 2018 as compared to the same period in 2017 due to a generally higher interest rate environment.
Provision for Loan Losses. We recorded a provision for loan losses of $2.2 million for the nine months ended September 30, 2018, compared to $0.6 million for the first nine months of 2017. The increase in provision for loan losses was due primarily to establishing an ALL on loans that were a part of the Waupaca acquisition and were initially recorded at fair value under purchase accounting rules which were renewing during the eleven months since that transaction.
Noninterest Income. Noninterest income increased $1.0 million to $9.0 million for the nine months ended September 30, 2018 compared to $8.0 million for the same period in 2017. The primary reason for the increase in noninterest income was stronger fees from service charges during 2018 as a result of the Bank’s added scale from the acquisition of Waupaca during the fourth quarter of 2017. Secondarily, other noninterest income increased due to rent received on three OREO properties which were acquired as part of that same transaction. Income from our minority-owned subsidiaries Ansay & Associates, LLC and UFS, LLC also saw increased profitability during the first nine months of 2018 compared to the same period in 2017. These increases were partially offset by reduced gains on sales of mortgage loans as we experienced a slowdown in mortgage originations during 2018. The major components of our noninterest income are listed in the table below:
Noninterest Expense. Noninterest expense increased $9.8 million to $29.8 million for the nine months ended September 30, 2018 compared to $20.0 million for the same period in 2017. The significant increase in noninterest expense was nearly entirely attributable to the added scale as a result of the Bank’s acquisition of Waupaca during the fourth quarter of 2017. Salaries, commissions and employee benefits expense for the nine months ended September 30, 2018 was $16.0 million compared to $10.9 million for the nine months ended September 30, 2017, an increase of $5.1 million, or 46.3%. This increase was attributable to an increase in the overall number of employees due to the Waupaca acquisition and also to support our continued growth, annual salary adjustments, increased bonus and incentives and increased benefit costs. Occupancy and data processing expense also increased due to the added scale as a result of the Waupaca acquisition. Net losses from sales and valuations of OREO increased in the nine months ended September 30, 2018 compared to the same period in 2017 due to the higher level of OREO which was a part of our acquisition of Waupaca in the fourth quarter of 2017. The increase in amortization of intangibles from the nine months ended September 30, 2017 to the same period in 2018 is the result of amortization of the core deposit intangible which resulted from the same acquisition of Waupaca. The category of other expense contains all other noninterest expenses which occur from operating the Bank. Significant increases from the first nine months of 2017 to the same period in 2018 occurred in the areas of costs related to foreclosure and maintenance on OREO, collection activities on loans which have deteriorated credit quality, and the costs of added scale of six branches acquired in the Waupaca transaction. The major components of our noninterest expense are listed in the table below.
Income Tax Expense. We recorded a provision for income taxes of $5.2 million for the nine months ended September 30, 2018, compared to $5.9 million for the same period in 2017, reflecting effective tax rates of 21.25% and 32.98%, respectively. On December 22, 2017, the President of the United States signed the Tax Cuts and Jobs Act, reducing the top tier corporate income tax rate from 35% to 21%. This is the primary reason for the decline in effective tax rates for 2018.
NET INTEREST MARGIN
Net interest income represents the difference between interest earned, primarily on loans and investments, and interest paid on funding sources, primarily deposits and borrowings. Interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate paid on total interest-bearing liabilities. Net interest margin is the amount of net interest income, on a fully taxable-equivalent basis, expressed as a percentage of average interest-earning assets. The average rate earned on earning assets is the amount of annualized taxable equivalent interest income expressed as a percentage of average earning assets. The average rate paid on interest-bearing liabilities is equal to annualized interest expense as a percentage of average interest-bearing liabilities.
The following tables set forth the distribution of our average assets, liabilities and stockholders’ equity, and average rates earned or paid on a fully taxable equivalent basis for each of the periods indicated:
Rate/Volume Analysis
The following tables describe the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volumes (changes in average balance multiplied by prior year average rate) and (ii) changes attributable to changes in rate (change in average interest rate multiplied by prior year average balance), while (iii) changes attributable to the combined impact of volumes and rates have been allocated proportionately to separate volume and rate categories.
Return on equity and assets
The following table sets forth our ROAA, ROAE, dividend payout ratio and average stockholders’ equity to average assets ratio for the periods indicated:
Three months ended
September 30,
Nine months ended
CHANGES IN FINANCIAL CONDITION
Total Assets. Total assets decreased $17.7 million, or 1.0%, to $1.74 billion at September 30, 2018, from $1.75 billion at December 31, 2017.
Cash and Cash Equivalents. Cash and cash equivalents decreased by $66.7 million to $35.3 million at September 30, 2018 from $102.0 million at December 31, 2017.
Investment Securities. The carrying value of total investment securities increased by $1.5 million to $160.5 million at September 30, 2018, from $159.0 million at December 31, 2017.
Loans. Net loans increased by $43.9 million to $1.44 billion at September 30, 2018 from $1.40 billion at December 31, 2017.
Bank-Owned Life Insurance. At September 30, 2018, our investment in bank-owned life insurance was $24.0 million, an increase of $0.3 million from $23.7 million at December 31, 2017.
Deposits. Deposits decreased $20.2 million, or 1.3%, to $1.49 billion at September 30, 2018 from $1.51 billion at December 31, 2017.
Borrowings. At September 30, 2018, borrowings consisted of short-term advances from the FHLB of Chicago, as well as notes payable and subordinated debt to other banks. Total FHLB borrowing increased to $46.0 million at September 30, 2018 from no FHLB borrowings at December 31, 2017. Notes payable decreased $6.5 million to $2.0 million at September 30, 2018 from $8.5 million at December 31, 2017. Subordinated debt remained at $11.5 million at September 30, 2018, the same balance as at December 31, 2017.
Stockholders’ Equity. Total stockholders’ equity increased $7.4 million, or 4.6%, to $169.1 million at September 30, 2018, from $161.7 million at December 31, 2017.
LOANS
Our lending activities are conducted principally in Northeastern Wisconsin. The Bank makes commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and a variety of consumer loans and other loans. Much of the loans made by the Bank are secured by real estate collateral. The Bank’s commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower, with liquidation of the underlying real estate collateral typically being viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are also often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment. Repayment of the Bank’s residential loans are generally dependent on the health of the employment market in the borrowers’ geographic areas and that of the general economy with liquidation of the underlying real estate collateral being typically viewed as the primary source of repayment in the event of borrower default.
Our loan portfolio is our most significant earning asset, comprising 83.1% and 79.7% of our total assets as of September 30, 2018 and December 31, 2017, respectively. Our strategy is to grow our loan portfolio by originating quality commercial and consumer loans that comply with our credit policies and that produce revenues consistent with our financial objectives. We believe our loan portfolio is well-balanced, which provides us with the opportunity to grow while monitoring our loan concentrations.
Loans increased $43.9 million, or 3.1%, to $1.44 billion as of September 30, 2018 as compared to $1.40 billion as of December 31, 2017. Our loan growth during the nine months ended September 30, 2018 compared to the year ended December 31, 2017 has been comprised of an increase of $50.6 million or 19.2% in commercial and industrial loans, an increase of $10.0 million or 1.5% in commercial real estate loans, a decrease of $7.8 million or 10.3% in construction and development loans, a decrease of $13.0 million or 3.4% in residential 1-4 family loans and an increase of $4.2 million or 11.3% in consumer and other loans. The increase in loans during the nine months ended September 30, 2018 is attributable to modest organic loan growth, which was offset by a planned reduction of a portion of the loan portfolio acquired from Waupaca. The reduction of a portion of the loan portfolio acquired from Waupaca focused on out of market loans as well as loans of poor asset quality. This reduction occurred without incurring significant losses.
The following table presents the balance and associated percentage of each major category in our loan portfolio at September 30, 2018, December 31, 2017, and September 30, 2017:
Our directors and officers and their associates are customers of, and have other transactions with, the Bank in the normal course of business. All loans and commitments included in such transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risk of collection or present other unfavorable features. At September 30, 2018 and December 31, 2017, total loans outstanding to such directors and officers and their associates were $81.0 million and $65.7 million, respectively. During the nine months ended September 30, 2018, $50.0 million of additions and $34.7 million of repayments were made to these loans. At September 30, 2018 and December 31, 2017, all of the loans to directors and officers were performing according to their original terms.
Loan categories
The principal categories of our loan portfolio are discussed below:
Commercial and Industrial (C&I). Our C&I portfolio totaled $314.1 million and $263.5 million at September 30, 2018 and December 31, 2017, respectively, and represented 22% and 19% of our total loans at those dates.
Our C&I loan customers represent various small and middle-market established businesses involved in professional services, accommodation and food services, health care, financial services, wholesale trade, manufacturing, distribution, retailing and non-profits. Most clients are privately owned with markets that range from local to national in scope. Many of the loans to this segment are secured by liens on corporate assets and the personal guarantees of the principals. The regional economic strength or weakness impacts the relative risks in this loan category. There is little concentration in any one business sector, and loan risks are generally diversified among many borrowers.
Commercial Real Estate (CRE). Our CRE loan portfolio totaled $653.8 million and $643.8 million at September 30, 2018 and December 31, 2017, respectively, and represented 45% and 46% of our total loans at those dates.
Our CRE loans are secured by a variety of property types including multifamily dwellings, retail facilities, office buildings, commercial mixed use, lodging and industrial and warehouse properties. We do not have any specific industry or customer concentrations in our CRE portfolio. Our commercial real estate loans are generally for terms up to ten years, with loan-to-values that generally do not exceed 80%. Amortization schedules are long term and thus a balloon payment is generally due at maturity. Under most circumstances, the Bank will offer to rewrite or otherwise extend the loan at prevailing interest rates.
Construction and Development (C&D). Our C&D loan portfolio totaled $68.0 million and $75.8 million at September 30, 2018 and December 31, 2017, respectively, and represented 5% of our total loans at both of those dates.
Our C&D loans are generally for the purpose of creating value out of real estate through construction and development work, and also include loans used to purchase recreational use land. Borrowers typically provide a copy of a construction or development contract which is subject to bank acceptance prior to loan approval. Disbursements are handled by a title company. Borrowers are required to inject their own equity into the project prior to any note proceeds being disbursed. These loans are, by their nature, intended to be short term and are refinanced into other loan types at the end of the construction and development period.
Residential 1 – 4 Family. Residential 1 – 4 family loans held in portfolio amounted to $364.3 million and $377.3 million at September 30, 2018 and December 31, 2017, respectively, and represented 25% and 27% of our total loans at those dates.
We offer fixed and adjustable-rate residential mortgage loans with maturities up to 30 years. One-to-four family residential mortgage loans are generally underwritten according to Fannie Mae guidelines, and we refer to loans that conform to such guidelines as “conforming loans.” We generally originate both fixed and adjustable-rate mortgage loans in amounts up to the maximum conforming loan limits as established by the Federal Housing Finance Agency, which is generally $424,100 for one-unit properties. In addition, we also offer loans above conforming lending limits typically referred to as “jumbo” loans. These loans are typically underwritten to the same guidelines as conforming loans; however, we may choose to hold a jumbo loan within its portfolio with underwriting criteria that does not exactly match conforming guidelines.
We do not offer reverse mortgages nor do we offer loans that provide for negative amortization of principal, such as “Option ARM” loans, where the borrower can pay less than the interest owed on his loan, resulting in an increased principal balance during the life of the loan. We also do not offer “subprime loans” (loans that are made with low down payments to borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (defined as loans having less than full documentation).
Residential real estate loans are originated both for sale to the secondary market as well as for retention in the Bank’s loan portfolio. The decision to sell a loan to the secondary market or retain within the portfolio is determined based on a variety of factors including but not limited to our asset/liability position, the current interest rate environment, and customer preference. Servicing rights are retained on all loans sold to the secondary market.
We were servicing mortgage loans sold to others without recourse of approximately $313.2 million at September 30, 2018 and $316.3 million at December 31, 2017.
Loans sold with the retention of servicing assets result in the capitalization of servicing rights. Loan servicing rights are included in other assets and are carried at fair value. The net balance of capitalized servicing rights amounted to $3.0 million at September 30, 2018 and $2.6 million at December 31, 2017.
Consumer Loans. Our consumer loan portfolio totaled $34.5 million and $33.6 million at September 30, 2018 and December 31, 2017, respectively, and represented 2% of our total loans at those dates. Consumer loans include secured and unsecured loans, lines of credit and personal installment loans.
Consumer loans generally have greater risk compared to longer-term loans secured by improved, owner-occupied real estate, particularly consumer loans that are secured by rapidly depreciable assets. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan repayments are dependent on the borrower’s continuing financial stability and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.
Other Loans. Our other loans totaled $6.8 million and $3.5 million at September 30, 2018 and December 31, 2017, respectively, and are immaterial to the overall loan portfolio. The other loans category consists primarily of overdrafted depository accounts, loans utilized to purchase or carry securities and loans to nonprofit organizations.
Loan Portfolio Maturities. The following tables summarize the dollar amount of loans maturing in our portfolio based on their loan type and contractual terms to maturity at September 30, 2018 and December 31, 2017, respectively. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less.
The following tables summarize the dollar amount of loans maturing in our portfolio based on whether the loan has a fixed or variable rate of interest and their contractual terms to maturity at September 30, 2018 and December 31, 2017, respectively. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less.
NONPERFORMING LOANS AND TROUBLED DEBT RESTRUCTURINGS
In order to operate with a sound risk profile, we focus on originating loans that we believe to be of high quality. We have established loan approval policies and procedures to assist us in maintaining the overall quality of our loan portfolio. When delinquencies in our loans exist, we rigorously monitor the levels of such delinquencies for any negative or adverse trends. From time to time, we may modify loans to extend the term or make other concessions to help a borrower with a deteriorating financial condition stay current on their loan and to avoid foreclosure. We generally do not forgive principal or interest on loans or modify the interest rates on loans to rates that are below market rates. Furthermore, we are committed to collecting on all of our loans and, as a result, at times have lower net charge-offs compared to many of our peer banks. We believe that our commitment to collecting on all of our loans results in higher loan recoveries.
Our nonperforming assets consist of nonperforming loans and foreclosed real estate. Nonperforming loans are those on which the accrual of interest has stopped, as well as loans that are contractually 90 days past due on which interest continues to accrue. The composition of our nonperforming assets is as follows:
At September 30, 2018 and December 31, 2017, impaired loans had specific reserves of $513,000 and $281,000, respectively.
Our nonperforming assets have increased from September 30, 2017 primarily due to the Waupaca acquisition, which included $19.4 million of loans which were considered nonperforming.
Nonaccrual Loans
Loans are typically placed on nonaccrual status when any payment of principal and/or interest is 90 days or more past due, unless the collateral is sufficient to cover both principal and interest and the loan is in the process of collection. Loans are also placed on nonaccrual status when management believes, after considering economic and business conditions, that the principal or interest will not be collectible in the normal course of business. We monitor closely the performance of our loan portfolio. In addition to the monitoring and review of loan performance internally, we have also contracted with an independent organization to review our commercial and retail loan portfolios. The status of delinquent loans, as well as situations identified as potential problems, is reviewed on a regular basis by senior management.
Troubled Debt Restructurings
A troubled debt restructuring includes a loan modification where a borrower is experiencing financial difficulty and we grant a concession to that borrower that we would not otherwise consider except for the borrower’s financial difficulties. These concessions may include modifications of the terms of the debt such as deferral of payments, extension of maturity, reduction of principal balance, reduction of the stated interest rate other than normal market rate adjustments, or a combination of these concessions. Debt may be bifurcated with separate terms for each tranche of the restructured debt. Restructuring a loan in lieu of aggressively enforcing the collection of the loan may benefit the Company by increasing the ultimate probability of collection.
A TDR may be either on accrual or nonaccrual status based upon the performance of the borrower and management’s assessment of collectability. If a TDR is placed on nonaccrual status, which would occur based on the same criteria as non-TDR loans, it remains there until a sufficient period of performance under the restructured terms has occurred at which it returned to accrual status, generally 6 months.
We did not have any specific reserves for TDR’s as of September 30, 2018 and December 31, 2017, and none of them have subsequently defaulted.
Classified loans
Accounting standards require the Company to identify loans, where full repayment of principal and interest is doubtful, as impaired loans. These standards require that impaired loans be valued at the present value of expected future cash flows, discounted at the loan’s effective interest rate, or using one of the following methods: the observable market price of the loan or the fair value of the underlying collateral if the loan is collateral dependent. We have implemented these standards in our quarterly review of the adequacy of the ALL, and identify and value impaired loans in accordance with guidance on these standards. As part of the review process, we also identify loans classified as watch, which have a potential weakness that deserves management’s close attention.
Loans totaling $73.6 million were classified substandard under the Bank’s policy at September 30, 2018 and loans totaling $79.0 million were classified substandard under the Bank’s policy as of December 31, 2017. The following table sets forth information related to the credit quality of our loan portfolio at September 30, 2018 and December 31, 2017.
ALLOWANCE FOR LOAN LOSSES
ALL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALL require the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows or impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on the consolidated balance sheets. Loan losses are charged off against the ALL, while recoveries of amounts previously charged off are credited to the ALL. 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.
The ALL consists of specific reserves for certain individually evaluated impaired loans and general reserves for collectively evaluated non-impaired loans. Specific reserves reflect estimated losses on impaired loans from management’s analyses developed through specific credit allocations. The specific reserves are based on regular analyses of impaired, non-homogenous loans greater than $250,000. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based in part on the Bank’s historical loss experience which is updated quarterly. The general reserve portion of the ALL also includes consideration of certain qualitative factors such as (1) changes in lending policies and/or underwriting practices, (2) national and local economic conditions, (3) changes in portfolio volume and nature, (4) experience, ability and depth of lending management and other relevant staff, (5) levels of and trends in past-due and nonaccrual loans and quality, (6) changes in loan review and oversight, (7) impact and effects of concentrations and (8) other issues deemed relevant.
There are many factors affecting ALL; some are quantitative while others require qualitative judgment. The process for determining the ALL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALL may be made for specific loans but the entire ALL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized. As an integral part of their examination process, various regulatory agencies review the ALL as well. Such agencies may require that changes in the ALL be recognized when such regulators’ credit evaluations differ from those of management based on information available to the regulators at the time of their examinations.
The following table summarizes the changes in our ALL for the periods indicated:
The level of charge-offs depends on many factors, including the national and regional economy. Cyclical lagging factors may result in charge-offs being higher than historical levels. The dollar amount of the ALL increased from September 30, 2017, to December 31, 2017, primarily as a result of loan growth and changes in the portfolio composition. The dollar amount of the ALL decreased from December 31, 2017, to September 30, 2018, primarily as a result of one significant charge off of a loan during that period. Although the allowance is allocated between categories, the entire allowance is available to absorb losses attributable to all loan categories. Management believes that the current ALL is adequate.
The following table summarizes an allocation of the ALL and the related percentage of loans outstanding in each category for the periods below.
SOURCES OF FUNDS
General. Deposits traditionally have been our primary source of funds for our investment and lending activities. We also borrow from the FHLB of Chicago to supplement cash needs, to lengthen the maturities of liabilities for interest rate risk management purposes and to manage our cost of funds. Our additional sources of funds are scheduled payments and prepayments of principal and interest on loans and investment securities and fee income and proceeds from the sales of loans and securities.
Deposits. Our current deposit products include non-interest bearing and interest-bearing checking accounts, savings accounts, money market accounts, and certificate of deposits. As of September 30, 2018, deposit liabilities accounted for approximately 85.6% of our total liabilities and equity. We accept deposits primarily from customers in the communities in which our branches and offices are located, as well as from small businesses and other customers throughout our lending area. We rely on our competitive pricing and products, quality customer service, and convenient locations and hours to attract and retain deposits. Deposit rates and terms are based primarily on current business strategies, market interest rates, liquidity requirements and our deposit growth goals.
Total deposits were $1.49 billion and $1.51 billion as of September 30, 2018 and December 31, 2017, respectively. Noninterest-bearing deposits at September 30, 2018 and December 31, 2017, were $410.0 million and $436.6 million, respectively, while interest-bearing deposits were $1.09 billion and $1.07 billion at September 30, 2018 and December 31, 2017, respectively.
At September 30, 2018, we had a total of $393.0 million in certificates of deposit, including $17.7 million of brokered deposits. Based on historical experience and our current pricing strategy, we believe we will retain a large portion of these accounts upon maturity.
The following tables set forth the average balances of our deposits for the periods indicated:
Nine months endedSeptember 30, 2017
Certificates of deposit of $100,000 or greater by maturity are as follows:
December 31,
2017
Retail certificates of deposit of $100,000 or greater totaled $174.6 million and $176.7 million at September 30, 2018 and December 31, 2017, respectively. Interest expense on retail certificates of deposit of $100,000 or greater was $1.7 million for the nine months ended September 30, 2018, and $1.4 million for the year ended December 31, 2017.
The following table sets forth certificates of deposit classified by interest rate as of the dates indicated:
Borrowings
Securities sold under repurchase agreements
The Company has securities sold under repurchase agreements which have contractual maturities up to one year from the transaction date with variable and fixed rate terms. The agreements to repurchase require that the Company (seller) repurchase identical securities as those that are sold. The securities underlying the agreements are under the Company’s control.
The following table summarizes securities sold under repurchase agreements, and the weighted average interest rates paid:
Year ended December 31,
Nine months ended September 30,2017
Short-term borrowings
The Company’s short-term borrowing consisted primarily of short-term FHLB of Chicago advances collateralized by blanket pledge agreement on the Company’s FHLB capital stock and retail and commercial loans held in the Company’s portfolio. Short-term FHLB advances totaled $46.0 million as of September 30, 2018. There were no advances outstanding from the FHLB at December 31, 2017. From time to time the Company utilized short-term FHLB advances to fund liquidity during these time periods.
The total loans pledged as collateral were $689.4 million at September 30, 2018 and $564.4 million at December 31, 2017. Outstanding letters of credit from the FHLB totaled $32.1 million at September 30, 2018 and $20.7 million at December 31, 2017.
The following table summarizes short-term borrowings (borrowings with maturities of one year or less), which consist of borrowings from the FHLB, and the weighted average interest rates paid:
Lines of credit and other borrowings.
We maintain a $5,000,000 line of credit with a commercial bank. At September 30, 2018 and December 31, 2017, we had outstanding balances on this note of $2,000,000 and $5,000,000, respectively. The note requires monthly payments of interest at a variable rate (4.50% at September 30, 2018) with a floor of 3.50%, and is due in full on May 25, 2019.
We also maintain another $5,000,000 line of credit with another commercial bank. There were no outstanding balances on this note at September 30, 2018 or December 31, 2017. Any future borrowings under this note would carry interest at a variable rate with a floor of 3.25%, due in full on May 19, 2019.
During September 2017, the Company entered into a term loan agreement with a commercial bank, where the Company had up to twelve months from entering this agreement to borrow funds up to a maximum availability of $5,000,000. As of December 31, 2017, the Company had borrowed $3,500,000 under this agreement. Borrowings bore interest at a variable rate and were payable in thirty-six equal quarterly installments beginning with the first quarter after the twelve month draw period. The Company repaid this note in its entirety during July 2018.
During September 2017, the Company entered into subordinated note agreements with three separate commercial banks, where the Company has up to twelve months from entering these agreements to borrow funds up to a maximum availability of $22,500,000. As of September 30, 2018 and December 31, 2017, the Company had borrowed $11,500,000 under these agreements. No further funds were borrowed subsequent to September 30, 2018 through the end of the draw down period. These notes were all issued with 10-year maturities, carry interest at a variable rate (5.75% as of September 30, 2018) payable quarterly, are callable on or after the sixth anniversary of their issuance dates, and qualify for Tier 2 capital for regulatory purposes.
INVESTMENT SECURITIES
Our securities portfolio consists of securities available for sale and securities held to maturity. Securities are classified as held to maturity or available for sale at the time of purchase. U.S. Treasury securities, obligations of states and political subdivisions and mortgage-backed securities, all of which are issued by U.S. government agencies or U.S. government-sponsored enterprises, make up the largest components of the securities portfolio. We manage our investment portfolio to provide an adequate level of liquidity as well as to maintain neutral interest rate-sensitive positions, while earning an adequate level of investment income without taking undue or excessive risk.
Securities available for sale consist of U.S. Treasury securities, obligations of states and political subdivision, mortgage-backed securities, and corporate notes. Securities classified as available for sale, which management has the intent and ability to hold for an indefinite period of time, but not necessarily to maturity, are carried at fair value, with unrealized gains and losses, net of related deferred income taxes, included in stockholders’ equity as a separate component of other comprehensive income. The fair value of securities available for sale totaled $119.6 million and included gross unrealized gains of $0.4 million and gross unrealized losses of $2.5 million at September 30, 2018. At December, 31 2017, the fair value of securities available for sale totaled $119.0 million and included gross unrealized gains of $1.6 million and gross unrealized losses of $0.5 million.
Securities classified as held to maturity consist of U.S. Treasury securities and obligations of states and political subdivisions. These securities, which management has the intent and ability to hold to maturity, are reported at amortized cost. Securities held to maturity as of September 30, 2018 are carried at their amortized cost of $40.9 million. At December 31, 2017, securities held to maturity totaled $40.0 million.
The Company recognized a net loss on sale of investment securities of $31,000 and $9,000 for the nine-months ended September 30, 2018 and 2017, respectively.
The following table sets forth the fair value of available for sale investment securities, the amortized costs of held to maturity and the percentage distribution at the dates indicated:
The following tables set forth the composition and maturities of investment securities as of September 30, 2018 and December 31, 2017. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized
Cost
The Company evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) credit quality of individual securities and their issuers are assessed; (2) the length of time and the extent to which the fair value has been less than cost; (3) the financial condition and near-term prospects of the issuer; and (4) that the Company does not have the intent to sell the security and it is more likely than not that it will not have to sell the security before recovery of its cost basis.
As of September 30, 2018, 82 debt securities had gross unrealized losses, with an aggregate depreciation of 2.00% from our amortized cost basis. The largest unrealized loss percentage of any single security was 6.31% (or $155,000) of its amortized cost. The largest unrealized dollar loss of any single security was $209,000 (or 4.24%) of its amortized cost.
As of December 31, 2017, 52 debt securities had gross unrealized losses, with an aggregate depreciation of 0.44% from our amortized cost basis. The largest unrealized loss percentage of any single security was 5.36% (or $55,000) of its amortized cost. This was also the largest unrealized dollar loss of any security. The unrealized losses on these debt securities arose primarily due to changing interest rates and are considered to be temporary.
LIQUIDITY AND CAPITAL RESOURCES
Impact of Inflation and Changing Prices. Our consolidated financial statements and related notes have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on our performance than they would on industrial companies.
Liquidity. Liquidity is defined as the Company’s ability to generate adequate cash to meet its needs for day-to-day operations and material long and short-term commitments. Liquidity is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We are expected to maintain adequate liquidity at the Bank to meet the cash flow requirements of customers who may be either depositors wishing to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our asset and liability management policy is intended to cause the Bank to maintain adequate liquidity and, therefore, enhance our ability to raise funds to support asset growth, meet deposit withdrawals and lending needs, maintain reserve requirements and otherwise sustain our operations.
We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all of our short-term and long-term cash requirements. We manage our liquidity based on demand and specific events and uncertainties to meet current and future financial obligations of a short-term nature. We also monitor our liquidity requirements in light of interest rate trends, changes in the economy and the scheduled maturity and interest rate sensitivity of the investment and loan portfolios and deposits. Our objective in managing liquidity is to respond to the needs of depositors and borrowers as well as to increase earnings enhancement opportunities in a changing marketplace.
Our liquidity is maintained through investment portfolio, deposits, borrowings from the FHLB, and lines available from correspondent banks. Our highest priority is placed on growing noninterest bearing deposits through strong community involvement in the markets that we serve. Borrowings and brokered deposits are considered short-term supplements to our overall liquidity but are not intended to be relied upon for long-term needs. We believe that our present position is adequate to meet our current and future liquidity needs, and management knows of no trend or event that will have a material impact on the Company’s ability to maintain liquidity at satisfactory levels.
Capital Adequacy. Total stockholders’ equity was $169.1 million at September 30, 2018, compared to $161.7 million at December 31, 2017.
Our capital management consists of providing adequate equity to support our current and future operations. We are subject to various regulatory capital requirements administered by state and federal banking agencies, including the Federal Reserve and the OCC. Failure to meet minimum capital requirements may prompt certain actions by regulators that, if undertaken, could have a direct material adverse effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measure of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the classifications are also subject to qualitative judgment by the regulator in regards to components, risk weighting and other factors.
In July 2013, the Federal Reserve, the FDIC and the OCC approved the implementation of the Basel III regulatory capital reforms and issued rules effecting certain changes required by the Dodd-Frank Act, which we refer to as the Basel III Rules, that call for broad and comprehensive revision of regulatory capital standards for U.S. banking organizations. The Basel III Rules implement a new CET1 minimum capital requirement, a higher minimum Tier 1 capital requirement and other items that will affect the calculation of the numerator of a banking organization’s risk-based capital ratios. Additionally, the Basel III Rules apply limits to a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified amount of CET1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.
The new CET1 capital ratio includes common equity as defined under GAAP and does not include any other type of non-common equity under GAAP. When the Basel III Rules are fully phased in 2019, banks will be required to have CET1 capital of 4.5% of average assets, Tier 1 capital of 6% of average assets, as compared to the current 4%, and total capital of 8% of risk-weighted assets to be categorized as adequately capitalized. The Basel III Rules do not require the phase-out of trust preferred securities as Tier 1 capital of bank holding companies of the Company’s size.
Further, the Basel III Rules changed the agencies’ general risk-based capital requirements for determining risk-weighted assets, which will affect the calculation of the denominator of a banking organization’s risk-based capital ratios. The Basel III Rules have revised the agencies’ rules for calculating risk-weighted assets to enhance risk sensitivity and incorporate certain international capital standards of the Basel Committee on Banking Supervision set forth in the standardized approach of the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”.
The calculation of risk-weighted assets in the denominator of the Basel III capital ratios are adjusted to reflect the higher risk nature of certain types of loans. Specifically, as applicable to the Company and the Bank:
Generally, the new Basel III Rules became effective on January 1, 2015, although parts of the Basel III Rules will be phased in through 2019. As of December 31, 2017, the Bank and the Company met all capital adequacy requirements to which it is subject. Also, as of September 30, 2018, the Bank was well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s category.
Federal banking regulators have issued risk-based capital guidelines, which assign risk factors to asset categories and off-balance-sheet items. The following table reflects capital ratios computed utilizing the implemented Basel III regulatory capital framework discussed above:
As previously mentioned, the Company carried $11.5 million of subordinated debt as of September 30, 2018 and December 31, 2017 which is included in total capital in the tables above.
FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
We are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to originate and sell loans, standby and direct pay letters of credit, unused lines of credit and unadvanced portions of construction and development loans. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in these particular classes of financial instruments.
Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments, standby and direct pay letters of credit and unadvanced portions of construction and development loans is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Off-Balance Sheet Arrangements. Our significant off-balance-sheet arrangements consist of the following:
• Unused lines of credit
• Standby and direct pay letters of credit
• Credit card arrangements
Off-balance sheet arrangement means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant has (1) any obligation under a guarantee contract, (2) retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement, (3) any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument, or (4) any obligation, including a contingent obligation, arising out of a variable interest.
Loan commitments are made to accommodate the financial needs of our customers. Standby and direct pay letters of credit commit us to make payments on behalf of customers when certain specified future events occur. Both arrangements have credit risk essentially the same as that involved in extending loans to clients and are subject to our normal credit policies. Collateral (e.g., securities, receivables, inventory, equipment, etc.) is obtained based on management’s credit assessment of the customer.
Loan commitments and standby and direct pay letters of credit do not necessarily represent our future cash requirements because while the borrower has the ability to draw upon these commitments at any time, these commitments often expire without being drawn upon. Our off-balance sheet arrangements at the dates indicated were as follows:
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates. Our market risk arises primarily from interest rate risk inherent in its lending, investment and deposit-taking activities. To that end, management actively monitors and manages its interest rate risk exposure.
Our profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact our earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis. We monitor the impact of changes in interest rates on its net interest income using several tools.
Our primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on our net interest income and capital, while configuring our asset-liability structure to obtain the maximum yield-cost spread on that structure. We rely primarily on our asset-liability structure to control interest rate risk.
Interest Rate Sensitivity. Interest rate risk is the risk to earnings and value arising from changes in market interest rates. Interest rate risk arises from timing differences in the repricings and maturities of interest-earning assets and interest-bearing liabilities (repricing risk), changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay home mortgage loans at any time and depositors’ ability to redeem certificates of deposit before maturity (option risk), changes in the shape of the yield curve where interest rates increase or decrease in a nonparallel fashion (yield curve risk), and changes in spread relationships between different yield curves, such as U.S. Treasuries and LIBOR (basis risk).
An asset sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate higher net interest income, as rates earned on our interest-earning assets would reprice upward more quickly than rates paid on our interest-bearing liabilities, thus expanding our net interest margin. Conversely, a liability sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate lower net interest income, as rates paid on our interest-bearing liabilities would reprice upward more quickly than rates earned on our interest-earning assets, thus compressing our net interest margin.
The Company actively manages its interest rate sensitivity position. The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements and to achieve sustainable growth in net interest income. The Company’s ALCO, using policies and procedures approved by the Company’s board of directors, is responsible for the management of the Company’s interest rate sensitivity position. The Company manages interest rate sensitivity by changing the mix, pricing and re-pricing characteristics of its assets and liabilities, through the management of its investment portfolio, its offerings of loan and selected deposit terms and through wholesale funding. Wholesale funding consists of, but is not limited to, multiple sources including borrowings with the FHLB of Chicago, the Federal Reserve Bank of Chicago’s discount window and certificates of deposit from institutional brokers.
The Company uses several tools to manage its interest rate risk including interest rate sensitivity analysis, or gap analysis, market value of portfolio equity analysis, interest rate simulations under various rate scenarios and net interest margin reports. The results of these reports are compared to limits established by the Company’s ALCO policies and appropriate adjustments are made if the results are outside the established limits.
There are an infinite number of potential interest rate scenarios, each of which can be accompanied by differing economic/political/regulatory climates; can generate multiple differing behavior patterns by markets, borrowers, depositors, etc.; and, can last for varying degrees of time. Therefore, by definition, interest rate risk sensitivity cannot be predicted with certainty. Accordingly, the Company’s interest rate risk measurement philosophy focuses on maintaining an appropriate balance between theoretical and practical scenarios; especially given the primary objective of the Company’s overall asset/liability management process is to facilitate meaningful strategy development and implementation.
Therefore, we model a set of interest rate scenarios capturing the financial effects of a range of plausible rate scenarios; the collective impact of which will enable the Company to clearly understand the nature and extent of its sensitivity to interest rate changes. Doing so necessitates an assessment of rate changes over varying time horizons and of varying/sufficient degrees such that the impact of embedded options within the balance sheet are sufficiently examined.
The following tables demonstrate the annualized result of an interest rate simulation and the estimated effect that a parallel interest rate shift, or “shock,” in the yield curve and subjective adjustments in deposit pricing might have on the Company’s projected net interest income over the next 12 months.
This simulation assumes that there is no growth in interest-earning assets or interest-bearing liabilities over the next 12 months. The changes to net interest income shown below are in compliance with the Company’s policy guidelines.
As of September 30, 2018:
As of December 31, 2017:
Economic Value of Equity Analysis. We also analyze the sensitivity of the Company’s financial condition to changes in interest rates through our economic value of equity model. This analysis measures the difference between estimated changes in the present value of the Company’s assets and estimated changes in the present value of the Company’s liabilities assuming various changes in current interest rates. The Company’s economic value of equity analysis as of September 30, 2018 estimated that, in the event of an instantaneous 200 basis point increase in interest rates, the Company would experience a 3.51% increase in the economic value of equity. At the same date, our analysis estimated that, in the event of an instantaneous 100 basis point decrease in interest rates, the Company would experience a 5.76% decrease in the economic value of equity. The estimates of changes in the economic value of our equity require us to make certain assumptions including loan and mortgage-related investment prepayment speeds, reinvestment rates, and deposit maturities and decay rates. These assumptions are inherently uncertain and, as a result, we cannot precisely predict the impact of changes in interest rates on the economic value of our equity. Although our economic value of equity analysis provides an indication of our interest rate risk exposure at a particular point in time, such estimates are not intended to, and do not, provide a precise forecast of the effect of changes in market interest rates on the economic value of our equity and will differ from actual results.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Management, including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), undertook an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report, and, based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report, in recording, processing, summarizing and reporting in a timely manner the information that the Company is required to disclose in its reports under the Exchange Act and in accumulating and communicating to the Company’s management, including the Company’s CEO and CFO, such information as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
No changes were made to our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the quarter ended September 30, 2018 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PART II. OTHER INFORMATION
We are a party to various litigation in the normal course of business. Management, after consulting with our legal counsel, believes that any liability resulting from litigation will not have a material effect on our financial position, results of operations or liquidity.
Additional information regarding risk factors appears in “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward-Looking Statements” of this Form 10-Q and in “Item 1A. Risk Factors” in our Registration Statement. There have been no material changes during the quarterly period ended September 30, 2018 to the risk factors previously disclosed in the Company’s Registration Statement.
(a)For the quarter ended September 30, 2018, state the number of (1) restricted stock issued to executive officers under the equity plan, (2) restricted stock issued to directors under the equity plan, and (3) number of company shares sold to and/or purchased from the 401(k)
(1) 0
(2) 0
(3) 985 shares purchased from the 401(k) Plan
(b) None.
(c) Issuer Purchases of Equity Securities:
The Company's Board of Directors authorized a $10 million share repurchase program that will expire in April, 2019. This program was announced on May 14, 2018. The table below sets forth information regarding repurchases of our common stock during the third quarter of 2018.
Total Number of Shares
Repurchased
Average Price Paid per
Share(1)
Total Number
of Shares
Repurchased as
Part of
Publicly Announced
Plans or Programs
Maximum
Approximate
Dollar Value
that May Yet Be
Purchased Under
the
(1) The average price paid per share is calculated on a trade date basis for all open market transactions and excludes commissions and other transaction expenses.
The foregoing repurchases during the third quarter of 2018 were purchased through open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act.
ITEM 3. – DEFAULTS UPON SENIOR SECURITIES
None.
Exhibit Index
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.